Day Trading Strategies For Beginners

When people use the term "day trading", they mean the act of buying and selling a stock within the same day. Day traders seek to make profits by leveraging large amounts of capital to take advantage of small price movements in highly liquid stocks or indexes. Here we look at some common day trading strategies that can be used by retail traders.

Entry StrategiesCertain stocks are ideal candidates for day trading. A typical day trader looks for two things in a stock: liquidity and volatility. Liquidity allows you to enter and exit a stock at a good price (i.e. tight spreads and low slippage). Volatility is simply a measure of the expected daily price range - the range in which a day trader operates. More volatility means greater profit or loss.

Once you know what kind of stocks you are looking for, you need to learn how to identify possible entry points. There are three tools you can use to do this:

• Intraday Candlestick Charts - Candles provide a raw analysis of price action.
• Level II Quotes/ECN - Level II and ECN provide a look at orders as they happen.
• Real-Time News Service - News moves stocks. This tells you when news comes out.

We will look at the intraday candlestick charts and focus on the following three factors:

• Candlestick Patterns - Engulfings and dojis
• Technical Analysis - Trendlines and triangles
• Volume - Increasing or decreasing volume

There are many candlestick setups that we can look for to find an entry point. If properly used, the doji reversal pattern is one of the most reliable ones.

Typically, we will look for a pattern like this with several confirmations:
1. First, we look for a volume spike, which will show us whether traders are supporting the price at this level.Note that this can be either on the doji candle, or on the candles immediately following it.
2. First, we look for a volume , which will show us whether traders are supporting the price at this level. Second, we look for prior support at this price level. For example, the prior low of day (LOD) or high of day (HOD). 3. We look at the Level II situation, which will show us all the open orders and order sizes.
If we follow these three steps, we can determine whether the doji is likely to produce an actual turnaround, and we can take a position if the conditions are favorable. Typically, entry points are found using a combination of these three tools.


Finding a TargetIdentifying a price target will depend largely on your trading style. Here is a brief overview of some common day trading strategies:

Strategy	Description
Scalping	Scalping is one of the most popular strategies, and it involves selling almost immediately after a trade becomes profitable. Here the price target is obviously just after profitability is attained.
Fading	Fading involves shorting stocks after rapid moves upwards. This is based on the assumption that (1) they are overbought, (2) early buyers are ready to begin taking profits and (3) existing buyers may be scared out. Although risky, this strategy can be extremely rewarding. Here the price target is when buyers begin stepping in again.
Daily Pivots	This strategy involves profiting from a stock's daily volatility. This is done by attempting to buy at the low of the day (LOD) and sell at the high of the day (HOD). Here the price target is simply at the next sign of a reversal, using the same patterns as above.
Momentum	This strategy usually involves trading on news releases or finding strong trending moves supported by high volume. One type of momentum trader will buy on news releases and ride a trend until it exhibits signs of reversal. The other type will fade the price surge. Here the price target is when volume begins to decrease and bearish candles start appearing.

You can see that, although the entries in day trading strategies typically rely on the same tools used in normal trading, the exits are where the differences occur. In most cases, however, you will be looking to exit when there is decreased interest in the stock (indicated by the Level II/ECN and volume). 

Determining a Stop-Loss
When you trade on margin, you are far more vulnerable to sharp price movements than regular traders. Therefore, using stop-losses is crucial when day trading. One strategy is to set two stop losses:

1. A physical stop-loss order placed at a certain price level that suits your risk tolerance. Essentially, this is the most you want to lose.
2. A mental stop-loss set at the point where your entry criteria are violated. This means that if the trade makes an unexpected turn, you'll immediately exit your position.

Retail day traders usually also have another rule: set a maximum loss per day that you can afford (both financially and mentally) to withstand. Whenever you hit this point, take the rest of the day off. Inexperienced traders often feel the need to make up losses before the day is over and end up taking unnecessary risks as a result.

Evaluating and Tweaking PerformanceMany people get into day trading expecting to make triple digit returns every year with minimal effort. In reality, around 80% of day traders lose money. A recent (January 2005) behavioral finance study of the Taiwanese stock market conducted by professors at the University of Taipei and the University of California suggests that "less than 20% of day traders earn profits net of transaction costs". Most of these people would be better off putting their money on the roulette table than using it for day trading! However, by using a well-defined strategy that you are comfortable trading, you can improve your chances of beating the odds.
How do you evaluate performance? Most day traders evaluate performance not so much by a percentage of gain or loss, but rather by how closely they adhere to their individual strategies. In fact, it is far more important to follow your strategy closely than to try to chase profits. By keeping this mindset, you make it easier to identify where problems exist and how to solve them.
ConclusionDay trading is a difficult skill to master - well over 50% of those who try it fail. But the techniques described above can help you create a profitable strategy and, with enough practice and consistent performance evaluation, you can greatly improve your chances of beating the statistics. 

