Intermediate Investing
by
K.C.Staar
SMASHWORDS EDITION
* * * * *
PUBLISHED BY:
Staar DD Services Ltd.
Fundamentals of Investing
Copyright © 2010 by K.C. Staar
Smashwords Edition License Notes
This ebook is licensed for your personal enjoyment only. This ebook may not be re-sold or given away to other people. If you would like to share this book with another person, please purchase an additional copy for each person you share it with. If you're reading this book and did not purchase it, or it was not purchased for your use only, then you should return to Smashwords.com and purchase your own copy. Thank you for respecting the author's work.
Table of Contents
1.3 Market Psychology Technical Indicators
2 Active Trading Styles & Strategies
2.1 Day Trading
2.2 Scalping
2.3 Momentum Trading
2.6 Swing Trading
2.7 Position Trading
2.8 Creating a Trading Strategy
4 Intermediate Fundamental Analysis
4.1 GAAP 32
4.3 Income Statement
4.4 Balance Sheet
5.3 Blending Technical & Fundamental Analysis
Disclaimers
The authors and publishers of the material contained herein have used their best efforts in its preparation. They make no representation or warranties with respect to the accuracy, applicability, fitness, or completeness of the contents of this material. The information contained herein is strictly for educational purposes. Therefore, whether and how you apply it is fully your responsibility.
There is no guarantee that you will earn any money using any of the techniques or ideas presented herein. Examples in this material should not be construed as a promise or guarantee of earnings, or as a recommendation to buy any specific security or investment product. Investing success is dependent upon a wide range of factors, including without limitation the time you devote to the activity, your finances, and your level of knowledge and skill. We cannot guarantee your success or take responsibility for your actions.
The material herein may contain information that includes or is based upon forward-looking statements as defined by the Securities Litigation Reform Act of 1995. Forward-looking statements give expectations or forecasts of future events, and can be identified by the use of such words as “anticipate,” “expect,” “project,” “intend,” “plan,” “believe,” and other words of similar meaning or connotation in connection with a description of potential financial performance.
The authors and publishers disclaim any warranties (express or implied), merchantability, or fitness for any particular purpose, unless such disclaimers are prohibited by state law. THE AUTHOR AND THE PUBLISHER SHALL IN NO EVENT BE HELD LIABLE TO ANY PARTY FOR ANY DIRECT, INDIRECT, PUNITIVE, SPECIAL, INCIDENTAL, OR OTHER CONSEQUENTIAL DAMAGES ARISING DIRECTLY OR INDIRECTLY FROM ANY USE OF THIS MATERIAL, WHICH IS PROVIDED “AS IS” AND WITHOUT WARRANTIES.
As always, the advice of a competent legal, tax, accounting, or other professionals should be sought.
INVESTMENT DISCLAIMER
No statement in this material should be construed as a recommendation to buy or sell a security or to provide investment advice. All investors should consult a qualified professional before trading in any security. Stock trading, option trading, and other investment techniques involve risk and are not suitable for all investors. Past performance does not guarantee future results. The authors and publishers make no representation that the information and opinions expressed are accurate, complete, or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. This material does not contain a complete discussion of the benefits and risks of different investment methods. All investments are subject to risk, including possible loss of principal.
TAX DISCLAIMER
The material herein
is being provided to you as educational material with the express
understanding that we are not engaged in rendering legal, accounting,
or other professional service(s). The scope of our service is solely
educational. If legal advice or other expert assistance is required,
the services of a professional should be sought. Nothing herein is
any substitute for the services, advice, or counsel of a properly
licensed CPA or attorney in the relevant state!
IRS CIRCULAR 230
NOTICE: To the extent that the information herein concerns tax
matters, it is not intended to be used and cannot be used by a
taxpayer for the purpose of avoiding penalties that may be imposed by
law.
Like any other human activity, the financial markets have a psychological aspect. While many believe the markets to be rational—more on this momentarily—there is undeniably a non-rational, emotional factor involved (more at some times than at others), and you will ignore its potential impact at your own peril. Market psychology refers to the generalized sentiment in the marketplace at a given time, and so is a blend or average of the feelings and attitudes of thousands of individual investors. Technical analysis factors can measure the current market psychology and attempt to predict the direction it is likely to drive the market. The term market sentiment is similar, but is generally used to refer simply to the overall bullish or bearish trend.
