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How to trade.  Part 1 A complete beginners guide to the concepts of trading 

 

Welcome  Ioana. Here is complete guide to the concepts of trading the stock market.  I have endeavoured to create a full and complete guide to take you through the learning curve of being a complete beginner to become a knowledgeable stock market expert.

 

Each section contains some questions with multiple choice answers.

 

 Preface

 

I was once a beginner too, and I made many mistakes along the way.

 

To give you a basic idea of how it all started, I received my first taste of trading shares by complete accident as I was given 100 free shares of Abbey National at 100 pence each ( £1 English ) which was worth £100. Abbey National was a local bank which floated on the stock market and everyone who had an bank account with them  was awarded shares.  Some years later I sold them for £2.74 and was very pleased about it.  I didn't know it at the time but this planted a seed inside me and here I find myself now as a full time professional trader doing very well. 

 

En-route to my success was a year of horrible pain where I had turned £6,000 into £47,000 in around 6 months trading "traditional options" and then lost the whole lot in a single one month nightmare during the "Brown Monday" event of 1997. 

 

At the time this was a most unpleasant experience I will never forget, but now as I reflect on it, it proved to be the best thing that ever happened to me. If you are intelligent and you make mistakes, surely you will learn from them. Well this is just what I did. I embarked on a solid year of educating myself and going over my errors and successes to figure out what went wrong.

 

Since restarting with my new found knowledge and system which I developed I became an authority on controlling risk and making optimal use of funds.

 In the thirteen years since my disastrous experience I have never had a single losing year, and have netted over 25,453% return. The most productive year I returned over 16,000% return and the least productive year saw a 25% return. Averaged out this equates to 79% per year growth AFTER withdrawals for living expenses.

 

So, please enjoy your learning experience here and I hope you can benefit from learning from my mistakes and successes.

                                                                                                                                                                                                

 

How to trade  Part 1

 

 Methods to make money in trading.

  1. Buy to profit from a rise in prices ( This is known as being "long" or  having a "long position")

  2. Selling short to profit from a falling price ( This is known as being "short" or having a "short position" and involves selling something that you do not own, by method of borrowing it from someone else first and being charged a fee by the lender)

 With the first choice of buying we have a limited risk and this is the most common position a beginner trader will take on, simply he or she will not even be aware that you can also profit from a move down by short selling.  So lets go into some details.

 

You can basically buy anything in the hope of selling it at a higher price just as people do with properties etc. The stock market has many thousands of markets type that can be bought and sold.  The basic types of instruments one can trade are as follows.

  • Stocks or "shares" ( these are small pieces of companies and the more you buy the bigger your share of that company)

  • Commodities ( these are items such as corn, wheat, gold, silver, palladium, platinum, copper, oil, natural gas )

  • Forex ( foreign exchange, this is popular as the deposits or margins are very low and is trading of the currency of one country v another)

  • Derivatives. ( Derivatives means "derived from" and these products are derived from the basic products above. There are several types including

  • Futures ( these are assigned each month or each quarter and are the markets best guess at the "future price" of a stock or commodity or index )

  • Options ( this is a more complex topic which will be covered later in the guide )

  • ETF's ( exchange traded funds )

  • Indices ( these are made up of a group of shares such as the top 100 shares in England are bundled into an index called the Financial times share index or FT-SE 100 index )

Stocks & Shares are often the most common products that beginners like to trade, so lets go through some simple examples.

 

 First of all the definition of a stock is a company which is floated on the stock market and can be bought and sold freely with a single phone call or a press of a mouse on your pc. Shares are those small pieces of that company which people own. 

 

E.G  A company such as Apple , Microsoft or Vodaphone are called stocks.  These companies have shares, and each share has a value which will be always a constant percentage of the actual value of the underlying company.

 

If people own a company such as a small office furniture shop and they work hard on it and expand and grow so that this company is worth a million pounds or euros or more, then floating on the stock market might be a good choice for them to make.

 

We shall call this company Furniture bonanza. It has a value of £1 million pounds based on a multiple of five times what it earns in one year.

Last year it made a profit of £200,000 so it uses this multiplier or PE ratio ( price to earnings ratio )to calculate its value. A fast growing company will attract a higher PE ratio that a slow growing company.

 

Once the company decides to list ( float ) on the stock market it will offer a percentage of its value in shares to investors. In this example the directors of the company will retain 20% of the shares which leaves £800,000 worth of the company to be divided into shares.  The company decides to issue 100,000 shares which will have a floatation value of £10 each. ( £10 x 100,000 = £1 million ). Initial investors who buy these shares in the offer will be paying the company directly to own a piece of it.  Once all the shares have been bought by investors the floatation ( listing on the stock market ) is completed.

