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The Stock Market and How We Trade It

The Stock Market and How We Trade It

To put it broadly, the financial markets is any system or place where buying and selling of financial instruments takes place. These financial instruments could be stocks, bonds, currencies, equities, futures… the list goes on and on. Generally, when people think of the financial markets, they think of the stock market. While this is not necessarily incorrect, the stock market is just one piece of the puzzle. While stocks can be bought and sold, they are actually part of a bigger group referred to as equities. Equites can include market indexes, sector analysis, industry groups, and yes individual stocks.

Right now, you might be thinking, “Whoa, let’s back up! So again, what are we referring to when we say financial markets?”

Well, in short, all of it. It sounds confusing and there is a lot involved. Think of the markets as being behind the scenes. When it comes to physically trading it, that is where the big show happens. We encourage you not to get caught up as much in what the markets are but instead in what they do and what you can do with them.

So, how do we trade them?

The reason you need an understanding of what the markets are is so you understand what and how you can trade them. Of course, you can trade stocks, but you can also trade other equities, as well as forex, futures, options, and the currently exceedingly popular, crypto currency. Within each of these larger categories are much smaller sub-categories that are bought and sold, or “traded.”

So how do you decide what to trade?

For some, this is just a matter of personal preference. What do you find interesting? Are you fascinated with crypto? Maybe you don’t have the funds to buy stock of a certain company, but you could afford to buy an option contract. There are many varied factors that come into play when it comes to trading. The one thing that holds true for every trader is how to trade, not what.

There are two main types of traders: fundamental or technical.

Just as it sounds, a fundamental trader focuses more on analyzing macroeconomic events. Things going on in the government, taxes, unemployment, inflation, the economy, money, and debt are all aspects that a fundamental trader will analyze before making any trades. A technical trader, on the other hand, focuses more on trading activity by reading charts. They analyze movement influenced by supply and demand. You can absolutely use both types of analysis and doing so can be beneficial. It is important to do your research when it comes to trading. No matter what type of analysis you choose, it plays an integral role in eliminating risk when it comes to trading.

Which brings me to my next point ... The first thing anyone, who is not professionally trained or educated says about the financial markets is, “I’d love to start but it’s too risky.” Read that again, notice the “not properly trained or educated” part. If you were handed the keys to a helicopter, could you fly it? It is possible, but not very probable. Now, if you had proper training would the probability of you being able to fly that helicopter go up? This is how we approach the financial markets. It is crucial to have the proper education to eliminate the risk. Luckily, we are here to provide that education to you.

What about financial advisors? They have to know what they’re doing, right? There is a risk any time we or someone else invest our money. When we allow someone else to be responsible for our financial success, we assume that it is less risky because they know what they are doing, right?

So, if we take that same idea, could we also not assume that if we educated ourselves, we could handle our own finances, while still eliminating some of the risk? Not to mention, we have complete control over our investments, we can check them daily, we can make money during a crash, and one of the biggest incentives, we are not paying someone else to do it for us. Remember it is all about our ROI (return on investment), return on investment.

Can we eliminate all risk? Of course not, and if anyone ever tells you they can…run! We cannot predict the markets with absolute certainty. What we can do is educate ourselves to minimize that risk. To do this, we must understand risk and what it is.

There are two types of risk to consider when it comes to trading. First is our trade risk. This is the difference between an estimated entry point and an estimated exit point. Essentially, the maximum amount of money you would be comfortable losing on any given trade. Second is our allocation risk. Yes, it does cost money to buy something, that is true, even in the financial markets. Allocation risk is how much capital you are willing to spend to open a position. The maximum amount of money you would be comfortable allocating to any given trade.

For example, if you estimate buying a stock at $32.00 and sell if it hits $28.00, your trade risk is $4.00.

$32.00 - $28.00 = $4.00

To understand trade risk in dollars, let’s say you have $10,000.00 in your account and you would feel comfortable losing $200.00, you are willing to risk 2% of your account.

While 2% might not seem like much, what if you have 10 losing trades? You have now lost 20% of your account. Not that you are going to have 10 losing trades but remember these are estimates and must be accounted for when we are considering all our risks.

Now, let’s look at our allocation risk. Remember, there is a cost to doing business. Let’s say you want to buy 100 shares of a $10.00 stock.

100 shares x $10.00 = $1,000.00

Or maybe you trade options (check out our website for more information on option trading), and you want to buy one option contract at $4.00.

