How to Trade Stocks and Options

The trading of options hold a special attraction for many traders due to the leverage they provide because they usually trade at only a fraction of the price of the underlying stock. And options can significantly boost profits on winning stocks.

Perhaps you have been thinking about trading options so that you will be able to produce a little extra income, or to improve gains for a retirement portfolio, or for some other reason.

If so, before you start, some words of caution:
Trading Options are considered by many to be a high-risk market activity so for that reason alone, unless you are already well informed, it will pay to learn a little more about how to actually trade them. The general belief held by most professional traders is that the vast number of retail traders, people like you and me, the non-professionals, lose money when they trade options.
But that should not necessarily deter you, what it should emphasize is the need to learn effective strategies, to apply them properly and be careful.

In reality, options originally were created to reduce risk by providing a method to acquire an asset of greater value at a fixed price within some specified time in the future without a commitment being made to actually complete the acquisition by the specified time. In which case, the fee paid for the option is the only real cost involved in the transaction.

In the above explanation, the option is a derivative, meaning its existence is derived as a byproduct of the original asset, whether that is a stock or other type of asset.

All forms of trading and speculating are accompanied by risk but in the case of trading options it is perhaps somewhat of an advantage for the option buyer to be able to set the maximum dollar amount that can be lost when a trade is made. That maximum amount at stake being the cost of the option, and that would only become a reality when the option expires. Although I believe that most options traded do expire worthless.

When an option trade occurs, the transaction identifies:

• the name of the stock, usually called the underlying stock.
• the price at which the underlying stock will be bought or sold if the option holder chooses to exercise the option, this is called the “strike price”.
• the expiration date, the latest date that the option can be exercised. The option  can be exercised at any time up to and including that date but after that date it no longer exists.  As mentioned above most options expire in this way. The unexpired time span is referred to as the term of the option.

The standard definition of an option
A stock option is a contract related to a particular stock, between a buyer and a seller that gives the buyer of the option the right, but not the obligation, to buy or sell (depending on the type of option) 100 shares of that stock at a specified price on or before a given date.

An owner of an option, the option holder, can re-sell that option during its term before expiration or can keep the option until it expires. The option could also be exercised in accordance with the terms of the options, although that does not happen in most cases.

Just for the record, there are several other styles of options we need make only a brief reference to here, the most common alternative being called the European-style option to differentiate it from the above description known as the American-style option. The only difference is that European-style options cannot be exercised before the expiration date. The names of the option styles do not limit them to any geographical location. In this article, all other references are to the regular options, the American-style options.

Options can be bought and sold
The seller of an option is called the “writer” of an option. To sell an option is to “write” an option. If an option is written, (sold) by a trader who does not own the underlying stock it is a short trade, a common occurrence. That type of trade comes with an obligation that is evoked if the option holder wishes to exercise the option in which case the writer of the option must deliver the stock, in other words must buy the specified stock. Not all sellers of options are short sellers, in many cases the underlying stocks is owned by the seller when selling an option to a buyer and this transaction is referred to as selling a covered call.

Terminology for stocks: Long, short, and covering transactions
A stock transaction can be referred to as either “long” or a “short”
long means to actually buy the stock and
short means to sell a  stock before owning that stock and in doing so it then creates the obligation to buy the stock at some later date, called a “covering” transaction.

Selling short is a technique used to profit from a fall in a stock’s price and where the expectation of the seller is to be then able to buy it at a lower price, an expectation not always realized. A situation much the same as a long purchase being made with the expectation of the stock rising in price and that does not always happen either.

When a stock is sold short, in theory, the stock is loaned to the seller by the seller’s stockbroker, who may have to borrow it from yet another stockbroker. Eventually the seller must buy back the stock sold short and return it to the broker, called covering the short position.

Terminology for Options: Calls and Puts
An option to buy a stock at a later date is termed a call option, buying a call option is termed buying a long call
An option to sell a stock at a later date is called a put option, buying a put option is termed buying a long put

A long call option is a simple  way to profit if you are correct in forecasting that the stock will gain in price, buying  a call is the most common choice made by beginning investors.

A long put option is a simple  way to profit if you are correct in forecasting that the stock will go down in price.

