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In order to trade the stock market, there are two basic ways - shooting in the barrel or using strategies to find out which stocks to buy, when to sell, and how to protect your investment dollars. Strategies do better than barrel shooting by a large margin.
The beginning investor is advised to investigate some of the basic strategies and see for himself how they perform.
Hedging is a way of protecting an investment by reducing the risks involved in holding a particular stock.
Within a certain frame, the risk that the price of the stock will drop can be make up for buying a put option that allows you to sell at the stock at a precise price. If the price of the stock falls, the value of the put option will increase.
The most expensive hedging strategy is buying put options against individual stocks. Buying a put option on the stock market itself is a better option if you have a broad portfolio.
This protects you against general market declines. Selling financial futures like the S&P 500 futures is another way to hedge against market declines.
During the 1990s, this is a strategy that became popular. By choosing the 10 stocks that have the lowest P/E ratios and the highest dividend yields, the idea is to buy the best-value stocks in the Dow Industrial Average.
The companies on the Dow Index are mature companies that offer consistent investment performance. The idea is that, over the coming year, the lowest 10 on the Dow have the most potential for growth. A new twist on the Dogs of the Dow is the Pigs of the Dow.
By looking at the percentage of price decline in the previous year, this strategy selects the worst 5 Dow stocks. As with the Dogs, the idea is that the Pigs stand to rebound more than the others.
Buying on margin means to buy stocks with borrowed money - typically from your broker. Margin gives you more return than if you were to pay the full cost outright since for a lower initial investment, you receive more stock.
Margin buying can also be unsafe since if the stock loses value your losses will be equally greater.
When buying on margin the investor should have stop-loss orders prepared to limit losses in the case of market reversal. The margin amount should be limited to about 10% of the value of your total account.
Dollar cost averaging involves investing a fixed dollar amount on a habitual basis. An example would be buying shares of a mutual fund on a monthly basis.
The investor will receive more shares for his money if the fund drops in price. On the other hand, the fixed amount will buy fewer shares when the price is higher. An alternative to this is value averaging.
The investor makes a decision on a regular value he wishes to invest. For example, he may wish to invest $100 a month in a mutual fund. The investor puts a higher amount in the fund when the price of the fund is high and he spends less money when the price is low.
This averages out his investment to the original $100 per month. As a percentage return on the money invested, value averaging almost always outperforms dollar cost averaging. It can help secure the growth of your investment fund when used as part of a broader trading strategy.
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