The most common question I am asked about trading is how I select what stock to trade. There are probably as many ways to select a stock as there are people searching for candidates. Systems of selection may be as simple as a friend told me about the company or as complex as an algorhythm created by a group of Nobel Prize winners. Actually, such an effort by some Nobel Prize winners almost literally destroyed the markets when it failed in practice. Some traders or investors may be wed to a fundamental approach while others may choose a technical tactic. It is not unusual to see a combination of fundamental research accompanied by a technical entry. No method yet devised is perfect and any chosen stock can go the wrong way so the best we can do in my estimation is attempt to give ourselves an edge.

There are some relatively simple devices to help in the selection process. For example, there is an old saying among traders: “don’t try to catch a falling knife.” Freely translated, that adage suggests that it may not be prudent to buy a falling stock since there is no way to tell where the fall will end. Companies like Lehman Brothers, Enron, and General Motors bear witness to the dangers of trying to catch a falling knife. Someone one much wiser than I once told me that a trader only gets one top and one bottom in his life, and while that may be an overstatement, it is something to keep in the back of our minds.

If buying while a stock is falling or trying to pick a bottom doesn’t give us the edge we may seek, what alternatives do we have? One thing I always talk about with coaching students is to try to trade the direction of the market. If a market is generally bearish, are we better making bullish plays or bearish plays? As a very general rule of thumb, if a market is bearish, we could estimate very roughly that about 70% or 80% of the stocks in that market are bearish as well -- otherwise, the market would not be bearish. If 70% or more of the potential candidates are bearish, how are our odds when we decide to make a bullish play? Undoubtedly, even in a bear market, some stocks will move up, but if 70% or 80% can be expected to move down is it a smart choice to pick against those odds?

Personally, I would prefer to have the odds on my side so if 80% of the stocks in a market are moving down, I am more likely to choose a bearish candidate and make a bearish play like selling a stock short or buying puts or putting on a bearish call spread than I am to buy a stock. I don’t mean that I would never buy a stock in a bearish market, I simply mean that the preponderance of my trades in a bearish market will be bearish.

Naturally, the opposite is true when the market is bullish. If most stocks are moving up, that seems to me a better time to buy stocks than when they are moving down. I understand and respect the thought of contrarians who say the best time to buy a stock is when the market is going down. Sometimes they achieve excellent results and are just proof of my earlier statement that there are probably as many ways to select a stock as there are people selecting. I just prefer to put the odds in my favor.

If a bullish market is a criteria for selecting a stock to buy, so, too, would be an advancing sector. One of the things I often look for is an advancing stock in an advancing market in an advancing sector. I am perfectly happy to take profit out of the middle of a move instead of trying to catch a bottom to buy. Having written that, I should quickly note that I also use technical analysis in an effort to catch a good entry. Just buying a stock because the market, sector, and it are rising does not solve the problem. I also want an entry suggested by technicals that also provides a nearby exit in the event I am mistaken about the direction. As an example, in a bullish market and sector, I might choose a stock that has just broken above the 30 day moving average. Essentially as long as it remains above that moving average it is going my way. A break down through that same moving average would be a signal that the price may be reversing and could well be a reason to exit the position.

In the previous paragraph, I illustrated a way to select a stock based solely on a technical event, i.e., a stock crossing a moving average. In that example, there were no fundamental considerations whatsoever. In some instances, when I want to combine the fundamental with the technical, I might look for a company paying a high dividend that has low debt and a price to book ratio less than 1. In my own trading, though those fundamental factors could generally be considered to be “good,” that would not necessarily be enough to satisfy me that I should buy the stock. What is missing in that scenario is my exit strategy. Although I like those fundamentals, I would still demand a good technical entry and a nearby exit in case the stock price went the wrong way.

These thoughts are just some of the innumerable combinations and permutations a trader might consider when attempting to select a stock. In my view, the planning must come first. What are you seeking in your trade or investment? Are you looking for a company that appears undervalued while paying strong dividends? Do you want something that is optionable? What exit strategy will you use? Have you considered what the upside appears to be and how does that compare to the risk you are taking? A key is to think about what you intend to do before you do it. Have a plan in place. In my first book, "Trade Your Way to Wealth," I devote several pages to the importance of a plan and then devote several more pages to how an individual can create a plan that suits his style, risk tolerance, strategy preference, and account size as well as a number of other significant factors.

Good Trading!
Bill Kraft

June 13, 2009

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