A Beginner's Guide to the Stock Market

by Matthew R. Kratter

The stock market is a complex emergent system. It won't listen to you or to anyone else. It's like the weather-- it just does what it does, so you might as well get used to it. Take the time to learn how the stock market really works.

You can also subscribe to my YouTube channel and follow along as I tell you what I'm seeing in the markets every week: https://www.youtube.com/c/traderuniversity

I skate to where the puck is going to be, not to where it has been.

The stock market does something similar. It tries to figure out what is most likely to happen over the next 3-6 months, and then prices stocks accordingly. That's why we say that the stock market is a "forward-looking mechanism" or "discounting mechanism."

An inexperienced trader will be tempted to buy a stock like this when it is down, but this is almost always a bad idea. It can take time for new information to get priced into a stock, which means that this stock could continue to move lower for days or even weeks.

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Some people like to buy stocks and hold them for many years. We call them "investors."

Other people like to buy and sell stocks more quickly, maybe holding them for only an hour, a day, a week, or a month. We call these people "traders."

A stock exchange is simply a place where buyers and sellers show up and exchange their shares for money, or their money for shares. A stock exchange is a little bit like an eBay for stocks.

The NYSE is best known for its blue chip (high-quality) stocks like Coca-Cola and McDonald's. The Nasdaq is best know for its tech stocks like Netflix and Apple.

This is because every stock has a bid price and an offer (or "ask") price. The bid is the price at which someone is willing to buy the stock. The offer is the price at which someone is willing to sell the stock. Memorize this phrase right now: “You sell to the bid, and you buy from the ask.”

The distance between the bid and the ask is called the "bid-ask spread."

A liquid stock is defined as a stock where you can buy or sell a lot of shares without moving the stock too much. Liquid stocks in the U.S. usually have a bid-ask spread of just a penny or two.

That is why it is usually best to stay away from illiquid stocks. If you absolutely must trade them, you can try putting in a limit order that is right in the middle of the bid-ask spread. But there is no guarantee that your order will ever be filled.

limit order is the second type of order, after a market order. Whereas a market order tells your broker to just get you into or out of the stock as fast as possible, a limit order specifies a price. So if you place a limit order to buy MSFT at 120.25, your order will only be filled if there is a seller that is willing to part with the shares at that price. If there is never a seller at that price, your order will never be filled.

A Day order will only be executed during regular market hours today. If the order has not been filled by the time the stock market closes for the day, it will be automatically cancelled by the broker.

A GTC ("good 'til cancelled") order will be good for today's market hours, as well as the following days and weeks. If you don't cancel it, it will still be working. Some brokers will automatically cancel a GTC order after a month or more, if it has not yet been filled. Check with your particular broker to find out their policies.

If you are going to trade before the market opens or in the after-hours market, always use a limit order.

Even normally liquid stocks can be quite illiquid (and hence volatile) during both of these trading sessions.

Until you become an advanced trader, it is probably best to stick to normal market hours. And please don’t ever trade an IPO using market orders. That is the ultimate newbie mistake. More on that in a later chapter.

Another well-known index is the Nasdaq 100, which contains mostly tech companies.

Some smart people came up with the idea of the ETF ("exchange-traded fund"). An ETF trades just like a stock. You can buy or sell it all day long in your brokerage account. Each ETF represents a certain index. So the ETF for the S&P 500 trades under the ticker SPY. The ETF for the DJIA trades under the ticker DIA. And the ETF for the Nasdaq 100 trades under the ticker QQQ.

Today indexing is widely considered the safest and best way for most people to invest in the stock market.

The longer you hold a dividend stock like this, the higher your effective yield becomes.

There's an easy way to own a piece of every Dividend Aristocrat: just buy some shares of NOBL. It is the ProShares S&P 500 Dividend Aristocrats ETF. It trades just like a stock, and you can purchase it using any brokerage account.

One of the great things about investing in dividend stocks is that you know that the company is making money. Otherwise it wouldn't be able to pay you every three months.

Owning a basket of dividend stocks over a long period of time is one of the best ways to build wealth. If you start early enough, you may even end up with millions like Ronald Read.

