How to Trade Stocks and Options

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Support and Resistance, usually recognizable on stock charts

Levels of support and resistance can be more easily understood by looking at a stock chart than by giving a written explanation. However, having said that, I will try to explain with some definitions.

In the up and down cycles in the life of a stock or a stock index that is represented on a stock chart, it can be seen that there are some price levels that a stock price reaches and then goes no higher in the case of an up trending stock or lower in the case of a down trending stock.

Those higher levels at which a stock trades but then trades no higher are called resistance, and conversely, the lower level at which a stock trades but then goes no lower is called the support level. The important thing is that these resistance and support levels often come into play again on subsequent up and down cycles and because of that they provide reference points as future alert points  for the person who analyses the chart of that stock.

But first a brief look at the chart:
The above is a chart of the SPX, our favorite index representing the overall general market. This chart covers the current period from February 2010 until 24 May, 2010.

The blue line was a resistance level on the left side of the chart from about February until about mid-March, but once the index broke through that resistance level it became a support level that was not violated until early May. It can be seen on the chart that from that point the market fell to about 1110, then reversed and went back up until it met the resistance level of the 50-day moving average, could not break through and reversed back down to where it closed today at 1074 and on the way broke through the 200 day support line at about 1103. So 1103 will now be a resistance level for the next upward move.

After a resistance or support level is reached, the stock may reverse and start going down or up again or it may trade at about the same price for a while, appearing to be moving sideway on a chart. The increasing or decreasing volumes of buying or selling is what changes the stock price. As in any form of trading, the supply and demand volumes dictate the prices that are paid.

Support, in terms of the price of a stock that is in a downward trend, is the price at which it stops falling. In terms of supply and demand, it is the point at which sufficient buyers move in to purchase the available supply of stock being offered which then stabilizes the stock and it stops faliing further in price.

Resistance is the highest level reached by a stock in its upward trend at which it stops rising.

For practical purposes, if a trader is ready to buy or sell a stock, the recognition of resistance and support levels is of value because it alerts the trader to the possibility of a breakthrough, a point at which to make the commitment, it can become a key guide for confirming a decision to enter or exit a position.

Sometimes a stock is a better buy at a higher price (or sale at a lower price)
Let us consider a trader wanting to buy a stock. It may mean that by waiting till after a breakthrough of the resistance level, the stock will trade at a higher price. But the breakthrough can signify room to continue moving upward now that the resistance level is left behind.

If a breakthrough does not occur, the price levels often become repeated barriers seemingly preventing the stock moving beyond them and the stock will appear to bounce back off them, until perhaps after a few such rebuffs, the stock price will eventually move beyond its confining resistance level on the way up or beyond its support level on the way down.

When a breakthrough of the support level does occur it then becomes a future resistance level and conversely, when a resistance level is overcome it then becomes a support level.

Moving averages can also serve as support and resistance levels, in the above chart the blue line is the 50-day moving average line and the red line is the 200-day moving average line. Any number of days can be selected to base a moving average on, but 50-day and 200-day are used on most charts. Additional lines of moving averages can also be shown on a chart, the 10-day and the 20-day are often used too.

Conclusion
Knowing the key support and recent levels is important in analyzing stock charts because of the alert it provides to the trader who is ready to take action.

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The Stop Loss, essential for risk management

The main topic of this post is to introduce the Stop Loss, which, as its name implies, involves establishing a price point that can limit the loss that will be suffered when a stock begins to fall in price below the price at which it was purchased.

But first some background
Most people, when learning how to trade in stocks after they have opened an account and are ready to begin actively trading, concentrate on what particular stock or stocks to buy, what the current trading prices of those stocks are, and what they are willing to bid for those stocks. Then they place the order and become a shareholder with the objective and expectation of watching the stock rise in price and make their stocks more valuable until there comes a day when, for whatever reason, they then sell those stocks, hopefully above the purchase price for a reasonable gain.

But there is something missing in that scenario, what if the stocks fall in price after the purchase, or even after first making a gain in price? It happens all the time. Sometimes a stock price reversal is small, of little consequence and the stock can continue to be held for the time when it will again increase in price. But sometimes the price drop is not small, and that is a frequent occurrence in both individual stocks and in the entire stock market.

Always have an Exit Strategy
When learning how to trade stocks, one of the principal lessons to be learned is to set an exit price, or a series of prices actually, even before the stock purchase transaction is completed. Which means knowing the target price at which the stock will be sold if it has achieved its full potential in the time considered appropriate or if it falls in price to below an acceptable level.

Depending on the basis on which a stock purchase was predicated, the trader should be able to estimate a target price that the stock can achieve based on what is then known about the specific stock and other related situations such as the overall performance of the stock’s sector and the general market, and perhaps, the chart pattern exhibited by the stock’s trading to date.

Obviously these conditions will change as time passes, sometimes for the better sometimes not, so the target price is subject to change but the trader can adapt and revise expectations to accommodate to whatever occurs. Keeping in mind that the holding period to reach the target should not be excessively long, a relative term but one that makes sense in the trading approach that is different from investing where the long term is usually the rule.

Set a “stop loss” price at the same time as making the stock purchase
A wise practice, essential for good risk management, is to set a selling price using a stop loss order, described below, entered with the instructions to the broker when the stock is purchased. If not then, do so soon after.

Not everyone agrees with the strategy of using a stop loss, suggesting it might be triggered in an unnatural fashion and the stock sold needlessly after which it soon bounces back. But not using a stop loss means that the action in the stocks must be watched closely with a clear and firm decision made immediately they fall to an exact lower price at which a sell order must be placed personally rather than automatically as in the case of the stop loss.

