Understanding the Stock Market - The Basic Rules Every Trader Should Know
Updated: January 29, 2019
The stock market is where many new students at Online Trading Academy are most comfortable when they arrive. They have traded stocks previously, either as individual shares or as components of a mutual fund purchased by their 401(k). They understand the concept of owning a piece of a company, and betting on how well that company is going to do in the near term. These stock market basics are very comfortable to them.
However, your familiarity with companies listed on the stock exchanges can actually be a disadvantage. It’s tempting and can even feel patriotic to buy a company’s stock because you like its products or its management, or because their headquarters are in your hometown. Stock market basics tell us that we should look for a strong company, with good management, in a growth industry—these are called “fundamentals”. The problem with the fundamental approach is that by the time a company flashes positive signals for all these qualities, its price has already increased to reflect a positive view from the market. Its further upside potential may be limited making it actually riskier rather than a “blue chip” stock to invest in.
The 4 Basic Rules of the Stock Market
Stock Market Basics Rule #1: Focus on Price
Educated traders follow a very different set of criteria. These traders focus on a single consideration: price. It may be a poorly run company but, if conditions call for a brief improvement in its price, it’s a good buy for the trader who knows when to get in and when to jump out for a quick profit. Conversely, a great company will sometimes climb out of its comfort zone to a price where suddenly there are more willing sellers than buyers. This means price is about to plummet, and it’s the informed short seller who could reap the benefits.
Stock Market Basics Rule #2: Stay Liquid
There are two main components to this rule. First, the stock has to be actively traded — at least 100,000 shares in daily volume. If trading stocks below that level, you run the risk of being stuck in a position simply because there are no traders on the other side. Second, you should stick to tickers with a price below $50 simply because the liquidity requirements above that level become distracting for most traders.
Stock Market Basics Rule #3: Practice Before You Jump In
This is arguably the most important stock market basics rule. Rather than investing in the broad market you could consider following a few tickers and getting to know their trading range very well. Remember, this is a stock market basics approach that focuses on price. Once you know where it “should” trade then you’ll be well positioned to be able to identify a departure from the norm and act quickly for a potentially positive result. This is the opposite of “buy and hold” because you may load up on a stock in the morning, dump it in the afternoon or a day or two later, then buy it again when conditions change. It’s an agnostic approach to the markets in which the most important consideration is your own desire to be successful.
Stock Market Basics Rule #4: Don't Try to Out-Think The Markets
Here’s a scenario you’ve probably witnessed: a company in a sector has a bad quarter, or maybe a product recall, and all stocks in that sector decline even though the other companies have done nothing wrong. It’s illogical but that’s how the market works. Similarly, mediocre companies will go up in price when the market is hot because “a rising tide lifts all boats”.
When you’re focused solely on price — the basis of the step-by-step trading strategy taught at Online Trading Academy — you don’t need the markets to be logical. You simply want to identify the zones where supply and demand are likely to be out of balance, then buy or sell when price enters these zones. Experience tells us there are large quantities of unfilled buy or sell orders at these price levels and, once the orders are filled, price will change direction regardless of what else is happening in the economy or the market.
The Basics of Stock Types and Investment Strategy
Most people have two types of buckets of money in their lives. The first bucket is our income (short-term). It is what we live off, take vacations on and run the household with. The other bucket is generally bigger and contains our wealth (long-term).
To fill our long-term bucket we need a plan. We need to ask ourselves a series of questions and be quite specific about the answers.
- Why do I want to invest? What are my specific tangible goals?
- How old am I?
- How much capital do I have to work with?
- What are my strengths and my weaknesses?
- How will I manage my risk?
Once we have the answers to these questions written down, then we can start to talk about the style of investing that's right for your goals.
Types of Stocks
There are two types of stocks: Common stock and Preferred stock. Briefly, common stock gives the stockholder voting rights, may or may not pay dividends and, if the company were to go bankrupt, would be paid after the bank and preferred stock holders. In contrast, preferred stockholders have no voting rights, own a fixed group of shares, earn higher dividends and are paid before the common stockholders if the company were to go bankrupt. Learn more about Stock Types.
There are two traditional styles of investment: Growth investing and Value investing.
What is Growth Investing?
Growth investing is taking advantage of new technological advances or medical breakthroughs with strong companies. Basically, investing in stocks that have a lot of room for growth. This type of investment will often have high profit to earnings or P/E ratio. This is the style of investing Peter Lynch became famous for.
What is Value Investing?
In value investing, you look for companies that have been beaten down, but still hold valuable assets that can be turned around into a profitable company later. Sir John Templeton, who was the master at Value investing, became a billionaire using this investing style.
What is Strategic Investing?
We’ve covered the traditional styles of investing, but today there is another option that could give investors more flexibility and additional techniques to manage risk. It’s an investing style we teach at Online Trading Academy called Strategic Investing.
Strategic Investing is a combination of growth and value investing, that also uses tools like options to reduce the cost of purchase, have the potential to create revenue while you’re waiting and give you an escape route should the stock not move as you expected.
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