That being said, there's a really easy way to pick stocks like Warren Buffett: Just copy him.

You could also just buy a basket of these stocks that Buffett owns. Buy the basket of stocks, and then sell a stock only when you hear that Buffett has exited the position.

That being said, there's one important lesson that we can all learn from Buffett's investing style. You want to own businesses that have good pricing power. This means that they can raise prices without losing customers.

On the other hand, if you have a strong brand or make a unique product, you have less competition and higher margins. If someone wants an Apple laptop or a pair of Nike shoes, there's only one place to get them. That's why Apple and Nike can charge premium prices.

The single most important decision in evaluating a business is pricing power. If you've got the power to raise prices without losing business to a competitor, you've got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you've got a terrible business.

P/E is a company’s “price to earnings ratio.” Let's say that a company's stock trades for $100 and that the company has earnings per share (EPS) of $6.50 over the last 12 months. We can calculate a trailing ("last 12 months") P/E ratio for that stock by simply dividing the stock price ("P") by the EPS ("E"), so 100/6.50 equals about 15.

Companies that are growing their revenues or earnings quickly ("growth stocks") tend to have P/E's above 25. So, for example, today Microsoft has a P/E of 27.70 and Amazon has a P/E of 79.

Companies that are in trouble often have P/E's below 10. So for example, today Bed Bath & Beyond (BBBY) has a P/E of 7.

Today people often confuse value investing with buying stocks with low P/E's. As we mentioned, that strategy worked well in the past when Warren Buffett was a ...

Until you become an advanced investor, don't ever buy a stock with a P/E of 10 or less. It's just a bad hole to fish in. It is full of companies with giant debt loads, falling revenues, or outdated products like faxes and t...

Another mistake that new investors make is buying "bargain stocks." In November 2015, the P/E of Bed Bath & Beyond (BBBY) hit a five-year low of 12.00, with the stock trading at around 60. When the P/E of a company hits a 5-year l...

Unfortunately, there is a very real tendency for cheap stocks ...

Paying a cheap price for a stock that is going to zero is never a good deal. We call these situations "value traps." They look like good values, but they turn out to be traps.

A low or falling stock price will make it difficult for the company to attract top talent. In this way, stocks don't just reflect a company's current prospects, but also play a role in determining a company's future prospects. A company with a high or rising stock price can use that stock to buy out competitors and pay for top talent. That's what Facebook did with WhatsApp and Instagram.

A growth stock is simply the stock of any company that is expected to rapidly grow its revenues or earnings.

Here's the first rule for trading growth stocks: Ignore the high P/E.

Companies with high P/E's are pricing in high growth in future earnings. If it looks like growth is slowing or that those earnings may never appear, the market will trash the stock. That’s why we always trade growth stocks with a clear stop loss.

I like to call these "rocket stocks." One way to find them is to constantly scour the list of stocks at 52-week highs or new all-time highs, which you can find here: https://www.barchart.com/stocks/highs-lows/highs?timeFrame=1y

Never buy a growth stock if the stock is trading below its 200-day moving average, or if the 50-day moving average is trading below the 200-day moving average.

If a growth stock is trading above its 50-day moving average, and the 50-day moving average is trading above the 200-day moving average, I am happy to be long.

Also, I like to look for growth stocks that have a market cap of $5 billion or less. It takes a lot less money to push a $5 billion stock higher than it does a $500 billion market cap stock.

I also like to look for growth stocks, where the float is less than 20% of the total number of shares outstanding. The “float” is simply the number of shares of a stock that are actually available for trading.

You can use this link to look up the float for any stock: https://finance.yahoo.com/quote/LYFT/key-statistics This link is set to LYFT, but you can use it to look up any stock’s float, just by changing the ticker in the URL. The float and total shares outstanding are listed in the middle of the far-right column.

I also like to look for growth stocks with a high short interest. “Short interest” is the quantity of shares that have been sold short by those who believe that the stock will go down. You can find a stock’s short interest here: https://finance.yahoo.com/quote/LYFT/key-statistics