how to do it TM Money & Business published by Barnes & Noble Stock Trading master the fundamentals by teaching yourself to: Get ready for the opening bell. Stock trading isn’t for the weak of stomach: it’s a fast-paced, risky, and exciting approach to making money in the markets. Before you place your first order, • Understand the difference between stock investing and stock trading • Evaluate various trading styles and decide which (if any) is right for you • Utilize popular trading strategies, including basic technical analysis Stock Trading vs. Stock Investing
Before you can decide whether stock trading is right for you, it’s important to understand the differences between stock trading and stock investing. Fundamental Analysis vs. Technical Analysis Stock investors use a technique called fundamental analysis to assess a company’s financial health, including its profitability and debt, to try to predict and profit from the long-term trend in the company’s share price. Investors buy stocks that they believe will increase in value gradually over time: most investors own stocks for at least a year, and some hold on to the same stocks for several decades.
Stock trading is the process of trading—buying and then selling—a stock within a brief time period, which ranges from a few seconds to a few months at the most. The main aim of stock trading is to profit from short-term trends in share prices, regardless of a stock’s long-term prospects. To predict short-term trends in stock prices, traders use a technique called technical analysis in which they assess the recent price movement through close examination of stock price charts. Critics of stock trading often dismiss technical analysis as a misguided and useless approach to investing.
Their main argument against technical analysis is based on the efficient market hypothesis, which states that stock prices constantly change to reflect all the available information that might affect a stock’s share price. According to the efficient market hypothesis, a stock’s recent price or volume trends don’t matter, because a stock’s price depends only on the relevant information about the stock that’s available at the present moment. Proponents of technical analysis refute the efficient market hypothesis, claiming that the market is not perfectly efficient.
For instance, they point out that people often buy and sell stocks based on hype or emotions, rather than on the “information” that should determine the stock’s share price. Because traders think that the market is not perfectly efficient, they believe that they can identify and profit from trends in share price and volume alone. Whether or not they’re right remains up for debate—no one has proven that technical analysis really works. Traders and investors don’t buy and sell stocks directly on stock exchanges. Instead, they use brokers. Full-Service and Discount Brokers
Stock investors tend to buy and sell stocks through either full-service brokers or discount brokers. • Full-service brokers: Major investment banks and brokerage houses, such as Merrill Lynch and Morgan Stanley. Since they are generally the slowest way to execute (fill) stock orders and charge the highest commissions ($50–150 per trade), full-service brokers are generally not suited for stock trading. Discount brokers: Smaller brokerage houses that offer fewer services, but charge much lower commissions ($7–50 per trade), than full-service brokers.
Beginner traders often use discount brokers to trade, which can work fine as long as you’re making only a few trades per month. If you begin to trade more often, you’ll probably pay less in commissions by working with a direct-access broker (see below). You’ll also most likely benefit from the more robust trading-related services that direct-access brokers provide. • Why Traders and Investors Buy Stocks Stock traders and stock investors share the same goal— to make money.
Even so, the reasons why traders and investors decide which stocks to buy—and when to buy and sell them—differ considerably. Stock Price Charts Stock price charts (called stock charts or charts for short) plot the share price of a stock over a certain timeframe. Stock charts also typically include the share volume, or the number of shares traded. Traders use software that superimposes indicators, or statistics, directly onto price charts. They can then interpret these indicators to help predict whether the stock will trend up (increase in price) or trend down (decrease in price).
One of the simplest indicators, the trendline, plots a line from the first price to the last (most recent) price on a stock’s chart and is thought to indicate the direction in which the stock will likely trade next. Direct-Access Brokers Rather than use full-service or discount brokers to buy and sell stocks, most traders use direct-access brokers. These brokers enable traders to trade stocks completely on their own—without dealing with an intermediary—by using an electronic trading platform called a direct-access trading system (DAT).
Direct-access brokers typically offer traders a fee structure that makes frequent trading more economical than with a full-service or discount broker. They also typically provide a suite of features designed for traders, including real-time quotes and real-time market data. Why Do Investors Buy Stocks? Most stock investors buy either individual stocks or baskets of stocks contained in stock mutual funds or ETFs (exchange-traded funds). Investors who buy an individual stocks believe that, over the long term, the stock will rise in value as the company’s fundamentals improve, which in turn hould increase demand for the stock. Investors who buy stock mutual funds or ETFs believe that the stocks contained in the fund or ETF will rise for the same reason—fundamentals will increase, which in turn will boost the price of the stocks in the fund or ETF. timeframe 18 On-Location Brokers On-location brokers serve professional traders. They offer trading rooms with complete trading terminals that you can “rent” by the day, week, or month. In addition to the service fees charged for renting a terminal, these brokers typically charge commissions as well.
