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Building Your Portfolio
In his groundbreaking bestseller, “Beating the Street”, Peter Lynch,
the former manager of the Fidelity Magellan Fund pointed to the
importance of really knowing the products you trade. While this may be
slightly less of an issue in day trading, because you’re not really
going to be holding on to your stock, it’s still pretty bad practice to
trade things you have never seen or heard of before. This is the first
point to consider as you begin to plan assembling a portfolio.
1. Types of Stock
The first step to understanding how to handle the stock market is to
understand stocks as they exist now. A stock is the smallest unit of
ownership in a company. When you own a share of a company’s stock, no
matter how long you own it, you own a part of the company.
Ownership of a single company stock gives you the right to vote on
issues affecting the company. Most important, if the company makes a
profit, part of the profit will be distributed to you; it will be
distributed to the shareholders.
Why are stocks a good way to invest in business, better than, say,
buying a company? One of the more attractive advantages to owning stock
is that you are not liable if the company loses a lawsuit and has to
pay a settlement. The worse that can happen on your end is the stock
will basically be worthless to you.
There are two types of stock:
• Common stock
• Preferred stock
As the name might suggest, common stock represents the majority of
stock held by the public. When you own this type of stock, you have
voting rights, along with the right to share in dividends from the
particular company. When you hear or read about stocks moving up or
down, it always refers to common stock.
Companies that issue preferred stocks usually pay consistent dividends
and preferred stock holders have first dibs.
On the current stock market, you can buy or sell shares from most
publicly traded companies when ever the markets are open. As a day
trader, however, you are likely to be concerned with common stocks
rather than preferred stocks, because common stocks are the more
volatile, and thus are more likely to produce activity for day traders.
2. Reviewing Your Companies
Professional traders use a variety of methods to pick the companies
they invest with. They also use a range of methods to determine when to
buy and sell stock from those particular companies.
Fundamental analysis is one of the most basic and effective methods for
reviewing stock and making smart investment decisions. The process
involves looking at a business at its most basic financial level.
Many experienced investors use fundamental analysis in combination with
other tools to evaluate stocks. However, a large number also use
fundamental analysis on its own to make investment decisions. The goal
of all traders is to determine the current worth of a stock and, most
importantly, how the market values the stock.
Company Earnings
The first thing you need to look at is earnings. This is one of the
best ways to determine how much money a company is making and how much
it is going to make in the future.
Earnings are one of the most fundamental indicators of company profits.
This may be complicated to calculate, but with practice, you will
become better at reviewing specific details like this.
The key points about earnings:
• An increase in earnings generally leads to a higher stock price and,
in some cases, a regular dividend
• A decrease in earnings generally leads to lower stock prices and a
fall in dividend.
There are a large number of people, professional and amateur analysts,
who follow company earnings very closely, scrutinizing the quarterly
earning reports. News travels quickly when earnings fall short and the
market, everyone from shareholders in the company to would be
investors, are likely to react and hammer the stock.
Earnings are a strong indicator of the direction the company’s stock is
going.
Earnings Per Share
Unfortunately, there is a problem in focusing on earnings alone as a
way to understand and compare stocks from one company to another,
which, at some point, every trader must do.
Comparing the earnings of one company to another is a very limited
method and doesn’t really make much logical sense. If company A is a
multimillion dollar corporation and company B is a small business
operating in a small area with
only a small staff, it doesn’t make much sense to compare the earnings
of company A with company B to determine which has the best stock.
Using the raw numbers overlooks the likelihood that the two companies
have a different number of outstanding shares.
Even if companies A and B earned the same amount per quarter, if
company A had 10 shares outstanding and company B had 50, you would
probably be better off buying shares with company A.
Why? Earnings Per Share is determined by dividing the Net Earnings
among the Outstanding Shares.
If company A and company B both earn $1000 over a quarter but company A
has only 10 shares outstanding and company B has 50, you would find the
following:
• Company A Earnings Per Share = $1000/10 = $100
• Company B Earnings Per Share = $1000/50 = $20
According to the Earnings Per Share (or EPS), company A is a better
investment. And while you shouldn’t make a determination based on the
earnings or the EPS alone, you should review the three types of EPS
numbers and factor them into your decision making:
• Trailing EPS – last year’s numbers and the only actual EPS
• Current EPS – this year’s numbers, which are still projections
• Forward EPS – future numbers, which are obviously projections
Price to Earning
You calculate the Price to Earning, or P/E, of a stock by dividing the
share price by the EPS. Among investors, the P/E Ratio is the most used
number of all. This looks at the relationship between the price of the
stock and what the company earns. It is one of the most popular ways to
analyze a stock.
P/E = Stock Price / EPS
For example, company A has a shares price of $10 and an EPS of 5. The
P/E of company A is thus 2, based on dividing $10 by 5.
The P/E is an important number because it lets you know what the market
is willing to pay for the company’s earnings. The higher the P/E the
more the market is willing to pay. A high P/E can mean an overpriced
stock but it can also mean that the market has high hopes for the
future of the stock.
A low P/E can be a strong indicator of a vote of no confidence from the
market, but it’s almost as likely that a low P/E means that the market
may be overlooking the stock.
Assessing the value of a stock based on the P/E ratio requires you to
use your own interpretation, your instincts. The P/E value, whether low
or high, can indicate a range of things.
High P/Es can suggest:
• the company has good long term prospects over and above its current
position.
• the company has a strong vote of confidence.
• the company has strong growth prospects for the future, or
• that traders have pushed a stock’s price beyond the point that there
is likely to be any near term growth.
Low P/Es can suggest:
• the company has a vote of no confidence from the market
• the company has poor prospects for the future, or
• traders are overlooking the company’s potential for growth
The PEG Ratio
People are always trying to project the future. This is no exception
when it comes to the market. Another ratio you can use to help you look
at future earnings growth is the PEG ratio.
