Hello and Welcome
I feel that in the spirit of due diligence I must begin with the basics of trading. There is no need to know the golden rule is buy low, sell high… Unless your shorting of course.
The four basic transaction types are:
Buying and selling are self evident, what about shorting and covering?
When you short a stock, you borrow it from your brokerage who sells it to another buyer. The proceeds of this sale go into your account. You then have to repay this loan by buying back the stock – covering – at a lower price (hopefully).
If I short 100 shares of C at $10 and C takes a plunge down to $5, I then cover and make a profit of $5 a share. If C goes up to $20 however, I will have to repay the brokerage at a loss of $10 a share.
Shorting can be immensely profitable in bear markets, however it has limitless loss potential. When you simply buy a share the biggest risk you incur is that your share goes down to $0. When shorting, your stock could potentially go so far up that you will be paying it off for years to come. For this reason, caution must be taken while shorting using something called stop loss.
These four transactions can be combined with order types to maximize your trading power.
- Stop Limit
- Trailing Stop
Market orders are processed at whatever price the ticker currently is at when the order is sent. This is not typically advised because you end up paying the higher ask price and foot the spread cost (more on this later). In other words, it’s like shooting a dart at a board – you’re just not sure what you’re buying at.
The better way to trade is to use limit orders. By setting a limit order on a transaction you are telling the broker the exact price at which you want to execute the order. This way you know exactly the price you are buying at and you are not a the whim of the execution speed and the spread costs. The downside of this is that if you set your limit to high or low, the price may never reach that limit and your order won’t be executed.
Stay tuned for Part 2 of The Basics where I will explain Stop, Stop Limit, and Trailing Stop orders.