Many people give little thought to life’s important decisions. They stumble into them by accidents of geography, time, or chance. Where to live, where to work, what markets to trade—many of us decide on a whim, without much serious thought. No wonder so many are dissatisfied with their lives. You can choose your markets on a whim or pause to think whether to trade stocks, futures, or options. Each of those has pluses as well as minuses.
Successful traders are rational people. Winners trade solely for the money, while losers get their kicks out of the excitement of the game. Where those kicks land is another question.
In choosing a market to trade, keep in mind that every trading vehicle, be it a stock, a future, or an option, has to meet two criteria: liquidity and volatility. Liquidity refers to the average daily volume, compared with that of other vehicles in its group. The higher the volume, the easier it is to get in and out. You can build a profitable position in a thin stock, only to get caught in the door at the exit and suffer slippage trying to take profits. Volatility is the extent of movement in your vehicle. The more it moves, the greater the trading opportunities. For example, stocks of many utility companies are very liquid but hard to trade because of low volatility—they tend to stay in narrow price ranges. Some low-volume, low-volatility stocks may be good investments for your long-term portfolio, but not for trading. Remember that not all markets are good for trading simply because you have a strong opinion on their future direction. They also must have good volume and move well.
A stock is a certificate of company ownership. If you buy 100 shares of a company that issued 100 million shares, you own one-millionth of that firm. You become a part owner of that business, and if other people want to own it, they will have to bid for your shares, lifting their value.
When people like the prospects of a business, they bid for its shares, pushing up prices. If they don’t like the outlook, they sell their stock, depressing prices. Public companies try to push up share prices because it makes it easier for them to float more equity or sell debt. The bonuses of top executives are often tied to stock prices.
Fundamental values, especially earnings, drive prices in the long run, but John Maynard Keynes, the famous economist and a canny stock picker, retorted “In the long run we’re all dead.” Markets are full of cats and dogs, stocks of unprofitable companies that at some point fly through the roof, defying gravity. Stocks of sexy new industries, such as biotechnology or the Internet, can fly on the expectations of future earnings rather than on any real operating records. Each dog has its day in the sun before reality sets in. Stocks of profitable, well-run companies may drift sideways to down. The market reflects the sum total of what every participant knows, thinks, or feels about a stock, and a declining price means large holders are selling. The essential rule in any market is “It’s OK to buy cheap, but not OK to buy down.” Don’t buy a stock that’s trending lower, even if it looks like a bargain. If you like its fundamentals, use technical analysis to confirm that the trend is up.
Warren Buffett, one of the most successful investors in America, is fond of saying that when you buy a stock, you become a partner of a manic-depressive fellow he calls Mr. Market. Each day Mr. Market runs up and offers either to buy you out of business or to sell you his share. Most of the time you should ignore him because the man is psychotic, but occasionally Mr. Market becomes so terribly depressed that he offers you his share for a song—and that’s when you should buy. At other times he becomes so manic that he offers an insane price for your share—and that’s when you should sell.
This idea is brilliant in its simplicity, but hard to implement. Mr. Market sweeps most of us off our feet because his mood is so contagious. Most people want to sell when Mr. Market is depressed and buy when he is manic. We need to keep our sanity. We need objective criteria to decide how high is too high and how low is too low. Buffett makes his decisions on the basis of fundamental analysis and a fantastic gut feel. Traders can use technical analysis.
Speaking of gut feel, this is something that an investor or a trader may develop after years of successful experience. What beginners call gut feel is usually an urge to gamble, and I tell them they have no right to a gut feel.
Which stocks should we trade?
There are more than 10,000 of them in the United States, with even more abroad. Peter Lynch, a highly successful money manager, writes that he only buys stocks in companies that are so simple that an idiot could run them—because eventually one will. But Lynch is an investor, not a trader. Stocks of many companies with little fundamental value can embark on fantastic runs, making heaps of money for bullish traders before collapsing and making just as much money for the bears.
The stock market offers a wealth of choices, even after we cut out illiquid or flat stocks. You open a business newspaper, and stories of fantastic rallies and breathtaking declines leap at you from the pages. Should you jump on the bandwagon and trade stocks in the news? Have they moved too far from the gate? How do you find future leaders? Having to make so many choices stresses beginners. They spread themselves thin, jumping between stocks instead of focusing on a few and learning to trade them well. Newbies who cannot confidently trade a single stock go looking for scanning software that will let them track thousands.
In addition to stocks, you can choose from their kissing cousins, mutual funds, called unit trusts in Europe. Long-term investors tend to put money into diversified funds which hold hundreds of stocks. Traders tend to focus on sector funds that let them trade specific sectors of the economy or entire countries. You pick a favorite sector or country and leave individual stock selection to the supposedly hot-shot analysts laboring at those funds.
Choosing a winning stock or fund is a lot harder than listening to tips at a party or scanning headlines in a newspaper. A trader must develop a set of fundamental or technical search parameters, have the discipline to follow his system, and spread a safety net of money management under his account. We will delve into all three areas in Part 2.
Where Do I Go From Here?
How to Buy Stocks by Louis Engel is the best introductory book for stock investors and traders. The author died years ago, but the publisher updates the book every few years—be sure to get the latest edition.
Futures look dangerous at first—nine out of ten traders go bust in their first year. As you look closer, it becomes clear that the danger is not in futures but in the people who trade them. Futures offer traders some of the best profit opportunities, but the dangers are commensurate with rewards. Futures make it easy for gamblers to shoot themselves in the foot, or higher. A trader with good money management skills needn’t fear futures.
Futures used to be called commodities, the irreducible building blocks of the economy. Old-timers used to say that a commodity was something that hurt when you dropped it on your foot—gold, sugar, wheat, crude oil. In recent decades many financial instruments began to trade like commodities—currencies, bonds, stock indexes. The term futures includes traditional commodities along with new financial instruments.
A future is a contract to deliver or accept delivery of a specific quantity of a commodity by a certain date. A futures contract is binding on both buyer and seller. In options the buyer has the right but not an obligation to take delivery. If you buy a call or a put, you can walk away if you like. In futures, you have no such luxury. If the market goes against you, you have to add money to your margin or get out of your trade at a loss. Futures are stricter than options but are priced better for traders.
Buying a stock makes you a part owner of a company. When you buy a futures contract you don’t own anything, but enter into a binding contract for a future purchase of merchandise, be it a carload of wheat or a sheaf of Treasury bonds. The person who sells you that contract assumes the obligation to deliver. The money you pay for a stock goes to the seller, but in futures your margin money stays with the broker as a security, ensuring you’ll accept delivery when your contract comes due. They used to call margin money honest money. While in stocks you pay interest for margin borrowing, in futures you can collect interest on your margin.