Discretionary or System Trading

One of the choices that every new trader has to make, is whether to be a discretionary trader or a system trader. Discretionary trading is decision based trading (i.e. the trader decides which trades to make), and system trading is rule based trading (i.e. the trading system decides which trades to make). Both discretionary trading and system trading have the potential to be equally as profitable, so the decision should be made based upon the personality of the trader. Some traders will instantly be able to recognize which type of trading is more suitable for them, while other traders may need to experience both types of trading before they can make a decision.

Discretionary Trading

Discretionary trading is decision based trading, where the trader decides which trades to make, based upon the information available at the time. A discretionary trader may still follow a trading system with clearly defined trading rules, but will use their discretion (hence the name discretionary trading) to decide whether or not to actually make each trade. For example, a discretionary trader might review their charts and find that all of their criteria for a long trade have been met, but decline to make the trade simply because they believe that the price is too high.

System Trading

System trading is rule based trading, where the decision to make a trade is based entirely upon the trading system (hence the name system trading). System trading decisions are absolute (if the criteria are met, the trade is made no matter what), and do not offer the opportunity to decline to make a trade based upon the trader's discretion. For example, a system trader might review their charts and find that their trading system's requirements for a short trade have been met, so they will make the trade without any further decision making process (e.g. regardless of whether they like the price or not).

As system trading decisions are absolute, system trading is perfectly suitable for fully automated trading. Once a computer program has been developed to recognise when a trading system's requirements have been met, the program can make the trade (including the entry, management, and exit) without any involvement of the trader. There are various trading and charting software that provides the ability for automated trading, such as VisualStation.

Are You a Discretionary or System Trader?

Discretionary trading and system trading have the same goal (making profitable trades), and may even make many of the same trades, but they are better suited to different trading personalities.

Discretionary trading is most compatible with traders that want to be in control of every trading decision (the entry, every aspect of the management, and the exit). Discretionary traders often feel uncomfortable when they think about giving complete control of their trading to a computer program. Discretionary traders often have backgrounds in artistic endeavours, such as writing and gardening. However, discretionary trading also appeals to traders with controlling personalities, and those who like to be in control in most aspects of their life.

System trading on the other hand, is most compatible with traders who want qualities like speed, precision, and accuracy in their trading. System traders have no qualms about letting a computer program make their trading decisions, and may even value the feeling of lessened responsibility that this allows. System traders usually have logical personalities, and often have backgrounds in areas such as computer programming and mathematics.

Combining Discretionary and System Trading

It is possible to be a discretionary trader that uses system trading, but it is not possible to be a system trader that uses discretionary trading. For example, a discretionary trader may follow a trading system for their entries and take every trade that the system identifies, but then manage and exit their trades using their discretion. A system trader does not have this option, because they must follow their trading system exactly. If a system trader ever deviates from their trading system (even for a single trade), then they have become a discretionary trader rather than a system trader.

Trading Order Types

All trades are made up of separate orders, that are used together to make a complete trade. All trades consist of at least two orders (one buy and one sell order), usually with one order to enter the trade, and one or more orders to exit the trade.

A single order is either a buy order or a sell order, and an order can be used either to enter a trade or to exit a trade. If a trade is entered with a buy order, then it will be exited with a sell order, and vice versa. For example, if a trader expected the market's price to go up, the simplest trade would consist of one buy order to enter the trade, and one sell order to exit the trade. Conversely, if a trader expected the market's price to go down, the simplest trade would consist of one sell order to enter the trade, and one buy order to exit the trade. If this last example seems backwards, see the shorting entry in the trading glossary for an explanation.

Traders have access to many different types of orders that they can use in various combinations to make their trades. The following explanations will explain each of the order types, and how these orders are used in trading. Note that many traders do not fully understand all of these order types, and they may seem slightly abstract at first, but their use will become clearer once you start to use them in your trading.

Market Orders (MKT)

Market orders are orders to buy or sell a contract at the current best price, whatever that price may be. In an active market, market orders will always get filled, but not necessarily at the exact price that the trader intended. For example, a trader might place a market order when the best price is 1.2954, but other orders might get filled first, and the trader's order might get filled at 1.2956 instead. Market orders are used when you definitely want your order to be processed, and are willing to risk getting a slightly different price.

Limit Orders (LMT)

Limit orders are orders to buy or sell a contract at a specific or better price. Limit orders may or may not get filled depending upon how the market is moving, but if they do get filled it will always be at the chosen price, or at a better price if there is one available. For example, if a trader placed a limit order with a price of 1.2954, the order would only get filled at 1.2954 or better, if it got filled at all. Limit orders are used when you want to make sure that you get a suitable price, and are willing to risk not being filled at all.

