Choosing the right stock trading strategies makes all the difference between the successful trader or investor and the unsuccessful one.
Think about it for a minute: just like in anything in life, you first need to learn how to do it before you can reap the rewards. You wouldn’t take your car on a road trip before you learn how to drive it and get some driving skills and experience on shorter trips. I’m sure you agree you had to learn a lot in your job before you could perform it and be as effective at it as you are today. We spend a big part of our lives in school and then university in order to get the skills and accreditation we need to get a good job and support ourselves and our family.
In all paths of live we first learn the basics and then we keep improving and getting more experience, and with that, we perform better. We first learn to crawl, then we learn to walk, and only then we can learn how to run. The exact same thing happens when you start trading or investing in stocks.
You first learn the basics and then you start practicing and developing your own trading or investment style and if you’re successful at it, you keep evolving.
There are multiple stock trading strategies. Beginners tend to feel overwhelmed with which strategy to choose and which one fits their risk taking personality as well as delivers the best returns on the long term.
Here are the best stock trading strategies you should start using today:
Best Stock Strategies
Fundamental Analysis – Better for long term investing
Fundamental analysis has been the investors best friend for decades. In this investment strategy, investors are looking at buying a part of a business. They are not trying to make a short term trade for a quick buck. They are investing on the long term and most of them plan to hold their stocks for years if necessary.
They look for stability and lower risks and they tend to prefer stocks that pay dividends.
The first thing to look for in fundamental analysis is to determine how much the company is really worth. Only then you can decide if the current market price is a good opportunity to buy the stock or not. Instead of thinking about the stock price, you should rather think about the value of the whole company. This means you should look at the Market Capitalization, since that’s the current price of the entire company. That’s a simplified version of the market cap definition, but it should give you the idea of why you need to look at it.
In order to calculate the fair value of a company, investors use, among others, financial metrics like the price/earnings, the price/book, price/sales, or price/cash flow. There are multiple strategies and metrics to determine the fair value of a company but the most important idea to keep in mind here is all these financial metrics greatly vary from industry to industry. Due to this, an investor not only needs to analyze these metrics but he also needs to compare them with the rest of the industry and with the broad market, in order to get a complete picture of the current stock value.
As Warren Buffett says, price is what you pay, and value is what you get. This clearly shows you the difference between the fair valuation of a company and the current market price.
When investing on the long term it makes all the sense to take this approach and to invest as if you were buying the entire company, not a few shares of it. While the investment value is different, the concept and approach should be the same.
This is the first step to a fundamental investor. Before you do anything else, you need to evaluate the entire company and only then look at the current market capitalization and see if there’s a good opportunity to buy right now on discount compared to the real value of the company.
In order to reduce the risks and increase the returns (the return on investment and the total profit), investors need to find companies that trade at a deep discount to their intrinsic value. The higher the discount the less risks you’re getting and the higher the rewards.
This is not an easy task to a new investor. It takes years of practice to find great opportunities consistently and to have the patience to wait for a good entry point. Patience will be crucial once again when you need to hold the investment for years to let it grow and reward you.
As I told you above, there are multiple financial metrics used to evaluate a company. I’ll just give you a small introduction to some of these metrics:
Price to Earnings Ratio (P/E):
One of the most popular fundamental analysis metrics. The PE is calculated by dividing the price of the stock by the earnings per share. PE below 15 usually represent cheap companies. However, this value greatly depends on the industry you’re analyzing.
PE needs to be above 0 and below 15 as a rule of thumb. Beware if PE is below 7 since most of the times that shows a company whose earnings are collapsing. If the earnings are growing and you can buy below PE 15 you’re on a good start.
The higher the dividend yield the better. Not only you make money on dividends while you’re holding the stock, as a solid dividend provides a higher degree of safety to the investor. Companies with solid dividends and history of increasing dividends yearly are safer than companies that don’t pay any dividend or companies that can’t even make a profit at the end of the year.
Don’t look at dividend stocks as a “no risk” kind of investment. The risk is there, it’s always there! That’s why it’s an investment, not a sure thing. But the companies that do pay dividends and that increase them for years tend to be less risky.
Price to Book Ratio (P/B):
Price to book ratio compares a stock current price with its book value. The book value is the value of a company’s assets on the balance sheet.
