Trading Basics
What You Need to Know Before You Start Investing in the Stock Market

By Jacquelyn Lynn

The Dow is up ...
The market closed lower ...
Today Wall Street reacted to news ...

These and similar phrases often lead the daily business news. If you find yourself intrigued by the stock market, you may want to use it as way to diversify your real estate profits or perhaps to generate some cash to invest in real estate. Both are great ideas, but before you open a brokerage account and start placing orders, you should understand the market and have some sound investing and trading strategies in place.

Begin with a clear picture of what you want to accomplish. "Make money" is not a sufficiently focused goal. Examples of investing goals may include paying for your children's college education, saving for retirement, or buying your dream home. Go beyond the idea of making money and think in terms of how you will use the money.

Next, consider your personal level of risk tolerance. Is the market risky? Certainly it can be—just about every investment carries some degree of risk. But different stocks and different investing strategies carry different levels of risk, and you can learn to minimize your risk by applying certain investment techniques.

For example, let's say you have $1,000 to invest in stock. You do your research and you find a stock that is selling for $25 a share. Based on all the indicators, you think the stock will go up to $30 a share in six months. So you buy 40 shares and if things work out the way you think they will, you can sell the stock in six months and you'll have $1,200, which is a 20 percent return (or 40 percent annual yield) on your investment. But before you buy, think about how much of your $1,000 you are willing to lose. Let's say that number is ten percent, or $100. So you set a stop loss (which is an order telling your broker to sell if the stock reaches a certain price) of $22.50. That means if the stock drops to $22.50, your broker will sell it, and you'll have $900 left.

So the potential of the trade looks like this: You think you could make as much as $200 and perhaps more, but your risk minimized because of the stop loss you have placed on the trade. Can you deal with that level of risk? If so, you've got a plan. If not, set different rules for your trades.

Something else to keep in mind is that it's possible to create profit potential in stock trading whether the stocks go up, go down, or stay the same. To do that, of course, you need to be able to identify the outlook on a stock and know what strategy to use.

The key to profitable stock trading is to win often and minimize your losses. You will not make money on every single trade, so you need to know how to limit your losses. Also, always keep in mind that you don't have to "make a killing" on any single trade to build wealth. Go for the solid returns and don't let greed drive you into making mistakes. Remember that sometimes the stock won't do what you thought it would do, no matter how thorough you were in your research. And sometimes, the stock will perform far better than you expected and you'll make more than you thought you would. It's possible the stock in our example will peak at $28 and begin to decline. It's also possible the stock could go well over the $30 you anticipated.

Remember that the markets are emotional; they react to natural disasters, fears, rumors, and successes because so many of the people who own stock make their buying and selling decisions based on their own emotional reaction to those same events. Train yourself to not be emotional or greedy; make your trades based on logic, information, and sound trading strategies. Learn when to cut your losses and when to take your profits. And always keep in mind that profitable trading is more about limiting loss and taking profit when it's there than it is about being right all the time.

Avoid these common mistakes

Without a solid plan and self-imposed rules, new and long-time investors will likely make these same common mistakes:

One is trading based on tips. Don't ignore tips, but don't trade blindly on tips from friends or the "hot stocks" highlighted by media "experts."

Another is trading stocks you t hink you know. Many successful investors find good investments based on products they use themselves. But does the fact that you enjoy using a specific product, eating at a particular restaurant, or shopping at a particular store mean you should buy shares of that company's stock? Maybe, but maybe not. Do your research and base your investment decision on your knowledge of the company and the stock.

Still another easy-to-make mistake is to get emotionally attached to a stock, which can cause you to hold the stock in your portfolio longer than you should. Make all your investment decisions based on sound, verifiable information that you understand and know how to analyze.