Stock Trading Basics
We define stock trading as tactics to generate gains in the stock market with a short-term outlook. What is a short-term outlook? We define short-term as anything between a few hours to a few months. So basically, the trade is based on making a judgment on the immediate near-term direction of the stock price as well as knowledge that there is momentum in that direction for the stock price.
As opposed to stock trading, investments in the stock market are more strategic in nature and are a judgment on the fundamental value and prospects of the company rather than their immediate momentum and direction. These investments can be done in one transaction or investors invest in what is called as a “dollar cost averaging” basis. This strategy is basically buying small portions of the stock price on a regular basis to average out the cost of acquisition.
For the most part, we are going to be discussing stock trading within TalkFN.com. Even though we are talking of stock trading, we typically trade in the options of the underlying stocks. This gives us tremendous leverage and also better and predictable risk management. Also, trading in options gives us the ability to go long (buy call options) or short (buy put options) on the stock price with ease. There are several other options trading strategies that we will discuss within this forum as we go along.
Options on stocks are derivatives on the underlying stock that provide some rights to the options holder. We will not go into a detailed discussion on options, as there are several good websites that provide that information. We will give an example as we think that examples are the best way to explain options.
Consider the stock price of Google (symbol GOOG). Let us assume that GOOG is currently trading (assume August 2009) at $600 per share in the stock market. We do our analysis and we determine that GOOG should go up to $650 within the next two months after its next quarterly results is announced in October 2009. Now, we have two ways to participate in this move up by GOOG. We can buy the GOOG stock that will cost us $600 per share or $60,000 for a 100 shares. The other way is to buy the October 2009 $650 call options of GOOG at a premium of $1,000 per contract. The contract here gives us control of 100 shares of the underlying stock. The $650 is the strike price, which we think is the price that the stock price will move to. The October 2009 is the expiration month when we think the stock will trade at that strike price. The premium we pay is the amount to buy this option (or right). What this call option means is that we now have the right to buy 100 shares of GOOG stock at the price of $650 on the expiration date of October 2009. So, effectively we are able to control $60,000 worth of stock value with a small premium payment of $1,000. Note that the premium of $1,000 is a notional amount and the true premium is what gets traded in the options market. This premium is very dependent on the current volatility in the market and we will explain in the next section as to how we make gains based on this premium going up or down. This basic note was to show how one could control a large value of stock by paying a nominal premium. In other words, how trading options contracts provides us high leverage.