Stop Orders (STP)

Stop orders are similar to market orders, in that they are orders to buy or sell a contract at the best available price, but they are only processed if the market reaches a specific price. For example, if the market price is 1.2567, a trader might place a buy stop order with a price of 1.2572. If the market then trades at 1.2572 or above, the trader's stop order will be processed as a market order, and will then get filled at the current best price. Stop orders are processed as market orders, so if the stop (or trigger) price is reached, the order will always get filled, but not necessarily at the price that the trader intended. Stop orders will trigger if the market trades at or past the stop price, so for a buy order, the stop price must be above the current price, and for a sell order, the stop price must be below the current price.

Stop Limit Orders (STPLMT)

Stop limit orders are a combination of stop orders and limit orders. Like stop orders, they are only processed if the market reaches a specific price, but they are then processed as limit orders, so they will only get filled at the chosen price, or a better price if there is one available. For example, if the current price is 1.2567, a trader might place a buy stop limit order with a price of 1.2572. If the market trades at 1.2572 or above, the stop limit order will be processed as a limit order. If the market continues to trade at 1.2572, the limit order will get filled at 1.2572 or at a better price if there is one available. Stop limit orders may or may not get filled depending upon whether or not the market reaches the chosen price, and then depending upon how the market moves. Stop limit orders will trigger if the market trades at or past the stop price, so for a buy order, the stop price must be above the current price, and for a sell order, the stop price must be below the current price.

Market if Touched Orders (MIT)

Market if touched orders are identical to stop orders, except that they are used when the market price has already traded past the stop price, and the trader only wants the order to be processed if the market price comes back to the stop price. For example, if the market price is 1.3010, and the trader places a buy market if touched order with a price of 1.3001, the order will only be processed if the market trades at or below 1.3001. If the order is processed, it will be processed as a market order, and will get filled at the current best price. Market if touched orders will trigger the opposite way than a stop order, so for a buy order, the trigger price must be below the current price, and for a sell order, the trigger price must be above the current price.

Limit if Touched Orders (LIT)

Limit if touched orders are identical to stop limit orders, except that they are used when the market price has already traded past the stop price, and the trader only wants the order to be processed if the market price comes back to the stop price. For example, if the market price is 1.3010, and the trader places a buy market if touched order with a price of 1.3001, the order will only be processed if the market trades at or below 1.3001. If the order is processed, it will be processed as a limit order. If the market continues to trade at 1.3001, the limit order will get filled at 1.3001 or at a better price is there is one available. Limit if touched orders will trigger the opposite way than a stop limit order, so for a buy order, the trigger price must be below the current price, and for a sell order, the trigger price must be above the current price.

Day Trading Charts - Bar, Candlestick, and Line Charts

Chart Types

Day traders use trading charts to watch the markets that they trade, and decide when to make their trades. There are several different types of trading charts, but they all show essentially the same trading information, such as the past and current prices. The most popular types of trading chart are :

·         Bar Charts

·         Candlestick Charts

·         Line Charts

Chart Timeframes

Regardless of the chart type, all trading charts have a timeframe that determines the amount of trading information that they will represent. Some timeframes are based upon time, while others are based upon pieces of trading information, such as numbers of trades or contracts. The most popular timeframes are :

·         Time

·         Tick (Number of trades)

·         Volume (Number of contracts)

·         Price Range

Reading Trading Charts

Each chart type displays its information slightly differently, so they are read and interpreted slightly differently during trading. Detailed tutorials with examples of real charts are available for each chart type :

• How To Read a Bar Chart
• How To Read a Candlestick Chart
• How To Read a Line Chart

Charting Software

Day traders use charting software to create and view their charts. Most day trading brokerages provide charting software, but many day traders prefer to use additional charting software. Some of the most popular brokerage provided charting software, and additional charting software, are :

·         Sierra Chart

·         TradeStation

·         ESignal

·         TradeMaven

All of the above charting software include bar, candlestick, and line charts, and allow the charts to be customized according to the trader's preference.

How To Read a Line Chart

Line charts are not the most popular trading charts, because of the limited trading information that they represent, but they are easy to read and interpret.

Line charts consist of individual points, that are connected with straight lines. Usually, each point shows the close of the timeframe, but this can usually be modified to show any one of the open, high, or low. Line charts also show the direction (upward or downward) of the timeframe.

 Here's How:

1.        Open - The open is the first price traded during the timeframe, and if the line chart is setup to show the open, it is indicated by the points on the line that correspond to the timeframe (e.g. every 1 minute).

2.        High - The high is the highest price traded during the timeframe, and if the line chart is setup to show the high, it is indicated by the points on the line that correspond to the timeframe (e.g. every 1 minute).

3.        Low - The low is the lowest price traded during the timeframe, and if the line chart is setup to show the low, it is indicated by the points on the line that correspond to the timeframe (e.g. every 1 minute).