Individual investors, of course, compose the market, and at the level of the individual, we talk about trading psychology. It should come as no surprise that people tend to be emotional about their money, nor that those emotions can impact behavior.
If you choose to become involved in the financial marketplace, and particularly if you are going to actively trade, you must understand your own emotional tendencies and reactions. When emotions dominate investing decisions, the outcomes are generally negative. The three primary hazards are greed, fear, and paralysis.
Greed has played a central role in economics since the first human possessed something that another human wanted. While the desire to acquire and possess drives our economic and financial systems, once that desire transforms into greed, it becomes corrosive. Greed tends to lead investors into two main traps. One is the unwise investment, choosing to put money into something that sounds too good to be true (and undoubtedly is). Con men have known, and exploited, this aspect of human nature from time immemorial.
The other can best be described as issues of bad timing. Acting out of greed, an investor may invest when an asset is becoming overvalued. While “buy low and sell high” seems to be unnecessarily stating the obvious, so often that is not what happens. Instead, investors watch a stock or other asset climb into the stratosphere and begin to envy those who are making substantial profits. Greed drives them to jump on the bandwagon, regardless of what fundamentals may say about the current valuation of the asset in question. The result is that they buy in near or at the top, the asset subsequently plunges in value, and they lose money.
Conversely, an investor may hang on to a successful investment as it climbs in value, hoping to wring “just a few dollars more” of profit before selling, and ultimately wait too long. The top comes, passes, and the asset price falls, and now what could have been a major gain has been turned by greed into a painful loss—hence the old bit of Wall Street wisdom, “Pigs get slaughtered.”
Fear can cause an investor to miss a good opportunity because of the associated risk. It may also cause him or her to withdraw from an investment too early, substantially reducing profits. In a bad market, it may even push the investor to withdraw completely and move into the safety of cash—and doing so in a down market will usually mean taking losses on every, or nearly every, active investment.
The third hazard is paralysis, sometimes referred to as “analysis paralysis.” The investor may become so caught up in the analysis of every detail of a potential investment that he or she never actually makes it, waiting for “the perfect time” and “everything to be right.” The fallacy, of course, is that no investment will ever be perfect, so the wait for perfection is a wait without end.
Typically, an investor will be routinely subject to either greed or fear, depending on his or her risk tolerance and other psychological traits; analysis paralysis can be seen as an offshoot or variant of fear. Either can cripple profits and lead to spectacularly unsuccessful investing. The key to overcoming these emotions is twofold: have a plan, and have the discipline to adhere to that plan, no matter what your emotions are telling you.
Decide, for example, in advance at what price you will buy or sell a particular stock. Decide what macroeconomic, company performance, or market events will drive your trades. Make those decisions, ensure that you are satisfied with your research and your facts before making the trade, and then stick with that plan. Fear in particular can be nonspecific; sometimes simply nailing down what it is you are afraid will happen can mitigate it, but knowing that you have a specific plan to prevent a negative outcome is even more powerful.
Since knowledge empowers better decisions, educate yourself about what you are doing, whether that is a specific company, a specific industry, or a specific trading technique. Fear of the unknown has much less power when you are dealing with far fewer unknowns.
Finally, assess your performance periodically—and do so honestly. Recognize that you are going to make mistakes, and allow yourself to do so. No one emerges from the womb as a skilled investor, and learning involves experimentation, sometimes successfully and sometimes not so much. An honest assessment of your strengths and weaknesses, of what has worked and not worked, will allow you to build on the positives and gradually reduce the negatives.
One of the foundations of modern financial theory is the efficient market hypothesis (EMH). Its accuracy, however, is also hotly debated. EMH says in essence that the market is efficient and incorporates all available information about a given asset (EMH is generally applied to stocks) so that a given stock always trades at its fair or “real” value. EMH has several important implications, the most significant of which is that there is no such thing as an “undervalued” or “overvalued” stock, and therefore it is impossible to “beat the market” (that is, outperform the overall market’s performance) through, for example, stock picking or market timing. The only way to obtain higher returns, then, would be to purchase riskier investments.
