The Many Ways Of Picking Direction
Traders and Investors use a multitude of ways to pick the direction of share prices, here we look at some of the commonly used methods.
There are many different ways that traders and investors use to try and determine future changes in a company’s value. As options traders, we primarily use forms of technical analysis to determine share price direction. However, it is also important to consider the methods that other traders and investors may be using, as all forms of analysis have the ability to influence prices.
There are two main schools of analysis that traders use to pick direction; Technical Analysis and Fundamental analysis. Each of these schools of analysis has their own various tools and methods that traders use to pick direction.
Technical analysis is the broad study of charts and mathematical indicators of past price and volume data in order to determine future prices.
The foremost method of technical analysis is the study of charts, and where traders identify key historic buying and selling points. The purpose is to help project a future selling or buying point, usually represented as a gradient known as a trend line, or, trade on the idea that these key points will once again be a strong level for either buying or selling, known as support and resistance levels respectively.
Traders can use a combination of these lines to identify patterns that commonly occur on charts and add a further layer of analysis to support their speculation. Common patterns include channel, triangle, and flag patterns.
Another common form of technical analysis is the use of technical indicators. These indicators are usually mathematic formulas that graphically represent various historic data like price, volume, volatility, etc.
Volume Weighted Average Price (VWAP) is yet another form of technical analysis. It is a mathematical calculation that uses volume data to determine the levels at which significant buying and selling occurs; which are then considered similar to support and resistance lines.
VWAP is often used by algorithmic and institutional traders to automate trading and make markets. As individual traders, consider looking at VWAP levels, and whether or not the market bounces from or breaks through these levels.
Fundamental analysts focus on analysing a company’s financial statements and reports, as well as wider economic information to conduct stock valuations. In addition, these valuations or other comparable data can help to calculate price targets, or can be used to compare different companies and prices.
One way that fundamental analysts can calculate price targets is by using formulas to calculate a present value of a stock, based on expected futures earnings, returns, or dividends. Such models include Discounted Cash Flow (DCF) and Dividend Discount Models (DDM), Capital Asset Pricing Models (CAPM), and many others. Once the mathematical values are calculated, they can then be compared to live market prices, to determine whether live prices are overvalued and likely to fall, or undervalued and likely to rise.
Some fundamentalists (as opposed to Technicians) use ratios, especially price/earnings (PE) ratios, and dividend yields, to create data that can be easily compared across different stocks and their prices. This allows company valuations to be compared on a relatively level playing field. This is often what value investors look at to determine whether a company is under or overpriced relative to its peers. This can help in picking direction over the medium to longer term, as undervalued companies will often rise, and overvalued companies will often fall.
Another way of determining price direction is by subjectively gauging market sentiment. It is not a secret that prices tend to fall when markets are worried about company or economic conditions, and prices tend to rise when markets become confident and optimistic. By reading news media, and conversing with traders and investors, one can get a rough idea of how positively or negatively people view the current market.
Finally, arguably the most basic form of fundamental analysis is speculating the effect a large economic event will have on the market or a particular stock. Events may range from a presidential election, to economic data like GDP or unemployment rates.
Any way of picking share price direction can be effective. The key to successfully picking direction over a long period of time is by finding a set of parameters that you can use to successfully pick direction, and then applying these parameters in a methodical and consistent manner.
TradersCircle is one of Australia's leading stock market education firms, and runs one of the country's busiest options trading desks. Learn more at www.traderscircle.com.au.