A stock trader is a person or entity engaged in the trading of equity securities, in the capacity of agent, hedger, arbitrageur, speculator or investor. Several different types of stock trading strategies or approaches exist including scalping, momentum trading, technical trading, fundamental trading, swing trading, day trading, etc. Last week, we discussed about three of the above strategies namely scalping, momentum trading and technical trading. This week’s article attempts to review a few more strategies.
4. Fundamental traders
Fundamental trading is a method by which a trader focuses on company-specific events to determine which stock to buy and when to buy it. Trading on fundamentals is more closely associated with the buy-and-hold strategy of investing than with short-term trading. There are, however, specific instances in which trading on fundamentals can generate some nice profits in a short period.
Moreover, fundamental traders often use information about the global and national economies and the financial state of the companies involved, as well as non-financial information such as the current political and weather information. Fundamental traders believe that the markets will react to events in certain ways and that they can predict future market prices based on these events.
For example, if a company receives the regulatory approval for a new product, a fundamental trader might expect the company’s stock price to rise. Conversely, if a company has a financial scandal, a fundamental trader might expect its stock price to fall. Fundamental traders need access to all of the available information as soon as it is available and are therefore, often institutional traders with large support teams, rather than individuals.
Fundamental analysis has probably been in use since there were markets to trade and has traditionally been done manually, but as computing power increases it has become possible for some fundamental information to be processed automatically.
Most equity investors are aware of the most common financial data used in fundamental analysis: Earnings per share, revenue and cash flow. These quantitative factors can include any figures found on a company’s earnings report, cash-flow statement or balance sheet. These factors can also include the results of financial ratios such as return on equity and debt to equity.
Fundamental traders may use such quantitative data to identify trading opportunities if, for example, a company issues earnings results that catch the market by surprise. One of the most closely watched fundamental factors for traders and investors everywhere is earnings announcements.
The most important situation surrounding earnings announcements is the pre-announcement phase, the time in which a company issues a statement stating whether it will meet, exceed, or fail to meet earnings expectations. A trader will want to trade immediately after such an announcement because a short-term momentum opportunity will likely be available.
Earnings announcements are actually closely associated with momentum trading, which keeps alert to unexpected events that cause a stock to trade a large volume of shares and move steadily either up or down. The fundamental trader is often more concerned with gaining an edge on information about speculative events that the rest of the market may lack.
To stay one step ahead of the market, astute traders can often use their knowledge of historical trading patterns that occur during the advent of share splits, acquisitions, takeovers and reorganizations.
When a Rs.200 stock splits four-for-one, the company’s market capitalization does not change, but the company now has quadrupled the number of shares outstanding, each at a Rs.50 stock price. Many investors believe that, since investors will be more inclined to purchase a Rs.50 stock than they would a Rs.200 stock, a stock split will soon increase the company’s market capitalization (but remember that this fundamentally doesn’t change the value of the company).
To trade successfully on stock splits, a trader must, above all, correctly identify the phase at which the stock is currently trading. Indeed, history has proven that a number of specific trading patterns occur before and after a split announcement: Price appreciation and therefore short-term buying opportunities will generally occur in the pre-announcement phase and the pre-split run-up and price depreciation will occur in the post-announcement depression and post-split depression. By identifying these four phases correctly, a split trader can actually trade in and out of the same stock at least four separate times before and after the split, with perhaps many more intra-day or even hour-by-hour trades.
Acquisitions, takeovers, reorganizations
The old adage “buy on rumor, sell on news”, applies to trading on acquisitions, takeovers and reorganizations. In these cases, a stock will often experience extreme price increases in the speculation phase leading up to the event and significant declines immediately after the event is announced.
That said, the old investor’s adage “sell on news” needs to be qualified significantly for the astute trader. A trader’s game is to be one step ahead of the market, so he or she is very unlikely to buy a stock in a speculative phase and hold it all the way to the actual announcement. The trader is concerned about capturing some of the momentum in the speculative phase and may trade in and out of the same stock several times as the rumor mongers work their magic.