Educational resources
Stock options are securities that are listed and traded on special exchanges, the world’s largest such exchange is the Chicago Board Options Exchange (CBOE). There are many sources for education and training in trading options, but the CBOE’s Learning Center might be a good place to start. CBOE tutorials can be found on the internet at http://www.cboe.com/LearnCenter/Tutorials.aspx

In Summary
There are many special terms used in trading options that we will cover in Part 2 of Trading Options, now in preparation, and we must also define some specific option trading strategies

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If you are an aspiring trader who want to know how to trade stocks, be warned, there is a lot to learn and the real world of stock trading is not kind to those who lack knowledge or make mistakes, in fact it can be very costly. So be prepared for a lot of reading, studying, and practicing, and even when you believe you are ready to join the throng and make your first trades, do so with caution, make sure you have a plan to follow and know how to manage risk.

The key part of managing risk is to limit the losses that you are inevitable going to have. All traders experience losing times, even the great Warren Buffet does, and his first rule of trading is “Don’t lose money.” And in case you haven’t heard it, his second rule is “Don’t forget the first rule.”

The would-be stock trader needs to open an account with a stockbroker. A stockbroker is the essential link between the trader and the stock exchanges where the buying and selling of stocks, bonds, ETF’s, options, futures, mutual funds, and other financial securities occurs.

In today’s online world, most trading activity takes place with online stockbrokers. It is not difficult to open an account with an online stockbroker but it will take a little time to become familiar with how to get around the trading platform interface, to learn how to place trades, get stock quotes, access stock charts and modify them to suit personal preferences. And there are other such things, including knowing what learning resources are available. To become proficient in getting around and accessing what you need to find will probably require the aid of a help desk or technical advisor from within the brokerage, but that in itself is an essential learning experience much like any computer involvement and it is relatively easy.

The basics of the basics in how to trade stocks
But adequate market knowledge in learning how to trade stocks is not something that can be accomplished by a few visits to the internet. It will take diligent study. There are books to read, and financial newspapers such as the Wall Street Journal or the Investor’s Business daily to read or at to least become familiar with in order to know what they have to offer, those and financial magazines should become reading material of habit over time especially when actually trading and gaining some success – which you will if you learn properly.

Internet resources
There are many informative videos and seminars available to watch and listen to, they are free and cover a wide range of stock market topics that can be absorbed gradually. In addition to instruction and training in specific stock trading topics, it is worthwhile to read more general material if sufficient time is available, to become familiar with the jargon and the lore of the stock market and trading of today and of the past, that can be a fascinating and diverting source of information. A good local public library should have many stock market related materials, books or videos, available.

While learning, check daily or every few days into Finance.yahoo.com or Marketwatch.com, those sites will bring you up to date with news of what is currently happening in the market plus there is plenty of other information of value to be found on them.

Stock charts, an important area of study
It is important to learn about stock charts and how to interpret patterns of stock movement that can readily be seen on a chart. Many recognizable stock patterns can provide fairly reliable signals upon which trading action can be based. Charts can depict clearly the underlying trends of the market and where areas of resistance or support are likely to occur. The trader frequently awaits those times to see when it can be confirmed that one of those confining levels is broken through, with the expectation of continued movement in the direction of the break out.

Virtual or Paper Trading
There are also resources for those learning how to trade stocks in which a form of virtual trading can be carried out, where real day-to-day trading actions to buy or sell can take place but without using real money. Using this method enables practice trading and implementation of much newly learned trading information such as trading strategies that identify what to trade and when to trade. From the results obtained, it may help determine whether the participant is ready for action in the market with real money. Many stockbrokers provide such facilities to their clients and there are many other sources on the internet, usually without charge. For more on this topic check out: Paper Trading.

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An introduction and where we go from here

Our objective is to explain, from the viewpoint of the trader and using a mainly technical approach, what is involved in assessing the stock market situation, how to interpret stock charts, at least at a simple level, and the ways to identify and select stocks to trade with some rules governing when to buy and sell.