 

 The next thing that happens is that these share prices of 1000p ( £10) will be reported in the newspapers, internet and online stock brokers and people will be able to trade them.  In this example you will be hoping to buy some of these shares as you think they will rise in value.

 

Your first imaginary trade entry ( via a conventional stock broker )

 

You read in the papers that Furniture bonanza is listed on the stock market and you love their high quality luxury Italian leather sofas so you believe they will be a great investment. You call up a stock broker and enquire about buying some shares. 

First of all you will ask the price of Furniture bonanza shares and your broker will say 101 at  102 he is quoting you two prices. The lower price is the selling price and the higher price is the buying price.  There are two prices because the dealers who sell you the stock have to make a living and generate their profit by making a small percentage commission on the buy and sell price ( known as the bid - ask  prices) .

 

As you have already decided you want to buy, you say buy 1000 shares at 102 limit.  This means that you refuse to pay more than 102 and if there are only 500 shares available to buy at 102 you will not be able to get any more. Another thing you could say is buy 1000 shares at market. This means you do not place any limit on the maximum price you will pay for them.  Remember, you can only buy something if there is another person who wishes to sell it. 

 

To keep it simple in this example you can buy 1000 shares at 102 and your broker on the phone confirms he has bought 1000 shares at 102 pence each.

You will now be asked to pay for them and it will cost you 102 x 1000 = £1020 + commission ( which is £10 in this example ) You will be given three days to pay for the shares and send off your cheque to the broker.

 

Now you are content you got the shopping done of your favourite stock and eagerly anticipate making lots of money.  After some time has passed you note that the price of Furniture bonanza has gone through the roof as is trading at 550-551 so you are sitting on a potential profit of more than five times what you paid. You decide to take your profit and sell them.

 

Your first imaginary trade exit.

 

You once again call your stock broker who now is your best friend and announce your intention to sell your shares.

 

He says they are 550 bid 551 offered.  You say sell 1000 shares at market!  He sells them all of them for you at 550p and you get your contract note through the next day confirming the trade is done.

 

Click the one below which you think is correct. No guessing allowed, sit down and work it out carefully.

 

 Question 1  

      

How much have you made from this transaction if your commission was £10 when buying and commission was £50 when selling?

Remember you bought 1000 shares at 102p and sold 1000 shares at 550p.

 

Click the one below which you think is correct. No guessing allowed, sit down and work it out carefully.

 

  A     £5500                  B    £5400               C     £4420                D    £4400               E      £4010

 

 

I hope you got the answer correct.

 

Next we will look an example of short selling

 

Short selling is the selling of shares that you do not own. It might take you a while to get your head around this concept, so I have a nice simple example to clarify this definition in an easy way.

 

You are the owner of a shoe shop. You sell shoes. ok?

Right then... you buy your shoes for £10 each and you sell them for £20 each and you do nicely in your business.

 

One day a customer comes in and says I want to buy 100 pairs of shoes from you. You look around the shop and you see that you only have 50 pairs of shoes in the shop.  So you ask him when he wants them delivered and he says in 5 days time it will be fine.

 

So you decide to take a chance and sell him 100 pairs of shoes at £20 each on the condition that you will deliver them in 5 days time.  You know you can buy the shoes at £10 each from your wholesaler so you are happy that you can make £1000 profit from this deal ( £10 x 100 = £1000 they cost you ) and ( £20 x 100 = £2000 that you sell them for )  expected result is £2000-£1000 = £1000 profit. So you accept the cash he gives you and sign a delivery contract and the man then leaves the shop.  I hope now that understand have a short position, you are short of 50 pairs of shoes. ok?

 

The next day you call your wholesaler and order 50 pairs of shoes to make up the total of 100 you need. He informs you that he is sold out.  Oh no!

So you call another dealer of shoes and he says he is sold out too!  You signed a contract but you cant get the shoes from the cheap wholesalers so you begin frantically calling around asking for prices. 

 

Question 2  

      

How much money is the maximum you can lose from this transaction? You must buy another 50 pairs of shoes to reach the total of 100 pairs you need to supply to your customer or you will be breaking your legal contract to deliver the shoes. In this example a person who breaks a legal contract will be put in prison, so think about it carefully before you answer.

 

Click the one below which you think is correct.

 

  A    £500                   B   £1000              C    £2000                D  £2500              E   Possible infinite amount of money

 

 

The above example is to illustrate in a simple way what being short actually means. Being short of a stock in the stock market is the same concept but not usually as scary as the above example as the are many traders the markets are usually very liquid ( making it easy to buy and sell as many people are trading)

 

Now we will look at a stock market short trade.  You heard that a company called  Green solutions is in financial trouble and you want to make profit from the price falling.  So you call your broker up and as a price. He quotes you 34 bid - 35 offered. You have decided to sell £3000 worth so you calculate you can sell 8823 shares ( 0.34 / 3000 ) as you are selling you will be trading at the lower "bid" price of 34p.