On-location brokers are intended for full-time traders, not for beginners. trendline 16 14 12 10 Why Do Traders Buy Stocks? share price Most stock traders ignore a company’s current fundamentals and long-term prospects. Instead, they focus only on recent movement in a stock’s share price and volume. • When the indicators signal an imminent uptrend, they buy the stock. When the indicators signal an imminent downtrend, they sell the stock. Sep05 Jan06 May06 Sep06 Jan07 3 2 1 share volume
Information that Traders and Investors Use To research stocks before buying them, investors and traders need access to stock-related information, such as pricing data and stock price charts. The most popular sources of free stock data are websites such as Google Finance • Does Technical Analysis Really Work? How Traders and Investors Buy Stocks www. quamut. com (finance. google. com) and Yahoo! Finance (finance. yahoo. com). The free stock data that these sites provide are typically delayed by at least 15 minutes.
Though free stock data can suffice for investors, delayed data is useless to most traders, since traders buy and sell stocks within very brief timeframes. Instead of the freely available data that investors use, traders use real-time market data—up-to-the-minute information that traders can stream onto their computers instantly as it’s published. The two types of data that traders use most often are: • • Real-time charts Real-time stock quotes of their standard quotes package and charge an additional monthly fee for Level II data. • Stock Trading
Over long holding periods (more than five years), investments with high risk and volatility tend to have a greater chance of increasing in value than investments with lower volatility and risk. This phenomenon explains why stocks have outperformed every other major type of investment over the long term. Microsoft (MSFT) Level II Data Bid Time 3:33:19 3:33:39 3:33:40 3:28:32 3:33:09 3:33:30 3:33:30 3:33:30 3:33:30 3:33:30 3:02:15 3:03:40 MMID REDI INCA INCA BRUT ISLD ISLD REDI INCA INCA BRUT ISLD ISLD Order Size 1,200 1,000 1,200 1,000 900 2,000 1,000 2,000 1,600 900 600 2,000
Bid 29. 63 29. 63 29. 63 29. 62 29. 62 29. 62 29. 62 29. 62 29. 62 29. 62 29. 61 29. 61 Ask 29. 72 29. 72 29. 72 29. 72 29. 72 29. 72 29. 72 29. 73 29. 74 29. 78 29. 79 29. 79 Order Size 800 2,000 1,600 600 1,000 800 2,000 800 2,000 1,000 1,000 1,000 MMID ARCA REDI INCA ARCA REDI INCA ISLD ISLD ARCA REDI INCA ISLD Ask Time 3:28:28 3:33:02 3:33:03 3:33:05 3:33:19 3:33:20 2:48:21 3:28:54 3:30:19 3:30:44 2:57:15 3:13:28 Stock trading involves brief holding periods, so it’s inherently very risky: a stock you buy today could be worth much less tomorrow, or even 10 minutes from now.
You must recognize this risk and accept the prospect of losing money at least as often as you make money when you trade. Real-Time Charts Real-time charts, also known as streaming charts, are constantly updated charts that traders can “stream” onto their computer monitors. With real-time charts, traders can plot indicators on a stock’s price chart to track and analyze the stock’s price movement as it happens. Most directaccess brokers provide real-time charts as a standard feature, though you can also buy stand-alone real-time charting software or use real-time charting services, such as PCQuote (www. cquote. com), MarketScreen (www. marketscreen. com), or StockCharts. com (www. stockcharts. com), that charge monthly fees of about $25–50. a screen showing a Level II price quote for Microsoft stock The Three Types of Stock Traders There are three main types of stock traders, differentiated by the length of time they hold the stocks they trade—that is, their holding period. The three main types of stock traders are day traders, swing traders, and position traders. • Day traders: Traders who rarely hold a stock for longer than one trading day.
If a day trader takes a position (places a trade) on a stock in the morning, he or she will almost always close out (sell) that position before the end of the trading day. Day traders often perform dozens of trades within a single trading day and often buy and sell a stock within a matter of seconds. Day trading is the riskiest type of stock trading. Swing traders: Traders who use longer holding periods than day traders do but who typically close out their positions within a few days, or a week at most. Position traders: Traders who take positions with holding periods from about a week to a few months at the most.
Though position traders use longer holding periods than swing or day traders, position traders are not stock investors—position traders still rely exclusively on technical analysis to guide their trades. Should You Trade Stocks? Due to the inherent risk of stock trading, generally you should consider trading stocks only if you meet all three of the following conditions: • Savings goals: If you haven’t achieved your basic personal finance goals, such as saving up an emergency fund of 3–6 months’ worth of expenses, you should not be trading stocks.
It’s also best to achieve all other major savings goals, including saving up for the purchase of a car or house, before you begin to contemplate stock trading. Balanced investment portfolio: Stock trading is not a viable alternative to building and maintaining a balanced investment portfolio. Before you begin trading, you should have already established a diversified portfolio of investments designed to meet your long-term financial goals. High risk tolerance: Risk tolerance refers to the amount of risk you can comfortably accept in your investments.