In theory, the price book tells you the real value of the company’s assets on the previous quarter. With this notion in mind, the price book is considered the value you would get per share if the company closes its doors tomorrow. Unfortunately, nothing is that simple when you’re investing. While the PB ratio is useful, it’s no X-Ray of the company. It’s just one useful ratio, and like any other ratio, it doesn’t provide you with all the data you need to make a decision by itself.
Plenty of negative conditions can impact the asset’s value of a company, so this book value can change in a quarter. Don’t get me wrong: the P/B ratio is useful but it’s not a magic bullet that gives you the fair value instantly.
A price book ratio below 1 tells you the assets of the company are higher then the current market capitalization. That’s a positive sign if you can confirm the book value won’t get affected by negative earnings or debt.
Overall, I use P/B ratio but I prefer to use it with other metrics like the Price earnings. Instead of trying to buy companies with a P/B ratio below 1, I mostly use it to compare the value across multiple companies in the same industry, and also in order to compare the historical P/B ratio with the current one. For me, the P/B ratio is useful for comparison, but I would never use it as a single indicator to find value opportunities.
Price to cash flow ratio:
The price to cash flow ratio is calculated by dividing the share price by it’s cash flow per share. This is another useful metric when evaluating a company fair valuation.
A price to cash flow ratio in the long single digits might indicate an undervalued company (if confirmed by other metrics), while a high ratio might show you the company is overvalued.
Once again, this ratio is useful to compare the current company valuation to it’s historical values, and to compare different companies across the same industry.
Growth investors focus on buying stocks of companies that offer you the best potential for growth on sales and earnings. When using this strategy, investors are not looking for value as fundamental investors. They are looking for companies that can keep the best growth rates which should translate into higher share prices.
Growth investors don’t need to check price to earnings or price to book ratios. Instead, they look at the quality of the business, the competition and, most importantly, at the rate at which the sales and earnings are growing. These investors look at new industries and technologies, and invest in recent IPOs.
While growth investing is not opposite to the fundamental investing, it’s extremely rare to find a growth company that fits the fundamental ratios in order to be considered a cheap company. Only during a massive bear market or on some news that impact the share price dramatically you can find such opportunities.
Closely related with the fundamental investing, dividend investors look for companies that pay solid dividends and in order to guarantee the safety of the dividends, they also need to look into the fundamentals. The higher the dividend yield the better, but anything above 7% has an increased risk that the dividend will be reduced or cut soon. Companies with larger market capitalizations that pay and increase dividends every year for decades are the best stocks to invest in this investment philosophy.
Momentum traders or investors look for companies whose stocks are showing strength and usually reaching new highs. Momentum investors tend to give more importance to the technicals than to the fundamentals. While most of these companies are running due to some fundamental news like an earnings beat or important news, truth is if you’re looking into finding good value in companies that are running and reaching all time highs, you’re headed for disappointment.
Momentum investing is particularly useful for swing trades while fundamental analysis is more useful for long term investments.
Technical Analysis Trading:
Technical traders base their trading decisions on the charts. The most important thing for them is the price and oscillators or technical indicators. Just like on Momentum Investing, technical trading is more suited for short term trades.
You can expand the length of a chart and trade for example on weekly charts instead of the daily charts, which would allow you to trade for the longer term. However, the performance of technical setups by themselves on the long term tends to underperform any other investment method.
I’m not saying technical analysis is not useful. But I personally prefer to use it for short term trades, since on the long term, price itself and fundamentals tend to perform better.
A Word on Market Capitalization:
The size of the company greatly defines the risk and volatility of any investment you make in the stock market. With that in mind, it’s useful to know the different market capitalization categories and to choose to only invest in the ones you’re comfortable with.
Micro Cap – Companies with a market capitalization below $300 Million.
Small Cap – Companies with a market capitalization between $300 Million to $2 Billion.
Mid Cap – Companies with a market capitalization between $2 to $10 Billion.
Large Cap – Companies with market capitalization above $10 Billion.
The bigger the market capitalization the smaller the volatility and risks. At the same time, the smaller the potential profits. Small Caps are more volatile; so, they provide you with bigger risks and profit potential. Large Caps sit on the other extreme providing you less volatility, more stability and less risks. The less risks you want to take, the larger the market capitalization you should invest on.