Beginners guide to investing in the stock market

Beginners Guide to the Stock Market

What are stocks?

A stock is a share in the ownership of a company. If you own a share of a company's stock, you have a claim to a part of everything the company owns and are entitled to a portion of the company's profits, which are often paid out in the form of dividends.

A special type of stock is exchange-traded funds. An exchange-traded fund, or ETF, is a basket of stocks that is bought and sold on a stock exchange as if it were a single stock. For instance, SPY is a bundle of 500 large U.S. stocks that track the performance of the S&P 500 Index.

Why issue stocks?

Why does a company issue stock? At some point every company needs to raise money. To do this, companies can either borrow funds or sell part of an interest in the company, which is known as issuing stock.

How stocks trade

Most stocks are traded (which in financial market jargon means they are bought and sold) on stock exchanges, which are places where buyers and sellers meet and decide on a price. The most well-known exchanges in the U.S. are the New York Stock Exchange (NYSE), NASDAQ and American Stock Exchange (AMEX).

Brokers are the individual investor's direct link to Wall Street. They charge a price (commission) to trade, so to trade stocks you need to sign up for a brokerage account. Whichever broker you decide to use, make sure he is covered by the Securities Investor Protection Corporation, which protects your assets in a brokerage account in the event the firm should fail.

A Web-based broker is simple to use, as all you have to do is log in through the broker's Web site and place your orders through a simple online form:

1.) You must fill in the ticker symbol for the stock you want to buy (for instance, the ticker symbol for S&P 500 is SPY).
2.) Fill in the amount of money you want to invest or select how many shares you want to buy.
3.) You can set the maximum price (limit price) you are willing to pay for each share, or trade at the current market price.

Risks of owning stocks

Just as a small business owner isn't guaranteed a return, neither is a shareholder. Shareholders can earn a lot if a company is successful, but they also stand to lose their entire investment if it isn't.

As an owner of a stock, you are not personally liable if the company is not able to pay its debts. Even if a company in which you are a shareholder goes bankrupt, you can never lose your personal assets. The amount of money you put at risk is absolutely limited to the amount you paid for the stock.

What causes stock prices to change?

The current price of a stock indicates what investors feel a company is worth. There are many factors that affect investors valuation of a company.

Stock prices are often influenced by company earnings and future earning estimates. The stock market is also affected by the current economic situation, interest rates, political decisions, investor sentiment (positive or negative) and psychology (greed and fear).

Supply and demand is another important factor in the development of stock prices. If more people want to buy a stock than sell it, the price moves up. If more people want to sell a stock than buy it, the price will fall. Even if there is nothing wrong with a company, a large shareholder or institutional investor who is trying to sell millions of shares at a time can drive the price of the stock down simply because there are not enough people interested in buying the stock he is trying to sell.

How to read stock price charts

A price chart is a sequence of prices plotted over a specific time frame.

On the chart, the y-axis (vertical axis) represents the price scale and the x-axis (horizontal axis) represents the time scale. Prices are plotted from left to right across the x-axis with the most recent plot being the furthest right. The time frame used for forming a chart can be: intraday, daily (most common), weekly, monthly, quarterly or annual data.

Perhaps the most popular charting method is the daily bar chart. The days open, high, low and close are required to form the price plot for each period of a bar chart. The open is the short horizontal line crossing the vertical bar on the left and the close is the short horizontal line crossing the vertical bar on the right. The high and low are represented by the top and bottom of the vertical line.

On a daily chart, each bar represents the high, low and close for a particular day.

Stock analysis

There are two general schools of stock analysis:

1.) The fundamentalist will select stocks purely on the basis of a company's financial statements (quarterly and annual reports). Fundamentalists use a wide variety of approaches, but below are the three most common ways to evaluate stocks based on fundamentals:

      * Value investors: Invest in stocks selling below their true value.
      * Income investors: Invest in stocks paying high and consistent dividends.
      * Growth investors: Invest in companies that exhibit signs of above-average growth.

2.) The technical analyst uses price charts and/or mathematical formulas to forecast future price direction (technical analysis). Technical analysis is based on the belief that price discounts everything. All known fundamental, political and economic information available to the market is reflected in the price. Technical analysts often rely on technical indicators. An indicator is a result of mathematical calculation, based on prices and/or volume. The figures received are used to measure current market conditions as well as to forecast price changes.

It is of course possible to use both approaches by using fundamental analysis when choosing which stocks to buy, and technical analysis for timing your entry and exit.

Stock market time frames

Markets often trend in more than one direction at the same time: The stock market can be in an upward trend for several years; while the secondary cycle corrects downwards over several months; and a short-term rally occurs during the current week. This is why stock traders can have very different time frames in mind:

   1. Long term investors will often hold their stocks for several months or years.
   2. Swing traders typically jump in and out of stocks more often, usually holding each stock just a few days or weeks.
   3. Day traders will hold a stock anywhere from a few seconds to a few hours, taking advantage of small price fluctuations during the day.