You should trade stocks only with money for which you have a very high risk tolerance. In other words, never trade stocks with money that you might need to use at a specific point in the near future. Real-Time Stock Quotes A stock quote is a snapshot of the supply and demand for a stock, including the stock’s most recent bid prices and ask prices, at any given moment. • • • Bid price: The price at which buyers are willing to buy the stock. Also called “the bid” for short. Ask price: The price at which sellers are willing to sell a stock. Also called “the ask” for short.
Bid-ask spread: The difference between the current bid and ask. Also called “the spread” for short. For instance, a stock with a $10 bid price and an $11 ask price has a spread of $1. • • • • Which Type of Trader Should You Be? Though you can apply the techniques in this guide to all types of stock trading, it’s best to start out by trying swing trading or position trading and to avoid day trading until you’re more comfortable with stock trading in general. Level I and Level II Quotes Stock quotes come in two types: • • Level I quotes: These display the highest bid and the lowest ask price for each stock on a particular market.
Level II quotes: These show a full picture of the market for a stock, including the stock’s most recent transactions. Level II quotes include order prices and sizes at or near the current bid and ask, as well as information about the source of each order (whether it was placed by an institution or an individual). On NASDAQ Level II, for instance, traders can see all relevant data about each of the NASDAQ’s market makers, including their MMID (market maker ID), the current bid and ask prices and order sizes for stocks they trade, and a record of their most recent transactions.
If you don’t yet meet all three criteria and aren’t sure what steps to take to get you there, see the Quamut guides to Personal Finance and Investing Basics, available in Barnes & Noble bookstores and online at www. quamut. com. A Trader’s Guide to Stock Markets Stocks are bought and sold on stock markets, also known as stock exchanges. In the United States, the three main stock markets are the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), and NASDAQ. The Riskiness of Stock Trading Risk refers to the uncertainty of an investment’s return over a given timeframe.
Volatility is the degree to which the value of an investment tends to fluctuate over time. Risk and volatility tend to correlate with an investment’s return: the higher an investment’s risk, the higher its volatility and potential returns. The risk and volatility of stocks depend primarily on your holding period. • Over brief holding periods (less than five years), investments with high risk and volatility, such as stocks, have a greater chance of losing value than investments with lower volatility and risk. How the NYSE and the AMEX Work
The NYSE and the AMEX are traditional exchanges with a physical trading floor and a manual, auction-based system for trading. On these exchanges, a specialist manages and oversees all trading activity for a specific stock. The specialist’s main role is to maintain a fair and orderly market for his specific stock by ensuring that a market of buyers and sellers exists for the stock. Though this old-fashioned system works fine for standard stock investing, it doesn’t work for stock trading, for two main reasons: Direct-access brokers typically offer Level I quotes as part
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Quamut and its employees are not liable for loss of any nature resulting from the use of or reliance upon our charts and the information found therein. This chart and the information contained in this chart are for general educational and informational uses only. The chart is not a recommendation, solicitation, or offer to buy or sell any security, investment, or fund. The chart is not intended to provide you with any personalized legal, financial, accounting, or tax advice. The chart should not be used as a substitute for personal advice from a legal, financial, accounting, or tax expert.
This chart does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information contained therein. www. quamut. com Copyright © 2007 Quamut All rights reserved. Quamut is a registered trademark of Barnes & Noble, Inc. 10 9 8 7 6 5 4 3 2 1 Printed in the United States Photo Credits: Page 1: fStop/SuperStock; Page 4: Courtesy of Village Tronic (photo 1), Scott B. Rosen/Bill Smith Studio (photo 2). Illustrations by Precision Graphics. www. quamut. com Speed of execution: Orders on these exchanges are not filled as quickly as orders placed on electronic exchanges such as the NASDAQ. Broker-related expenses: On electronic exchanges, traders can often buy and sell stocks directly from market makers without the use of a broker, a financial professional who serves as a middleman between traders and the market. Brokers typically charge commissions for every trade they execute, which can make frequent trading prohibitively expensive. TD Ameritrade (www. tdameritrade. com), Fidelity (www. fidelity. com), Scottrade (www. scottrade. om), and Charles Schwab (www. schwab. com). Consider using a direct-access broker: If you’re an experienced trader; if you want access to the most comprehensive suite of real-time market data, charting features, and markets (including ECNs); and/or if you intend to place more than 10 trades per month. The leading direct-access brokers are TradeStation (www. tradestation. com), CyberTrader (www. cybertrader. com), MB Trading (www. mbtrading. com), and Terra Nova (www. terranovatrading. com). Stock Trading amounts for trading accounts, though these minimums are often negotiable.