Accepting EMH means that value investing, fundamental analysis, and technical analysis are all useless. It means that managed mutual funds are useless. This may give you some idea as to why the notion is so hotly debated. While there is substantial evidence for the hypothesis, there is also much stacked against it—Warren Buffet, the famous (and quite successful) value investor, being one well-known example who has beaten the overall market’s return over the long term. Opponents of EMH also point to massive, sudden crashes of the market, such as those in October 1987 and May 2010, as evidence of non-rational volatility.
Many minds far better qualified than us have argued this subject, and we are not going to attempt to solve the question here. Rather, we will settle for pointing out that numerous academic studies have shown the existence of market phenomena that cannot be explained by EMH alone. A branch of finance called behavioral finance attempts to explain the impact that the psychology of market participants has on the market.
Some investor behavior results from an imperfect understanding of available data. (Keep in mind that EMH assumes the market perfectly incorporates all available data in the pricing of stocks—which rather bravely assumes that every market participant is perfectly incorporating such data.) For example, the gambler’s fallacy represents an imperfect understanding of probability. When a binary outcome is presented (a flipped coin landing on heads or tails, a stock going up or down, a roulette ball landing on red or black), the gambler’s fallacy believes that after several occurrences of the same outcome, the odds of the opposite outcome increase—the roulette wheel has hit black six times in a row, so the odds are higher that it will hit red this time. In reality, each event—each coin toss, stock trading day, or roulette wheel spin—is an independent event, with the same 50/50 probability each time. Yet acceptance of the gambler’s fallacy would lead an investor to believe that since a stock he owns has risen four, five, or more days in a row, it is becoming increasingly likely to go down, and so he should sell it. This is neither rational behavior nor perfect incorporation of available data, yet it happens on a daily basis in the markets.
Other investor behavior may result from the observation of the actions of others. Seeing other investors buying or selling a stock en masse may trigger the basic greed or fear reactions we discussed previously. (Such behavior is referred to as herd instinct.) Once more, in such a case trading decisions are being made based on emotions rather than perfect incorporation of all available data.
A final example is what is called the media effect. This occurs when a widely-circulated media story influences the behavior of investors, often resulting in some form of herd instinct action. While it can be argued that this is merely the incorporation of available data about a stock, the higher-than-average visibility of that particular data set thanks to media exposure can disproportionately enlarge its impact.
In part stemming from efforts to account for these various effects, EMH has diverged into three classifications. The strong efficiency version is the original and claims that all information, whether public or private, is accounted for in a stock price, so nothing—not even insider information—can give an investor an advantage. The semi-strong efficiency version assumes that all public information is incorporate into share prices, which means that neither fundamental nor technical analysis will be effective. Finally, the weak efficiency version claims that all past price information is incorporated into a stock price, meaning that technical analysis cannot beat the market.
Whichever version you prefer (if any), a comfortable middle-ground position on EMH is that while the market is probably efficient on the whole and over the long term, irrational actions by investors and imperfect access to information produce volatility and the undervaluation and overvaluation of individual assets in the short term, meaning there are opportunities to be found. After all, value investing would not work if the market did not eventually realize that a given stock was undervalued and return it to its fair value.
In the end, you should also recognize that while pundits will on a daily basis attempt to explain the market’s movements, such explanations are little more than educated speculation. Consider how many times the same factor has been used to explain both upward and downward movements of the market. For example, we have heard a drop in oil prices credited with a market rise because it will reduce the price of gasoline and free up consumer spending to drive the economy, but on a different day blamed for a market drop because it is an indicator of shrinking demand and economic contraction. Keep in mind that someone who could accurately explain market movements would then be able to predict them and would be making money hand-over-fist.
1.3 Market Psychology Technical Indicators
While the psychology of an individual investor will likely remain opaque for a long time to come, the technical analysis school possesses tools that let us judge the mood and likely resultant direction of the overall market, or investor sentiment regarding a specific stock. We will examine the specific application of several indicators to market psychology here.
