People who are interested in playing the stock market should be aware of the pros and cons of investing and speculation. They should also be comfortable with the strategies that can help them protect their profits and limit their downside. This write-up aims to provide useful stock information for beginners who may end up becoming savvy investors.
Although speculation is a distinct possibility, it is a very risky proposition. Thus, beginners should focus on investing rather than speculation.
Buying Stocks without a Broker
Direct Stock Purchase (DSP) Plans and Dividend Reinvestment Plans (DRIP) enable people to buy stocks without a broker, since these plans allow investors to purchase stocks directly from the issuing company. DSP allows people to set up a stock purchase account and purchase shares from the issuer without paying a commission to the broker. Unfortunately, direct stock purchase plans are not offered by all publicly traded companies.
DRIP requires the investor to purchase the first stock from the broker. After the initial purchase, an investor can buy stocks from the company using cash dividends and capital gains. Although this is a good option for people with less money, the main disadvantage is that, people buy stocks on an ongoing basis and it becomes difficult to calculate the capital gains.
Discount and Full-Service Brokers
People may use a discount broker if they are interested in trading stocks, for beginners may find it difficult to pay for the services of a full-service broker. A full-service broker provides useful investment advice, retirement tips, estate planning advice, and tax advice in addition to offering the usual buying and selling services. Full-service brokers are very expensive as compared to discount brokers, and are meant for wealthy investors.
Playing the Stock Market
Stock investing involves buying undervalued stocks and selling overvalued securities. An undervalued stock is one that is worth more than the current price at which it's trading. The investor is required to estimate the actual value of the security. This can be done using the dividend discount model (DDM), the free cash flow model, or the residual income model. Generally, firms that have a history of dividend payments are ideal candidates for DDM. The free cash flow model and the residual income model are appropriate for firms that have positive cash flows and reliable book values respectively. If the actual value of the stock is greater than the current market price of the security, the stock is undervalued, and one must buy the shares. If the actual value is less than the market price, a prudent investor should short sell the security. Short selling involves selling borrowed security and it's a very risky proposition, since inaccurate market timing may make it difficult for the borrower to sell the security at the desired price.
Stock Trading Strategies
Investors generally place a market order when they are confident that the stock can be bought/sold at the desired price. In case of uncertainty, investors should place a limit order. For instance, if a stock is trading at USD 55, an investor may ask the broker to buy the stock at USD 50 by placing a buy limit order. One must bear in mind that the limit order will be fulfilled only if the market price reaches USD 50. Similarly, another investor can place a sell limit order at USD 65 for the same stock.
The investor also has the option of placing a stop order. For instance, one may buy a stock at USD 50. If after purchasing the stock, the price falls, one may place a stop sell order at USD 45 to limit losses. The stop order will be fulfilled only when the price of the stock falls below USD 45. The investor may also use the stop order to protect profits. The investor may place a stop order at USD 55 to guarantee profits.
Investors may also place a stop limit order which is a combination of a stop order and a limit order. This may be used to buy a stock within a narrow price range. For example, if a stock is trading at USD 50 and the investor is unsure about the direction of the market, he/she can place a stop order at USD 55 and a limit order at USD 57. In other words, if the price of the stock exceeds USD 55, the stop order becomes a limit order and the stock will be purchased at USD 57 or less. However, if the price jumps to USD 58 the order will not be fulfilled. Had the investor purchased a call option, with an exercise price of, say USD 52, he/she could have still purchased the stock trading at USD 58. Call and put options on stocks are highly risky and are meant for savvy investors. Similarly, margin trading is not advisable for beginners and hence we shall not be discussing the same.
Hopefully, this in-depth discussion will be useful to the novice trader. Savvy investors can consider options trading to augment their income. Margin trading or leverage may also be used for increasing the return on investment.