Once your account is established, you can typically begin trading right away. Any commissions you incur as you trade will be deducted automatically from your account balance. If you need to replenish or add to your balance, you can do so by mailing in a check to your broker or by transferring money electronically into your account. • • Margin Accounts A margin account is a type of account that allows you to trade with borrowed money. Most brokers allow traders to borrow up to 50% of their brokerage account balance for trading on margin (with borrowed money in a margin account).
Traders are often tempted to use margin because doing so opens them up to the prospect of making more money—if they had double the balance, they think, they might make double the profit. Despite this temptation, there are three reasons why you should never trade on margin: • Interest charges: Your broker will charge you interest per day on any margin balance you maintain overnight. If you’re a day trader, interest charges likely won’t affect you, but if you’re a swing trader or a position trader, they add up quickly and cut into your returns.
Debt from losses: Margin funds are loaned money that you’re responsible for paying back, even if you lose all or part of your margin balance as a result of trading. If you can’t pay back your broker, your trading privileges will likely be suspended, and more serious financial consequences—such as a lower credit rating—will soon follow. Margin calls: Strict rules govern the amount of money that you can use to trade on margin. In short, the stock positions you own not on margin must equal a certain proportion of your overall account balance.
If it falls below that proportion, you’ll get a margin call, which forces you to come up with the cash to bring the balance back in line. If you don’t have the cash, your broker will sell stock from your account to make up the difference. How the NASDAQ Works The NASDAQ is an entirely electronic stock exchange: it has no physical location, trading floor, or manual, auction-based system. Instead, the NASDAQ operates as an electronic bulletin board on which professional traders called market makers can post the number of shares of a particular stock they would like to buy or sell.
For each block of shares, the market maker lists a bid price (if he’s looking to buy) or an ask price (if he’s looking to sell). Unlike on the traditional auction-based exchanges, on the NASDAQ traders can view market makers’ postings and then place and fill their own orders directly. This system, known as the Small Order Execution System (SOES), enables traders to execute orders instantly and avoid dealing with brokers. Broker Fees Before you decide on a specific broker to use, it’s essential to know the types and amounts of the fees that the broker charges. Discount brokers: Discount brokers typically charge a commission (fee) of $7–50 for each trade (regardless of the number of shares you trade) but charge no additional monthly fees. That means that if you plan to make five trades per month with a discount broker, you can expect to pay about $35–150 per month in commissions. Look for a broker who charges no more than $10 per trade and who offers an “active trader” package with reduced commission rates for traders who place a certain number of trades per month. Direct-access brokers: Direct-access brokers usually charge substantial monthly fees ($99–300) for all accounts.
Typically the fee is higher for accounts that fail to meet certain trading minimums or maintain a minimum account balance. For instance, TradeStation, the leading direct-access broker, charges a $99 monthly fee on stock trading accounts, though it waives this for accounts that meet certain criteria— if your balance exceeds $1 million or if you trade more than 5,000 shares per month, for instance. In terms of fees, the main benefit of working with a direct-access broker is that they often charge commissions per share rather than per trade.
For instance, TradeStation charges just $1 for 100-share trades. Since most traders trade in 100-share blocks, called round lots, a pricing structure like TradeStation’s can save you money on a per-trade basis. • E-DAT Systems The introduction of NASDAQ’s SOES during the 1980s ushered in the era of Electronic Direct Access Trading (E-DAT), which has made bona fide stock trading accessible to individuals, not just to institutions, insiders, and market professionals. Soon after the NASDAQ introduced its SOES, the NYSE and AMEX introduced their own E-DAT systems.
The NYSE’s is called the Super Designated Order Turnaround System (SuperDOT), and the AMEX’s is called the Auction and Electronic Market Integration (AEMI) platform. These systems make stock trading possible on the NYSE and the AMEX, though traders still favor the NASDAQ because it has the world’s largest and most active E-DAT system. • • After-Hours Trading The three main stock markets operate from 9:30 a. m. to 4:30 p. m. EST and are closed on weekends and major holidays. Electronic communication networks (ECNs) are electronic systems that allow traders to trade around the clock, including after normal trading hours.
Like the NASDAQ’s SOES system, ECNs allow traders to buy and sell directly from market makers. Two of the most popular ECNs, Instinet (www. instinet. com) and Archipelago (www. nysearca. com), have been acquired by the NASDAQ and NYSE, respectively, and now operate as subsidiaries of those companies. Individual traders typically can access ECNs only through direct-access brokers, some of whom charge extra fees for ECN-routed trades. Set Up a Trading Station Traders use the term trading station to refer to the homebased computer setup they use to trade stocks.
