In the last piece in this series, we discussed what you need to know to get started analyzing companies. Yet for many investors, it's the more advanced techniques that prove tricky to master. MACD, straddles, short squeezes -- it's enough to make your head spin. Let's run through a quick discussion of technical trading, the use of options, and investing short to see if any of these tools are right for you.
Most investors assess a stock's value by reading financial statements, which is known as fundamental analysis. Yet some investors are much more interested in how a stock moves, rather than how the underlying company is performing. They use technical analysis to find stocks to buy and sell. There are dozens of technical tools, but we need only look at a few to get a sense of how they work:
- Moving average (MA) analysis: For many technicians, how a stock is doing in relation to the recent past is an important indicator. For example, they'll look at the average price a stock has traded at over the last 100 days. If it has just moved above that 100 day MA, then it's a bullish signal and time to buy. If a stock has simultaneously moved above its 100 day MA and its 200 day MA, well then that's a very bullish sign.
- Resistance: Technicians also like to look at recent areas that represent a floor and a ceiling on a stock, and then look for breakouts. For example, if a stock has been trading between $10 and $15 for a fixed period of time (say six months), and just popped to $16, then it has broken through resistance on the upside -- a very good sign. Conversely, if it falls to $9.50, then technicians figure it may go well lower than that.
- If you really want to become a technician, you'll have to learn such terms as "oscillation," "candle-stick reading," and "MACD" (which stands for Moving Average Convergence Divergence indicator).
Just like technical analysis, options require a great deal of education to use them effectively. Many investors have found them to be a great way to magnify returns, generate income or simply hedge their exposure. In a nutshell, there are bullish options (known as calls) and bearish options (known as puts). These are simply corollary financial instruments that relate to an underlying stock.
Options give their holder the right, but not the obligation, to purchase (with a call) or sell (with a put) the underlying security at a pre-determined price (strike price). Buying a call option can be a bullish move if you think the underlying share price is going to be higher than the price you agreed on. Vice versa, if you think the underlying share price is going to fall, you may want to buy a put option.
Like most advanced strategies, there are many subtleties to buying call and put options. Numerous factors -- including the underlying asset price, the asset's volatility, the option's expiration date and the option's strike price -- play important roles in determining the option's price.
Just to muddy the waters, investors can actually make bullish bets by selling puts or bearish bets by selling calls. In addition, the call writer can make an extra income yield if the options are never exercised. Suffice it to say, you'll need to dig much deeper into this topic if you want to invest with options. One of our most popular tutorials, Profiting from Options, is a great place to start.
We're conditioned to find stocks that will rise in value. And over the long haul, that's what happens with most stocks. But in the short-haul, certain stocks, or the broader stock market, can also post steep declines. Let's say you've come across a company that is about to be outfoxed by a competitor's new widget. Well, you can buy shares of that competitor (going long) or you can bet against the vulnerable company by building a short position.
The process may seem complex, but is actually straightforward. When going short, you borrow shares from another investor with a promise to pay them back later, hopefully at a lower price. Of course, your broker is actually taking care of the messy details. If you think Microsoft will fall from $24 to $18, you simply place an order to buy a certain amount of shares short, and the broker takes care of the rest.
Simply buying and selling stocks based on the fundamentals is the easiest to route to building a portfolio. Some investors like to research stocks on a fundamental basis, and then check in to see how a stock looks form a technical perspective before placing an order. Others like to go long stocks, but use options as a way to protect their investment in case it falls. There are myriad ways to structure a trade.
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