How to choose stocks for trading

Regular readers of this blog need not feel let down by the subject of today’s post. I am a firm proponent of generating wealth through long-term investment by carefully choosing stocks, using both fundamental and technical analysis.

Though I occasionally indulge in longer-term trading in cyclical and FMCG stocks, intra-day or short-term trading remains a strict no-no. The odds for success are too low and the scales are heavily tipped towards the professional traders.

So, why write a post about how to choose stocks for trading? Last week, I had written a post explaining why good investment stocks may not be good trading stocks – and vice versa. The chart patterns of Titan and Reliance were used for comparison. The concluding statement in the post was: “Whether you are a trader, or investor, or both – it improves your chances of making big money if you do your homework in selecting stocks.”

I have already written a series of three posts on how to pick stocks for investment. If you haven’t read those posts, I would strongly recommend that you do so. But because of my antipathy towards trading, I had refrained from writing about choosing stocks for trading.

Why then the sudden change of heart? Let me explain. I have been working on this theory about suicides: If any one is hell-bent on committing it, it should be my duty to guide that person towards the least painful method.

If some one is planning to commit financial suicide (which I reckon a few readers may already have attempted), then it is also my duty to guide them towards the process that may be less painful.

Enough preamble. Now let us get down to brass tacks. Though any stock can be chosen for trading – regardless of its fundamentals – it helps to have a plan and some background knowledge.

High value stalwart stocks typically do not fall too much during down trends, neither do they rise much during up trends. That makes them good picks for stability in one’s long-term portfolio. Not so great for trading.

Penny stocks (i.e. those trading below Rs 10) tend to be irregularly and thinly traded most of the time. Only a few hundred shares being bought and sold can change the stock’s price by a significant amount. While that may appear attractive for trading, being able to buy or sell any decent quantity when you want to can pose a problem.

Mid-priced stocks – say those trading between Rs 30 – 80 – may be the best bets for trading success. Of course, such stocks should trade regularly and with decent volumes. Make a list of such stocks, and start studying their chart patterns. Short-list the ones that are most volatile (i.e. the ones that give big swings from high to low in short periods of time).

Even after going through the above exercise, you may have a short-list that is not so short. Checking the charts of more than 20 or 25 stocks on a regular basis can be a daunting task unless you are doing it full-time. Use the ‘Circle of Competence’ concept to drill down to about 20 stocks, and then spend a period of ‘paper trading’ to fine tune your short-list.

Drop the ones where your paper trades turn sour. Add a few more from the original short-list till you are comfortable with the final choice of the stocks you would like to trade.

Happy trading! (Don’t blame me if you get killed – you are the one attempting to commit financial suicide.)

How small investors can widen their Circle of Competence

Warren Buffett is a strong believer of the Circle of Competence concept. If a company or business doesn’t fall within his Circle of Competence, he won’t touch it. He famously avoided buying into any high-tech company in the 1990s – when every one and his brother-in-law were investing in dot.com companies. He didn’t understand how high-tech companies were making money, and whether they had sustainable businesses. He missed the boom – and the inevitable bust that followed.

Warren Buffett is one of a kind. You and I will never be able to match his skill and wisdom in investing. That doesn’t mean we shouldn’t follow some of his money-making principles. What if our Circle of Competence is too limited? Is there a way to widen the Circle?

Let me give you the bad news first. You can’t widen your Circle of Competence in a hurry. It is a process that will take a lot of time and effort. The good news is that the process is not difficult or complicated. It takes patience, perseverance, and a plan.

First make a short-list of all the knowledgeable people you know. The list isn’t likely to be a long one if you are looking for people with real knowledge. Not some one who knows how many hundreds Tendulkar scored before the age of 25, or the exact locations of the seven wonders of the world. But some one who knows about the economy, business and industry.

Next, figure out how you can meet such people without imposing too much on their time and patience. May be he is a friend’s father or your wife’s uncle. If you inform them in advance that you want to meet them, and the reasons for the meeting, knowledgeable people will be more than happy to share some of their experiences.

Don’t know anyone knowledgeable enough? Join discussion forums and investment groups. There are many in cyberspace. Each group or forum will have a few knowledgeable members. Try and pick their brains.

Going to a family wedding or a party? Don’t just waste your time eating and drinking and being merry. Introduce yourself to people you don’t know, and find out about what they do. If you show genuine interest in their activities, they will give you a lot of information that you won’t find in TV channels or pink papers.

Carry on this process for some time, and you will be amazed at how much wider your Circle of Competence can become. Then, have the discipline to stick to your Circle of Competence when choosing stocks to buy. That will prevent you from getting badly stuck in the shares of a company that you really know nothing about. Like Suzlon, or Punj Lloyd, or Bartronics.

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What is your Circle of Competence?