And when the actual announcement is made, he or she will likely have an entirely different trading opportunity: The trader will likely short the stock of an acquiring company immediately after it issues news of its Intent to acquire and thereby ending the speculative euphoria leading up to the announcement. Rarely is an acquisition announcement seen positively, so shorting a company that is doing the acquiring is a doubly sound strategy.
By contrast, a corporate reorganization may very well be viewed positively if the market had not been expecting it and if the stock had already been on a long-term slide due to internal corporate troubles. If a board of directors suddenly ousts an unpopular CEO, for example, a stock may very well exhibit short-term upward movement in celebration of the news.
Trading the stock of a takeover target presents a special case since a takeover offer will have a price per share associated with it. A trader has to be careful to avoid getting stuck holding stock at or near the offer price because the stock will generally not move significantly in the short-term once it finds its narrow range near the target. Particularly in the case of a rumored takeover, the best trading opportunities will be in the speculative phase, the time in which a rumored price per share for the takeover offer will drive actual price movement.
5. Swing traders
Swing trading has been described as a kind of fundamental trading in which positions are held for longer than a single day. This is because most fundamentalists are actually swing traders since changes in corporate fundamentals generally require several days or even a week to cause sufficient price movement that renders a reasonable profit.
But this description of swing trading is a simplification. In reality, swing trading sits in the middle of the continuum between day trading to trend trading. A day trader will hold a stock anywhere from a few seconds to a few hours but never more than a day; a trend trader examines the long-term fundamental trends of a stock or index and may hold the stock for a few weeks or months.
Swing traders hold a particular stock for a period of time, generally a few days or two or three weeks, which is between those extremes and they will trade the stock on the basis of its intra-week or intra-month oscillations between optimism and pessimism.
The first key to successful swing trading is picking the right stocks. The best candidates are large-cap stocks that are among the most actively traded stocks in the market. In an active market, these stocks will swing between broadly defined high and low extremes and the swing trader will ride the wave in one direction for a couple of days or weeks only to switch to the opposite side of the trade when the stock reverses direction.
It should be noted that in either of the two market extremes, the bear-market environment or raging bull market, swing trading proves to be a rather different challenge than in a market that is between these two extremes. In these extremes, even the most active stocks will not exhibit the same up-and-down oscillations that they would when indexes are relatively stable for a few weeks or months.
In a bear market or a raging bull market, momentum will generally carry stocks for a long period of time in one direction only, thereby confirming that the best strategy is to trade on the basis of the longer-term directional trend.
The swing trader, therefore, is best positioned when markets are going nowhere - when indexes rise for a couple of days and then decline for the next few days only to repeat the same general pattern again and again. A couple of months might pass with major stocks and indexes roughly the same as their original levels, but the swing trader has had many opportunities to catch the short-term movements up and down.
Much research on historical data has proven that in a market conducive to swing trading liquid stocks tend to trade above and below a baseline value, which is portrayed on a chart with an exponential moving average (EMA). In his book ‘Come Into My Trading Room: A Complete Guide To Trading’ (2002), Dr. Alexander Elder uses his understanding of a stock’s behaviour above and below the baseline to describe the swing trader’s strategy of ‘buying normalcy and selling mania’ or ‘shorting normalcy and covering depression’.
Once the swing trader has used the EMA to identify the typical baseline on the stock chart, he or she goes long at the baseline when the stock is heading up and short at the baseline when the stock is on its way down.
So, swing traders are not looking to hit the home run with a single trade - they are not concerned about perfect timing to buy a stock exactly at its bottom and sell exactly at its top (or vice versa). In a perfect trading environment, they wait for the stock to hit its baseline and confirm its direction before they make their moves.
When it comes time to take profits, the swing trader will want to exit the trade as close as possible to the upper or lower channel line without being overly precise, which may cause the risk of missing the best opportunity. In a strong market when a stock is exhibiting a strong directional trend, traders can wait for the channel line to be reached before taking their profit, but in a weaker market they may take their profits before the line is hit.
Novice traders might experiment with each of these techniques, but they should ultimately settle on a single niche, matching their investing knowledge and experience with a style to which they feel they can devote further research, education and practice.