Requiring such an action involves not only a lot of effort in tracking the movements but also carries the risk of the very human tendency to procrastinate or waver undecidedly while the stock falls further, creating greater losses. On the other hand, the stop order is like an insurance policy, a form of protection.

The Stop Loss
Setting the stop loss price serves to minimize the downside risk in the event that the stock falls lower in price from its purchase price.

The stop loss also serves to protect a gain that may have occurred since the original purchase price but where the stock, after reaching a higher price, begins to fall back.

The amount of acceptable loss can be set in several ways, perhaps at a fixed dollar amount, or as a percentage of the purchase price. A commonly used amount is 8 percent, but note this is a target price that when reached becomes a commitment to sell “at the market”.

The actual sell price may be lower than the stop loss price
The Stop Loss is a predetermined order to sell a stock at some future time should the stock reach the given stop price and then it becomes executable as a market order immediately.

But note: as a market order, if and when the stock reaches that given price, it then causes the stock to be sold at the prevailing bid price which in reality may be lower than the price specified as the stop price, that might be a little or a lot different depending on the trading volatility of the issue.

The stop loss cannot guarantee the sell price, only that an order to sell will be triggered when the stock reaches the set price of the stop loss, but the best price possible at the time will be obtained once the stop loss is triggered.

I see little value in an alternative method where the stop price can be specified to sell at only at a specific price. This might seem plausible when setting to sell at a satisfactory higher target price but if that price is not quite reached and the stock falls back, the trader is left holding a stock that could have made a profit, and having not done so, may even fall to a much lower price.

Whatever the gain in price that a stock has achieved above the purchase price it is not a profit until it is sold. Don’t let profits just fade away, a stop loss can help protect profits before they do.

The Trailing Stop
A Trailing Stop is an excellent form of stop loss because it moves up and down in concert with the underlying stock’s movement, rising if the stock rallies and falling if the stop reverses but maintaining the same range of difference, whether it be by percentage or fixed dollar amount.

When learning how to trade stocks there is always lots more to cover, as I have mentioned elsewhere, than can be fully explained on this website or any other single source.

An important market information source for learning how to trade stocks:
A great daily reference that encompasses a wide range of stock market activity, news, stock lore, charts, stock ratings and research tools, in fact everything up to date and relevant is the IBD, the Investor’s Business Daily, available at many city newsstands for about $3 a day, Tuesday’s through Saturday, 5 days a week.

Next post coming in this How to Trade Stocks Guide:
A Look at Support and Resistance Levels.

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A brief outline of the sequence of steps involved

As usual for all articles in this series of How to Trade Stocks, we will assume all transactions are being made online with an online brokerage house in which the trader has an active account already established.

Once the market is open for the trading day, the millions of stock transactions that take place between sellers and buyers will establish the prices of individual stocks. The prices will fluctuate throughout the trading day, ranging between a high and a low, in response to the patterns of supply and demand, the same as in any trading process.

There will also be a bid price and an asking price, usually with a difference in those two prices, referred to as the spread.

Perhaps some of these explanations of such simple details are almost a matter of common sense but in learning how to trade stocks it is necessary to understand even the minor aspects and formalities that govern the many activities that take place.
Using the internet or other media sources, up to the minute information is readily available on stocks and stock prices, their trading volumes and their movement in relation to each and every previous trade.

From this, the stock trader can be aware of how the markets and selected stocks are performing at a given time and having made a decision to take a position, either as a buyer or a seller can then place an order with a broker to make the transaction.
To make a trade is an easy and speedy process and whether buying or selling, the routine differs only slightly, but for simplicity let us just consider buying a stock.

The routine of buying a stock that is being traded in the marketplace is a simple transaction based on the buyer placing a bid through a stockbroker to buy a particular stock at a given price. As mentioned, the price of the stock at any moment is already established by the trading activity that is then taking place in the stock and is often fluctuating slightly from transaction to transaction.

Execution price depends on the type of buy order conditions placed by the buyer
The price at which the transaction to buy is executed depends on the form of buying instruction given by the would-be stock purchaser.

The buying price can be set in two ways, either a market order or a limit order. An order to buy expires at either the end of the day or is good until cancelled, according to whatever the buyer signifies as their choice when placing the order.

Market order
In the case of a market order, the stock price of the stock purchase is the price at which the stock is trading at the moment the transaction is completed, which is almost immediately once a purchaser has placed an “At the market” buy order.

The limit order
Provides a way for the buyer to set a specific buy price at which the offer to purchase is made and therefore guarantees the buyer of having the order filled at that price or a lower price. If the limit order bid is lower than the asking price, and if the stock does not reach that specified bid price the order will not be filled.

On a practical basis, unless there is a wide spread between the bid price and the asking price, to avoid the possible of not getting an order filled on a stock that the trader wants, the limit order will be priced at the current asking price, allowing the transaction to be completed but not being at the mercy of committing to an unexpected inflated price caused by some momentary spike in the price that can happen on occasion.

Immediately set the sell price by using “stops”, always have an exit strategy
When the stock purchase is completed, the trader also will have a target sell price in mind, a higher price at which to make an exit for all or part of the holding, there is also a way to set a lower sell price at which the stock is to be sold if the price falls from the initial purchase price or falls back after having made a gain. This is done by setting a stop order, of which there are several types.
Setting a stop order is not mandatory but the wise trader will invoke the process. Always have an exit strategy

Stops will be the subject of our next post in this series of How to Trade Stocks, to see that go to next post:

Selling a Stock – Exit Price Consderations

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