Which Stocks to Trade

Published: 24 Feb 2023

This page discusses main considerations and some ideas on how to select which stocks to trade.

Specialist vs. opportunist approach

There are two approaches traders take:

Some traders have a constant "basket" of stocks they follow at all times and rarely consider any other stocks. We can call these traders specialists. Criteria for selecting stocks for the basket can vary – often they are stocks from a particular sector or company size (more on these further below).

Other traders choose different stocks every week or every day, depending on where the action and profit opportunities are at the moment. We can call them opportunists.

Each of these two methods has pros and cons. Either is better than trying to trade everything at all times, without a method.

Generally, the more discretionary and fundamental your trading style, the more you should consider being a specialist, because your success depends on knowing your stocks really well.

On the contrary, the more automated and rule-based your trading style, the more likely the opportunist approach will work.

You can also combine both methods to get the best of each. Let's see how.

Narrowing down the stocks universe

With several thousand listed stocks in the US alone, a single trader can't possibly know and trade them all. Although Warren Buffett famously said "Start with the A's" when asked which stock to focus on (meaning to start with the A's and continue all the way to the Z's, i.e. know and trade them all), it is not a realistic approach, at least not when you have less than six decades of stock market experience.

You must specialize.

You must narrow down the universe of stocks from the thousands to perhaps one hundred or less.

There are several ways how you can choose the right stocks for your "trading basket", for example:

  • By market capitalization (large caps vs. mid caps vs. small caps vs. micro caps)
  • By sector (financials, tech, energy, phrama, transportation, consumer staples etc.)
  • By trading and price action (volume, volatility, average daily price range etc.)

You can again combine these criteria, which often gets the best results.

By the way, what do we mean by results? What are our objectives when choosing stocks for our trading basket? They are mainly the following:

  • Our stocks and the way they trade give us a good competitive position in the market.
  • There are good trading opportunities every day.

Your competitive position as a trader

Let's briefly think about competitive position. As an individual trader with limited capital, you have a number of disadvantages against big professional traders and institutions:

  • Higher transaction costs (although the competition among brokers reduced the gap in the recent years, you still can't compare to the institutions).
  • No access to enterprise level technology and research (same as above – it has improved, but the gap is still there).
  • Less human capacity (even a small fund may have a team of analysts, while you do everything alone, and there is only so much work/research/trading/admin you can do in a day).

That said, you also have some advantages:

  • You don't report and answer to anyone.
  • Your small trades are easier to execute than a fund's big trades. Buying 1,000 shares won't more the market; 1,000,000 shares will. Big funds have to worry about liquidity and market depth; you don't (not as much).

You can trade smaller, less liquid stocks, where the available size is simply too small for big institutions.

Large caps vs. mid caps vs. small caps

The above is why the most popular blue chip stocks (the Apples and Googles and Microsofts) may not be the best choice for a small trader. Yet, majority of beginner retail traders love them and unnecessarily make their trading harder than it needs to be.

Focus on second or third tier stocks – those still liquid enough even for day trading, but with smaller volume and less competition. Going extreme and focusing on micro caps may work for some traders with good execution skills. But for most, the middle ground is best.

In sum, leave the blue chips (the stocks in the Dow and S&P500 indexes) to the banks and funds. You can find plenty of interesting names in the mid cap and small cap indexes like S&P MidCap 400, S&P SmallCap 600, or Russell 2000. These are still fairly large, established companies, and their trading volume is usually more than enough for a small day trader. They just don't make headlines like the blue chips do.

Which sectors to trade

Stocks in some sectors tend to be more volatile (= more frequent and better trading opportunities) than in other sectors. Technology, financials and energy are examples of more volatile sectors. On the other hand, notoriously lazy low beta sectors include utilities or telecoms. This is not to say you can't sucessfully day trade telecom stocks – just that trading opportunities may not be as frequent.

When choosing sectors to trade, one approach is to only focus on a single sector, where you have (or gradually build) expertise. For example, if you are a pilot, you can focus on airline stocks (they are good movers); if you are a doctor, trade pharma stocks etc. Trading is extremely competitive. Whenever you have an opportunity to improve your competitive position, take it. Even when your day trading is mostly based on technical analysis and price action, knowing the fundamentals and current stories in the industry still helps, unless your trading is completely automated.

The downside of sector specialization is that stocks in the same industry often move together (they are highly positively correlated). For instance, when Citi reports bad earnings, other financial stocks are also likely to be affected. Therefore, if you focus on a single sector, you will see days when all your stocks make big moves, while on other days all your stocks go nowhere. This is bad, because you want to see good trading opportunities ideally every day. Many trading mistakes and losses arise from trying to make up trades when there are no good opportunities.

There is again a middle ground. Instead of one, you can choose three or four sectors, 8-15 stocks in each, and get to know them well – not only the fundamentals and stories, but also the typical price action patterns and trading "character" of the individual stocks. This way, you will have about 50 stocks with good trading opportunities almost every day.

Although we previously mentioned that blue chip stocks may not be best for trading, when focusing on a particular sector you should also closely watch the biggest companies in that sector, as they are often the drivers of the news and price moves in the entire industry.

Screening and filtering stocks for day trading

So far we have focused on choosing stocks for our "basket" or watchlist. In a particular week or day, not all the stocks from our basket will be good for trading – in fact, most of the time we will only want to trade a small number of names. The following are a few criteria which you can use to systematically select stocks for trading on a daily or weekly basis:

  • High historical volatility or trading range in recent days or week. Stocks which were more volatile yesterday are generally more likely to also be more volatile today.
  • Above average trading volume in recent days or weeks. Volume often goes hand in hand with volatility. Both are signs that something is going on in that particular stock.
  • Upcoming earnings. Stocks can make big price moves not only on the earnings release day itself, but often also in the days before and after. You may want to create a spreadsheet with next earnings dates for all the stocks in your basket.
  • News and social media activity. When there is above average activity in social media discussions about a company (e.g. the Twitter tag for the stock symbol), it may be a sign that more people than usual are paying attention to it, which may result in moves in price. Note that with social media, it is important to also consider what kind of people are discussing and what the topics are – some are more relevant to stock price action than others.

The big picture

These are some of the ways you can narrow down the thousands of listed stocks to a manageable number of names to watch and trade. In practice, it is often best to combine multiple methods, e.g. choose to only consider tech, financials and energy stocks and then use criteria like recent volume or volatility to screen them for trading on a particular day.

As with other things in trading, consistency is key. Whatever approach you choose, stick with it over a period long enough to be able to evaluate whether it adds value to your trading or not. If not, you can adjust it. But changes in method should be based on evidence (keep records), not emotions.

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