Trading stocks can be an exciting and potentially very lucrative endeavor. However, before jumping in with both feet, it is essential to familiarize oneself with the various available tools to help you make informed decisions.
Exposure to these tools will increase the likelihood of success in your trading endeavors and ensure that any mistakes you make bring about only limited losses. In this article, we discuss how understanding how to use various indicators, leveraging what you have through borrowing, and managing risk can help form the foundation of a solid trading strategy.
When it comes to stock trading, there are a variety of financial tools available to investors. That can include everything from charts and indicators to leverage and risk management.
One of the most important aspects of stock trading is understanding how to read charts. Charts can provide investors valuable information about a stock’s price history and recent movements. By understanding how to read charts, investors can make more informed decisions about when to buy or sell a stock.
In addition to charts, another essential tool in stock trading is indicators. Indicators can help investors identify trends and potential opportunities. Various indicators are available, so it’s necessary to learn about the different types and how they can be used before making investment decisions.
Another critical aspect of stock trading is leverage. Leverage allows investors to control more shares than they would otherwise be able to afford. While power can lead to greater profits, it also comes with increased risk. Therefore, it’s essential to carefully consider the risks and rewards before using a currency strength meter.
Finally, risk management is an essential part of successful stock trading. By managing risk, investors can help protect themselves from losses in the market. Risk management techniques typically include stop-loss orders, position sizing, and diversification.
Leverage and its pros & cons
Leverage is one of the most overlooked and misunderstood tools in stock trading. It allows traders to control a more significant amount of capital with a smaller amount of money which can be highly profitable when the right opportunity is spotted.
Using leverage in stock trading increases profits and reduces risk, depending on how you execute your strategy.
When used to power up great-looking trade with a minor margin requirement, it can generate 5-10x returns. If used recklessly, it can hurt the investor’s portfolio badly. Understanding how to use leverage correctly and always manage risk properly is essential.
Most investors go wrong and choose to overleverage when leveraged accounts should not take on more than a maximum of 1:10 leverage at any time.
There are various types of charts used by stock traders to represent data visually. Candlestick charts and bar charts are the most popular, but there are other types, such as line charts, point and figure charts, and Renko charts.
Candlestick charts show each period’s price for open, high, low, and close (OHLC). Candlesticks can be used to identify patterns that may predict future market direction.
Bar charts are also OHLC data, but rectangular bars instead of candlesticks represent them. These bars can help identify trends and support and resistance levels.
Line charts connect successive closing prices with a line. That makes it easy to see trends but harder to identify specific support and resistance levels. Point and figure charts only plot price movements that exceed a certain amount (the box size). That makes them suitable for spotting long-term trends but not so useful for short-term trading.
Chart reading is problematic because it takes time to learn what pattern to trust and what pattern might be a false indicator. Most veteran investors can spot a healthy chart within a few seconds. Study hard, and you’ll be able to see “through” the diagrams to make better predictions of what’s to come.
The average investor more commonly needs to understand indicators. Most beginners focus on technical indicators, which are said to predict the future price of any given stock as long as they know how to use them.
Indicators used by professional investors are more performance-based than predictive, as they rely solely on how well the company behind the stock is doing.
The five most essential indicators include.
- P/E Ratio (Price-to-Earnings) – This ratio measures how much you pay for every dollar a company earns. A high P/E ratio means you’re paying more for the company’s earnings, which could mean the stock is overvalued. A low P/E ratio means you’re paying less for the company’s profits, which could mean the stock is undervalued.
- EPS (Earnings Per Share) – This number tells how much profit a company made per share of stock during the most recent quarter. A higher EPS means that the company is doing well and is potentially undervalued. A lower EPS implies that the company is doing poorly and is potentially overvalued.
- ROI (Return on Investment) – This number tells you how much profit a company made compared to how much money was invested in the company. A high ROI means that the company is doing well and is potentially undervalued. A low ROI implies the company is doing poorly and potentially overvalued.
- Dividend Yield – This number tells you what percentage of a company’s stock price is paid out in dividends. A high dividend yield means that the company is doing well and is potentially undervalued. A low dividend yield means the company is doing poorly and potentially overvalued.
Managing Risk to Maximize Portfolio Value
No matter what financial goals you have, stock trading comes with risks. However, by understanding and utilizing these different financial tools, you can manage these risks to help maximize the value of your portfolio.
Some best practices for managing stock risk include.
1. Diversify Your Portfolio
When you diversify your portfolio, you protect your investments from the likelihood of a company going bankrupt—which can happen much more quickly than you think. Spread your investments across different sectors and industries to decrease the possibility that they should all experience a downturn simultaneously.
Also, as different sectors move up and down with the economy’s ebb and flow, having a well-diversified portfolio will let you take profits and re-invest frequently, which is what you are looking for in a long-term portfolio.
2. Use the correct position size for your risk profile
It’s wise to get comfortable with trading before investing capital. Once satisfied, use position sizing and stop loss limits to reduce your exposure to significant risks that could ruin your strategy.
A typical beginner mistake is to bet most of the capital on one or a few select stocks that look promising. However, the wiser choice is always to spread your investment capital evenly over a set of 5-10 high-quality companies.
3. Review Your Investments Regularly
Reviewing the investments in your portfolio on at least an annual basis can be one of the best risk management strategies because it allows you to ensure continued progress toward goals and objectives, rebalance positions when necessary, update investment instructions as personal circumstances change and take advantage of opportunities as they arise.
4. Set a price for when to exit
No investment is 100% secure. For example, if your investment falls more than 30% in weeks or months, it might be wise to re-evaluate the company and see if it is still a good investment.