Fundamental trading is a method where a trader focuses on company-specific events to determine which stock to buy and when to buy it. Trading on fundamentals is more closely associated with a buy-and-hold strategy rather than short-term trading. There are, however, specific instances where trading on fundamentals can generate substantial profits in a short period.
Different Types of Traders
Before we focus on fundamental trading, here's a review of the main types of equity trading:
- Scalping: A scalper is an individual who makes dozens or hundreds of trades per day in an attempt to "scalp" a small profit from each trade by exploiting the bid-ask spread.
- Momentum Trading: Momentum traders seek stocks that are moving significantly in one direction in high volume. These traders attempt to ride the momentum to the desired profit.
- Technical Trading: Technical traders focus on charts and graphs. They analyze lines on stock or index graphs for signs of convergence or divergence that might indicate buy or sell signals.
- Fundamental Trading: Fundamentalists trade companies based on fundamental analysis, which examines corporate events, particularly actual or anticipated earnings reports, stock splits, reorganizations, or acquisitions.
- Swing Trading: Swing traders are fundamental traders who hold their positions longer than a single day. Most fundamentalists are really swing trading since changes in corporate fundamentals typically require several days or even weeks to produce a price movement sufficient for the trader to claim a reasonable profit.
Novice traders might experiment with each of these techniques, but they should ultimately settle on a single niche matching their investing knowledge and experience with a style to which they are motivated to devote further research, education, and practice.
Fundamental Data and Trading
Most equity investors are aware of the most common financial data used in the fundamental analysis including earnings per share (EPS), revenue, and cash flow. These quantitative factors include any figures found on a company's earnings report, cash flow statement, or balance sheet. They can also include the results of financial ratios such as return-on-equity (ROE) and debt to equity (D/E). Fundamental traders may use such quantitative data to identify trading opportunities if, for example, a company issues earnings results that catch the market by surprise.
Two of the most closely watched fundamental factors for traders and investors everywhere are earnings announcements and analyst upgrades and downgrades. Gaining an edge on such information, however, is difficult since there are literally millions of eyes on Wall Street looking for that very same advantage.
The most important component of earnings announcements is the pre-announcement phase—the time when a company issues a statement stating whether it will meet, exceed, or fail to meet earnings expectations. Trades often occur immediately after such an announcement because a short-term momentum opportunity will likely be available.
Analyst Upgrades and Downgrades
Similarly, analyst upgrades and downgrades may present a short-term trading opportunity, particularly when a prominent analyst unexpectedly downgrades a stock. The price action in this situation can be similar to a rock dropping from a cliff, so the trader must be quick and nimble with his short selling.
Earnings announcements and analyst ratings are also closely associated with momentum trading. Momentum traders look for unexpected events that cause a stock to trade a large volume of shares and move steadily either up or down.
The fundamental trader is often more concerned with obtaining information on speculative events that the rest of the market may lack. To stay one step ahead of the market, astute traders can often use their knowledge of historical trading patterns that occur during the advent of stock splits, acquisitions, takeovers, and reorganizations.
When a $20 stock splits 2-for-1, the company's market capitalization does not change, but the company now has double the number of shares outstanding each at a $10 stock price. Many investors believe that since investors will be more inclined to purchase a $10 stock than they would a $20 stock, a stock split portends an increase in the company's market capitalization. However, remember that this fundamentally does not change the value of the company.
To trade stock splits successfully, a trader must, above all, correctly identify the phase at which the stock is currently trading. History has proven that a number of specific trading patterns occur before and after a split announcement. Price appreciation and, therefore, short-term buying opportunities will generally occur in the pre-announcement phase and the pre-split run-up, and price depreciation (shorting opportunities) will occur in the post-announcement depression and post-split depression. By identifying these four phases correctly, a split trader can actually trade in and out of the same stock at least four separate times before and after the split with perhaps many more intraday or even hour-by-hour trades.
Acquisitions, Takeovers, and More
The old adage "buy on the rumor, sell on the news," applies to those trading in acquisitions, takeovers, and reorganizations. In these cases, a stock will often experience extreme price increases in the speculation phase leading up to the event and significant declines immediately after the event is announced.
That said, the old investor's adage "sell on news" needs to be qualified significantly for the astute trader. A trader's game is to be one step ahead of the market. Thus, the trader is unlikely to buy stock in a speculative phase and hold it all the way to the actual announcement. The trader is concerned with capturing some of the momenta in the speculative phase and may trade in and out of the same stock several times as the rumormongers go to work. The trader may hold a long position in the morning and short in the afternoon being ever watchful of charts and Level 2 data for signs of when to change position.
When the actual announcement is made, the trader will likely have the opportunity to short the stock of the acquiring company immediately after it issues news of its intent to acquire, thereby ending the speculative euphoria leading up to the announcement. Rarely is an acquisition announcement seen positively, so shorting a company that is doing the acquiring is a twofold sound strategy.
By contrast, a corporate reorganization is likely to be viewed positively if it was not anticipated by the market and if the stock had already been on a long-term slide due to internal corporate troubles. If a board of directors suddenly ousts an unpopular CEO, for example, a stock may exhibit short-term upward movement in celebration of the news.
Trading the stock of a takeover target is a special case since a takeover offer will have an associated price per share. A trader should be careful to avoid getting stuck holding stock at or near the offer price because shares will generally not move significantly in the short term once they find their narrow range near the target. Particularly in the case of a rumored takeover, the best trading opportunities will be in the speculative phase (or the period when a rumored price per share for the takeover offer will drive actual price movement).
Rumor and speculation are risky trading propositions, particularly in the case of acquisitions, takeovers, and reorganizations. These events create extreme stock-price volatility. However, because of the potential for rapid price movements, these events also potentially serve as the most lucrative fundamental trading opportunities available.
The Bottom Line
Many trading strategists use sophisticated models for trading opportunities associated with events leading up to and following earnings announcements, analyst upgrades and downgrades, stock splits, acquisitions, takeovers, and reorganizations. These charts resemble the charts used in technical analysis but lack mathematical sophistication. The charts are simple pattern charts. They display historical patterns of trading behaviors that occur close to these events, and these patterns are used as guides for predictions on short-term movements in the present.
If fundamental traders correctly identify the current position of stocks and subsequent price movements that are likely to occur, they stand a good chance of executing successful trades. Trading on fundamentals may be risky in cases of euphoria and hype, but the astute trader can mitigate risk by using historical patterns to guide their short-term trading. In short, investors should do their homework before jumping in.