4.        Close - The close is the last price traded during the timeframe, and if the line chart is setup to show the close, it is indicated by the points on the line that correspond to the timeframe (e.g. every 1 minute).

5.        Direction - The direction of the line is indicated by the locations of the points. For example, if the most recent point is above the previous point, the timeframe has been an upward timeframe, and if the most recent point is below the previous point, the timeframe has been a downward timeframe.

How To Read a Candlestick Chart

Candlestick charts are one of the two most popular trading charts, because of the range of trading information that they represent, and their ease of reading and interpretation.

Candlestick charts consist of a wide vertical line, and a narrow vertical line. Each candlestick includes the open, high, low, and close, of the timeframe, and also shows the direction (upward or downward), and the range of the timeframe.

 Here's How:

1.        Open - The open is the first price traded during the candlestick, and is indicated by either the top or bottom of the wide vertical line (the bottom for an upward candlestick, and the top for a downward candlestick). In the example chart, the upward candlesticks are colored green, and the downward candlesticks are colored red.

2.        High - The high is the highest price traded during the candlestick, and is indicated by the top of the thin vertical bar (the wick of the candlestick).

3.        Low - The low is the lowest price traded during the candlestick, and is indicated by the bottom of the thin vertical bar (the upside down wick of the candlestick).

4.        Close - The close is the last price traded during the candlestick, and is indicated by either the top or bottom of the wide vertical line (the top for an upward candlestick, and the bottom for a downward candlestick). In the example chart, the upward candlesticks are colored green, and the downward candlesticks are colored red.

5.        Direction - The direction of the candlestick is indicated by the color of the candlestick (specifically the wide vertical line). Usually, if the candlestick is green, the candlestick is an upward candlestick, and if the candlestick is red, the candlestick is a downward candlestick, but these colors can usually be customized. In the example chart, the upward candlesticks are colored green, and the downward candlesticks are colored red.

6.        Range - The range of the candlestick is indicated by the locations of the top and bottom of the thin vertical line (the wicks). The range is calculated by subtracting the low from the high (Range = High - Low).

How To Read a Bar Chart

Bar charts are one of the two most popular trading charts, because of the range of trading information that they represent, and their ease of reading and interpretation.

Bar charts consist of an opening foot, a vertical line, and a closing foot. Each bar includes the open, high, low, and close, of the timeframe, and also shows the direction (upward or downward), and the range of the timeframe.

Here's How:

1.        Open - The open is the first price traded during the bar, and is indicated by the horizontal foot on the left side of the bar. In the example chart, the opening foot is colored blue.

2.        High - The high is the highest price traded during the bar, and is indicated by the top of the vertical bar. In the example chart, the vertical bar is colored green or red.

3.        Low - The low is the lowest price traded during the bar, and is indicated by the bottom of the vertical bar. In the example chart, the vertical bar is colored green or red.

4.        Close - The close is the last price traded during the bar, and is indicated by the horizontal foot on the right side of the bar. In the example chart, the closing foot is colored yellow.

5.        Direction - The direction of the bar is indicated by the locations of the opening and closing feet. If the closing foot is above the opening foot, the bar is an upward bar, and if the closing foot is below the opening foot, the bar is a downward bar. In the example chart, the upward bars are colored green, and the downward bars are colored red.

6.        Range - The range of the bar is indicated by the locations of the top and bottom of the bar. The range is calculated by subtracting the low from the high (Range = High - Low).

What is Day Trading?

Day trading (and trading in general) is the buying and selling of various financial instruments, such as futures, options, currencies, and stocks, with the goal of making a profit from the difference between the buying price and the selling price. Day trading differs slightly from other styles of trading in that positions are rarely (if ever) held overnight or when the market being traded is closed.

Day trading was originally only available to financial companies (such as banks), because only they had access to the exchanges and market data. But with recent technology such as the Internet, individual traders now have direct access to the same exchanges and market data, and can make the same trades at very low cost.

Trading Styles

There are several different styles of day trading, suited to different day trader personalities. The styles range from short term trading such as scalping where positions are only held for a few seconds or minutes, to longer term swing andposition trading where a position may be held throughout the trading day. Most day trading systems have a lot of flexibility, and can have open positions for anywhere from a few minutes to a few hours, depending upon how the trade is doing (whether it is in profit). Some day traders will trade multiple styles, but most traders will choose a single style and only take that type of trade.

Day trading also has different types of trade, such as trend trades, counter-trend trades, and ranging trades. Trend trades are trades in the direction of the current price movement (i.e. buying if the price is moving up), and counter-trend trades are trades against the direction of the current price movement (i.e. selling if the price is moving up). Ranging trades are trades that go back and forth between two prices, and are used when the market is moving sideways. Most day traders will choose a single type of trade, but some traders will take different types, and choose which one to trade depending upon the current condition of the market.