The components you’ll need for your trading station vary depending on whether you’ll be trading with a direct-access broker or a discount broker: • Direct-access broker: A direct-access broker provides you with software that you run on your computer. Your computer will have to meet their software platform’s system requirements (the minimum system requirements that a computer needs in order to run the software effectively). Discount broker: If you trade with a discount broker, you’ll place your trades on the broker’s website using a standard internet browser, so no special hardware or software is required.
Broker Bias Many brokers have an active role in the trading of specific stocks. For instance, some brokers are also market makers in many of the stocks that their clients trade. These arrangements can lead to conflicts of interest that can harm traders, so it’s best to work with an agency-only broker. Agency-only brokers have no stake in the stocks or other investments that they help you trade. Before you choose a broker, ask whether they’re agency-only. If they aren’t, ask for a detailed breakdown of the investments in which they maintain a stake that could lead to a conflict of interest.
How to Get Started Trading Stocks It doesn’t take much time or money to start trading stocks, and you can trade from any location that has a computer with internet access. To get started stock trading, you’ll first need to take the following steps: • • • Decide which type of broker to use. Open a trading account. Set up a trading station at home. • Real-Time Market Data If you plan to make fewer than 10 trades per month, Level I price quotes should suffice. If you intend to trade more actively, you might consider paying for additional market data, including Level II quotes.
Most direct-access brokers offer real-time data, though some traders use more robust stand-alone market data services, such as eSignal (www. esignal. com), which charges monthly fees from $85–185. You can also get real-time quotes and other market data from Yahoo! Finance for a significantly lower monthly fee. Components of a Typical Trading Station There are four basic components of a typical trading station: a computer, a monitor, internet access, and a power supply. The following list provides specs for each of these components based on the standard system requirements for the trading platforms of the leading direct-access brokers.
Decide Which Type of Broker to Use As a trader, you’ll need to decide whether to work with a discount broker or a direct-access broker. • Consider using a discount broker: If you’re a beginning trader or if you’re experienced but plan to make 10 trades or fewer per month. This way, you’ll be able to trade but will pay less than the average monthly fee that direct-access brokers charge. The leading discount brokers include e*Trade (www. etrade. com), Computer Most DATs run on Windows PCs. If you’re using Windows, you’ll want to run Windows XP or Vista on a Pentium 4 computer with a 1GHz processor or faster.
You’ll need 100MB of free hard-drive space and at least 512MB of RAM (though 1GB or more is preferable). You can buy a PC with these specs for under $500 (not including a monitor or other peripherals). Open a Trading Account A brokerage account—also called a trading account— is an account through which you can buy and sell stocks and other investments. The process of setting up an account is simple: you complete a few forms and make an initial deposit of $1,000–5,000 to establish the account. Some brokers may have substantially higher initial deposit www. quamut. om If You Have a Mac If you’re using a traditional Mac, you can either buy a PC that runs Windows, or you can use special software, such as Microsoft Virtual PC®, that allows you to run Windows programs on your Mac. If you’re using an Intel-based Mac, you can run most Windows software right out of the box. • If the order is placed through a discount broker: The broker will relay the order to the market on which the stock is listed, such as the NYSE, the AMEX, or the NASDAQ. Once the order arrives at the market, a market maker or specialist will execute the order.
Orders placed by discount brokers on E-DAT systems, such as the NASDAQ’s SOES or the NYSE’s SuperDOT system, typically are filled as quickly as orders placed with direct-access brokers. Stock Trading When to Use Market and Stop Orders Use market orders only if you absolutely must sell your shares of a stock, regardless of price. Similarly, use stop (or stop-loss) orders only if you’re willing to buy or sell a stock at any price. As a trader, you should ideally never be in a situation that justifies using a market or stop order. Monitor
Most experienced traders use several monitors arranged side-by-side, which allows them to keep an eye on market data and price charts on one or more monitors while making trades using another monitor. You don’t need a multiplemonitor setup to get started trading, but at the least you’ll want to use a flat-panel 20″ LCD monitor with a resolution of 1280? 1024 or higher. Monitors with these specs cost in the range of $250–400. You’ll also need a video card (an internal device that affects the speed and quality with which your computer renders graphics) with at least 128MB of RAM that produces a resolution of 1280? 024 or higher. Such cards typically cost in the neighborhood of $50–75. (Your computer might come with an adequate video card preinstalled, so check before buying an additional card. ) Variations on the Main Order Types The following variations place further limitations or contingencies on the various types of stock orders. Though many more variations exist, these tend to be the most popular. • Good-till-cancelled: All orders that do not specify a time limit are cancelled at the end of each trading day. A good-till-cancelled (GTC) order remains in effect until the end of each month.
Day traders almost never use GTC orders, since they typically have holding periods of less than one day. But swing traders and position traders may find GTC orders useful. Fill-or-kill: These apply to limit and stop-limit orders. The broker or E-DAT will attempt to fill the order at the limit price three times in succession. If the order cannot be executed, the order is cancelled right away. Traders use fill-or-kill orders to get immediate confirmation of a trade when using limit orders. One cancels the other: The trader can place two orders for the same stock simultaneously.