Moving Average Convergence-Divergence (MACD): The MACD can be used to measure shifts from bullish to bearish market sentiment and vice versa. It is a trend-following momentum indicator calculated by subtracting the 26-day exponential moving average (EMA) from the 12-day EMA. A 9-day EMA, known as the signal line, is plotted over the MACD. (The signal line is shown in solid black on the chart at right.) The MACD can be applied to an individual stock or to a market index, depending on your needs.
If the MACD crosses below the signal line (a downward crossover), this indicates a shift to bearish sentiment; conversely, the MACD crossing above the signal line (an upward crossover) is a bullish indicator.
The divergence of the stock price or index from the MACD signals the end of the existing trend.
A sharp rise in the MACD indicates an overbought situation and an impending correction to normal price levels.
Note also that the zero line is important; an MACD above zero signals upward price momentum while one below zero indicates downward momentum. As seen in the sample chart, a sustained crossing of the zero line is a significant event and tends to indicate a long-term change in momentum.
Average Directional Index (ADX): The ADX measures the strength of a trend. While the ADX itself is non-directional, a pair of co-charted factors known as the Directional Movement Indicators shows the direction of that trend.
As the chart labeling indicates, having the ADX cross below 40 shows that the trend is likely to reverse soon. Examine the sample data, and you will note that the ADX line crosses below 40 just before the stock price hits its peak. Recognize, however, that the DMIs do not cross until the stock price actually starts downward; they are not leading indicators.
Rate of Change (ROC): ROC is a measurement of momentum, and in this context a measure of general investor optimism or pessimism regarding a specific stock or the market as a whole (depending on what is measured). The typical measurement period for short-term analysis is 10 days to six months; long-term analysis may look at 26 to 52 weeks.
The sample chart at right shows the stock price for Exxon Mobil in March through September of 2001. The effects of the 9/11 attacks are extremely visible; however, you can also see the $2 rebound in share price that took place on September 24, 2001, causing the upturn in the ROC graph.
To evaluate ROC, visualize the path of a ball thrown straight up into the air. At first it will rise quickly, but then gradually slow as gravity overcomes its momentum until for an instant it hangs motionless before starting its fall. In much the same way, when a stock price or index is moving in one direction or another, ROC will tend to decrease shortly before the top or bottom is reached—the slowing in momentum that precedes a change in direction. Looking at the sample chart for Exxon, you can see that ROC peaks in late April, just as the share price flattens out and roughly a month before it peaks and starts downward.
Williams %R (Wm%R): The Wm%R, developed by (and named for) Larry Williams, is a form of stochastic oscillator (about which more in a moment). It is also a measure of momentum. It is calculated by taking a stock’s daily closing price and comparing it to the stock’s high-low range over a given period of time, commonly 14 days, assigning a value ranging from 0 to 100. The critical points are 20 and 80; a reading in excess of 80 shows that the stock is oversold and likely to turn upward; conversely, a reading less than 20 is a sign that the stock is overbought and likely to turn downward. Compare the Wm%R graph in the chart at left to the price of the hypothetical stock and note how the indicator would have warned of the largest drops in value.
Stochastic Oscillator (%K): Stochastic oscillators include a variety of related indicators; the Wm%R is one form, and next we will look at another, the RSI. The main difference among various oscillators is the exact method of calculation, so once they are charted, they look much the same. The underlying theory is that with upward momentum, a stock or index will close near its intra-period high, and near its intra-period low with downward momentum.
In order to reduce its sensitivity to price changes and produce fewer false signals, %K (which is the “fast,” or more responsive, indicator) can be recalculated as a moving average; the three-period moving average of %K is labeled %D (the “slow” indicator).
Trading signals are generated when %K crosses %D (which is easier to see on the larger chart at right). %K is the black line; %D is in red. Note in the following example that as %K crosses above 80 and thereby indicates an overbought status, the stock’s price momentum flattens out and soon heads down (the red arrows in late June). As %K hits 20, indicating an oversold status, the price bounces sharply upward (the blue arrows in both early April and mid-July).
Relative Strength Index (RSI): Another stochastic indicator, RSI is typically calculated over a period of seven or nine days; while it also produces a result in the range of 0 to 100, the RSI crossing points are at 30 (oversold) and 70 (overbought) rather than 20 and 80.