In addition to the style and type of day trading, there are other variances between day traders. Some day traders like to make many trades throughout the trading day, while others prefer to wait for what they consider the best conditions for their trade, and perhaps only make one trade per day. However many trades are made, the trading process that is used, and the desired goal of making a profit, are the same.

Markets

There are many different financial instruments, or markets, that can be day traded, and they are offered by various exchanges throughout the world. The main types of day trading markets are futures, options, currencies, and stock markets. Within these types, there are groups of markets based on stock indexes (such as the Dow Jones, and the DAX), currency exchange rates (such as the Euro to US Dollar exchange rate), and commodities (such as gold, and oil). Day traders can have access to all of the exchanges and their markets via direct access brokers, so called because they offer direct access to the exchange, which provides faster trade execution at lower cost. 

Fundamental Analysis: Conclusion

Whenever you’re thinking of investing in a company it is vital that you understand what it does, its market and the industry in which it operates. You should never blindly invest in a company.

One of the most important areas for any investor to look at when researching a company is the financial statements. It is essential to understand the purpose of each part of these statements and how to interpret them.

Let's recap what we've learned:

• Financial reports are required by law and are published both quarterly and annually.
• Management discussion and analysis (MD&A) gives investors a better understanding of what the company does and usually points out some key areas where it performed well.
• Audited financial reports have much more credibility than unaudited ones.
• The balance sheet lists the assets, liabilities and shareholders' equity.
• For all balance sheets: Assets = Liabilities + Shareholders’ Equity. The two sides must always equal each other (or balance each other).
• The income statement includes figures such as revenue, expenses, earnings and earnings per share.
• For a company, the top line is revenue while the bottom line is net income.
• The income statement takes into account some non-cash items, such as depreciation.
• The cash flow statement strips away all non-cash items and tells you how much actual money the company generated.
• The cash flow statement is divided into three parts: cash from operations, financing and investing.
• Always read the notes to the financial statements. They provide more in-depth information on a wide range of figures reported in the three financial statements.

Fundamental Analysis: A Brief Introduction To Valuation

While the concept behind discounted cash flow analysis is simple, its practical application can be a different matter. The premise of the discounted cash flow method is that the current value of a company is simply the present value of its future cash flows that are attributable to shareholders. Its calculation is as follows:


For simplicity's sake, if we know that a company will generate $1 per share in cash flow for shareholders every year into the future; we can calculate what this type of cash flow is worth today. This value is then compared to the current value of the company to determine whether the company is a good investment, based on it being undervalued or overvalued.

There are several different techniques within the discounted cash flow realm of valuation, essentially differing on what type of cash flow is used in the analysis. The dividend discount model focuses on the dividends the company pays to shareholders, while the cash flow model looks at the cash that can be paid to shareholders after all expenses, reinvestments and debt repayments have been made. But conceptually they are the same, as it is the present value of these streams that are taken into consideration.

As we mentioned before, the difficulty lies in the implementation of the model as there are a considerable amount of estimates and assumptions that go into the model. As you can imagine, forecasting the revenue and expenses for a firm five or 10 years into the future can be considerably difficult. Nevertheless, DCF is a valuable tool used by both analysts and everyday investors to estimate a company's value.



Ratio Valuation Financial ratios are mathematical calculations using figures mainly from the financial statements, and they are used to gain an idea of a company's valuation and financial performance. Some of the most well-known valuation ratios areprice-to-earnings and price-to-book. Each valuation ratio uses different measures in its calculations. For example, price-to-book compares the price per share to the company's book value.

The calculations produced by the valuation ratios are used to gain some understanding of the company's value. The ratios are compared on an absolute basis, in which there are threshold values. For example, in price-to-book, companies trading below '1' are considered undervalued. Valuation ratios are also compared to the historical values of the ratio for the company, along with comparisons to competitors and the overall market itself.

Fundamental Analysis: Introduction to Financial Statements

The massive amount of numbers in a company's financial statements can be bewildering and intimidating to many investors. On the other hand, if you know how to analyze them, the financial statements are a gold mine of information.

Financial statements are the medium by which a company discloses information concerning its financial performance. Followers of fundamental analysis use the quantitative information gleaned from financial statements to make investment decisions. Before we jump into the specifics of the three most important financial statements -income statements, balance sheets and cash flow statements - we will briefly introduce each financial statement's specific function, along with where they can be found.

The Major Statements The Balance Sheet The balance sheet represents a record of a company's assets, liabilities and equity at a particular point in time. The balance sheet is named by the fact that a business's financial structure balances in the following manner:

Assets = Liabilities + Shareholders' Equity

Assets represent the resources that the business owns or controls at a given point in time. This includes items such as cash, inventory, machinery and buildings. The other side of the equation represents the total value of the financing the company has used to acquire those assets. Financing comes as a result of liabilities or equity. Liabilities represent debt (which of course must be paid back), while equity represents the total value of money that the owners have contributed to the business - including retained earnings, which is the profit made in previous years.

