How to trade stocks

  • How to trade stocks - the beginner’s guide to stock trading

    How to trade stocks

    In this article, we look to cover some basics of stock trading, and demonstrate the different approaches and strategies traders use when deciding what position to take.

    We'll also show you why CFD trading and spread betting is a unique and cost-effective alternative to traditional shares trading, and how it could help you maximise your trading potential.

    How stock trading works

    A firm's share price typically moves in three ways; up (if a company is performing well), down (if a company is underperforming) or sideways (if investors are unsure how the company will perform in the future). What traders seek to do from the movement of share prices is attempt to predict where they will head to next and profit from this prediction.

    For example, at the end of December 2000, Marks and Spencer's share price was valued at 187p. Investing £10,000 in Marks and Spencer would have gotten you approximately 5,348 shares in the company.

    Fast forward to 27th April 2007, and Marks and Spencer's share price peaked to 759p. That means your 5,348 shares are now worth £40,591.32 - a profit of over £30,000.

    However, timing your trading decisions are absolutely crucial as Marks and Spencer's share price then slid to 386.75p a share in the year by 15th January 2008, which would have reduced the value of your holding to £20,683, around half its value from a mere nine months earlier.

    Knowing when to sell your stock is just as integral as knowing when to buy and its crucial decisions like these which will determine how much profit or loss you'll make trading shares.

    In traditional shares dealing, you would have to pay your broker the total of the value of the shares you wish to purchase. So, 5,348 shares in Marks and Spencer in December 2000 would have cost you around £10,000 up front. You would also have had to pay a small commission charge for the trade, which varies from broker to broker.

    Spread betting and CFD trading

    The reason that spread betting and CFD trading are an attractive alternative to physical shares trading is because it allows you to take a position on the share price without paying the full value up front.

    So, with City Index, you only have to deposit a small percentage of the total trade value to maintain the same level of exposure.

    Let's go back to the Marks and Spencer example. If we charge a margin rate for M&S of 4% of the total value, you would only need to deposit £400.03 (5,348 x 187p x 4%) for the same £10k exposure. This means that your investment capital can go much further than it could with conventional trading and your potential returns when compared to your initial investment amount are also much greater. However, this also means that should prices not move in the way you expect, you could also lose more than you invested, which is why risk management is a crucial part to long term successful trading.

    There are a few key things to remember when you spread bet or trade CFDs. Firstly, you don't actually own the shares as you would with buying stocks - you're simply speculating on the price movement of that share. Secondly, because spread betting is a leveraged product, your profits and losses are magnified, so please be aware of the risks involved. Thirdly; you can profit from falling markets as well as rising ones, which is explained in more detail below.

    Ability to profit from falling markets as well as rising

    One of the most unique aspects of spread betting and CFD trading is the fact that you are able to profit from falling markets as well as rising. This gives you complete trading flexibility to take advantage of any market movement, be it up or down.

    If you believe a share price will rise in value, you 'buy' or go long and you'll profit from every increase in prices above your opening level. Alternatively, you'll lose for every price fall below your open level.

    If you believe a share price will fall in value, you 'sell' or go short and you'll profit from every fall in price below your opening level. Alternatively, you'll lose for every price increase above your open level.

    For example, if you believe that Facebook's current value is overpriced, and you expect it to fall to a more reasonable level over the coming days, you can go short and 'sell' Facebook shares at a price of $76.50. (Please note that this price is accurate at the time of writing, but is subject to market volatility.) For every cent or dollar that the value of Facebook's share price decreases, you earn a profit.

    You cannot do this when trading shares physically.

    Trading stocks with City Index

    As a leveraged product, you can use spread betting or CFD trading to make your investment capital go further, but you must make sure you are aware of the risks involved.

    • No capital gains tax or stamp duty*
    • No commission to pay when spread betting - just the dealing spread
    • Take advantage of falling and rising share prices
    • You can use spread betting and CFDs to fit your strategy, with varied levels of risk
    • You can access global shares with over 10,000 markets to choose from

    When spread betting or trading CFDs on shares, there are a number of ways to approach evaluation before investing.

    Choosing which shares to trade

    Which stocks you trade on is going to depend on a number of different factors, including your level of experience, how much capital you have available, your trading plan, and the analysis you employ.

    Fundamental analysis and technical analysis are the two main methodologies when it comes to trading the financial markets.

    Essentially, fundamental analysts look at a number of factors, known as fundamentals, to help them understand whether current share prices undervalue or overvalue a company. In financial terms, a fundamental analysis attempts to measure a company's intrinsic value using information on the company's balance sheet, cash flow statement, income statement and many other factors.

