It’s ultimately a matter of personal choice to decide whether one wants to engage in day trading, swing trading, or follow the fundamentals by taking a long-term view of the stock market. Every investment style has its pros and cons. For instance, if one adopts day trading, they really have to keep an eye on market news and technical analysis, which may include decoding patterns and candlesticks, as well as a myriad of technical indicators to inform their investment decisions. On the other hand, those who use fundamentals adhere to the terminology of “slow and steady wins the race,” and ultimately achieve a better rate of return on their investments. Day trading, swing trading, and following the fundamentals all have their fan following. It’s still debatable which style of investment is the best one. I will present here my view of these three approaches.
Disclaimer
This post is purely meant for educational purposes and does not serve as any investment advice in any form. The purpose of this post is to describe the differences between the broader category of investment styles and their pros and cons.
Day Trading
These days, accessing the second-by-second market information has never been easier, thanks to high-speed broadband internet and the plethora of online brokerage firms providing speedy buy and sell services. The combination of access to the stock tickers and the quick buy and sell services enables the advent of the rapid trading strategy called day trading.
Day trading is exciting for any newbie who thinks about making a fortune from the stock market in the short term. But as exciting as it seems, it can also potentially lead to investment loss. To play this game successfully, one has to decode stock chart patterns, adjust their risk-to-reward ratio, and keep an eye on news that could drive the market or a particular stock up or down.
The followers of day trading believe that the chart patterns essentially factor in all the bad and good news of the companies in the market and the economy. As true as it seems, there are a lot of caveats to such a theory. These caveats are not from the market chart itself, but from the established patterns. For example, once you start learning about day trading, you might hear 2:1 or 5:1, etc. What that means is a spread between the profit and loss. It means that you make an entry (buy) in the stock with a reward-to-risk ratio of 2:1. If the stock goes up 2 percent from your current buying price, you can take out your profit, and if it goes down by 1 percent from your buying price, you can just sell and endure the small loss.
Although it seems like an easier task on the surface, it can quickly turn into gambling and chance if one doesn’t carefully understand the chart patterns and market sentiment.
One of the disadvantages of day trading is that day traders are always after the hot stocks, the stocks where the beta value is larger than 1. It makes sense because if one is day trading, they will always search for the stocks that have more volatility. The higher the volatility, the higher the chances of success and loss. In other words, they follow the market sentiment. However, market sentiment does not show the real value or performance of the underlying business, which always leads to speculations.
Another, rather relaxed, form is the short-term technical analysis. This group of traders looks at the stock chart that spans 4 weeks to 8 or 12 weeks. A 200-day moving average of the stock price, or a 21-point average, is commonly discussed among this group of traders. For example, a stock might show a bullish pattern if its price crosses the 200-day moving average, and conversely, is bearish if it is below its 200-day moving average.
Whatever variety of trading strategy you take, if there is a lack of sufficient knowledge of market sentiment, industry cycles, and a lack of practice and knowledge, there is a high chance that it will lead to loss rather than success.
Swing Trading
The swing trading is another approach that people often use for long-term and short-term gains. Swing traders typically wait for a bearish market or a price dip to enter (or buy) a stock. The selling point is then the bullish cycle of the stock. Therefore, in general, they buy in the bear cycle and sell in the bull cycle.
However, it is difficult to identify the bearish and bullish periods in the short term. Identifying short-term swings will lead to market timing and speculation. In the long term, spanning at least a few weeks, it might be possible to spot the bullish and bearish periods of any particular stock. Importantly, although swing trading is a simple idea, the bear and bull periods may span months or even years for a particular stock. Often time the irregular periods of rising and falling of the stocks are misinterpreted as the bull and bear periods, respectively. Therefore, it is important to supplement market information with company fundamentals when identifying the bull and bear periods.
Investment by Following Fundamentals
A less risky approach, which is quite effective, is to isolate oneself from market charts and focus on the company fundamentals. The stock price of a company always follows earnings. If a company reflects positive earnings, its stock price will likely reflect that. Hence, it is more prudent to focus on the company’s earnings rather than the fluctuation in its stock price. It further saves one’s time from gluing to the charts.
However, earnings alone are not enough to determine whether the company’s stock will perform better, average, or worse in the near and long term. The key here is to identify stocks reflecting strong “fundamentals”. You might have heard terms such as price-to-earnings ratio (P/E), earnings per share (EPS), price-to-earnings growth ratio (PEG), cumulative annual growth rate (CAGR), etc. If you don’t know about these, don’t worry, as I will explain them in the subsequent paragraphs. Those who focus on the valuation of the company place considerable importance on these metrics. It helps them to determine whether the stock of the company is undervalued, overvalued, or fairly valued. Investors who follow the fundamentals always look for undervalued stocks that can gain back their fair valuation over time. At this point, it might seem that there is a correlation between buying at the dip (swing trading) and buying by following the fundamentals. However, there is an important distinction between swing trading and investing by following fundamentals. An investment by swing trading may not consider the reasons for the price of the stock falling down from its fair valuation and overvaluation. On the other hand, investors who follow the fundamentals will always check for the reasons why the stock price is below its fair valuation. They will invest only if the stock is undervalued, but reflects the strong fundamentals.
Now, how to identify a stock with strong fundamentals but a lower price? At this point, our statement, “price follows the earnings,” might seem contradictory. If the stock earnings are positive throughout the period, why would the stock price fall? There are multiple answers to this question. However, the common reasons are mispricing. News about the economy and inflation can drive the overall market up and down, and so the individual stocks whose business is solid with strong fundamentals will also soar or suffer. This mispricing, if the stock price falls, creates a buying opportunity as the stock with strong fundamentals will eventually rise back to its fair valuation over time. In such cases, the P/E ratio of the stock gets lower, and hence the premium that one needs to pay on the stock is also lower. Another common reason for the stock to fall is the overvaluation. The market optimism about the stock can drive the stock up to the level where the fundamentals deteriorate significantly. This results in significantly high P/E ratios that are difficult to justify with the stock’s earnings. The market optimism creates overvaluation of the stocks, which forces the institutions (those who hold a large number of stocks in a company) to sell their positions, bringing the stock back to its fair valuation, or, in most cases, to the levels of undervaluation. However, there are multiple other reasons why the stocks can get undervalued and overvalued, which might require a separate article.
Conclusion
In this article, we have discussed multiple styles of buying and selling in the stock market. Not a single strategy is risk-free. Every strategy requires learning about its basic concepts before embarking on it. Some investment strategies, like day trading, are more risky than weekly trading or monthly, or swing trading. It’s still debatable which investment strategy is the best one. However, most of the fortune has been made with the investment strategy that follows the fundamentals, and we have seen people like Warren Buffett or Peter Lynch making spectacular gains by following the fundamentals.