100 X $4.00 = $400.00

Again, to understand in dollars. You have that same $10,000.00 in your account and you allocate $2,500.00 to a trade; you are comfortable allocating 25% of your account to making that trade.

In any trade, we look at our risk vs. allocation … How much are we willing to risk and how much is it going to cost us. Would we be willing to allocate more money to a trade if our risk were less? Or vice versa, would we be willing to risk more if our costs were less?

Whatever your risk rules are, it is imperative that you are consistent and abide by those rules on every trade. Remember, the number one rule of trading is, Do Not Lose Money!

You have made the decision. You want to start trading in the financial markets. Great! Now what? There are some things that need to be in place before you can take the next steps towards your financial future. Preparation is the name of the game when we are just starting out. Certain things need to be in place before we can even think about conducting any trades. Besides, where do we even go to place these trades?

The first step is to get yourself prepared mentally. I am not just talking about motivation. You have already made the decision you want to do this. I am talking about creating routines. Routines will become particularly important and will eventually turn into healthy habits that you carry out daily.

The first behavior you need to develop is the habit of studying the markets. You will need to review the news, study charts, make notes of price levels, and determine your bias (bullish, bearish, neutral). A lot of trading is analyzing and researching. We never just jump and make a trade based on a 50-50 chance of either going up or down.

Next, you need to schedule time for your trading business. Is this going to be your new full-time job or are you just doing this to supplement your income and bring in some extra cash flow? Always remember to start small and most importantly be consistent. Starting out, spend 3-4 hours a week studying the markets, and getting accounts set up, till you can start devoting more time. The key is, you need a routine, and you need to be consistent with it.

So, what is your plan? This is your how, why, and when of trading. You need to establish some risk rules. These are rules you are going to consistently follow to protect your capital. You need to set goals and have a strategic plan for how you are going to make money. That plan should include the strategies you are going to use, how you are physically going to trade. Develop your routine, including analyzing the markets and most importantly educate yourself. What are you going to do to continue learning and developing new skills?

Awesome! You have a plan. What’s next? Well, in order to execute these trades, we are going to need some tools. We need some resources where we get our information. You are going to need a charting resource as well as a fundamental research resource. A charting resource is where we can see the technical analysis of how things are moving in the markets. A fundamental resource is where we go for our news and information. We are also going to need a broker and a virtual trading platform. There are tons of these out there and ultimately it is your decision but there are certain criteria you want to look for (listed at the end of this article). Lastly, we are going to keep a trading journal. It is imperative that you keep notes and records during your trading process.

Developing this routine will also help you discover what type of trader you are or want to be. Are you a day trader? You plan, enter, and exit trades within the same trading session or within a 24-hour period. Are you a swing trader? You plan and enter trades that anticipate, at a minimum, an overnight hold and can last up to several weeks. Are you a position trader? You plan and enter trades based on longer term fundamentals and perspectives that extend beyond typical short-term swing cycles and can last months to years if the trend persists. The amazing thing about this is that you can, and probably will be all three. Once you learn the fundamentals, you allow the markets to tell you what type of trader you should be.

This may sound like a lot of work but that is what is so great about it. It allows the flexibility to go at your own speed. There is NO COMPETITION! You, your mother, your neighbor, and Warren Buffet could all make the exact same trade. So don’t get caught up in feeling like you’re missing out and you want to jump right in. It is more about learning the system, developing a routine, and mostly being consistent. The first step is to just get started.

In order to get started trading, we first have to choose a broker. When it comes to trading, there are several different brokers out there. So how do you know which one is right for you? That answer is simple. In short, the one that you choose is the right one for you. We all have our own personal preferences, and each broker has different things they offer. However, to help you decide, here is a list of a few things you should consider.

  • What instruments do they trade?
  • Basic interface vs. sophisticated?
  • Virtual trading
  • Advanced order entry
  • Customer service
  • Industry accolades
  • Commissions & fees
  • Execution
  • Analytics
  • Tools & gadgets/technology
  • Do they offer mobile trading or have an app?
  • Are they insured?

Everyone will have their own personal preferences when it comes to trading in the financial markets. Just remember to follow the rules and practice, practice, practice! Check out some of our other articles on the fundamentals of trading for more information.

Legacy’s Building Wealth Club offers you the financial education needed to pursue your goals. Let our education and experience lead the way!

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