Trading equities is a science that requires very specific trading principles for the venture to be profitable. In this article, we will break down the best manner to go about trading. Note however, that this piece will be predicated on the assumption that the investor is engaging in long – term trading as opposed to day trading. The strategies for day trading are based on the principles of support and resistance and other indicators such as Bollinger Bands and trade stochastics.
The main strategy we will be looking at for long–term equity trading will be a systematic trading strategy. This is a strategy that follows basic principles on the financial health of a company before purchasing its stock in the belief that this fundamental analysis may be a viable estimate of the stock’s intrinsic value. Note that these strategies are applicable to local investors as well as investors engaging in international share trading.
Basis for systematic trading strategy
The fundamental analysis of a company can be done through the use of financial ratios. These are figures that compare two aspects of the company and give one a bearing on the managerial capability of the firm, the firms leverage levels as well as the liquidity of the company. The financial ratios shall be discussed later with regards to the strategy employed.
The second basis for the systematic trading strategy would be the efficient market hypothesis. This hypothesis postulates that any opportunities for excess returns (unusual returns above the normal expected returns) are almost always immediately taken away through the action of the market’s multiple participants. The best example of this would be by examining this through the lens of supply and demand. The higher the demand for a good, the higher the price. In the same way, if a stock’s return is higher than usual then the market’s high demand for the stock will raise the price and thus the excess returns will whittle away. In this case, the investor would be working in a market that is semi – efficient and thus corrects itself after some time.
Value investing strategy
This strategy involves investing in company stocks with strong fundamentals which are selling at a bargain price. The hope here is that the investor adds an undervalued stock to their portfolio in order for the market to eventually correct the stock’s price in valuation. The most relevant ratios for this would be the Price/Earnings ratio (P/E), the Price/Book Value (P/BV) ratio, the Debt/Equity (D/E) ratio and the quick ratio (current assets/current liabilities).
The investor would typically look for a low P/E ratio for value investing. What this means is that the stock is selling at quite a low price for the company’s earnings signifying that the stock may be undervalued. The same principle applies for the P/BV. If the price of the stock is lower than the book value (per share) of the company then the stock is definitely undervalued. The D/E ratio serves as a reinforcer of this. This ratio should be less than 1 to signify that the company is not over – leveraged. This may also translate to higher returns on shareholder equity due to lower finance costs. Current assets/current liabilities should be more than 2. What this means is that the company can comfortably pay off all its immediate standing obligations. All these indicators in totality show that the company is undervalued.
Growth Investing Strategy
Growth investors look at the promise of growth in the company’s fundamentals and are not quite as- concerned with the stock’s current price.
The investor would look for a large growth in the Earnings per Share (EPS), the profit margin and return on equity (ROE).
A growing earnings per share indicate a growth in the company’s income per shareholder. This implies that the company’s intrinsic value must necessarily be increasing and therefore the return earned by the investor will increase over time. The same principle applies for the profit margin as well as the return on equity.