Getting promising candidates from a stock scanner is just the first step in your trading journey. It’s important to understand that a stock scanner is not a complete buy/sell system – think of it as your initial filter. To make well-informed trading decisions, you need additional confirmation methods before considering any position.
Before analyzing chart patterns and setups, it’s crucial to evaluate whether a stock meets your risk management criteria. Let me share the key factors you should examine to determine if a stock is suitable for trading:
1) Enough Trades Per Second
A sufficient number of trades per second (TPS) is essential – it ensures the stock’s activity is sustainable and indicates potential momentum continuation. One of the most challenging situations traders face is being trapped in a position with low trading activity, where it becomes difficult to exit at a favorable price.
If you’ve reviewed our earlier section on TPS metrics, you’ll recall that a minimum of 1 trade per second is absolutely crucial (even better: a minimum of 10 TPS). Any stock falling below this threshold should be automatically eliminated from your watchlist. Low TPS indicates insufficient market liquidity, which can lead to:
- Difficulty executing trades at desired prices
- Increased slippage
- Limited momentum potential
While our MomentumDetector scanner identifies stocks making daily highs and lows with adequate TPS, it’s vital to verify this metric on your charts before entering any position. You will find more information on how to setup your software to display the number of trades per second on your chart in the education category of this blog.
2) Small Horizontal Spread:
Let’s consider a hypothetical example with stock ABCD’s Level 2 data showing price levels:
A tight spread between the best bid and ask prices is crucial for successful trading. This narrow spread ensures you can exit your long positions by hitting the bid with minimal price impact. For stocks trading in our target range of $1 to $20, here’s what to look for:
Acceptable Spread Range for a stock < $20:
- Ideal: $0.01 – $0.02 (as shown in our left example)
- Maximum acceptable: up to $0.05/$ 0.1
- Warning zone: Above $0.1
- Avoid: Spreads of $0.46 (like our right example) indicate erratic price movement and high risk
Remember: Wide spreads often signal irregular price patterns and increased trading risk. They typically result in larger slippage and can significantly impact your trading profits. Always verify the spread before entering a position – it’s a key indicator of a stock’s tradability.
3) Small Vertical Spread:
When analyzing Level 2 data, pay close attention to the price gaps between bid levels. The closer these price levels are to each other, the better. Let’s look at our example stock ABCD: In the favorable scenario on the left, the best bid is $3.95, with the next bid level at $3.90 – a minimal gap of $0.05. This tight spacing indicates excellent liquidity.
However, when price gaps between bid levels are large, you’re looking at a potentially dangerous situation. Take the right-side example of ABCD, where the best bid is $3.50 and the next level drops to $3.11 – a concerning gap of $0.39. Such wide spreads create significant risk, as the bid price can collapse quickly, leading to substantial slippage when exiting a long position.
Low-float stocks present an interesting case. Under normal conditions, they typically show three unfavorable characteristics: low trading frequency, large vertical spreads, and wide horizontal price level gaps. However, when these stocks catch fire, these same indicators can flip to optimal levels – signaling that the stock is active and primed for movement.
This behavior contrasts sharply with high-cap stocks like Tesla or Apple, where these criteria matter less. Their Level 2 order books are consistently thick with activity, making significant price movements rare. You’re unlikely to see the explosive moves common in our more volatile stock picks.
4) News Supporting the Move:
Always verify if there’s fundamental news driving a stock’s momentum. Recent press releases, earnings reports, or other significant announcements can explain and validate price movements, adding another layer of confidence to your trading decisions.
Conclusion:
For optimal risk management, focus your trading on low-float stocks that demonstrate three key characteristics:
- High trading frequency (numerous trades per second)
- Minimal spreads between price levels in the order book
- Ideally, backed by concrete news catalysts
This strategic approach helps minimize trading risks while ensuring you’re participating in actively traded securities with genuine market interest. By following these criteria, you’re better positioned to execute trades efficiently and reduce the likelihood of getting caught in illiquid positions.