How to trade-Complete guide for beginners and intermediate traders
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Begin the education. I have sufferred great pains to learn all these points, you
get them free.
Lets get started.
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.
Stocks
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 Tate Bros PLC. 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 Tate Bros PLC 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
Tate Bros PLC 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 or "The spread") .
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. Same applies to selling
it, you need a buyer don't you?
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
Tate Bros PLC 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.
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.
Imagine you are the owner of a shoe shop. You sell
shoes.
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 entire
shop. So you ask him when he wants them delivered and he says
in five 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 contractually agreed 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.
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.
Basically your customer knew the supplies were
low and tricked you. You are the victim of a "bear squeeze"
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.
Consider it carefully.
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
stock markets are usually very liquid ( making it easy to buy
and sell as there are 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. (Meaning you have it if you want it, but you did not
"lock it in" yet)
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 in the
above example ).
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 13% per year finance
charge.
While the stock is lent he gets paid 13% a year
and cannot do anything with the stock he lent.
Interestingly the higher the rate asked, the more risky the
stock is to trade.
I went short of HMV at 4p and paid
25% interest for 3 months, it was good (for me, and not for my
lender) as they went bust so my exit price was zero. 100% gain
for me.
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. Do you follow me?
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 (long
means you bought something) 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 )
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 )
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? Remember you
short sold
$3000 worth of British Airways stock.
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 )
The main thing 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 your losses. 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
Your "stop order" gets triggered and you get
filled on your order. You exit your long trade at 400p
So you lose a bit of money. If the company went bust you would
laugh wouldnt you? Right, if it went straight up again you
would cry wouldn't you?
This happens ALL THE TIME, just
get used to the fact that it is OK to make lots of small
losing trades. Remember your winning trades? They will pay for
all the losing ones. Scroll up and watch the video again, see
the huge winners? Note the small losers? Add it up!
Question 6
How much
money have you lost on this trade above?
As you spent
$5000 when you bought at 500p and you sold at 400p (
Commissions are not included in the answer )
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.
THEY WILL BLAME THE MARKET FOR THEIR
LOSS.
EVERYTHING
THAT GOES WRONG IN YOUR STOCK MARKET TRADING IS YOUR FAULT -
BE ACCOUNTABLE-
ACCEPT
RESPONSIBILITY FOR YOUR OWN MISTAKES - OR YOU WILL FAIL.
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. INTERNALIZE THESE POINTS MAKE THEM SECOND NATURE
LIKE BREATHING.
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 )
If you got some of them wrong, repeat the exercises
above until you get all answers correct as this is very
important to understand.
If you got most of them wrong,
then maybe you can repeat them again.
If you are a
quitter you can leave and you have clearly learnt that trading
is not for you, as quitters never suceed in trading. The good
thing is you have learnt this without losing a dime. Bye
and good luck in a regular type career.
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About
Precision Trading Systems was founded in 2006
providing high quality indicators and trading systems for a wide range of
markets and levels of experience.
Supporting NinjaTrader, Tradestation and
MultiCharts.
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PPage updated July 8th 2023 from
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