To calculate the PEG, you take the P/E and divide it by the projected
growth in earnings.
PEG = P/E / (projected growth in earnings)
For company A with a P/E of 5 and projected earning growth of 5%, it
has a PEG of 1.
Like all ratios, PEG shows a relationship.
The rule for PEG: the lower the number, the less you pay for each unit
of future earnings growth.
While it’s a popular method of analysis, remember that PEG is about
year-to-year earnings growth and that it relies on projections, which
may not always be accurate.
Price to Sales Ratio
The methods of analysis featured above all focus on the earnings of a
company. Not all companies have earnings to review so traders have a
range of alternative methods for analysis, as you might expect.
One ratio is the Price to Sales, or P/S ratio, which considers the
current stock price relative to the total sales per share. To calculate
the P/S, you need to divide what’s called the market cap of the stock
by the total revenues of the company or you can divide the current
stock price by the sales per share.
P/S = Market Cap / Revenues or
P/S = Stock Price / Sales Price Per Share
Much like P/E, the P/S number reflects the value placed on sales by the
market;
The lower the P/S, the better the value of the stock according to
conventional wisdom.
However, when dealing with a young company, don’t use the P/S without
other tools. With a new or young company, you won’t get a good picture
of the stock value using the P/S alone.
Price to Book Ratio
When you use one or more of these tools to review the value of stock
and make a determination about investing, you really need to be
conscious of the types of investors that you are competing with. You
and your closest professional contemporaries, investors looking for hot
stocks, aren’t the only ones reviewing the markets to find valuable
stocks to invest in. A group of value investors will specifically be
looking for companies that the market has passed over.
With due diligence and a little bit of luck, many value investors have
become wealthy finding and holding on to sleepers, companies that
haven’t received much attention from the market.
The reason you should consider value investors is that they are always
thinking outside of the box; look for indicators besides earnings
growth to make a determination on where a stock is going.
One of the tools value investors frequently use is the Price to Book
ratio, or P/B. This measurement looks at the value the market places on
the book value of the company. To calculate the P/B ratio, divide the
current price per share by the book value per share.
P/B = Share Price / Book Value Per Share
When it comes to assessing the P/B, remember that the relative value
works the same way as the P/E ratio. The lower the P/B is, the better
the value of the stock.
Dividend Payout Ratio
The Dividend Payout Ratio (or DPR) is not a popular tool for analyzing
stock. Most investors cannot agree on what it indicates. It measures
what a company pays out to investors in the form of dividends.
To calculate the DPR, divide the annual dividends per share by the
earnings per share.
DPR = Dividends Per Share / EPS
If company A paid out $10 per share in annual dividends and had $30 in
EPS, the DPR would be 33%. ($10 / $30 = 33%).
Whether 33% is a good or a bad indicator is definitely subject to
interpretation. If you find yourself easily overwhelmed by information,
you don’t even need to refer to the DRP.
If you want a wealth of information to work with, however, you should
consider that a growing company will typically retain more profits to
fund growth and pay lower or no dividends. Whereas a company that pays
higher dividends may have little room for growth; paying higher
dividends is the best way to dispose of profits.
If you decide to refer to the DRP and use it as a tool for analysis,
you should view it in the context of the company and the industry in
which the company operates.
When you’ve found a company that meets your general criteria, say, high
earnings, high earnings per share, high P/E, low P/E, low P/S, low PEG,
etc, then it’s probably time to invest.
Pick several companies you are interested in, that you think have
potential to be quite volatile.
3. When to Buy, and When to Sell
Ideal stocks for day trading have good liquidity and volatility. For
day trading, a stock needs to have good liquidity so that you can enter
and exit the stock at a good price. You will quickly become familiar
with the terms tight spreads and low slippage, which mean that stock
value doesn’t move so much that you’re going to loose a lot of money
suddenly.
After you have determined the kind of stock you are looking for, you
need to identify entry points. There are three major tools to help you:
• Intraday Candlestick Charts - Candles provide a raw analysis of price
action.
• Level II Quotes/ECN - Level II and ECN provide a look at orders as
they happen.
• Real-Time News Service – A change in the News can move stocks.
There are certain patterns to look for using these tools:
o A volume spike
o Prior support at the price level, and
o Level II situation showing open orders and order sizes
Once you’ve identified the company you want to invest in, you need to
spot the right time to make your move. The ‘right time’ is a concept
that depends on the style of trading you decide to use. There are three
main trading styles and, as a beginner, you are likely to find one or
another that suits you.
Scalping:
This is one of the most popular strategies. As a day trader, you would
buy stock that you have identified as potentially good for the day. You
would then proceed to sell the stock almost as soon as it becomes
profitable for you to do so.
Fading:
This involves shorting stocks after a rapid jump in price. You assume
that the stocks you’ve identified are over priced, that early buyers
are ready to take a profit, and existing buyers are panicking. Everyone
is thinking, sell, and the price will drop. The price target if your
strategy is fading: when buyers begin to step in again.
Daily Pivots:
Buy the stock at the lowest price of the day (LOD) and aim to sell it
at the high of the day (HOD). To succeed with this strategy you must be
well versed in the company trends.
Momentum:
Trading on news releases can be a very effective move. Another momentum
trading method revolves around high volume. Your target for buying is
when the price is down before the news release or when it’s down in
keeping with the general trend pattern.
When you are a day trader, your exist strategies for a stock will
revolve around the point at which there is evidence of a decreased
interest in the stock indicated by the Level II/ECN and the volume of
trades.
The information
in this guide and on this
site should not be construed as financial advice and are for
information purposes only. The authors and publishers are not financial
advisers. You should rely on your advisers and lawyers for financial
advice.
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