Money Management

Most investment professionals agree that money management is the most important factor helping you reach your long-range financial goals while minimizing your risk. As a investor your money management strategy is the one variable that will give you the biggest edge in trading stocks. You cannot control the stock market but you can control your money and your risk on each and every trade that you make.

1. Even if the odds are stacked in your favor, it is usually inadvisable to risk a large portion of your capital on a single trade. The portfolio theory tells us that after 10-12 diversified stocks, you are very close to optimal diversification. Of course you need to split your investment capital among a variety of companies from different industries.

2. Never buy a stock without a plan to get out. Then if the market moves against you are prepared. Price corrections where the price temporarily turns down before the uptrend continues is perfectly normal. However there is no reason to hang onto any stock that is sharply declining when you could own a rising stock instead. Make a decision in advance to sell a stock if its price falls more than a predetermined percentage from its highest point (trailing-stop) or below a predetermined percentage of the price at which you bought it (stop-loss).

3. A general rule for equity markets is to never risk more than 1-3 percent of your capital on any one stock.

4. The biggest risk that any trader faces is that they will lose their capital. Sooner or later they encounter a string of losing trades (drawdown) that either wipes them out or wipes out a big enough portion of their capital that they quit trading. By managing your money correctly on every trade you can relax because if you incur a loss it will be insignificant to your account. This will also relieve the emotional pitfalls that plaque so many investors.

The following table will help illustrate the importance of keeping drawdowns to a minimum:

% Drawdown    % Gain required to recoup loss from drawdown
10% drawdown 11% required to recoup losses
15% drawdown 17.6% required to recoup losses
20% drawdown 25% required to recoup losses
25% drawdown 33.33% required to recoup losses
30% drawdown 42.85% required to recoup losses
40% drawdown 66.66% required to recoup losses
50% drawdown 100% required to recoup losses

Trading psychology

Don't let emotions take control of your trading. Always stick to your trading plan and avoid impulse trades. Never a trade with a gamblers mindset. Stock trading is not gambling, and the stock market is not a casino.

Emotion is the greatest enemy of the trader, particularly the emotions of fear, e.g., the fear of suffering a loss or the fear of missing out on an opportunity. Stay emotionally detached from the market. Avoid getting caught up in the short-term excitement, or you'll be changing your mind and your position every few minutes.

If you are unsure of your trading strategy, you are likely to make emotional decisions that may result in losses.

Advanced trading tools

The most common trading strategy is simply to buy a stock, wait for the price to increase, then sell the stock for a profit. However more advanced trading strategies are also available:

1. Margin trading is a way to magnify your buying power by borrowing money from your broker. Margin is a high-risk strategy that can yield a huge profit if executed correctly. A 50% initial margin allows you to buy up to twice as much stock as you could with just the cash in your account. It's easy to see how you could make significantly more money by using this strategy. Of course, trading on margin magnifies both your profits and your losses. In a margin account, you are investing with your broker's money.

2. Short selling is the selling of a stock that the seller does not own, or any sale that is completed by the delivery of a security borrowed by the seller. Short sellers assume that they will be able to buy the stock at a lower amount than the price at which they sold short. Short sellers make money if the stock goes down in price. Short selling requires a margin account.

3. Option trading. An option is a contract that gives the buyer the right (but not the obligation) to buy (calls) or sell (puts) a stock at a specific price on or before a certain date. A stock option contract represents 100 shares of the underlying stock. Traders use options both to speculate and hedge risk.

4.) Financial spread betting: Spread betting allows you to bet, or take a position, on whatever you think a financial market will do next. The more the market moves in your favour, the more you profit, with unlimited potential. Conversely, the more the market moves against you, the more you could lose - and you may lose more than your initial deposit.

5.) A CFD (or Contract For Difference) is simply an agreement to exchange the difference in value of a particular share between the time at which the contract is opened and the time at which it is closed. CFD trading is very similar to normal share dealing in two respects. You deal at the cash price of the share, and pay a commission which is calculated as a percentage of the value of the transaction.

How to Make Money in Stocks

The most important thing you need to know about building wealth in the stock market is the power of compounding (making regular periodic investments and reinvesting the profits).

The results you'd get following this discipline are surprising. Say you start with nothing, but decide to put $500 of your income into an investment account every month, and you commit to letting your money ride. Throughout stock market history (100 years), the average yearly return has been around 10%. If you achieve that same return, you'd have $1 million if you stick with the plan for 28 years.

The longer you invest, the smaller the amount you need to put away each month to reach $1,000,000. Thus the younger you are when you start investing, the younger you'll be when you join the million-dollar club. Of course, skilled investors might beat the stock market average and achieve even higher returns in a much shorter time frame. The millionaire calculator shows you how long it will take YOU to become a millionaire