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Stock Trading
master the fundamentals by teaching yourself to:
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
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 stocks share price. According to the efficient market hypothesis, a stocks recent price or volume trends dont matter, because a stocks price depends only on the relevant information about the stock thats 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 stocks 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 theyre right remains up for debateno one has proven that technical analysis really works.
Traders and investors dont buy and sell stocks directly on stock exchanges. Instead, they use brokers.
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 ownwithout dealing with an intermediaryby 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.
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
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share volume
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(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 dataup-to-the-minute information that traders can stream onto their computers instantly as its 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.
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 its 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 stocks price chart to track and analyze the stocks 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.pcquote.com), MarketScreen (www.marketscreen.com), or StockCharts.com (www.stockcharts. com), that charge monthly fees of about $2550.
The information contained in this and every Quamut guide is intended only for the general interest of its readers and should not be used as a basis for making medical, investment, legal or other important decisions. Though Quamut makes efforts to create accurate guides, editorial and research mistakes can occur. Quamut cannot, therefore, guarantee the accuracy of its guides. We disclaim all warranties, including warranties of merchantability or fitness for a particular purpose, and must advise you to use our guides at your own risk. 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.
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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.
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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.com), and Charles Schwab (www.schwab.com). Consider using a direct-access broker: If youre 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 moneyif 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 youre a day trader, interest charges likely wont affect you, but if youre 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 youre responsible for paying back, even if you lose all or part of your margin balance as a result of trading. If you cant pay back your broker, your trading privileges will likely be suspended, and more serious financial consequencessuch as a lower credit ratingwill 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, youll get a margin call, which forces you to come up with the cash to bring the balance back in line. If you dont have the cash, your broker will sell stock from your account to make up the difference.
Broker Fees
Before you decide on a specific broker to use, its essential to know the types and amounts of the fees that the broker charges. Discount brokers: Discount brokers typically charge a commission (fee) of $750 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 $35150 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 ($99300) 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 TradeStations can save you money on a per-trade basis.
E-DAT Systems
The introduction of NASDAQs 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 NYSEs is called the Super Designated Order Turnaround System (SuperDOT), and the AMEXs 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 worlds 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 NASDAQs 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.
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 its 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 theyre agency-only. If they arent, ask for a detailed breakdown of the investments in which they maintain a stake that could lead to a conflict of interest.
Computer
Most DATs run on Windows PCs. If youre using Windows, youll want to run Windows XP or Vista on a Pentium 4 computer with a 1GHz processor or faster. Youll 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).
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If You Have a Mac
If youre 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 youre 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 NASDAQs SOES or the NYSEs 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 youre 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 dont need a multiplemonitor setup to get started trading, but at the least youll want to use a flat-panel 20" LCD monitor with a resolution of 12801024 or higher. Monitors with these specs cost in the range of $250400. Youll 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 12801024 or higher. Such cards typically cost in the neighborhood of $5075. (Your computer might come with an adequate video card preinstalled, so check before buying an additional card.)
Internet Access
Youll need a reliable, always-on broadband internet connection, ideally from a reputable network provider. Broadband internet access typically costs about $50 per month.
Power Supply
To protect your trading station from power surgesand, 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. Theyre sold at electronics stores, office supply stores, and online retailers for about $75100.
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Though traders sometimes use basic line charts to get a quick overview of a stocks activity, to do technical analysis traders use two types of more complicated charts: OHLC charts and candlestick charts.
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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 stocks 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 lines will indicate the open and the close, respectively.
high open high close
close low this stocks close was lower than its open
open low this stocks 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
resistance level
breakout
stock price
stock price
stock price
day
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day
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day
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Trends
A trend is a consistent pattern of movement in a stocks 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 stocks share price Downtrend: Occurs when a trendline shows a steady decrease in a stocks share price
Traders analyze charts to find reversals, points at which it looks like a stocks 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).
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 stocks share price declines. Since selling short is very risky, its best to avoid this type of trade entirely, unless youre an experienced trader or investor.
crossover
30-day SMA
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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.
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.
Traders use a stocks RSI to identify trends in which the stocks 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.
reversal occurs
90
share price
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100 80 50 20 0
Volume Indicators
Traders use volume indicators to assess a stocks 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 stocks 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 stocks 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 stocks 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.
upper band
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30-day SMA
downtrend occurs
price change
15 10 5
lower band
40 0 20 40
volume
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share price
20