 

He sells the shares for you at 34p and you eagerly await the price to collapse.  A few days pass and the price of Green solutions has fallen to 22-23 which is a nice "unrealised" profit. As you sold at 34 and now you can buy them back at 23.  You decide that you will "cover your short" which means buy them back to complete the transaction ( this is the same as delivering the shoes to the customer ).

 

You call up and buy the shares back at 23p  8823 shares x 0.23 = £2029 value.  Remember you sold them at 34p which was a sale value of £3000 so you have made the difference between £3000 - £2029 = £971 ( less commissions)

 

At this point if you do not understand what happened I will add more clarification. You may be thinking how it is possible to sell something you do not own?

 

When you called your broker and told him to sell short 8823 shares at 34p there was something he did in the background to make the deal possible.

He found someone who was prepared to lend the stock to you and then borrowed that stock in return for a small percentage fee.

 

Put yourself in the position of that stock lender for a moment.  Mr Smith owns 100,000 shares of Green solutions and is not happy with his position as the shares have been falling in value.  He is not a smart investor because he is continuing to hold Green solutions even though the price keeps going down. So rather than sell his stock and take a big loss he decides to offer it for lending in the stock in return for 3% per year finance charge.

While the stock is lent you get paid 3% a year and cannot do anything with the stock you lent. 

 

When you sold short those 8823 shares of Green solutions, your broker borrowed them on your behalf from Mr Smith for a few weeks which made Mr Smith 2 weeks interest on the average value of the shares during that period. ( Basically Mr Smith made only 3% per anum for 2 weeks which is £1.73 per week x 2 weeks which is £3.46, but you will note that you made £971 less commission and this is the unrealised loss that Mr Smith had to tolerate on this losing trade.

 

Mr Smith was long and lent his stock to you so you could sell short. Ok?

 

Now we will look at some comparisons of risk and reward.

 

You decide to buy £4000 worth of a stock called Vodaphone.  The price is 171 bid 171.5 ask.  So you can compute how many shares you can buy thus.

 

4000 divided by 1.715 = 2332 shares.  Now we will look at the risk of this trade and the reward potential also.

 

Question 3  

      

How much money is the maximum you can make from this transaction?  As you are long you have to consider the maximum price that Vodaphone can rise to. Once you decided on that price you can calculate the answer ( Commissions are not included in the answer )

 

Click the one below which you think is correct.

 

  A    £4000                   B   £1000             C    £2323                D  £1715              E   Possible infinite amount of money

 

 

Now we are going to look at the risk of being in a short position. The next example you are going to sell short £3000 worth of British Airways stock.

The price is 677 bid and 678 offered, so you can compute the amount of shares you can go short of.

3000 divided by 6.77 ( lower bid price) =443 shares.

 

 

Question 4

      

How much money is the maximum you can lose from this transaction?  As you are short  you have to consider the maximum price that British Airways stock can rise to. Once you decided on that price you can calculate the answer ( Commissions are not included in the answer )

 

Click the one below which you think is correct.

 

  A    £3000                   B   £1000             C    £433                D  £866              E   Possible infinite amount of money

 

 

Now we repeat the above example. But this time we will look at the reward potential of a short position.

So you will again sell short  £3000 worth of British Airways stock.

 

The price is 677 bid and 678 offered, so you can compute the amount of shares you can go short of.

3000 divided by 6.77 ( lower bid price) =443 shares. 

 

Question 5

      

How much money is the maximum you can make  from this transaction?  As you are in a short position you want the price to go down to make a profit, once you decide the minimum price that British Airways stock can fall to then you can compute the answer. ( Commissions are not included in the answer )

 

 

Click the one below which you think is correct.

 

  A    £3000                   B   £1000            C    £433                D  £866              E   Possible infinite amount of money

 

 

 

The main this to realise from all the above example is a simple lesson in the risks and rewards possible from being long ( buying shares ) or being short ( short selling shares ) 

 

Key points to remember about buying in the stock market. ( Being long )

 

The amount you can make in profit is unlimited or infinite. The amount you can lose is 100% of the cost you spent out when you bought the stocks if the company you bought went bankrupt.

 

Key points to remember about short selling in the stock market. ( Being short )

 

The amount you can make in profit is limited to 100% of the sale value of your initial trade. This would occur if the company you sold short went bankrupt. Although it is a sad event for the company it is a good event for the short seller. The maximum amount you can lose is unlimited or infinite because there is not limit on how much a price can go up.

