Picking good stocks to trade requires an information-driven strategy and an understanding of what moves markets
Liquidity and bid/ask spreads are critical considerations in choosing stocks to trade
High-volatility stocks can present more opportunities for traders but also greater risk
The daily stock market dance offers an abundance of potential partners. Prudent traders choose wisely. So how does the active trader pick stocks worth trading? It’s a complex subject, but traders can lay the groundwork for a sound stock selection strategy with a few relatively simple components.
Here’s a good place to start: Knowledge is power. A well-informed trading strategy requires a well-informed trader. If information moves markets, information may be the most valuable asset out there.
Here are a few pointers on how to select stocks to trade.
Trade What You Know (and Know What You Don’t Know)
Viable stock trading ideas might be right under your nose. How did you get to work this morning, what did you have for lunch, and what sort of entertainment might you be enjoying tonight or this weekend? Think about products and services you, your family, friends, and neighbors use or consume more and more every day. What kinds of things aren’t you consuming as much?
Also, beware of startups in new, unproven, or unfamiliar businesses. Such “hot” stocks may generate the higher volatility sought by some retail traders, but they can also burn you if you’re not careful (more on volatility below).
Identify Companies and Build a Watchlist
Once you get a sense of the companies and industries that may present trading opportunities, it’s time to build your own “control panel” of stocks. Fire up the thinkorswim® platform from TD Ameritrade and get to tinkering. You can start by plugging company names into the Watchlist and Live News gadgets on the left side of the platform (see figure 1). Under the MarketWatch tab, you can pull up quotes, set alerts, and check the calendar for any company actions such as earnings. And under the Analyze tab, there’s a whole host of fundamentals to help you narrow your search.
FIGURE 1: FUNDAMENTAL ANALYSIS. Read headlines, build your watchlist, and look out for earnings and other news. Source: the thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
“Any number of real-world events can move stock prices on any given day,” said Alex Coffey, senior specialist, trader group at TD Ameritrade. “Traders follow financial news for relevant macro- and micro-information on asset classes and to identify specific companies that are moving.” So it’s a good idea to regularly monitor earnings releases as well as economic reports, geopolitics, and other factors.
Study Stock Patterns; Get a Sense of Momentum and Other Technical Indicators
Getting educated on a stock’s fundamentals, such as revenue, earnings or losses per share, price-to-earnings ratios, and other metrics, is just one step in formulating a stock trading strategy. “To find good stocks to trade, it also helps to give the charts a good eyeballing. Grasp some technical indicators and gain a bigger-picture perspective,” Coffey explained.
Once you identify a potential market or stock to trade, you’ll need more information. Coffey pointed to historical stock performance as one thing to check. How has this stock performed over the last week, last month, and last year? For example, is the stock near its 52-week high or 52-week low? Is the stock’s price diverging from its industry peers or the broader market?
“By asking such questions, traders can help manage their expectations around what may happen in the future and establish a strategy for a particular trade,” Coffey said.
Of course, past performance is not an indicator of future results, but brushing up on your history can’t hurt.
Momentum indicators, for example, are among the technical tools that incorporate trading volume and other factors to measure how quickly a stock price has been moving up or down and the likelihood it may continue going that direction. When markets are in the process of changing direction, momentum readings often “diverge,” flattening out or turning the opposite way.
Seek Liquidity and Tight Bid/Ask Spreads; Avoid Slippage
If you bought a stock, how fast could you sell it if you absolutely had to? The answer depends in large part on how liquid its shares are. In a liquid market, it’s easier to execute a trade quickly and at a desirable price because there are abundant buyers and sellers. Changes in supply and demand have a relatively small impact on price. But in illiquid markets, it may be tougher for sellers to find buyers and vice versa.
Liquidity is an important consideration if you don’t intend to hold a stock for a long time, Coffey pointed out. “If I’m only going to be in this trade for a short period, will I be able to get out of it when I want to?”
One measure of liquidity is trading volume, or the number of shares that change hands every day. Trading volume in excess of 1 million shares per day may be considered “healthy” for many large U.S. companies, but volume levels vary widely across different companies in different industries.
“In general, the bigger the volume, the healthier the liquidity,” Coffey explained.
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Liquidity, or the lack of it, is also reflected in the bid and ask prices for a stock. The most actively traded U.S. stocks may have a difference of only a penny or two between what the buyers seek (the bid) and what the sellers want (the ask)—a “tight” spread, in other words. Conversely, does the bid/ask for a stock look wide compared to other shares? If so, watch out.
The bid/ask “is the ultimate test of liquidity,” Coffey said. “The closer the bid/ask, the better.”
Ascertaining good liquidity is more art than science, Coffey cautioned, but if a bid/ask spread is only a few pennies, “buyers and sellers are essentially in agreement on what the price should be. As a bid/ask spread widens, it reflects more uncertainty about where that price should be. There may not be enough active participants in that stock to determine a fair price.”
Sufficient liquidity can also help traders avoid slippage, which is the difference between the price at which you might expect to get filled on an order and the actual, executed price. “Slippage can occur in less liquid markets,” Coffey said, “and it can make trading more expensive and require more for the trader to overcome to gain returns on the trade.”
What’s Moving: The Importance of Understanding Volatility
Some traders live and breathe volatility. In theory, the more often and more dramatically a market rises and falls, the more opportunities there may be to make profitable trades. But volatility can be measured in different ways—historical volatility (HV) versus implied volatility (IV), for example—and can mean different things for different stocks and trading strategies.
When considering volatility in a stock trade, traders should ponder several questions. Does this stock have a history of sharp price swings? Is a potentially price-moving event coming up? How does this stock’s implied volatility compare to a broad market benchmark such as the Cboe Volatility Index (VIX)?
IV reflects the market’s perception of future volatility. Some of the more volatile U.S. stocks may have an IV of over 50%; the highest top 90%. These stocks are often “on the move” and may garner attention from many active retail traders. But high volatility can be fleeting.
“Although increased volatility can lead to increased opportunity, it also leads to possible increased risk,” Coffey said. “It’s always important for traders to define their risks and be comfortable with the risks they’re taking in the market.”
Shares of some companies, including Tesla (TSLA) and Netflix (NFLX), have been popular among retail traders in recent years “because they tend to trade with much higher volatility than the general market,” Coffey said. “But it’s also important for traders to be aware of a stock’s implied volatility relative to its historical volatility.” An easy way to gauge volatility is to check the options stats on the thinkorswim platform. IV and HV, the Sizzle Index, and the put/call ratio are just a few of the options stats available.
There’s no right or wrong way to pick stocks to trade. It all comes down to finding your comfort level. Do you love price action, or does the idea of 80% volatility give you anxiety? Does a stock have sufficient liquidity, or are there pockets where everyone heads to the exit at the same time? Alternatively, are you (at least occasionally) OK with “watching-paint-dry” calmness in the stocks you trade?
Take your pick.
All investing involves risk including the possible loss of principal.