Part of a disciplined and systematic approach to trading is analyzing the current value of any stock before you buy it.
Traders do this in two ways
with fundamental analysis and technical analysis.
Fundamental analysis is a way to assess a company, using factors such as revenue and earnings growth
to see if conditions at a company are improving, stable, or deteriorating.
When traders are planning a longer hold time, they often use fundamental analysis
to eliminate potentially weak companies
and focus on those that show better financial strength.
They also use it to determine if the stock’s price may be a good value at the moment
by looking at measures such as the price to earnings, price to sales,
price to book value, and price to earnings growth.
For short-term trades, it’s all about price.
And traders use technical analysis to track price and volume over time
to try to determine which way the stock might move
and where they want to enter and exit a trade.
Technical analysis assumes that all the available information is already baked into the price.
It can provide an idea of where a price move may stop or break to a new level.
Instead of being emotionally swayed by the news,
they can stay focused on price data and make trades based on perceived risk versus reward.
The risk being how much you’re willing to lose on a particular trade,
and the reward being how much you’re hoping to gain.
Your trading style will determine whether you use fundamental or technical analysis,
or a combination of the two.
Technical analysis can help you decide what to buy and when, based on price.
But what about how much to buy?
You can calculate that with two important numbers:
how many dollars are at risk for each share, determined by your risk-reward ratio,
and the maximum loss per trade you set in your plan.
Divide the maximum loss by the dollars at risk per share to see how many shares
you can purchase without risking more than you can stand to lose.
When you are ready to buy, you can use one of four common order types:
market, limit, stop, and stop-limit.
Market orders execute almost immediately during normal market hours,
at the current price.
However, depending on how fast the market is moving, that price could be higher or lower than the last price you saw.
Essentially, this order says, “I want these shares now―the price is not important.”
If price is important, use a limit order to set a maximum price you will pay.
If your order is filled, it will be at your limit or better.
But there is no guarantee your order will be filled.
Depending on how long you think it might take to get the price you specify,
you can set this as a day order, which stays in effect throughout the regular market hours,
or you can place a good-till-canceled order,
which can remain active for weeks or months, depending on your broker.
A buy stop order is an order to buy a stock at the market price once the stock trades at or above a specified price
known as the trigger price.
Traders use the buy stop order when they believe that if a stock breaks through a certain price,
it will continue to rise.
Remember that there’s no guarantee that a stop order will be executed anywhere near the stop price.
A buy stop-limit order combines a stop order and a limit order and works to keep traders from overspending.
Both a trigger price and a limit price are set.
That way, the trade is executed once the trigger price is met, but only up to the limit price.
This is another case where trade execution is not guaranteed,
but it does ensure that if executed, the price is at or better than the limit price.
One thing that can’t be stressed too much is the importance of knowing your exit strategy before entering a trade.
Watch the next video in our series to learn how to sell.