If one fills, the other is immediately canceled. Traders use this variation when they’re unsure whether a stock will rise or fall in price—with this variation, they have a chance at filling the order either way. The Four Main Order Types You can make trades using four different types of orders. The type of order can impact various aspects of the trade, such as the price at which the trade is triggered and the maximum price you’re willing to pay for the stock. The four main types of stock orders are market orders, limit orders, stop orders, and stop-limit orders. Market order: You agree to buy or sell a particular stock at the current market price. The market price is the price for which the stock is currently selling, which usually is somewhere between the stock’s current bid and ask price. With market orders, you have no control over the specific price at which you actually buy or sell the stock—the market sets the price, which can be substantially higher or lower than the price you expect. Limit order: You specify the maximum price at which you’re willing to buy, or the minimum price at which you’re willing to sell.
If your order can’t be filled at that price, the order is added to the list of outstanding orders and will be executed in the order it was received, when (or if) sufficient demand for the stock exists in the market at the price you set. For instance, if a stock is currently trading for $5 per share and you place a limit order to buy the stock with a limit price of $4. 50, your order will execute only when (or if) the market price drops to $4. 50 or lower. If the price drops below $4. 50, the order will execute at a price less than or equal to $4. 50. If it drops to $4. 51 but not lower, your order will not execute.
Stop order: You agree to buy or sell a stock if it reaches a certain price, called a stop price, which is either below or above the current market price. The main difference between a stop order and a limit order is that once the stop price is reached, the order becomes a market order, which means it can potentially be executed at any price set by the market. A stop order in which the price you set is below the current market price is called a stop-loss order. Stop-limit order: This order works just like a stop order with one crucial difference—it becomes a limit order, not a market order, once the stop price is reached.
For instance, say a stock has a current share price of $10. You might place a stop-limit order that stipulates that you’d be willing to buy the stock once its price crosses $11 (the stop price) but for no more than $12 (the limit price). This way, you might benefit from any upward momentum in the stock price but would be protected from being obligated to buy the stock if it shoots way up beyond your stop price. • • • a trading station with multiple monitors Internet Access You’ll need a reliable, “always-on” broadband internet connection, ideally from a reputable network provider. Broadband internet access typically costs about $50 per month.
How Stock Charts Work Since technical analysis is based on the close examination of stock price charts, the first step toward doing your own technical analysis is understanding how stock charts work. Power Supply To protect your trading station from power surges—and, equally importantly, to keep your computer and your trading software running in the event of a power failure— get an uninterruptible power supply (UPS). These both protect from power surges and provide an interim source of power, should your electricity go out. They’re sold at electronics stores, office supply stores, and online retailers for about $75–100.
How to Create Stock Charts Traders generate charts using charting software provided by direct-access brokers or third parties. You can also generate charts for free using financial websites, such as Yahoo! Finance (finance. yahoo. com), StockCharts. com (www. stockcharts. com), and BigCharts (www. bigcharts. com). • The Anatomy of a Stock Chart All stock charts show the share price (and often the share volume) of a stock during a given timeframe, which can range from several seconds to several decades. The most basic stock chart, called a line chart, uses lines to plot the movement of a stock’s share price. 5. 8 5. 6 •
How to Make Stock Trades Traders make stock trades by placing orders to buy or sell a specific number of shares of a certain stock. • • Traders using direct-access brokers enter orders directly into their trading software. Traders using discount brokers submit orders through their broker’s website using a standard internet browser. 5. 4 5. 2 5. 0 4. 8 4. 6 Feb 2 Mon Feb 5 Tues Feb 6 Wed Feb 7 Though traders sometimes use basic line charts to get a quick overview of a stock’s activity, to do technical analysis traders use two types of more complicated charts: OHLC charts and candlestick charts. Which Order Type Should You Use?
In general, it’s best to use limit orders (or stop-limit orders) every time you buy or sell stock. You can avoid the main drawback of using limit orders—that your order won’t execute at all—by setting a bid price equal to your stock’s current ask price. For example, if you want to buy a stock with a current ask price of $20 (and you’re comfortable paying that price), place an order that specifies $20 as your limit. You’ll be certain to obtain the shares as long as the seller is offering as many shares as you’d like to buy. At the same time, the limit order guarantees that you won’t pay more than $20 per share.
