My Strategy for Identifying a Stock to Trade – Popular, Volatile, Established and Cheap

By June 12, 2014Trading Strategy

The development of my strategy mimicked my children…all thrust and no direction. And I love them for every minute of it! I’ll take you through the craziness of how I got to this strategy later. For now, let me lay out how I’m choose my stocks to get to my goal of $5k/month in trading income.

Through much gnashing of teeth, pulling out hair (the few remaining) and many beers later I arrived at four characteristics stocks must have to fit my needs:  popular, volatile, established and cheap. We’ll tackle these one at a time.

Popular

Unlike my time in high school, I want the stock I work with to be sought after by everyone. I want it to be highly active in the stock market to ensure there are TONS of people who are willing to buy and sell my stock. It should be a name or symbol those guys you see on the trading floor are constantly yelling out to trade with someone else.

How do you know if it’s popular? One word…volume. What’s that you ask? It’s a measure of how many shares of that stock traded hands during the trading day. It’s that simple. If you’d like a more “text book” definition, check out Investopedia’s definition here.

How much is enough volume? More is always better. This ensures there’s a lively market of people out there willing to buy or sell your stock. A stock with a high volume will never leave you holding something you want to sell or vice versa.

A good rule of thumb is to look for stocks with a volume over 1M shares. This may sound like a lot, but trust me it’s easy to find. On June 10, 2014 (the day I’m writing this) Cliffs Natural Resources’ (CLF)  volume was 2,705,400 shares. Compared to Intel (INTC) with 34,257,000 shares on the same day it’s a drop in the bucket, but it suits my needs.

Rule #1:  Select a stock with a volume over one million.

 

Volatile

Volatility makes you money. Generally, the more volatile the stock the more you get paid to sell an option for it. Traditional investors tend to steer clear of volatility. I know I did when I invested in stocks or mutual funds and hoped they’d stop bouncing around and just make a nice steady climb up. But I’m not traditional anymore and volatility is now my drinking buddy.

Don’t look at a chart to tell if a stock is volatile. It can get skewed based on a host of different factors and you may misread something. I know I have. I’ll point you towards Investopedia again for the book definition of volatility. Really all I use is a measure called Beta.

Stocks with a Beta of one or higher are generally considered “volatile”. Using Cliffs again as my example, the Beta for Cliffs today is 1.02. Intel is .92. Lots more volume traded with Intel, but’s it’s a little less extreme than what you get with Cliffs.

Rule #2:  Select a stock with a Beta over one.

 

Established

Okay, so I may have sort of kind of messed this one up with Cliffs. Don’t get me wrong, Cliffs has been around for a while in some form or fashion since 1847. But what I’m looking for here is a company which won’t keel over and die on me while I’m trading it.

I sincerely doubt this will happen to Cliffs. I think the stock will sink significantly, but I don’t think it will close its doors. Again, I use Intel as a comparison to Cliffs. Even without looking at all the financials for Intel or doing some “deep dive” analysis, I know with reasonable certainty Intel will not shut its doors in the next six months or a year.

Granted, everyone thought that about Lehman Brothers and the other “too big to fail” companies and we know how that turned out. There is always the chance something will catch you by surprise but that is part of the risk you take investing in a company. You’re taking that risk right now too if you’re invested in any mutual funds.

How do I determine this? Google. I Google the hell out of the company and get a general feel for what people think about it. Really, that’s all it is. I’m not looking for the most stable or best company, just one that won’t close its doors before I’m done with it!

Rule #3:  Select a stock that won’t close its doors.

 

Cheap

I want companies that are cheap. How do I know they’re cheap? Good question.

This can be the most time intensive part of the strategy, but is key for starting out with a small account size. I only started with $4,861 in my account. When you’re trading options which represent 100 shares at a time that money can get eaten up quickly. A quick example.

We’ll stick with Intel (INTC) as an example. It’s currently trading at $28.24/share. If a put option I sell represents 100 shares, then I need to have $2,824 in my account. If I wanted to sell two put options, representing 200 shares, then I would need double the $2,824, or $5,648 in my account, which I can’t do with only $4,861 in my account.

The cheaper the stock is, the more options you can sell against it and the more income you can make. This was another reason I was drawn toward Cliffs. At the time I began selling options against it, it was trading around $19-$20/share. This meant I could sell two options against Cliffs, which is why you frequently see that mentioned in the “Quantity” of my Income Reports.

Now, don’t get my idea of cheap mixed up with getting a company at a discount. Getting a company at a discount implies it’s worth more, but for some reason it’s currently selling for less. Buying stock for companies in this manner is considered value investing. If you haven’t read the Intelligent Investor by Benjamin Graham, you should. He’s the father of value investing, the man Warren Buffet credits with teaching him everything he needed to know, and his principals are timeless.

ModernGraham.com is a site which is “Devoted to the study and modernization of the theories of Benjamin Graham”. Benjamin Clark, the co-founder of ModernGraham.com, provides analysis of some of the largest companies traded on the various US stock exchanges. He’s not an investment advisor nor does he suggest investing in specific companies, however his methodologies for identifying undervalued companies work for finding discounted companies.

If you can find a company that is cheap and it’s a discount from what it should be valued, that’s a winner as long as everything else fits.

 Rule #4:  Select a stock that’s cheap.

 That’s it! Popular, volatile, established and cheap. The only four words needed to remember my strategy for identifying the stock to trade around. Shortly before I’m done trading around Cliffs, probably around August or September of this year, I’ll go through the process of picking my next target and I’ll lay it all out here, naked for you to see!

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