Understanding and owning trade ideas, and how they are used to establish specific trades, is extremely important for every trader. A trade idea embodies a hypothesis, or a conceptual framework for how the markets might move. Trade ideas themselves emerge out of painstaking analysis and research. Technical, fundamental and sentiment analysis are just a few of the methodologies a trader might use to generate a trade idea. The trade idea is the catalyst for a particular trade – as a trader gains experience, they’ll learn to store and access the conceptual frameworks they create for their relative success.
Trade ideas are usually attempts by a trader to spot a predictive pattern or trend that they think will translate into future price action – such as buying a stock when the shares are consistently bid up after a quarterly earnings release. In other cases, macro (big picture) economic changes may inspire an idea to short the stock market when interest rates go up, or short stocks in particular sectors.
In a sense, ideas are the plans from which traders act in the financial markets. Ideas cannot guarantee that all trades will be profitable and that all plans will be well executed. However, a hypothesis that is crafted and vetted thoroughly does allow a trader to approach the market’s dynamism with greater clarity and conviction.
There is an art to finding stocks to trade, a relative term that curves when you zoom in: identifying a leading sector that can move the broad market can be a starting point, but you can dive into other levels, as deep as a single stock, to find something tradable. Teasing out signals from noise, whether trading on potential or actual emerging trends, is an iterative process of thinking and acting, looking for patterns in price history as well as facts from the fundamentals. Where do you begin? By surveying the landscape of market trends, understanding where it is going, along with the broader macroeconomic conditions that can determine the performance of a particular sector, or the fate of an individual stock. The basic methods are well tested and sound: technical and fundamental analysis. Technical analysis focuses on historical price movements and trading volume, taking those patterns and drawing conclusions about potential future performance. Fundamental analysis dives into a company’s financials, looking at line items in a divechart through reports of earnings (the most popular and controversial metric), revenue growth, debt burden, management efficiency, and so on.
This might involve starting with a list of, say, a hundred stocks and applications that help to choose stocks by screening for one or more criteria (eg, stocks with a market capitalisation in excess of £1 billion, dividend yield above 3 per cent, P/E ratio below 15, etc). A second set of help might come by being alert to news events and corporate announcements. Third, one might monitor social sentiment suggesting, for example, conversations on Twitter or financial newsgroups that are conveying news or changing generalised sentiment about a stock. Identifying stocks that are potentially worth trading depends on pulling together all these disparate information sources in a strategy fitted to the individual investor’s risk appetites and objectives.
Thus we pit ‘stocks to trade’ against ‘trade ideas’, nuanced but distinct: A ‘trade idea’ can be built from a macro-strategy, such as ‘limiting yourself to stocks of the top five Sector X companies, using, say, stochastics, MACD and the commodity price’ … and then from more substantial theories and processes that impact investing in Sector X.A ‘trade idea’ becomes a conceptual wrapper for how one would analyse the market – from identifying potential picks to protecting against loss.
But going from there to picking (or selling) specific stocks is the difference between vague ideas and specific decisions. It requires looking at individual companies and assessing their current and future financial health, their market position and competitive situation and making a judgment about them. Stock selection is essentially taking the vague notion of a trade idea and putting flesh on its bones, to turn an abstract strategic idea into a real investment decision.
In short, trade ideas are most useful because they give you a macro-level ‘how’ and ‘why’ to shape an overall trading strategy. Selection of stocks gives you the micro-level ‘how’ to execute it. Both are fundamental to the act of trading but they serve distinct functions in how you approach the investment process. Once you understand how they can work together, you can become a much better investor.
Making suggestions for possible trades often means using a variety of tools and resources to sort through massive amounts of market data, looking for likely opportunities. Along with many different types of fundamental analysis tools, which can be used to glean insights into the health of a company, future growth prospects, its earnings potential and so on (financial statements, earnings reports, economic indicators etc), technical analysis tools are utilised by traders to ascertain sentiment around a security and spot trends or patterns (using chart patterns, trendlines, moving averages, the Relative Strength Index, or RSI, to name a few).
News aggregators and financial news websites offer up-to-the-minute coverage of market-moving events. If something significant is going on, traders can react immediately to a breaking development. Social media and forums give traders access to prognosticating ideas and crowd-sourced opinions that can inspire new trade ideas. Stock screeners provide the ability to filter stocks by certain traits, such as P/E ratio or dividend yield. With these tools and resources, traders can cultivate actionable trade ideas that fit within their investment goals.
Identifying stocks to trade requires more than just watching the top 100 stocks for the day. Fundamental analysis is of great value, setting aside some of the hype and examining the real numbers that indicate the health of a company. That means looking at a company’s earnings per share (EPS), which tells you how much profit the company is making line by line. You can then compare that to other metrics such as the price-to-earnings (P/E) ratio to get a picture of the market’s valuation of the company in question. The P/E ratio is the value of the share price divided by its EPS. Looking at things that way can give an idea of whether a share is being under- or overvalued. Another important indicator is revenue growth, which enables you to determine whether a company is actually growing and thriving.
Just as important is technical analysis, which analyses previous price movements and volumes of trades to predict future moves. Patterns, known as M moving averages, relative strength index (RSI) and Bollinger Bands are useful in finding entry and exit points.
Moreover, for a complete picture, the economic background should be considered. Macroeconomic notice relative factors like interest rates, inflation and geopolitical events that can dramatically affect performance of stocks. Sentiment analysis of news sentiment or social media can signal the general attitude towards the market, and so be helpful in recognising a nascent investor attitudes before they reflect in the stock market. Utilising different analytical approaches enhance and augment your stock trading evaluation. Looking for relevant information in social media, news and stock market forms used to be painful and tedious, but not anymore. SentientTrader software combines them all in one place.
This process of turning trade ideas into a trading strategy is nuanced because you need to convert rather conceptual analysis into action. Before you can put a trade through, you need to carefully sift and filter the trade ideas that come across your desk – if you are not coming up with trade ideas yourself. Of course, such an analysis requires tools. For instance, you might use technical analysis. You might use fundamental data. You might look at market sentiment indicators. And once you have an idea, you need to assess it for the fit with your overall strategy, your risk appetite and your time frame.
You need a system to trade or invest in ideas from added value sources of ideas that incorporates risk management and strict entry and exit rules, and allows for monitoring and modifying positions based on market feedback.
It also calls for flexibility – traders must be willing to adapt or surrender a retreats if the market conditions change or the higher-level plan times out. A robustly integrated combination of separated ideas, each with its own rationale, can inoculate trading against the pitfalls of poor decision-making.
One case study where a strong trade idea led to the execution of a trade successfully in a live market is in the ploughing of a fund that discovered a trade idea in a burgeoning new market for renewable energy. By analysing macroeconomic data to identify key shifts in policy, technology and capital flows, the fund’s analysts pitched a trade based on specific solar energy stocks: equities in First Solar and SunPower, among others.
In the more than two years that followed, many of these stock trades turned into outsized returns as pent-up demand for renewable energy began running hot again.
Elsewhere, an intrepid lone trader went against the norm by using technical analysis to capitalise on short-term moves in tech shares. Armed with advanced charting techniques and momentum oscillators, the trader zeroed in on entry and exit levels to execute well-conceived trade ideas in the likes of Apple and NVIDIA. This discipline to sticking to a process that exploited the junior part of his fractal DQ index is what ultimately translated to a steady stream of profits over several months.
These examples demonstrate how good analysis and smart execution can turn academic notions of trade into moneymaking stock trades.