There are two basic ways to trade the stock market –
shooting in the barrel or using strategies to determine which
stocks to buy, when to sell, and how to protect your investment
dollars. Needless to say, strategies outperform barrel shooting
by a large margin. There are, however, hundreds of trading
strategies to choose from. Of all of these there are a couple
of tried and trued methods that have worked well for investors
over many years. The beginning investor is advised to
investigate some of these basic strategies and see for himself
how they perform. New strategies can be explored once the basic
ones are well-understood.
Hedging is a way of protecting
an investment by reducing the risks involved in holding a
particular stock. The risk that the price of the stock will
drop can be offset by buying a put option that allows you to
sell at the stock at a particular price within a certain time
frame. If the price of the stock falls, the value of the put
option will increase.
Buying put options against individual stocks is the most
expensive hedging strategy. If you have a broad portfolio a
better option may be to buy a put option on the stock market
itself. This protects you against general market declines.
Another way to hedge against market declines is to sell
financial futures like the S&P 500 futures.
Dogs of the Dow
This is a strategy that
became popular during the 1990s. The idea is to buy the
best-value stocks in the Dow Industrial Average by choosing the
10 stocks that have the lowest P/E ratios and the highest
dividend yields. The companies on the Dow Index are mature
companies that offer reliable investment performance. The idea
is that the lowest 10 on the Dow have the most potential for
growth over the coming year. A new twist on the Dogs of the Dow
is the Pigs of the Dow. This strategy selects the worst 5 Dow
stocks by looking at the percentage of price decline in the
previous year. As with the Dogs, the idea is that the Pigs
stand to rebound more than the others.
Buying on Margin
Buying on margin means
to buy stocks with borrowed money – usually from your broker.
Margin gives you more return than if you were to pay the full
cost outright because you receive more stock for a lower
initial investment. Margin buying can also be risky because if
the stock loses value your losses will be correspondingly
greater. When buying on margin the investor should have
stop-loss orders in place to limit losses in the case of market
reversal. The amount of margin should be limited to about 10%
of the value of your total account.
Dollar Cost and Value Averaging
cost averaging involves investing a fixed dollar amount on a
regular basis. An example would be buying shares of a mutual
fund on a monthly basis. If the fund drops in price the
investor will receive more shares for his money. Conversely,
when the price is higher, the fixed amount will buy fewer
shares. An alternative to this is value averaging. The investor
decides on a regular value he wishes to invest. For example, he
may wish to invest $100 a month in a mutual fund. When the
price of the fund is high he puts a higher dollar amount in the
fund and when the price is low he spends less money. This
averages out his investment to the original $100 per month.
Value averaging almost always outperforms dollar cost averaging
as a percentage return on the money invested. When used as part
of a broader trading strategy it can help secure the growth of
your investment fund.
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