The Basics of Buying, Selling, and Controlling Securities
5.1 Owning the Asset and the Bid/Ask Spread
There is always a difference between the asking price and the selling price. This difference is called the ‘spread’. It may be a few points or it may be a wide gap. This is the profit margin for the market maker or the broker who holds the securities and stands ready to buy or sell at any time. The ask price is the price sellers are willing to part with the asset. The bid price is what buyers are willing to pay.
If you place a market order, the price you will pay for the stock will be whatever is the going rate, in this case, $19.99. However you could place a limit order. A limit order tells the market you are only willing to pay this specific amount, or less to buy the security. In this case, you might set your limit order at $19.78. Then the seller gets to decide if they are willing to take that price or not.
You may get your asset cheaper than others pay… but if the equity rips higher, your order may not be filled and you won’t get the asset at that price. Then your choices are to rebid a limit order, pay the market price, or forgo the security at this price. You can almost always get the security for less than the ask price in a wide spread. Often the order will be filled even if you choose the midpoint of the spread because the price tends to fluctuate during the day.
Profitable buying requires patience to wait for the best entrance and patience to let a trade pass you by rather than chasing the trade. Chasing the trade means buying at a more expensive price than is a good value because the price keeps going up. This is caused by fear of losing out and often results in a loss when the price settles back down.
Buying: The traditional way to own a security is to buy it outright. When you own it, you can take physical possession of the stock certificate, the gold, or the currency. People who intend to buy and hold a security for decades or generations will typically buy the security outright.
The purchase comes with commissions and perhaps other fees. With traditional investment brokers equity purchase and sales used to cost $100 or more per transaction. Fintech has reduced these fees. Some purchase transactions are now less than $10, regardless of the number of stokes moved.
Selling: You face the same commissions when you sell your equity. Thinly traded securities may not have enough liquidity to sell right away. You may have to wait for a buyer.
When you sell your security, you may sell at the market price (whatever the ask price is) or put in a limit order. Then you tell the broker or trading platform you will sell at this set price or higher.
Often traders want to protect their investments and pre-set a sale price if the equity reaches a certain point. This point may be determined by a percent against the asset’s gain or as a fixed amount. On a price drop, the fixed amount sale is called a stop loss. A trailing loss is triggered when the equity falls a certain percentage below its highest price while you owned the equity. With ABC Company you could sell when it falls to $15 (or lower) or when it drops 25%.
You may also want to set stops to sell your security when it reaches a certain profit point. Again, you can set the sale to trigger when the security rises a certain percent or a specific fixed amount.
On many trading platforms, the stop loss triggers do not guarantee you will sell your equity at that price. In a fast falling market, the price may blow through your stop. By the time the order is filled, the price you receive could be much less. Some trading platforms allow you to protect yourself from this kind of flash-crash by letting you bracket your sale. You tell it to sell at $15…but not if it falls below $13.50, for example. However, in a fast falling market, your asset might not be sold at all and you’d be left holding it at a price perhaps far below $13.50.
Some trading platforms do guarantee the stop loss price you set. Then the trading platform will take the loss if the sale cannot be made in time. Check with your broker or platform to see which rules apply to you.
Stop loss and profit points can be a significant part of a trader’s arsenal to reduce risk and increase protection in a changing market. They can be immensely helpful many times, but they are not foolproof.
Options let you control a block of securities without owning the security. Options are priced individually, but traded in 100 share lots. When you open 1 option trade, at say $1.15, the cost is multiplied by 100 ($115.00) and you control 100 stokes of stock.
Options are for a fixed price and a fixed time. You can trade options for as short as a few minutes or as long as two years.
Most option traders do not want to actually own the asset. They want to profit from the movement of the asset. When the price of the asset moves toward the option price, the option increases in value. Traders may sell for several reasons:
- When the option gains an attractive profit
- When the option falls below the traders determined stop loss
- When it looks like the option will expire out of the money, the trader may salvage some of the premium by selling the option they bought
When an option is out of the money, it means the price of the asset has not reached the strike price, or the agreed upon price the stock needs to reach to trigger the option. At the end of the option period an out of the money option expires and has no value. The trader who sold the option keeps the profit from the sale. The trader who bought the option takes the loss.
If the asset price reaches the strike price or higher, it’s called in the money. If an option is in the money at the end of the option period, the trading platform will automatically execute the order to buy or sell that option. The seller must either buy the option back or execute the trade. For example:
On February 6th ABC Company sells for $19.99/share. Frank believes the stock will stay the same price or go down. So he sells 10 call options of ABC at $21 a share with an expiration date of 21 April, 2017 for $1 a share. Since options control 100 stokes, Frank will earn $100 x 10 = $1000.
If ABC stays below $21 on the expiration date, Frank keeps the $1000 and has no obligations. But if the stock grows to $24 a share, the option price will go up as well— to perhaps $3.25. Now Frank must either buy back the options at a cost of $3250, (a $2250 loss) or have the $24,000 in his account to buy the stock at option expiration. And then turn around and sell it to the option holder for $21 a share for a loss of $2000.
Or Frank may have made a covered call. This is when he already owns the 1000 stokes of ABC Company. Perhaps he bought them at $17. Then, when the stock is called at the $21 option price, he still made $4 a share on the stock… although he missed the possible profit if he’d kept the stock and sold it at the current $24.
