The stock market is going through a transformative time right now — millions of new traders, armed with the convenience of retail trading apps like Robinhood and the abundance of free time afforded by lockdowns, found themselves drawn to the intimidating yet promising world of stock trading. I of course, am one of them. Through these few months of toying around with different forms of trading, I am delighted to discover that beneath the jargons of ‘securities’ and ‘volatility’ and ‘short-selling’ lies a highly intuitive system that can easily be understood in everyday terms.
As such, this article is dedicated to sharing, in as simple terms as possible, what I have learned about the what of trading (for there are already hundreds of ‘gurus’ on the Internet offering advice on the how of trading). This includes the ideas behind longs, shorts, spreads, technical/fundamental analysis, as well as a brief summary of the role and history of stock markets. Without further ado, let’s dive into the basics:
The Longs and the Shorts
Going “long” on a position means to purchase a security (any tradable asset, e.g. stocks, bonds) with the expectation that it will increase in value. This is the most conventional form of investment and sometimes grants you additional perks, such as dividends or company voting rights. Since the expectation is that the security performs well under current market conditions, it is also referred to as the bullish position.
Almost all securities allow you to take on a long position. These include but are not limited to stocks, bonds, ETFs, futures, options, cryptocurrencies and gold/oil funds. Going long on certain stocks may also entitle you to dividends (distribution of a company’s profit to shareholders, usually on a quarterly basis) during the company’s pay period.
On the other hand, going “short” on a position means to bet on the fall in the price of a security. Although the process is largely automated by brokers, a short can actually be broken down into a series of transactions:
- Borrow security from a lender
- Sell borrowed security at market price (known as short-selling)
- At a later date of your choosing, buy security to be returned to lender (known as covering the position)
The resulting consequence of this schema is that if the price does go down, you profit from the difference between the future price and the current market price, e.g.
Microsoft trading at $180 on Feb 1 -> $160 on Feb 28, you’ll have a net cash-flow of +180 (short-selling) -160 (covering) = +20
It may come across as an ethical quandary that one should bet against the success of a productive company, but shorts actually serve an important regulatory role by preventing securities from staying overpriced. This works as short-sellers (i.e. those who take on short positions) generate a negative pressure by withholding the supply of a security until the price goes down.
A short position is also known as a bearish position to contrast the bullish position of a long.
Ask, Bid and Spread
To guide you in opening your long/short positions, it may be helpful to look at the telltale feature of any security — its bid-ask spread. In essence, bid is the maximum price that a buyer is willing to pay while ask is the minimum price that a seller is willing to accept in a transaction. The resulting spread, i.e. the difference of the lowest ask and the highest bid.
The bid-ask spread reveals important information about how liquid a security is, or in other words how easily you should expect your trade to go through should you ask/bid for it at market price. If the spread is wide, then it is likely that a position placed at market price will take a while to go through. This situation is more common in penny stocks (small companies that trade for less than a dollar), and usually will not be an issue in blue-chip companies (reputable big companies with large market capitalization) like Microsoft or Amazon, unless there is a panic buy/sell. Blue-chip companies have high trading volumes which means that large number of shares do successfully exchange hands each day.
Fundamentals, Technicals and Quantitative
At this point, you might wonder how to use the above information to your advantage. Without getting bogged down in the details of different strategies, it is useful to examine their assumptions and intuitions. First we dive into the three main approaches (click on the underlined keywords for a recommended further read)-
Fundamental analysis (FA): Using a business’ financial statements as well as general market conditions to determine a security’s fair-market (or intrinsic) value. This involves burying your head in quarterly reports, press releases and analyst estimates. Intuition: some securities are either underpriced or overpriced due to market inefficiencies, and one can profit by taking a long or short position respectively, when the price realigns in the not-too-distant future.
Technical analysis (TA): Using trends in price levels to extract knowledge about market sentiments. This involves analyzing indicators, trade patterns. Intuition: Based on the idea that future prospects of a company can be predicted using historical data. Additionally, price fluctuations can also be seen as containing information about market events, which one can ‘read into’ in predicting price trajectories.
Quantitative analysis (QA): Using quantifiable metrics (e.g. Price-to-Earning ratio (P/E), cash flows, dividends), as well as statistical methods to determine a security’s intrinsic value. This is a new approach made possible by computers and is usually used in automated trading (unless you can do math really quick). Intuition: Based on the premise that the financial market can be modeled mathematically.