Because it is based on averages of up day closes and down day closes within a given period, it tracks closely with the actual stock price. You can see by examining the sample chart at right that by itself, RSI is only a useful predictor of major upward and downward movements, accurately warning of the significant bottoms in late March and early October and the top in early August. It would not, however, have provided any guidance during the volatility that occurred from April through July, since neither the 30 nor 70 thresholds were crossed.
Volume: The simple measure of market volume can be a valuable indicator as to investor mood. Relatively low volume does not produce substantial gains or losses for a large group of investors and so does not generate strong emotional responses. (A minor loss or gain in a day does not have a major psychological impact, even though consistent small daily changes may over time accumulate into a large gain or loss.) For this reason, trends tend to last the longest in a low- to moderate-volume market.
A sharp change in volume (toward either unusually low or high volume) often indicates an approaching reversal of the current trend. Low volume may show that the losers (those holding long positions in a declining market or short positions in a rising market) have finally give up and sold or covered; high volume in particular is indicative of mass investor movements in a particular direction. It should not be surprising given our discussion of herd mentality that it has been observed that amateur traders and investors tend to break under the stress of an unfavorable market at roughly the same time. The slow accumulation of losses or gains, once recognized as an uncomfortably large number (one that the investor cannot accept in the case of a loss or is fearful of losing in the case of a gain), will cause an appreciable number of investors to move at nearly the same time. As the momentum builds, fear and greed grow, and even psychologically stronger investors will feel the rising pressure and finally move as well.
2 Active Trading Styles& Strategies
The advent of the Internet and powerful desktop computers, along with online brokerages, permitted individual investors to undertake the kind of trading previously reserved for institutional investors—albeit on a much smaller scale. Though “day trading” is the term probably best known to the general public, what are more properly called “active trading” styles have evolved into varied approaches to making money in the markets over the short term.
Day trading is, quite simply, the buying and selling of a security within a single trading day. Though it may be performed in any market, the style is widely used in the FOREX and stock markets. The average day trader is highly educated and has access to large amounts of trading capital. They rely on high levels of leverage and employ strategies to benefit from small, short-term price movements in currencies or stocks, which must necessarily be highly liquid. Day traders actually provide the markets with two vital services: they improve market efficiency through the arbitrage process and are major providers of liquidity, particularly for stock markets.
Despite (or perhaps because of) its relative fame, day trading suffers from probably the greatest degree of misunderstanding surrounding any subject in the financial world. Plenty of Internet-based scams have promised fantastic returns virtually overnight, while the media often promotes day trading as a no-fail means of getting very rich very quickly. While many have engaged in this trading style with insufficient knowledge or capital—to their ultimate detriment—plenty of day traders do make quite comfortable livings.
An argument frequently trotted out by financial professionals is that there are no famous day traders, as opposed to iconic figures like Peter Lynch and Warren Buffett who made their money employing investing styles that are more traditional. Day traders counter that there is money to be made, while still acknowledging that success is harder to attain because of greater complexity, increased risk, and the various scams.
The main point of agreement is that day trading carries substantial risks and as such is not for everyone. It also requires a thorough understanding of market mechanisms and a range of strategies for capturing short-term profits. Following is a list of requirements to achieve success as a professional day trader:
Investing experience and market knowledge. Jumping into day trading without detailed knowledge of market fundamentals generally results in failure.
Adequate trading capital. Assuming that you will turn profits from day trading is foolhardy, so this is a trading style that best employs only risk capital. In addition to the obvious benefit of preventing financial ruin, it also helps remove emotions from trading decisions. Because intra-day price changes are usually relatively small, profiting from them will normally require fairly large investments.
Effective trading strategies. A day trader must have at least a small advantage over other market players. Whatever the strategy, it must be refined with the goal of producing profits consistently and limiting losses effectively.
Discipline. No matter how effective the strategy, it will be useless in the absence of discipline. It is easy to lose large sums of money by ignoring the rules of a chosen trading strategy. The Wall Street wisdom is “Plan the trade and trade the plan.”
Professional day traders fall into two main categories: one group—arguably the better-known one—works alone, but the majority of day traders are actually employed by an institution. Members of this second group have resources that for individual traders are the stuff of dreams: direct lines to the dealing desks, plenty of capital and easy access to leverage, high-end analytical programs, and so on. These traders tend to emphasize easy profits and so focus on news event-based trades and opportunities for arbitrage. Here their privileged resources give them the opportunity to exploit these lower-risk trades, often before individual traders are even aware of them.