The Income Statement While the balance sheet takes a snapshot approach in examining a business, the income statement measures a company's performance over a specific time frame. Technically, you could have a balance sheet for a month or even a day, but you'll only see public companies report quarterly and annually.

The income statement presents information about revenues, expenses and profit that was generated as a result of the business' operations for that period.

Statement of Cash Flows The statement of cash flows represents a record of a business' cash inflows and outflows over a period of time. Typically, a statement of cash flows focuses on the following cash-related activities:

•  Operating Cash Flow (OCF): Cash generated from day-to-day business operations
•  Cash from investing (CFI): Cash used for investing in assets, as well as the proceeds from the sale of other businesses, equipment or long-term assets
•  Cash from financing (CFF): Cash paid or received from the issuing and borrowing of funds

The cash flow statement is important because it's very difficult for a business to manipulate its cash situation. There is plenty that aggressive accountants can do to manipulate earnings, but it's tough to fake cash in the bank. For this reason some investors use the cash flow statement as a more conservative measure of a company's performance.

10-K and 10-Q Now that you have an understanding of what the three financial statements represent, let's discuss where an investor can go about finding them. In the United States, the Securities And Exchange Commission (SEC) requires all companies that are publicly traded on a major exchange to submit periodic filings detailing their financial activities, including the financial statements mentioned above.

Some other pieces of information that are also required are an auditor's report, management discussion and analysis (MD&A) and a relatively detailed description of the company's operations and prospects for the upcoming year.

All of this information can be found in the business' annual 10-K and quarterly 10-Q filings, which are released by the company's management and can be found on the internet or in physical form.

The 10-K is an annual filing that discloses a business's performance over the course of the fiscal year. In addition to finding a business's financial statements for the most recent year, investors also have access to the business's historical financial measures, along with information detailing the operations of the business. This includes a lot of information, such as the number of employees, biographies of upper management, risks, future plans for growth, etc.

Businesses also release an annual report, which some people also refer to as the 10-K. The annual report is essentially the 10-K released in a fancier marketing format. It will include much of the same information, but not all, that you can find in the 10-K. The 10-K really is boring - it's just pages and pages of numbers, text and legalese. But just because it's boring doesn't mean it isn't useful. There is a lot of good information in a 10-K, and it's required reading for any serious investor.

You can think of the 10-Q filing as a smaller version of a 10-K. It reports the company's performance after each fiscal quarter. Each year three 10-Q filings are released - one for each of the first three quarters. (Note: There is no 10-Q for the fourth quarter, because the 10-K filing is released during that time). Unlike the 10-K filing, 10-Q filings are not required to be audited. Here's a tip if you have trouble remembering which is which: think "Q" for quarter. 

Fundamental Analysis: Qualitative Factors - The Industry

Each industry has differences in terms of its customer base, market share among firms, industry-wide growth, competition, regulation and business cycles. Learning about how the industry works will give an investor a deeper understanding of a company's financial health. 


Customers Some companies serve only a handful of customers, while others serve millions. In general, it's a red flag (a negative) if a business relies on a small number of customers for a large portion of its sales because the loss of each customer could dramatically affect revenues. For example, think of a military supplier who has 100% of its sales with the U.S. government. One change in government policy could potentially wipe out all of its sales. For this reason, companies will always disclose in their 10-K if any one customer accounts for a majority of revenues.

Market Share Understanding a company's present market share can tell volumes about the company's business. The fact that a company possesses an 85% market share tells you that it is the largest player in its market by far. Furthermore, this could also suggest that the company possesses some sort of "economic moat," in other words, a competitive barrier serving to protect its current and future earnings, along with its market share. Market share is important because of economies of scale. When the firm is bigger than the rest of its rivals, it is in a better position to absorb the high fixed costs of a capital-intensive industry.

Industry Growth One way of examining a company's growth potential is to first examine whether the amount of customers in the overall market will grow. This is crucial because without new customers, a company has to steal market share in order to grow.

In some markets, there is zero or negative growth, a factor demanding careful consideration. For example, a manufacturing company dedicated solely to creating audio compact cassettes might have been very successful in the '70s, '80s and early '90s. However, that same company would probably have a rough time now due to the advent of newer technologies, such as CDs and MP3s. The current market for audio compact cassettes is only a fraction of what it was during the peak of its popularity.

Competition Simply looking at the number of competitors goes a long way in understanding the competitive landscape for a company. Industries that have limited barriers to entry and a large number of competing firms create a difficult operating environment for firms.