What we will do now, at the beginning:

1. Let us start out with a few general comments about the trading process that we can build on as we go along.
   2. Then we can introduce and examine some stock charts, a basic source of information that most traders refer to.
   3. We will pick a couple of “live” stocks to look at and follow their market action as the days and weeks go by, usually with expectation of holding for about 3 months.
   4. We will try to identify a few stocks that we will put on a list commonly known as a Watch List.
   5. There will also be a series of commonly used terms applied to various market aspects that we should define as we go, we can call that our Glossary.
   6. The reasons- to choose the first trade example

Some of the things we will discuss in future posts:

1. Stock charts, what they can tell us
   2.  Stocks to trade, how to find and assess them, the criteria to look for in their selection
   3.  Guidelines for entry and exit, the signal to buy and timing to sell, for profit or to cut losses
   4.  Other matters in no particular sequence

We should also describe briefly what is traded on the Stock Exchanges, NYSE, NASDAQ, ASE, TSE, FTSE etc. A stock exchange is an organization that provides facilities for trading stocks and other financial instruments.

Our Blog title is How to Trade Stocks but the real objective is to point out How to Trade Stocks Successfully, which obviously means profitably.

Not every trade in the stock market makes a profit but unless at the end of a reasonable time period there are enough gains that exceed losses there is not much point even if you end up knowing the mechanics of how to trade.

If required, the stock broker will advise on setting up a brokerage account
You can find out from the broker of your choice how to open a personal brokerage account and how to make a trade. And that account should be an on-line account that you will be able operate from your own computer. You will be provided with instructions on the procedures of obtaining a quote and placing a trade and monitoring the daily activity. And the broker will probably have a wealth of information and resources for you to access, free of charge, once you have learned what it is that you need to know.

We discuss what’s involved in selecting a stock to trade and tracking its performance
We are always faced with the question of “What are we going to buy? And Why? And once we’ve bought an issue, when should we sell it? What is our exit strategy, our profit or loss point that will trigger the sale?

Behind the answers to those questions is a lot of know-how involving decision-making, research, strategy, risk management, capital allocation, information and data sources, and so on. So that is what we have to become familiar with by making reference to it here and examining actual situations and data relating to the stocks we have chosen to trade and how those matters relate to the stock market in general.

While we are not participating here in real trades in the stock market, we can in the next few days, if the market conditions are right, try to identify a few stocks that do meet specific trading criteria to warrant making a trade or two and we can then follow their performance each trading day. We can also build a short “Watch List” of stocks of interest to monitor that may soon meet the criteria to trade. In doing those things, we can introduce the various reasons leading to the choice of the particular issue to trade and what needs to be taken into account to arrive at a final commitment of cash resources.

We can monitor such trades by using the many readily available resources and tools on the web to help us judge our progress. This should help make it a little easier to understand the various steps in making a decision and we can consider other alternatives or matters in reference to those trades and to the market in general as time passes.

You will be able to follow what is happening by going to a free site such as YahooFinance.com and entering there the details of the “pretend” trades that we select and in that way you can see for yourself what is happening each day as the stocks moves back and forth as they will do throughout the trading days and weeks. It is necessary to keep a watchful eye on your stocks and the market in general, but it is definitely not necessary to spend too much time to the extent it becomes obsessive and interferes with the normal enjoyments of life. By following this scenario we should be able to cover the basics in our aim to learn how to trade stocks.

Trading, not Investing

At the outset, I think we should establish that trading is not investing, at least not in the traditional sense. My own take is that trading is an action in speculation, usually of relatively short-term duration, meaning a few weeks to a few months but not years. There are exceptions to everything of course and there are several possibilities we might encounter.

There are also different approaches to trading and what suits one person’s temperament may not be appropriate for another. But this is a learning process and what we do on this blog should be of value as an introduction to  market situations that are common to many other trading activities and approaches and from which a wider extension of knowledge and trading style can emerge.

Caution:
This comments in the posts and articles on this How to Trade Stocks blog-site, do not make recommendations or suggestions to actually buy or sell particular stocks, I am not allowed by law to do this and anyway, I would not want you to risk your own money on something that has been chosen for the purposes of illustrating the trading processes and background research that is involved. All the matters discussed are to enable the introduction and explanation of the many aspects of stock market trading. So, learn what you can but I must emphasize: Do not invest in any stock featured on this site.

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