Traders in the first
group tend to manage other people’s money or just use their own.
Rarely do they enjoy access to a dealing desk, though they do usually
have a close association with a brokerage (thanks to the substantial
commissions they generate) and various resources that still outstrip
those of the average individual investor. However, those resources
are not adequate to enable them to compete on the institutional day
traders’ turf, so the only alternative is to engage in riskier
trades. Individual traders most often uses wing trading and technical
analysis strategies, along with a smaller degree of leverage, to
squeeze more modest profits from small price movements.
Here
is some indication of the types of resources required for successful
day trading:
Access to the trading desk is normally an advantage that is limited, as we said, to traders employed by institutions or managing large sums of money. Access to the dealing desk translates to nearly instant order execution, which is particularly vital when a trader is faced with sharp or sudden price changes. Faced with the announcement of an acquisition, for example, traders planning merger arbitrage can execute orders ahead of other market players and benefit from the price differential.
Multiple news sources are crucial. In the movie Wall Street, the infamous character Gordon Gekko proclaims, “Information is the most important commodity when trading.” News is the source of most day trading opportunities, which means being the first to know about significant events is crucial. Most trading rooms provide access to the Dow Jones Newswire, constantly display CNBC and other news channels, and utilize analysis software that continuously scrutinizes a variety of news sources seeking important stories.
Analytical software is an absolute necessity for nearly all day traders, particularly those relying on technical or swing trading strategies. While expensive, such software boasts powerful capabilities, including
Automatic pattern recognition, which enables the software to independently identify technical indicators—channels, triangles, head-and-shoulders patterns, and even more complex indicators like Elliott Wave patterns.
Neural networks and genetic algorithms that enable trading software to more accurately predict future price changes.
Broker integration, a direct interface that enables instant and in some cases automatic trade execution, which helps eliminate the emotion that can intrude on trading decisions and improves execution times.
Back testing, which analyzes how a given strategy would have performed when applied to historical data in order to test how it may perform as a predictor of future events.
Some of these capabilities are absolutely awe-inspiring, which makes it easy to understand how so many inexperienced traders without access to them lose money.
Scalping is an active trading style that focuses on achieving small profits on a large number of trades (hence the name, with its allusion to quickly taking a little bit off the top). In order to be successful, this trading style requires a high percentage of “wins” or profitable trades, since only a few losses will destroy profits. It is based on four premises:
Most stocks will move in the desired direction over a brief period of time (sometimes called “completing the first stage of a movement”).
Minimizing the duration of exposure to the market minimizes risk.
Smaller price changes are easier to obtain.
Small price changes are more frequent than large ones.
A trader who uses scalping as a primary style will make tens to hundreds of trades each day. Because the style focuses on small, rapid price changes, precision tools such as one-minute charts, real-time quote systems (Nasdaq Level II, Total View, and Times and Sales are examples), and a direct-access broker to provide high-speed order execution are necessities.
Scalping may also be used as a supplementary style, generally when the markets refuse to break out of a narrow range and no long-term trends are visible. Scalping may also be used as part of a longer-term strategy by taking a long position in a stock and then repeatedly entering and exiting short-term trades in the same stock as it develops in the expected long-term direction. This exploitation of short-term trends allows some hedging in the event the long-term trend does not work out as expected.
Two specific scalping techniques are used and require a moving stock (that is, one that is actively changing in price). The first technique is simply to purchase a large number of shares (generally measured in the thousands) and wait for a price increase that is usually measured in cents. Obviously, this approach requires the capital to purchase the necessary number of shares (keep in mind that given a five-cent gain, forty shares will be required just to cover every dollar of purchase and sale commission before any profit accrues) and a stock that is sufficiently liquid to allow the near-instantaneous execution of buy and sell orders for a block of several thousand shares.
The second technique is slightly less ambitious (and, incidentally, can be executed from more traditional trading platforms). It involves purchasing a stock, establishing a stop-loss at a set point, and selling at a price that produces a 1:1 risk/reward ratio. In other words, if you purchase at $10.00 per share and set a stop order at $9.90 to limit your loss to $0.10 per share, your sell point would be $10.10—the point at which your potential reward equals your potential risk.