George took the other side of the trade. He paid the $1/share to buy the option. If ABC Company stays below $21 at the expiration date, George loses the $1000 he invested. He might sell the option sometime before expiration for perhaps $.70 and have a smaller loss. But if ABC soars to $24, George can sell his option for $3.25 and his $1000 investment returned him 325% gains.
There are four ways or sides of option trading:
- Buying puts (the option to sell an asset when it drops to a specific level)
- Selling puts (the obligation to buy an asset if it drops into the money)
- Buying calls (the option to buy an asset if it rises to a specific level)
- Selling calls (the obligation to sell an asset if it rises above a specific price)
When you sell you incur an obligation and unlimited risk because the stock could soar or drop to zero in price. You reduce that risk if you have covered the option by owning the stock or being willing to buy the stock at the put price. When you buy you have a fixed risk. It will be no more than what you paid for the option.
Selling options uses leverage and thus can give investors both vast profits and staggering losses. Buying options gives large upside, but limits losses to the amount paid for the option. Successful traders use charts and fundamental analysis to predict high probability trades and use strict stop loss orders to reduce losses. They may also use complex combinations of these four option trades. This gives up some potential profits in order to reduce the risk.
5.3 Contract for Difference (CFD)
A CFD is a contract between the trader and the broker to exchange the difference between the opening and closing price of a specific security. The trader never owns the security. Rather the CFD is a derivative because the contract is based on an underlying security.
These instruments are exceptionally easy to trade. Some platforms even have one-click trading.
Here are six ways CFDs offer more flexibility than other methods of trading securities.
- Accessibility: Trades are accessible, and small investors can trade securities that might otherwise be impossible to have access to.You can trade CFDs across a broad range of assets. Stocks, commodities, currencies, indices, and ETFs can all be traded with a Contract for Difference. You also can trade a wide variety of international equities not always available to traders who buy and sell securities.
- Leverage: You can use more leverage for your trades. CFDs can be traded without leverage or with high leverage, depending on what your broker offers. When using leverage, a smaller amount of your money can fund a larger investment amount. This may create outsized gains. It can also lead to your losing more than your original investment. Some trading platforms limit the amount of money you can invest in high leverage trades and they encourage strict stop loss placements to reduce the risk.
Margin or Leverage
You may balance some of the risks by spreading your trades over a range of securities in various sectors. Also, never risk a large sum of your portfolio on any one trade, or even on multiple trades of the same security.
- Low Commissions: The initial cost of the trade can be much less than buying or selling a security. Some trading platforms only charge the spread difference. This is the difference between the buy and sell price. For stocks and commodities, it may be a few pence or a small percentage difference. For currency, it will be listed as ‘pips.’ PIP is short for ‘price interest point’, and measures the amount of change in the exchange rate for a currency pair. A pip is usually 1/10,000 or .0001% of the asset. In 10K currency lots, that comes to about $1 or £1. There is also an overnight fee that can be a debit or a credit depending on the direction of the trade.
- Upside and Downside Profit Potential: You have the potential to make money in both a rising and falling market. CFDs let you buy, or go long, when you believe the market will rise. You can also sell, or go short, when you believe the market will fall. Thus, your investment options are not limited to only a rising market as when you trade stocks.
- Tax Advantages: There may be tax advantages to CFDs. In the UK, you avoid Stamp Duty because you are not actually buying or selling the security.
- Insurance: CFDs can be a convenient way to hedge equities you own if you are concerned they may be in a temporary downtrend. You can sell a CFD to earn money on the difference in price should the equity drop. This compensates for the lost value of the equity you own.
CFDs are easy to trade for potential profit as the asset rises or falls. However, on small moves in equities, the spread, or cost of the transaction, can eat away at your profit. Some platforms list their CFDs commissions on the fees page. Other platforms do not let users know the spread.
Suppose ABC company has a bid/ask difference of 10 pence per trade. If you sell when the asset rises only 25 pence, you’ve lost 20 of that to your buy and sell commissions. So your net profit is only 5 pence.
When you use leverage, even a smaller amount of gain can produce an attractive return on your investment. Here is an example:
You want to buy XYZ Company that has a sell price of £9.9 and a buy price of £10.0 and your broker allows a 10x leverage. You buy 1000 stokes for £1000 using 10x leverage. You expect the stock to rise. It goes up £1 and now has sell/buy price of £10.9/£11.0. You sell it at £10.9 and make an £900 profit on the £1000 you invested. That’s an 90% return.
The stock may not move as you anticipate. Suppose it drops £1 and now has sell/buy price of £8.9/£9.0. You sell it at £8.9 and incur a loss of £1100. You just lost 110% or more than your initial investment. This is why most CFD buyers use stop losses to close the position before the stock drops below a certain point. It helps to limit their losses.
Investing can be a remarkably profitable way to increase your wealth and your retirement security. As you understand the fundamentals of a profitable company and as you learn the technical analysis of market trends you are better able to take advantage of profitable trades.
You are more likely to see existing trends. You can trade within the cycles of commodities and calendars. You can optimise buy and sell timing and set suitable stop losses to limit the downside.The more you learn, the more prepared you will be to manage your risks and make decisions that best suit your risk tolerance.
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