One of the biggest risks within a highly competitive industry is pricing power. This refers to the ability of a supplier to increase prices and pass those costs on to customers. Companies operating in industries with few alternatives have the ability to pass on costs to their customers. A great example of this is Wal-Mart. They are so dominant in the retailing business, that Wal-Mart practically sets the price for any of the suppliers wanting to do business with them. If you want to sell to Wal-Mart, you have little, if any, pricing power.

Regulation Certain industries are heavily regulated due to the importance or severity of the industry's products and/or services. As important as some of these regulations are to the public, they can drastically affect the attractiveness of a company for investment purposes.

In industries where one or two companies represent the entire industry for a region (such as utility companies), governments usually specify how much profit each company can make. In these instances, while there is the potential for sizable profits, they are limited due to regulation.

In other industries, regulation can play a less direct role in affecting industry pricing. For example, the drug industry is one of most regulated industries. And for good reason - no one wants an ineffective drug that causes deaths to reach the market. As a result, the U.S. Food and Drug Administration (FDA) requires that new drugs must pass a series of clinical trials before they can be sold and distributed to the general public. However, the consequence of all this testing is that it usually takes several years and millions of dollars before a drug is approved. Keep in mind that all these costs are above and beyond the millions that the drug company has spent on research and development.

All in all, investors should always be on the lookout for regulations that could potentially have a material impact upon a business' bottom line. Investors should keep these regulatory costs in mind as they assess the potential risks and rewards of investing. 

Fundamental Analysis: Qualitative Factors - The Company

Fundamental analysis seeks to determine the intrinsic value of a company's stock. But since qualitative factors, by definition, represent aspects of a company's business that are difficult or impossible to quantify, incorporating that kind of information into a pricing evaluation can be quite difficult. On the flip side, as we've demonstrated, you can't ignore the less tangible characteristics of a company.

In this section we are going to highlight some of the company-specific qualitative factors that you should be aware of.

Business Model
Even before an investor looks at a company's financial statements or does any research, one of the most important questions that should be asked is: What exactly does the company do? This is referred to as a company's business model – it's how a company makes money. You can get a good overview of a company's business model by checking out its website or reading the first part of its 10-K filing (Note: We'll get into more detail about the 10-K in the financial statements chapter. For now, just bear with us).

Sometimes business models are easy to understand. Take McDonalds, for instance, which sells hamburgers, fries, soft drinks, salads and whatever other new special they are promoting at the time. It's a simple model, easy enough for anybody to understand.

Other times, you'd be surprised how complicated it can get. Boston Chicken Inc. is a prime example of this. Back in the early '90s its stock was the darling of Wall Street. At one point the company's CEO bragged that they were the "first new fast-food restaurant to reach $1 billion in sales since 1969". The problem is, they didn't make money by selling chicken. Rather, they made their money from royalty fees and high-interest loans to franchisees. Boston Chicken was really nothing more than a big franchisor. On top of this, management was aggressive with how it recognized its revenue. As soon as it was revealed that all the franchisees were losing money, the house of cards collapsed and the company went bankrupt.

At the very least, you should understand the business model of any company you invest in. The "Oracle of Omaha", Warren Buffett, rarely invests in tech stocks because most of the time he doesn't understand them. This is not to say the technology sector is bad, but it's not Buffett's area of expertise; he doesn't feel comfortable investing in this area. Similarly, unless you understand a company's business model, you don't know what the drivers are for future growth, and you leave yourself vulnerable to being blindsided like shareholders of Boston Chicken were.

Competitive Advantage Another business consideration for investors is competitive advantage. A company's long-term success is driven largely by its ability to maintain a competitive advantage - and keep it. Powerful competitive advantages, such as Coca Cola's brand name and Microsoft's domination of the personal computer operating system, create a moat around a business allowing it to keep competitors at bay and enjoy growth and profits. When a company can achieve competitive advantage, its shareholders can be well rewarded for decades.

Harvard Business School professor Michael Porter, distinguishes between strategic positioning and operational effectiveness. Operational effectiveness means a company is better than rivals at similar activities while competitive advantage means a company is performing better than rivals by doing different activities or performing similar activities in different ways. Investors should know that few companies are able to compete successfully for long if they are doing the same things as their competitors. Professor Porter argues that, in general, sustainable competitive advantage gained by: A unique competitive position Clear tradeoffs and choices vis-à-vis competitors Activities tailored to the company's strategy A high degree of fit across activities (it is the activity system, not the parts, that ensure sustainability) A high degree of operational effectiveness

Management Just as an army needs a general to lead it to victory, a company relies upon management to steer it towards financial success. Some believe that management is the most important aspect for investing in a company. It makes sense - even the best business model is doomed if the leaders of the company fail to properly execute the plan.

So how does an average investor go about evaluating the management of a company?