Either form of scalping requires rigid discipline on the part of the trader, since succumbing to greed to get “just a few more cents of profit” can result in the stock price reversing and a loss on the transaction.
There is a third scalping technique, but it is risky, very difficult, and normally used only for immobile stocks (that is, securities that are trading at a high volume but with little real price change), which can be a challenge to find in and of themselves. This scalping technique is called “market making,” and involves simultaneously posting a bid and offer for a specific stock, capitalizing on the spread. Additional challenges include the fact that the trader is competing with true market makers on both the bids and the offers, and the fact that the profit margin is so slender that any adverse movement in the stock price will wipe out the trader’s profits.
The momentum trading active trading style is predicated on find stocks that are making significant moves in one direction with high volume (in other words, that have strong momentum up or down). A momentum trader may hold positions for a few minutes, a couple of hours or even the entire length of the trading day, depending on how quickly the stock moves and when it changes direction.
The typical momentum
trader will begin preparing roughly an hour prior to the start of
trading, checking various news sources to find stocks currently
attracting an unusual amount of attention. Such stocks may have
generated trading alerts resulting from analyst recommendations or
earnings reports and are thus likely to make the most substantial
price movements and generate high volume in the upcoming session.
Examining the morning equity options quotes will reveal stocks with
sharply-rising call volumes, which is a key indicator that prices are
expected to head above or below the option premium.
As the trading
session begins, the watch list of stocks generated from this analysis
is evaluated against the broader market to see whether any are
trending opposite the overall market or showing strong momentum. The
watch list is then winnowed down to include those stocks with the
strongest movement.
At this point, the momentum trader applies technical analysis to this new leaner watch list. Not surprisingly, the most significant technical indicator in this trading style is the momentum indicator. As you may recall from our introduction to technical analysis in the Fundamentals guide, the momentum line is plotted alongside price and shows an axis of zero; positive values indicate strong upward momentum and negative values indicate potentially sustained downward momentum.
The momentum indicator will often herald a breakout, in which case only one or two sessions of sustained momentum can be enough to send the stock in the indicated breakout direction. With real-time access to trading data (known as Level 2), the trader can watch for evidence of a push, the situation in which bids begin lining up (as shown by the prevalence of market maker limit orders) and offers begin disappearing.
Once a breakout is identified with reasonable certainty—which may mean exercising patience rather than immediately buying or shorting—the trader is prepared to trade. A market order is entered on the next breakout tick. Once the position is entered, the true stress begins. Hopefully the stock will continue strongly following the momentum trend. On the other hand, it might immediately reverse or flatten, proving the momentum chart wrong (something that may point to a trap created by the market maker).The breakout might also simply die out quickly, providing a little profit but not enough to make the trade worthwhile.
The trader begins watching for the point of saturation, at which orders begin to pile up on the offer and bidding begins to slow or thin at the market price a few levels back on the Level 2 display. While the saturation point doesn’t necessarily indicate that momentum will cease immediately, it may signal that “the end (in this case the top) is nigh. “For the trader, it is time to sell (or cover the position if it is a short sale), taking profits to conclude the session or to contemplate action on the next stock on the watch list.
Should a breakout go wrong, a momentum trader does not hold the position hoping for another reversal, but rather immediately mitigates the losses by selling (or covering) the position. Taking a small loss immediately is more advisable than hoping for a reversal at some point in the session, because odds are that small loss is only going to grow larger as the day progresses. As such, trading discipline is critical for the momentum trader: some trades will unavoidably go wrong and recognizing and properly responding to them is the only way to manage losses.
As you can probably tell, timing is crucial to momentum trading and is related to nearly all of the key risks involved:
Entering a position too early; it is vital to confirm a momentum move.
Closing a position too late; closing must occur before saturation is reached.
Failing to catch trend changes, reversals, or indicators of unexpected news in time.
Keeping a position open overnight, since factors after the close of trading have the potential to produce substantial changes in both prices and patterns in the next trading session.
Failing to act quickly and close a position in the event it goes bad.
