Successful long-term trading - investing with the intention of holding a security for one year or more - means paying attention to the big picture, even when a grim short-term outlook sends investors running for the exits. In other words, buy-and-hold investing requires focus, patience and, most importantly, discipline. In order to succeed, investors must avoid getting caught up in violent market swings or other short-term influences, and invest in stocks that they feel comfortable holding for the long term. Let's take a look at how to find these stocks using both fundamental and contrarian indicators.
Fundamental indicators are among the key tools used in long-term trading. Fundamental analysis is one way to determine whether a stock is undervalued or overvalued. It involves looking at a company's earnings, cash flow and other financial benchmarks in relation to its industry and to the overall stock market, its historic growth and future growth potential, among other factors.
Good Fundamental Indicators
Many good indicators can help you determine whether a stock is a good long-term buy. These include:
- Price/Earnings Ratio (P/E)
A price earnings (P/E) ratio is calculated by dividing the price of the stock by the earnings per share (EPS). A company that has a higher P/E ratio compared to its competitors or the industry could mean that investors are paying more for every dollar of earnings, which suggests that the stock is overvalued. A lower number compared to the company's competitors or industry might signal that the stock is undervalued.
Contrarians believe that the crowd is always wrong, and that when everyone is overwhelmingly optimistic, it is time to sell stocks and take profits or to focus purchases in neglected corners of the market. On the other hand, contrarians believe investor pessimism presents opportunities to purchase overlooked stocks at low valuations. The key is to wait until everyone feels certain about something and then do the opposite. Successful outcomes can sometimes take a year or more to develop, so the strategy requires patience. Contrarian indicators such as those below should be used with other tools to spot good long-term buys.
- Short Interest
Short interest is the number of shares sold short that have not been repurchased. This is a good contrarian indicator because it shows how pessimistic investors are about a particular stock. It can be a useful tool in long-term trading, as steadily rising short interest could be a sign that the stock is becoming undervalued due to excessive fear. When using this indicator, look at the short interest ratio to gauge investor pessimism. The higher it is, the more pessimistic investors are about the stock.
The Bottom Line
Successful long-term trading requires that you have a time horizon of one year or more and be willing to focus on the big picture. Investors can use fundamental indicators, such as the price-earnings ratio, book value, cash flow and debt, to determine whether a company is financially sound and if its stock is trading at an attractive price. Contrarian indicators, such as short interest and the put-call ratio, can gauge how optimistic or pessimistic investors are, and can be used in conjunction with fundamental indicators to find a good long-term buy.
More From Investopedia
- 5 Things To Know About Asset Allocation
- Learn To Invest In 10 Steps
- 10 Tips For Choosing An Online Broker