What Happens After You Place an Order? The time required and the method used to execute a stock order differs depending on whether the order is placed through a direct-access broker (via a direct-access trading system) or through a traditional discount broker. • If the order is placed with a direct-access broker: It will most likely be filled by computers without any human involvement. DAT-based orders are typically filled within seconds (assuming the stock has sufficient liquidity), whereas broker-based orders generally take longer to fill. OHLC (Open High Low Close) Charts
OHLC charts use a series of vertical bars, high each of which has small horizontal lines close that extend to the left and right of the vertical bar. Together these bars indicate various aspects of the stock’s price movement for the current trading day (or another set open time period). The top of the bar indicates low the stock’s highest price (called the high), the bottom of the bar indicates the lowest price (called the low), a line jutting off to the left side of the bar indicates the opening price (called the open), and another small line jutting off to the right side indicates the closing price (called ww. quamut. com the close). A vertical line with just one horizontal line indicates that the stock opened and closed at the same price. Stock Trading Support and Resistance Levels When a stock is following a trend, typically it will trade within a narrow range of prices around the trendline, occasionally testing the extremes of that range. • • Support level: The price represented by a line drawn through the lowest points below the trendline Resistance level: The price represented by a line drawn through the highest points above the trendline
Candlestick Charts Candlestick charts use a vertical line to represent a set time period, such as one trading day. The endpoints of the vertical line indicate the stock’s low and high for that time period. A rectangle is then superimposed on the line to indicate the open and the close. If the stock closed higher than it opened, the rectangle will be either white or green, and its top and bottom lines will indicate the close and the open, respectively. If the stock closed lower, the rectangle will be black or red, and its top and bottom ines will indicate the open and the close, respectively. high open high close close low this stock’s close was lower than its open open low this stock’s close was higher than its open Traders examine support and resistance levels to identify breakouts, points at which a stock seems to be falling through its support level or moving upward through its resistance level. Traders often buy when a stock breaks through its resistance level, since they believe that this breakout may indicate the beginning of a new uptrend.
On the contrary, traders often sell when a stock plunges through its support level, which they believe tends to signal the beginning of a new downtrend. new uptrend The Three Types of Charts in Context The images below show a single stock’s price movement over a 28-day period using the three main types of charts. 14 13 12 11 10 9 8 7 6 5 4 14 13 12 11 10 9 8 7 6 5 4 14 13 12 11 10 9 8 7 6 5 4 resistance level breakout stock price stock price stock price 1 7 day 14 21 28 1 7 day 14 21 28 1 7 day 14 21 28 support level
How to Analyze Trends, Support, and Resistance in Stock Charts Traders tend to do two types of analysis on stock charts. The more complex and intricate type involves the use of technical analysis indicators that help traders predict where the share price of a stock might go next. A more rudimentary form of stock chart analysis involves spotting trends and support and resistance levels. How to Use Technical Analysis Indicators to Analyze Stock Charts Technical analysis indicators are statistics that traders use to analyze stock charts.
Traders use software to plot one more indicators on a stock’s price chart, usually in real time. Indicators help traders identify points at which to buy or sell stocks, known as entry points and exit points, respectively. Indicators are classified as lagging, time-current, or leading, to indicate whether they reflect a stock’s price movement in the past, present, or future. Traders use dozens of indicators. The most popular indicators break down into two main groups: • • Moving average indicators Momentum indicators Trends A trend is a consistent pattern of movement in a stock’s price over time.
A trendline is created by drawing a line from a particular point on the chart to another. Trends can be up or down: • • Uptrend: Occurs when a trendline shows a steady increase in a stock’s share price Downtrend: Occurs when a trendline shows a steady decrease in a stock’s share price Moving Average Indicators A moving average (MA) is a lagging indicator that shows the average share price of a stock during a given time period. Traders use a stock’s MA to identify trends and to track when the stock might break through a support or resistance level.
For instance, a stock trading consistently above its MA might be at the beginning of a new uptrend. A stock trading steadily below its MA might be poised to break through its support level. Four of the most popular MA indicators that traders use are the simple moving average, exponential moving average, moving average convergence/divergence, and Bollinger bands. Traders analyze charts to find reversals, points at which it looks like a stock’s trend might be changing. If a trader spots what looks like the beginning of a new uptrend, the trader would likely buy the stock.
If a trader thinks a new downtrend is forming, the trader would likely either sell the stock (if he or she owns it already) or sell the stock short (see below). Simple Moving Average (SMA) downtrend uptrend The simple moving average (SMA) is the average (arithmetic mean) of the share prices at which a stock traded during a specific time period. For instance, a 15-day SMA plots the average price of a stock during the previous 15 trading days. Traders usually plot two or more SMAs on the same chart, each of which plots a different number of days—the 15-day, 30-day, 50-day, and 200-day SMAs are the most popular.