 

 

After read the key points above, you may wonder why anyone would sell short if the potential risk is unlimited? Well the unlimited infinite loss is given as it is the only mathematically correct answer, but in reality all good traders would never allow a short position to wipe out their account and they would limit their risk by using a stop loss.

 

 

 

What is a stop loss?

 

The definition of a stop loss is exactly literal. It stops you getting a big loss.  Here is an example of a trade which you will do and this time use a stop loss to protect yourself from excessive risk.

 

The amount you cash you have decided to invest is £5000 but you have no desire to risk all of that amount.  So you will protect your money by using a stop loss.  You decide to buy £5000 worth of Delta platinum mining and you think they might be a bit risky, as the price of platinum is volatile and mining stocks are often high risk trades. Delta platinum mining is trading at 499-500 and you think it could go up a lot more. As you have looked at the chart you see the price is volatile and might perhaps fall to 450 or 400 and then go higher in the worse case scenario.

 

So you call your broker up and buy £5000 worth of Delta platinum mining which is 5000 / 500 = 1000 shares. You have already decided that if the price falls below 400p you will sell it and take a loss. So you inform your broker to place a stop loss at 400p for 1000 shares. 

 

An important point to remember is that once the stock price become equal to or below 400 it will automatically activate a "sell at market order"  so it is not guaranteed that the order will be "filled" at exactly 400p.

In some cases the price might open in the morning some distance below 400p and you would suffer what is known as "slippage" however in the example we will assume the price is done at your stop loss price exactly.

 

Unfortunately you got it wrong and the price of platinum declines which adversely affects the price of Delta platinum mining and the shares fall to 400p

so your order gets triggered and you get filled on your order. You exit your long trade at 400p

 

Question 6

      

How much money have you lost on this trade?  

As you spent £5000 when you bought at 500p and you sold at 400p ( Commissions are not included in the answer )

 

 

Click the one below which you think is correct.

 

 A    £1000                   B   £5000            C    £4000              D  £500              E   Possible infinite amount of money

 

 

An important part of trading is to be bold enough to admit when you are wrong. If you can do this you can do the correct action and cut your losses when they face you. Traders who cannot do this will always wipe out their account in the long run as their ego will never allow them to admit they are wrong and henceforth they will not be able to close a trade while it is losing a large amount.

 

Another added bonus of using a stop loss is that it causes a drastic enhancement of the mathematic probabilities of getting huge profits. Thus.

 

No stop loss on the above trade gives us 100% risk (£5000 risk) and infinite reward potential.

Using a stop loss on the above trade gives us 20% risk ( £1000 risk ) and infinite reward potential.

 

The mechanics are obviously favourable when using a stop loss. Consider this example.

 

If you take a 10% loss on a trade you need to make 11.1% profit on the next trade to get back to level account ( break even )

If you take a 50% loss on a trade you need to make 100% profit on the next one to get back to break even level.

If you take a 100% loss on a trade  you can never get back to break even as you have no money left!

 

Got it? I hope it is clear that is really vital to understand.

 

 

 In the next example of how to trade we shall examine a short trade with a trailing stop loss.

 

You decide to sell  short of 1000 shares of British Petroleum stock as you think the price will go down and you wish to profit from it. 

 

You sell 1000 shares at 600p and place a stop loss at 650p risking 50 points x £10 per point = £500 ( assuming the price is filled at stop level ). The price begins falling more and more over the next few weeks drops to 400p so you decide to lock in some profit by lowering you stop loss to 440p ( maintaining 10% distance from the lowest price achieved during a trade )

In some time the price falls further to 300p so you place your stop loss at 330p ( 10% distance away )  so you now have an open position profit of

 

  ( 600p short entry price x 1000 shares )(£6000 cost ) - ( 300p current price x 1000 shares)(£3000 value) = £3000 "unrealised profit" and the profit that is locked in by your stop loss is ( 600p short entry price x 1000 shares )(£6000 cost ) -( 330p stop loss  price x 1000 shares)(£3300 value) = £2700 "locked in profit"

 

Remember that a stop loss is not guaranteed to be filled exactly at the price intended.  So the next morning British Petroleum has some good news and the price opens at 339-340 with good liquidity ( which is 10 points above your stop loss price )

 

 

Question 7

      

How much money have you made on this  trade?   ( Commissions are not included in the answer )

 

 

Click the one below which you think is correct.

 

 A   £3400              B  £2700          C   £3000            D  £2590          E   2600

 

 

 

Congratulations If you got all the seven questions correct then you can proceed to page 2 of the beginners guide.

 

 

If you got some of them wrong, maybe repeat the exercise until you get all answers correct as this is very important to understand.

 

 

 

 

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