This is one of the areas in which individuals are truly at a disadvantage compared to professional investors. You can't set up a meeting with management if you want to invest a few thousand dollars. On the other hand, if you are a fund manager interested in investing millions of dollars, there is a good chance you can schedule a face-to-face meeting with the upper brass of the firm.

Every public company has a corporate information section on its website. Usually there will be a quick biography on each executive with their employment history, educational background and any applicable achievements. Don't expect to find anything useful here. Let's be honest: We're looking for dirt, and no company is going to put negative information on its corporate website.

Instead, here are a few ways for you to get a feel for management:

1. Conference Calls
The Chief Executive Officer (CEO) and Chief Financial Officer (CFO) host quarterly conference calls. (Sometimes you'll get other executives as well.) The first portion of the call is management basically reading off the financial results. What is really interesting is the question-and-answer portion of the call. This is when the line is open for analysts to call in and ask management direct questions. Answers here can be revealing about the company, but more importantly, listen for candor. Do they avoid questions, like politicians, or do they provide forthright answers?

2. Management Discussion and Analysis (MD&A) The Management Discussion and Analysis is found at the beginning of the annual report . In theory, the MD&A is supposed to be frank commentary on the management's outlook. Sometimes the content is worthwhile, other times it's boilerplate. One tip is to compare what management said in past years with what they are saying now. Is it the same material rehashed? Have strategies actually been implemented? If possible, sit down and read the last five years of MD&As; it can be illuminating.

3. Ownership and Insider Sales Just about any large company will compensate executives with a combination of cash, restricted stock and options. While there are problems with stock options, it is a positive sign that members of management are also shareholders. The ideal situation is when the founder of the company is still in charge. Examples include Bill Gates (in the '80s and '90s), Michael Dell and Warren Buffett. When you know that a majority of management's wealth is in the stock, you can have confidence that they will do the right thing. As well, it's worth checking out if management has been selling its stock. This has to be filed with the Securities and Exchange Commission (SEC), so it's publicly available information. Talk is cheap - think twice if you see management unloading all of its shares while saying something else in the media.

4. Past Performance Another good way to get a feel for management capability is to check and see how executives have done at other companies in the past. You can normally find biographies of top executives on company web sites. Identify the companies they worked at in the past and do a search on those companies and their performance.



Corporate Governance Corporate governance describes the policies in place within an organization denoting the relationships and responsibilities between management, directors and stakeholders. These policies are defined and determined in the company charter and its bylaws, along with corporate laws and regulations. The purpose of corporate governance policies is to ensure that proper checks and balances are in place, making it more difficult for anyone to conduct unethical and illegal activities.

Good corporate governance is a situation in which a company complies with all of its governance policies and applicable government regulations (such as the Sarbanes-Oxley Act of 2002) in order to look out for the interests of the company's investors and other stakeholders.

Although, there are companies and organizations (such as Standard & Poor's) that attempt to quantitatively assess companies on how well their corporate governance policies serve stakeholders, most of these reports are quite expensive for the average investor to purchase.

Fortunately, corporate governance policies typically cover a few general areas: structure of the board of directors, stakeholder rights and financial and information transparency. With a little research and the right questions in mind, investors can get a good idea about a company's corporate governance.

Financial and Information Transparency This aspect of governance relates to the quality and timeliness of a company's financial disclosures and operational happenings. Sufficient transparency implies that a company's financial releases are written in a manner that stakeholders can follow what management is doing and therefore have a clear understanding of the company's current financial situation.

Stakeholder Rights This aspect of corporate governance examines the extent that a company's policies are benefiting stakeholder interests, notably shareholder interests. Ultimately, as owners of the company, shareholders should have some access to the board of directors if they have concerns or want something addressed. Therefore companies with good governance give shareholders a certain amount of ownership voting rights to call meetings to discuss pressing issues with the board.

Another relevant area for good governance, in terms of ownership rights, is whether or not a company possesses large amounts of takeover defenses (such as the Macaroni Defense or the Poison Pill) or other measures that make it difficult for changes in management, directors and ownership to occur.

Structure of the Board of Directors The board of directors is composed of representatives from the company and representatives from outside of the company. The combination of inside and outside directors attempts to provide an independent assessment of management's performance, making sure that the interests of shareholders are represented.

The key word when looking at the board of directors is independence. The board of directors is responsible for protecting shareholder interests and ensuring that the upper management of the company is doing the same. The board possesses the right to hire and fire members of the board on behalf of the shareholders. A board filled with insiders will often not serve as objective critics of management and will defend their actions as good and beneficial, regardless of the circumstances.

Information on the board of directors of a publicly traded company (such as biographies of individual board members and compensation-related info) can be found in the DEF 14A proxy statement.

We've now gone over the business model, management and corporate governance. These three areas are all important to consider when analyzing any company. We will now move on to looking at qualitative factors in the environment in which the company operates.