Strategies
These are the main things that I check before getting involved in the market. After utilizing all of these procedures, I will then determine the proper way to trade the stock. This could simply mean just being long or short the stock, or perhaps a volatility spread with options. Determining the best play is all subjective, but remember that it's always a good choice to hedge your bets and use a collar or spread play just to be safe.Technical Analysis:
10/20/30 Test - This test combines three different chart overlays which gives insight into the trend of the stock price. A 10 day (or week) simple moving average is combined with a 20 day (or week) and 30 day (or week) exponential moving average. When the 10 day SMA crosses the 20 and 30 day EMA's from underneath, the 102030 test is showing a BUY signal. Conversely, the 102030 test shows a SELL signal when the 10 day SMA crosses the 20 and 30 day EMA's from above. To optimize buy or sell timing, time your trades so they are executed as the SMA begins to curve from a downtrend into an uptrend or the opposite. An ideal time to use the 102030 is shown below.
Relative Strength Indicator - This is an excellent tool to determine whether a stock is overpriced or underpriced. When the RSI value is above the top line (over 70) then it is deemed overpriced and will typically fall. On the contrary, when the value is below 30, then the stock is undervalued. The best way to use this tool is to make sure not to buy when the stock is overvalued or on a consistent downward sloping trend. Ideal buy conditions will be when the stock is undervalued or on an upward sloping trend.
Stochastic Oscillator - Similar to the RSI, this is a momentum indicator that allows us to see whether or not a stock is overbought or oversold. Ideal buy times are when this is sloping upward and ideal sell times are when this slopes downward. Try to avoid stocks that have long periods where the stochastic line is above the overbought (80) level.
On Balance Volume - A very useful volume tool which shows the difference between volume on up days and down days. This can be useful for determining trends in a similar fashion to that of the underlying stock. Check for support and resistance levels and identify convergence or divergence. An optimal buy sign would be when the stock has formed a strong OBV support level and is well under resistance.
Risk Analysis:
Historical Regression - This is a very useful process that involves regressing a dependent variable (usually a stock's returns) on an independent variable. By choosing different independent variables, it is easy to identify risk components. This is helpful when making stock decisions based off of economic statistics or predictions. It is important to check whether or not the stock is effected by one of the Fama-French Factors and to see how much residual to expect versus other similar stocks.
Descriptive Statistics - Simple statistic procedure in Excel that can tell us all the basics. Here we can see the volatility of returns and can apply various formulas that we may find useful. Personally, I like to use the Treynor and Sharpe Ratios just to see how the stock looks versus a benchmark. (Note: some figures will have to either be taken from the regression or from a financial statistic website)
Other Important Decisions:It's always a good idea to check the overall performance of an industry before getting involved in the stock. If everything in the industry is doing well, there is probably sound economic reasoning, and you can probably join in and make a buck like the rest of the big money. This is NOT always the case and its very possible that you can hit it too late, so be careful. Checking the news constantly and staying up to date with the economic announcement calendar is a great idea too.