Although we just saw how the momentum trader uses technical indicators—relying predominantly on the momentum indicator—a wide range of technical tools are available to the trader. Technical trading is a much less narrowly-focused style, and while we will consider it here as a trading style, as we have seen elsewhere it can also be an overall philosophy of investing.
Technicians attempt to use distinct, recognizable patterns found in historical trading data as a predictor of what may occur in the future. One of the hurdles in technical analysis is also a benefit: the sheer wealth of available technical indicators. No one indicator can be considered “the best,” because each indicator or category of indicators is often appropriate only to specific circumstances. Those circumstances may be particular industries, market capitalization, liquidity ranges, or any of a variety of others. In fact, considering that highly traded stocks can produce their own individual patterns, it is entirely possible to have an indicator that is appropriate for a single individual stock!
For purposes of short-term trading, technical indicators are not reliable for predicting precise trading timing, but what they do well is determine which stocks are appropriate for more detailed analysis. Technical analysis is thus a starting point, since historical patterns rarely provide a precise prediction of what will occur in the future.
Since other sections of these guides address technical analysis, here we will only discuss the common categories and offer an introduction and sense of how they can be applied by the technical trader.
Relative Strength Indicator (RSI):RSI measures a stock’s recent performance against its previous strength by comparing the quantity and size of recent and previous up and down closes. An RSI reading above 80 generally indicates an overbought condition; one below 20 generally means the stock is oversold.
Trading ranges: Support and resistance lines are plotted across the top and bottom of a stock’s high, low, and closing price plots for a given period of time. A breakout has occurred when the stock’s price makes a sustained movement across one of the lines.
Pattern analysis: Price charts are analyzed to find particular patterns that have previously appeared in that stock or for more generalized patterns observed in a wide range of stocks over time. Some of the most common patterns include the head-and-shoulders, triangles (either up or down), rounded tops and rounded bottoms, and the cup-and-handle formation.
Trend analysis: A much more complex and mathematically-based set of indicators, trend analysis evaluates short-term and long-term trends, with the goal of identifying the points at which prices cross their long-term averages. These long-term averages are moving averages, designed to smooth price data over a given period by averaging the data points. The moving average convergence divergence (MACD)can identify crossovers, overbought and oversold conditions, convergence, and divergence.
Gap analysis: A gap is created when a stock opens substantially higher or lower than it closed the prior trading session, usually because of significant news released after the last session ended. This gap is likely to presage further movement—either as the gap widens or the price rebounds—and can serve as an initial indicator to momentum traders.
Given the massive number of technical indicators, there is no way that these guides can adequately cover the discipline of technical analysis in proper depth. We will therefore refer you to some books which are widely accepted as excellent sources of information on the topic.
Technical Analysis of the Financial Markets by John Murphy
Technical Analysis of Stock Trends by Robert Edwards and John Magee
Encyclopedia of Chart Patterns by Thomas Bulkowski
Although trading
based on fundamentals is less a short-term trading style and more a
strategy for long-term, buy-and-hold investing, there are
nevertheless cases in which trading on fundamentals can produce
respectable profits in fairly quick order.
We have already touched
on the basic financial data employed in fundamental analysis—revenue,
earnings per share, and cash flow—and we will shortly be taking a
much more in-depth look at these and more. This data comes directly
from a company’s financial statements or may be calculated in the
case of ratios like ROE and debt-to-equity. Fundamental traders can
take advantage of quantitative data like this to identify trading
opportunities—for example, in the case of a company that issues
unexpected earnings results.
For this reason, earnings
announcements and downgrades and upgrades from analysts are closely
watched by the markets. Gaining a trading edge by watching this
information is challenging, though, since quite literally millions of
others—many of them with access to far better news resources—are
doing the same thing.
The pre-announcement period actually matters
more than the earnings announcements themselves, since this is when
companies issue guidance as to whether they will exceed, meet, or
fail to meet earnings expectations. The trading window of opportunity
opens just after an announcement such as this and is not open long,
but there will be a brief chance to make short-term trades on
momentum. Changes in analyst opinions may likewise create a
short-term trading opportunity; this is especially true for the
downside, such as if a major analyst issues a surprise downgrade.