Traders then look for crossovers, points at which the shorter (more recent) SMA crosses over the longer SMA. reversal 15-day SMA Selling Short Selling short (also called simply shorting) is a type of trade in which a trader “borrows” shares of a stock that he does not actually own and immediately sells them, with a commitment to buy them back later. In doing so, the trader can profit if the stock’s share price declines. Since selling short is very risky, it’s best to avoid this type of trade entirely, unless you’re an experienced trader or investor. crossover 30-day SMA www. uamut. com • • Points at which the more recent SMA surpasses the longer SMA tend to indicate a new uptrend in share price, so traders would tend to buy the stock. Points at which the more recent SMA falls below the longer SMA tend to indicate a possible downtrend, so traders would tend to sell the stock. Stock Trading Momentum Indicators Momentum indicators are the largest and most diverse group of indicators. Traders use most momentum indicators to detect stocks that might be overbought or oversold. • Overbought stocks: These tend to have risen rapidly in price and volume.
Traders often expect overbought stocks to show a trend reversal and begin downtrending. Oversold stocks: These tend to have plunged rapidly in price and volume. Traders often expect oversold stocks to show a trend reversal and begin uptrending. Exponential Moving Average (EMA) The exponential moving average (EMA) weights the recent share prices more heavily than older share prices. Some traders think of the EMA as a more time-current version of the SMA, but in reality the EMA often differs only slightly from the SMA and is used in much the same way for trading purposes. •
Momentum traders aim to buy stocks at the bottom of an oversold trend, hold the stock as it rises in share price, and sell at the top of an overbought trend. Moving Average Convergence/Divergence (MACD) The moving average convergence/divergence (MACD) shows the difference between two MAs of different time periods. For instance, a trader might use the MACD indicator to track a stock’s 15-day and 30-day MAs (the stock’s average share prices during the past 15 and 30 days). The MACD plots the average of those two MAs and compares it to another, more recent SMA or EMA—called the signal line or trigger line—such as the 5-day EMA.
Traders then examine points of divergence at which the signal and the MACD differ. The extent of the divergence is usually plotted as a histogram in which longer lines indicate a greater divergence between the MACD and the signal. Here are few of the main ways traders react based on how the signal relates to the MACD: • • • • If If If If the the the the MACD MACD MACD MACD falls below the signal, traders sell. moves above the signal, traders buy. rises significantly, traders sell. falls significantly, traders buy. Relative Strength Index (RSI)
One of the most popular momentum indicators is the relative strength index (RSI) indicator. Traders use the RSI indicator to assess the price performance of a stock based on its average recent closing prices. RSI is measured on a scale of 1–100, in which: • • An RSI of 75 or higher indicates that the stock is overbought and will likely experience an imminent reversal and begin downtrending. An RSI of 25 or lower indicates that the stock is oversold and will likely experience an imminent reversal and begin uptrending.
Traders use a stock’s RSI to identify trends in which the stock’s RSI fails to move up in tandem with the stock price. This type of divergence may signal an impending reversal, as shown in the example below. share price makes new highs reversal occurs 90 share price 80 70 RSI fails to make consistent new highs 100 80 50 20 0 MACD exponential moving average divergence Volume Indicators Traders use volume indicators to assess a stock’s price movement relative to its share volume (the number of shares traded in a given trading day).
In general, traders believe that the higher the volume of shares that accompany a price change, the stronger the move. For instance, a stock moving lower on high volume is believed to be a stronger signal of an imminent downtrend than a stock trading lower on light volume. Perhaps the most popular volume indicator is the on-balance volume indicator, explained below. Bollinger Bands Bollinger bands are lines drawn at set standard deviations above and below a stock’s MA during a given timeframe.
By default, Bollinger bands use a 20-day MA and plot lines two standard deviations above and below that MA. Traders use Bollinger bands to get a sense of a stock’s trading range, the range of prices between its support level and its resistance level. Traders often use Bollinger bands with other indicators, such as the SMA, to try to identify opportune exit and entry points. For instance, on a chart that plots a stock’s 30-day SMA and its Bollinger bands, a trader would look for points at which the SMA moved either above the top band or below the bottom band. • When the SMA approaches the upper band, traders would tend to interpret that move as a sign of a breakout and a possible new uptrend. They would buy the stock. When the SMA approaches the bottom band, traders would tend to interpret that move as a sign of a possible new downtrend. They would sell the stock. On-Balance Volume (OBV) The on-balance volume indicator compares share price to share volume—it shows traders whether a stock’s price movements are accompanied by an increase or a decrease in volume.
Traders use this indicator to evaluate the strength of a recent move in a stock’s share price. The OBV indicator plots volume on a scale in which 0 is the average volume. • • Price changes accompanied by positive volume readings indicate a strong uptrend or downtrend. Price changes accompanied by negative or average volume readings indicate a weak uptrend or downtrend. 30 upper band SMA approaches lower band strong uptrend follows 25 30-day SMA downtrend occurs price change 15 10 5 lower band positive volume reading 40 0 –20 –40 volume 20 share price 20