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If you’ve ever flipped through CNBC or read the Wall Street Journal, you’ve probably seen investors commenting on how they pick stocks, short sell companies, or day trade successfully. “It can’t be that easy” you might be thinking to yourself. And for most, it isn’t.
Even for the more advanced investors, the risk and time requirements for these methods of investing can be off-putting. In this post, we hope to guide you through the world of stock picking and day trading. Could it be right for you? Let’s find out.
What is Stock Picking?
Picking stocks (aka, stock picking) has been around from the inception of the stock market. With this method of investing, you will examine each individual company that you wish to invest in before making any decisions with your money.
If you find that a company continually beats financial performance goals or is rapidly expanding, you might choose to invest in this company. This is opposed to investing in a more passive manner through ETFs, mutual funds, or investing through a money manager.
Pick stocks successfully and you could never have to work again. Pick stocks unsuccessfully and you can amount significant losses.
Picking stocks can be extremely risky and is best left for more advanced traders with access to large amounts of capital.
How do Investors Pick Stocks?
Investors have hundreds of ways they end up picking stocks including analysis of the companies financial performance over time, examining the companies leadership team, and even going with their gut feelings about the company.
Steven Lynch, one of the most well-renowned stock pickers in history, used a formula of investing in stocks with low price-to-earnings-growth. In other words, the companies that Lynch invested in were priced lower relative to what he believed their growth potential was.
Others choose a more simple approach to investing. Warren Buffet, currently one of the world’s richest men, picks stocks based on more traditional financial metrics. He takes a value investment approach, picking stocks that aren’t the sexiest but have consistent performance with a long life ahead of them. Some of his investments include positions in Coca Cola, American Express, Apple, and Bank of America.
Some investors choose to look at a companies offerings and the competitive landscape in the industry. Companies that offer a unique product without much competition tend to be valued much more than those in an extremely competitive business, say food delivery.
When answering the question “How should I pick stocks?” you might’ve realized that there is not one single approach. There are many different methods for choosing which investments deserve your money but they all have one thing in common. How long you hold your stocks can have a drastic impact on your portfolio’s performance. Historically, the longer you hold your positions, the larger returns you will obtain. You should keep this in mind when determining how you will invest.
What is a Day Trader?
Day traders do exactly what you might think, trade stocks throughout the day. They aim to make small profits with enough volume to have substantial gains. Day trading can be extremely risky as you attempt to profit off of short term volatility within the market.
Day Trading Techniques
There are several ways day traders tend to operate. Similar to picking stocks, there is no right or wrong way to day trade. Day traders will choose a strategy that suits their beliefs and capital and will become professionals after years of optimizing their behavior.
The scalping technique of day trading relies on making small profits on several trades throughout the course of the day. You can often find stocks that increase and decrease throughout the trading day. Scalpers will use this to their benefit by trading on the ups and downs of the day.
News Based Trading
The news based trading technique relies on the news (economics data, company announcements, or political updates) to make trades based on intra-day market volatility. News based trading can be difficult to profit from because of the unknown.
High Volume Trading
This technique is usually used by the most advanced traders looking to exploit differences in buy-sell spreads. It is usually completed by algorithms looking to make small profits on a large scale.
This technique looks for resistance or technical levels and will execute trades based on reaching those levels. Similar to high volume trading, these traders will often use computer algorithms to determine their trades.
What about Short Selling…
Short selling is different than the previous two terms. Short selling is essentially investing against the company. It is a method of investing in which you believe the companies stock price will go down in value.
Short sellers are also stock pickers. They tend not to “bet” against the market as a whole, rather individual companies they believe are overvalued for select reasons.
CAUTION: Note the phrase “stock will go down in value”. Even if a companies financial performance deteriorates, it’s stock price can still increase, leaving you with a loss.
How Short Sellers Pick Stocks
Short sellers will typically look for stocks in which they believe have poor management or have a poor financial outlook. They will often heavily research the company from top to bottom looking for inconsistencies in their finances or work environment.
Many of the top companies shorted will have fundamental issues leading to long term distress in their performance.
When you think of the biggest busts, you’ll probably think of Enron or Valient, but there are many others.
Many short sellers will have a team of analysts searching the company to get a better understanding of how they do and should operate.
In the case of Valient pharmaceuticals, short-sellers began to criticize the company’s lack of spending on research and development of new drugs. When compared to the rest of the pharmaceutical industry, they spent significantly less developing new drugs. Because they spent less developing new drugs, they were forced to raise the price of existing drugs to increase profits. The company also participated in fraudulent accounting practices to hide its poor performance. The stock fell more than 90% from its high once the news broke, creating tremendous value for short-sellers and significant losses for investors.
Is Stock Picking or Day Trading Right for You?
Even some of the most successful day traders and stock pickers make bad decisions.
The life of these types of investors can be extremely overwhelming with massive swings of gains or losses each day, week, or month.
Below are a few questions to ask yourself before deciding if stock-picking and day trading is right for you.
Are You Comfortable Losing Your Investment?
Before making any investment (whether picking stocks or not), you need to be comfortable with the possibility of losing your money. If you have large amounts of debt or a job without much security, investing your money might not be the best idea. Instead, consider working on ways to reduce debt or increasing your income.
Do You Have Time to Invest?
Picking stocks and day trading requires not only money but time. You’ll need to heavily research your investments before pulling the trigger. If you don’t have the time available, it’s probably better to take a more diversified approach to your investing, like a low-fee ETF or mutual fund.
Do You Enjoy Analyzing Financial Statements?
For some people, they love to crunch numbers and examine financial statements. If this is you, picking stocks might be right up your alley.
What are Your Investing Goals?
Are you looking to invest your money over 10+ years or less than a few? Do you anticipate returns of greater than 10%? How you answer these questions will help you to determine if day trading or picking stocks is right for you.
Those seeking larger returns will need to invest riskier than those looking for average returns.
Do You Have a Strategy?
Having an investment strategy is necessary to achieve long term gains. No matter your method of investing, optimization is vital. Every investor will make mistakes along the way. Successful investors are capable of learning from these mistakes to avoid them in the future. Finding patterns will help you to become a stronger investor over time.
Before You Get Started!
If you are determined to become a day trader, you’ll need to jump through some hoops to get started.
Federal regulations require certain things to be met before you can become a day trader.
Your brokerage account may be flagged as a “pattern day trader” if you do not disclose that you are a day trader. A pattern day trader is defined as “trade four or more times in five business days and your day-trading activities are greater than six percent of your total trading activity for that same five-day period.” If you are flagged, you may not be capable of any more trades until you speak with an advisor about your behavior.
To become a day trader, you’ll need to have $25,000 in your account at all times to meet margin requirements. This can be a combination of your holdings and cash. You can read more of the rules and regulations of day trading here.
Any investor should have a meticulous plan for how to invest their money. This may, or may not, include stock picking, day trading, or short-selling positions.
It’s important to remember that there is no right or wrong way to invest. You should do what you feel comfortable with.
For those wishing to pick stocks, day trade, or short sell, DO YOUR RESEARCH. Lack of fully understanding every detail of the company they chose to invest in can lead to poor investments and significant losses.
Day trading and stock picking are RISKY. Unless you are comfortable with losing your investment or have enough money to diversify your positions, it’s most likely better to invest in an ETF or mutual fund to limit risk.
Have you tried stock-picking or day trading before? Let us know your experience in the comments below!
Forrest is the owner of Don’t Work Another Day, a personal finance, investing, and entrepreneurship blog dedicated to helping others live a life on their own terms.