Stock Trading Basics

When we start talking about Stock Trading Basics, we like to start with differentiating between Investing and Trading. We do believe there is a big difference. In very simple terms, we like to think of Investing in terms of a long-term strategy for making gains. On the other hand, we look at Trading as more of a short-term tactic to generate gains. Primarily, it is the time period outlook that differentiates the two activities. Of course, depending on what one is engaging in, the tools of analysis will be different.

In this article we are going to discuss trading activities and why one should be engaging in it. We also want to dispel some long-standing myths that have been circulated over the years regarding trading. First of all, we subscribe to a balance of short-term and long-term investment and trading strategies for everyone. We do not recommend that anyone only engages in long-term investments or anyone only engages in short-term investments. There are some great companies out there, which we think will deliver strong gains year after year. So, there is no point in doing short-term trading on these companies other than for very specific reasons such as risk mitigation and protection. But there are a lot of companies out there that have sporadic momentum and then long spells of sideways movement. There are also several companies that for years will trade at a range. One easy example is Microsoft (stock ticker: MSFT) which has been range bound for the last 10 years now. It has been trading mostly between $20 and $30 through this 10-year period. Incredibly, the stock price was around $30 in January 2001 and it is around $30 in January 2010.

So, where does that leave a long-term investor in Microsoft stock? Exactly where he started. Are the fundamentals of Microsoft good? Yes. Is it a great company? Yes. Does it always have healthy profits and dominates its markets? Yes. So, how do we explain to the long-term investor that he made a mistake and should have invested somewhere else for long-term gains? We really cannot. But what we can tell him is that he should have mixed his long-term buy-and-hold strategy with some short-term trading to generate his gains.

So, what do we main by short-term trading? Staying with the Microsoft stock price here, the stock has traded in the range of $20 and $30 as mentioned above. So, effectively, if we had bought at $20 and sold at $30 every time it traversed this range, we would have made 50% gains each time. One may read this and say easier said than done. How do we exactly know when to buy and when to sell? The answer is that it is not easy, but it is possible to get close to trading the range if one does technical analysis and identifies support and resistance levels. A support level is nothing but a trading point at which the stock price ”hits support” and typically stops trending downward and starts moving up again. A resistance level is exactly opposite of that. It is a trading level around which the stock price “hits resistance” and stops trending upward and starts moving down again. There are typically several support and resistance levels for a stock price depending on the time frame that one looks at in the stock chart. Suffice it to say that the long-term support for Microsoft has been around the $20 level and the long-term resistance has been around the $30 mark.

This is the basic premise of stock trading. A trader looks at these support and resistance levels and trades the stock within this range to generate short-term gains from the price movement. Microsoft has actually been one of the safest trading stocks over the years because of its strong linkage with support and resistance levels.

This is the first and basic level of understanding one should have before thinking of stock trading. More on this will follow soon.