There are two broad philosophies in the world of stock market investing. The first is fundamental analysis and the second is technical analysis. In this article we will discuss a low risk approach which combines technical and fundamental analysis into a strategy that can yield excellent returns. Fundamental analysis is used to find the strongest companies in a particular sector while Technical analysis is used to find the overall trend of the market and the exact time to execute the trade.
Overview of the trading strategy
This type of analysis makes use of broad economic indicators and company financial statements to choose the best company to invest in. The basic framework that can be used to do the analysis is listed below.
-Determine the current market trend
-Find a list of companies that are aligned to your personal values.
-Analyse each company and find the ones that are strongest.
-Use charts to choose the right moment to trade.
-Determine the current market trend.
Dow theory is a set of ideas formulated by Charles Dow from 1882 to 1902. Dow considered a trend to have three parts, primary, secondary and minor. The primary trend can last for years, secondary trends are corrections in the primary trend and can last from three weeks to three months and minor trends are corrections that last for a few hours to a couple of weeks. The major or primary trend is of interest here. The primary trend according to Dow has three distinct phases:
An accumulation phase: This is the phase where the most astute investors are doing the buying.
Public participation phase: This is where most technical analysts start to buy because prices are going up and business news is good.
Distribution phase: This phase is when economic news is good, newspapers are printing positive stories about the stock market and when public participation in the stock market is on the increase. This is where the informed investors begin to “distribute” before anyone else starts selling.
It is important not to buy during the distribution phase or when the market primary trend is down. The markets have roughly 4 to 5 year cycles when it is strongly going up and then a period of about a year when the primary trend is down and the market prices just drop. Be aware of where the markets are in their cycle and when stock prices are priced too high as it is not prudent to buy during this phase.
Find companies aligned to your values
It is important to pick those companies that you can relate to as an individual. Analyse all the things that interest you and the values that you relate to and then choose a company that aligns to this. For example if you love restaurants and eating out then see if the restaurant chain that you love is listed on the stock exchange. If you believe in them and their value then this is a good place to start. If you don’t approve of gambling then it would not make sense to invest in a company that has casinos or sports betting as their primary focus. Yahoo finance has a comprehensive listing of stocks and the sectors that they fall in and this will enable you to find a company that you can relate to.
Once a list of companies have been written down then the next step is to analyse each company to find how strong they are in their industry. We are looking for companies so strong that they have a monopoly in their industry. There is no other company better or more productive than they are in their particular niche. The easiest way of finding this out is to look at the following information:
-Sales figures must be increasing over the last 5 years.
-Cash flow must be increasing over the last 5 years.
-Return on investment. ROI must be increasing over the last 5 years.
-Earnings per share. EPS must be increasing over the last 5 years.
-Equity or Net asset Value must be increasing over the last 5 years.
-Growth estimate for next year must be over 20%.
-Growth estimate for next 5 years must be over 20%.
-Earnings surprise must be positive for the last two quarters.
-This information can easily be found on yahoo finance or the stock broking platform that you are using for online trades.
Use charts to choose the right moment to trade
It is at this stage that we switch from fundamental analysis to technical analysis. Charts are the best way to determine the correct time to execute the trade When we look at the price graph of a company we need to check on three important things.
Make sure that the current trend of the stock is upwards.
The price of the stock must be above the 20 day moving average.
The ADX indicator must be moving upwards and must be below 40.
The above three checks will confirm that our stock is in a strong upward trend and that we can buy with confidence. The most risk that we expose ourselves to is 1% of our capital on any one trade. Our stop-loss must be placed at a price below our purchase price and the amount of our loss must not exceed 1% of our capital if we hit this stop-loss. If the price of our stock moves upwards then adjust the stop-loss so that we don’t lose more than 1% of our capital if the stop-loss is hit.
Exiting the trade.
The key is to let the trade run as long as possible. This will ensure that we win big but lose small. A signal that can be used to exit the trade is if the ADX indicator goes over 40 and the indicator starts visually flattening. This means that the strength of the trend is beginning to diminish and it is time to exit the trade. If you are constantly moving the stop-loss to follow the increase in the price then you can also be stopped out of the trade.
The above method uses fundamental analysis to find those companies that are strong in the market and then technical analysis to execute the trade. A quality company with strong economic fundamentals can experience price corrections but the primary trend will tend to be upwards. If the bullish trend is found early enough then good profits can be made with very little risk. The tactic of using a moving stop-loss will also decrease the risk of losing large amounts of money. In summary you will have big wins and small losses and even if your win to lose ratio is even, good profits will still be made. Read more as you go to website.