    Fundamental analysis approaches the company much in the same way as property investors go about purchasing a property - you would look into certain factors before you made your decision. You would look at its foundations, schools in the area, crime rate and value growth potential to help you decide whether it's a property worth buying.

    In this approach, trading decisions can be easy to make - if the price of a stock trades below its intrinsic value, it could be a buy trade potential. On the other hand, if the price of a stock is trading well above its intrinsic value, it could be a sell trade potential.

    Here are some terms that you may come across concerning fundamental analysis of a stock:

    The fundamental approach:

    • Balance sheet: Also known as the statement of financial condition, the balance sheet is a summary of a company's assets, liabilities, and owners' equity
    • Earnings: Net income for the company during a period - usually divided into four financial quarters
    • Management team: The people who administer a company, create policies, and provide the support necessary to implement the owners' business objectives
    • Market share: Also known as market penetration, this is used in the context of general equities, and refers to the percentage of trading volume in a stock that a particular market maker trades
    • Mergers/acquisitions: Acquisition in which all assets and liabilities are absorbed by the buyer - but more generally, any combination of two companies
    • P/E ratio: This is the current stock price divided by annual earnings per share
    • Revenue outlook: Also known as revenue forecasting or market outlook, this is a calculation of the amount of money a company will receive from sales during a particular period

    Technical analysis, on the other hand, looks at the historical price movement and price activity of a share and uses this data to predict its future activity. Technicians believe that the fundamentals of a company are already built into the company's share price, so they believe all the information they need about a stock can be found in its charts. One of the key beliefs of market technicians is that history tends to repeat itself.

    Here are some terms that you may come across concerning technical analysis of a stock:

    The technical approach:

    • Trends: The general direction of the market (up, down or sideways)
    • Support levels: Refers to a price level where buyers have historically emerged, typically giving support to prices as a result. A market tends to stop falling because there is more demand than supply, and can be identified on a technical basis by seeing where the stock has bottomed out in the past
    • Resistance levels: Refers to a price level which is supposedly difficult for a market to rise above and has historically seen sellers emerge, pushing prices lower as a result. This is a ceiling which technical analysis notes persistent selling of a commodity or security
    • 52-week high/low range: The highest and lowest prices that a stock has traded at during the previous year. Many traders view the 52-week high or low as an important factor in determining a stock's current value and predicting future price movement
    • Moving average: This is the average stock price over a certain period of time - this can be as short as a few days or as long as several years

    Technical vs. fundamental

    When you start shaping your trading strategy, you might wonder whether fundamental or technical analysis is best for you when entering new positions. While many consider the approaches to be polar opposite, there's also an argument that the two can co-exist, meaning that you employ both methods when considering your next move.

    As with many things, there is not one correct answer. There are pros and cons to both approaches, but what's really important is that you find the philosophy that best works you. It's up to you to apply your education and your research to your own strategy.

    In the meantime, however, here are some key differences between the two approaches that may help you decide which is best suited for you:

    Time-frame

    Fundamental analysis takes a relatively longer-term approach to analysing the market compared to technical analysis. Looking at data from a number of years, fundamental analysis is more commonly used by long-term investors, as it helps them accurately select stocks that will increase in value over time.

    Technical analysis takes a comparatively short-term approach to analysing the market, and can be used in a time frame of weeks, days, or even minutes. Technical analysis is used more commonly by day traders, whose philosophy is to select assets that can be sold to someone else to a higher price in the short term.

    Sources

    Fundamental analysts use data from economic reports, news events, and industry statistics. They'll often compare current news events against historical events, and report expectations against actual outcomes.

    Technical analysts use data from analysing charts, and utilise trends, support and resistance levels, and price patterns.

    Top-down vs. bottom-up

    You may also be familiar with the terms 'top-down' and 'bottom-up' as additional approaches to trading.

    A top-down investor involves looking at the big picture. Investors use this approach to look at the economy, and try to forecast which industry has the greatest potential for big returns and value growth. For example, using the top down approach, you may decide that a certain industry or sector is going to benefit from current economic factors, so you can choose to trade within that industry. An example of this may have been investing in the mobile tech and chipmaker sector over the past decade, which has seen tremendous growth as a result of the popularity of smartphones and tablet devices.

    A bottom-up investor overlooks these economic conditions and seeks strong companies with good prospects, regardless of industry of macroeconomic factors. A bottom-up investor will use fundamental analysis to evaluate a company; such as p/e ratios, earnings growth, etc.