Often times these approaches are blended when making a trade decision, as they mutually impact each other (sentiment affects company valuation which affects its capital access etc.), and are sometimes overlapping —e.g., Fundamental & quantitative analysis both look at P/E, RoE metrics, but FA uses it mainly for screening before diving into more holistic assessment while QA attempts to perfect the selection criteria by optimizing the weighing of different metrics.
Off tangent — what is it that traders do?
One question that I had prior to diving into trading is how exactly do traders and investors contribute towards the economy or societal progress at large. I found that the many articles urging one to buy bonds or ETFs for steady income never sought to answer the curious question of where the income comes from. If by investing you are guaranteed steady income, why doesn’t everyone invest in the stock? Who exactly are the losers when you gain income, for it can’t be a free lunch can it?
A brief look at the history of stock markets showed that it served a very practical purpose in the heyday of colonialism. The Dutch East Indies Company (VOC) was the first to offer bonds and stocks to the public in the 1600s. Prior to this development, investment in trade voyages to the West Indies was extremely risky because the frequent shipwrecks and pirate raids would lead to huge losses of capital. A public stock offering allowed for the loss and dividends to be spread over a larger pool of investors and therefore mitigated risk exposure for individual investors. Within the course of a decade, various derivatives such as shorts, and options became actively traded on the market, and it was not long after that VOC became the first transnational corporation in the world.
In the modern day, the New York Stock Exchange and Tokyo Stock Exchange take on the same role of risk distribution and capital raising, but at far greater complexity. A common practice is that teeming young companies (e.g. Tesla in 2010) will reach a turning point at which they decide to bring their business scale to the next level by selling stocks to the public and raising large amount of funds, in a process known as initial public offering (IPO). This distributes the risk of their bold projects onto a pool of public investors of hope to profit from it.
Hedging and Diversification
It is commonly advised that one should ‘diversify’ their portfolios so as to minimize risk. Then there are hedge funds that offer to ‘hedge’ against the market. Here we take a brief look at each approach and their general intuitions.
One of the key concerns of a long position trader is the price of a security plummeting. If that happened and the trader has not done their homework beforehand, then their only options are to quickly close the position by selling the securities, or to sit nervously watching their position accrue huge losses in hopes of it bouncing back up.
There are two main ways that one can prevent this. The first is diversification, which in essence means to not put your money all in one basket. Open positions in securities that are uncorrelated (different sectors, industries) so that the bad performance of one does not expose you to too much risk. Above is an example of a well-diversified portfolio by investor David Swenson who managed to consistently grow Yale University’s endowment assets at an annualized average return rate of 16.3%.
Of course you may not always have the time and resources to research a broad range of market for this purpose. In that case, ETFs or index funds are highly recommended because they consist of a plethora of stocks which are naturally diversified. Examples include SPY (500 largest companies listed in the U.S.), VTV, VEA (developed markets), VWO (emerging markets) and XLK (technology ETF, which has achieved steady growth since April, unaffected by pandemic).
Aside from diversification which involves going broad across the market, you also manage risk while sticking to a single sector by hedging. Hedging involves opening positions that are anti-correlated, which is to say that if one stock performs better than the other should theoretically perform worse (e.g. the financial sector and gold funds). That way your bottomline is covered because if let’s say your Goldman Sachs investment comes tumbling down then at least the flock of traders to gold funds (as often happens in market crises) will offset some of your loss. Another strategy is to place a put option upon the underlying stock (further read on options). For a retail investor with small capital, hedging by purchasing options is less viable of an option (no pun intended) because an option contract covers a minimum of 100 shares and thus will not be applicable unless one holds a position worth thousands of dollars in a specific stock.
Takeaway
This article aims to dispel the notion that stock trading is accessible only to professionals in business suits or risk-takers with a huge bank up their cuffs, and instead encourages anyone interested in exploring the functioning of the market to partake in this fascinating human endeavor. Retail brokers like Robinhood and Webull are now offering commission-free trading anywhere in the world, and one can begin trading with capital as low a lunch’s cost. Although financial profit is not guaranteed, I believe that one can only gain by familiarizing themselves with this trillion-dollar industry.
Disclaimer: This article consists solely of personal opinions and does not constitute any professional financial advice. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication.