    Top down investing is a global approach that doesn't just limit itself just to looking at the markets, but also takes political aspects into consideration. Seasoned market watchers and professionals take a bottom-up approach which just looks at assets. For an individual investor, a 'top down' investor is probably the more logical approach.

    Geopolitical aspects

    Politics plays a huge part in affecting stocks and shares. The market is sensitive to all types of geopolitical events - for example, the sliding price of oil in 2014 has affected the profits and thus the market value of major global companies around the world.

    Geopolitical factors for 2015:

    • The price of crude oil
    • China's economic slowdown
    • Eurozone economic stagnation
    • Greek exit risk
    • Japan deflation/stimulus/hyperinflation
    • Russia/Ukraine
    • Syria/ISIS/Middle East
    • UK general election

    Read on for more 2015 market predictions.

    View from the floor: Ken Odeluga, market analyst at City Index

    Now we've set the scene for our deliberations about the market, we can drill down further to make an assessment of the specific market (or markets) we're interested in.

    Ken Odeluga is a market analyst with over 13 years' experience in reporting and analysing on the financial markets. He has a wealth of experience and specialises in the indices and equities markets. Here, we ask Ken for some general guidelines when it comes to approaching trading strategy.

    How do you go about picking which stocks to trade?

    I usually take a 'top-down' approach combined with technical analysis. I look to hold for at least a couple of months and as much as several years, so perhaps that categorises me as more of an 'investor' rather than a trader.

    But for short-term situations, I will primarily rely on a wide assessment of news and very probable momentum using technical analysis. I'll use indicators like Moving Average Convergence Divergence (MACD), Stochastic, Percentage Price Oscillator and others.

    Do you prefer to go long or short?

    I prefer buying and holding over a period of months or years rather than selling stocks. Still, like most involved in the market in some way, going short can provide a quicker thrill than a steady long-term investment, and sometimes that temptation is difficult to resist.

    What was your best stock pick of 2014?

    My best pick for 2014 was Activision Blizzard Inc (ATVI).

    What was your worst?

    Poundland (PLND) was a dud! I bought in March quite soon after its IPO and it's still down on a net basis despite a bounce since January.

    How do you analyse your stocks?

    For the sake of simplicity let's think about the near to medium-term outlook for the UK's FTSE 100.

    We've seen a FTSE 100 whose recent gains have taken it 71 points away from its best closing level ever, on a weekly basis, whilst its companies report only moderately successful quarters.

    The transatlantic context is an S&P 500 that is performing well in earnings terms, although admittedly, a significant portion of these corporate earnings are being reinvested in the stock market itself - which should be born in mind in considering the US market's strength.

    As for US share prices, it's fair to say there's been a broad, if moderate, retreat.

    In conjunction with the approaching FTSE 100's all-time high and pause in the rise of the US benchmark, we might decide a cautious undertone would become more obvious in sentiment over UK blue-chip stocks for the medium term.

    We can try to take into account the extent of weight investors would press on the market from the over-arching influences of (still) weak crude oil demand, falling consumer prices, caution ahead of the UK's general election, and uncertainty in the stagnant Eurozone economy from current negotiations between Greece and the EU.

    In such a scenario, the index might remain largely within its current range for the year-to-date.

    Which stocks suit this scenario?

    Following our exercise to its logical conclusion we would then decide which segments of our chosen market(s) to focus on for interest, either on the short side or long side.

    My current view undoubtedly lends itself to a more 'defensive' stance over the time-frame we are considering, and therefore sectors regarded as having such properties make sense.

    Financial firms and healthcare companies tend to be traditional defensive sectors, although there are many factors that can modify such basic assumptions in context, and these would need to be born in mind.

    Still, my FTSE 100 choice to buy might well veer more towards blue-chip bank stocks like HSBC and Barclays, asset managers and commercial real estate firms like Aberdeen Asset Management and Land Securities.

    If I'm looking to go short or to reduce existing holdings, those segments traditionally regarded as more risky, or 'high-growth' ought to come under our scrutiny.

    The telecom and technology mainstays like BT Group and Vodafone, ARM Holdings, and Sky, should be considered in this respect.

    A nod to current conditions that modify customary assumptions makes sense because these may widen or narrow the list of companies which, for instance, one can regard as being 'higher-risk'.

    A good example of such changes in the last year has been Britain's supermarket sector which has suffered severely, sending its stocks to multi-year lows.

    Expressing a negative view on erstwhile blue-chip stocks like Tesco and Marks & Spencer would be a context-specific decision that would have made less sense for the average investor in years past.

    You can read more about Ken's views and analysis via our market analysis section.

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