A Beginner's Guide to the Stock Market

by Matthew R. Kratter

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 like Microsoft (MSFT) or Apple (AAPL) will have a bid-ask spread of just a penny. So right now as I'm writing these words, there is someone at the bid for Microsoft who is willing to buy 2,200 shares for 120.25. And there is someone at the ask who is willing to sell 1,200 shares for 120.26. That's a bid-ask spread of just a penny ($0.01). 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.

Investing in dividend stocks is one of the best ways to build wealth. The reason it works so well is that you can take the cash from a dividend payment and use it to buy more dividend stocks. Then those dividend stocks will pay you more dividends. If you keep doing this over many years, you will end up like Ronald Read. He spent the first half of his life as a gas station attendant, and the second half of his life as a janitor at a J.C. Penney department store. He lived a simple, frugal life and funneled much of his earnings into dividend stocks. When he died at the age of 92, he left behind an $8 million fortune, all in dividend stocks.

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.

As Buffett says: 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.

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.

Low P/E stocks are almost always pricing in future bad news. Don't ever expect to find good stocks in the bargain bin—

In 2009, Netflix had earnings of $116 million. In 2018, Netflix had earnings of $1.2 billion. On 28 December 2009, Netflix had a market cap of roughly $3 billion. That means that if you bought a share of Netflix stock at the end of 2009, you were literally buying it at a future P/E of 2.50 ($3 billion divided by $1.2 billion).

If earnings are going to collapse, that P/E of 8 that you are paying might turn out to be a P/E of 100.

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.

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

Value investors will always tell you to stay away from companies with high P/E's or companies that are losing money. But if you do that, you will miss out on some of the greatest stock runs of all time. Microsoft, Starbucks, Home Depot, and Amazon all traded at very high P/E's for many years. Amazon still does. But these stocks have gone on to make their holders very rich.

I like to buy growth stocks that are hitting new 52-week highs, or even all-time new highs.

If you study the greatest growth stocks of the past, you will begin to notice that they spend a lot of time trading at all-time new highs. This makes sense simply because any stock that goes up a lot must (almost by definition) spend a lot of time trading at new highs.

There is, in fact, something wonderful and magical about a stock at an all-time high: Every single holder of the stock has a profit.

By contrast, when a stock has crashed or is constantly hitting new 52-week lows, there are many investors and traders that have been left holding the bag. If the stock then tries to rally, these investors will be happy to get out by selling their shares at their break-even price. This provides constant downward pressure, and thus makes it more difficult for the stock to bounce back.

a new all-time high, everyone who has shorted the stock previously now has a losing trade on their hands. They are sweating bullets. And there's only one thing that they can do to stem their losses: they must "cover" their shorts by buying back the stock. This buying only adds more fuel to the fire, driving the stock higher, and forcing out more short-sellers.

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

The next step is to look at a daily chart of each stock. I want to make sure that the stock is trading above its 50-day moving average; and that the 50-day moving average is above the 200-day moving average. That looks something like this:

This is a chart of The Trade Desk (TTD). The upper line is the 50-day moving average, and the lower line is the 200-day moving average. When a stock looks like this, you know that it is in an uptrend.

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 either of those two criteria are true, the stock is in a downtrend. There is nothing more dangerous than a growth stock in a downtrend. A growth stock might go up 300% over 3 years...

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.

When a stock keeps hitting new 52-week lows and it has a high short interest, you want to stay away.

High short interest is simply more fuel for a rocket stock’s ascent. That’s why if a growth stock is hitting new 52-week or all-time highs and it also has a “Short % of Float” that is greater than 10%, I get very interested. As the shorts get squeezed, a stock like this can sometimes move up 30% or more in a very short period of time.

if you ever buy shares of an IPO, remember who you are buying from. You are buying from smart insiders who know everything about how the company operates, its strengths and weaknesses, and its future prospects.

The smart insiders might be selling their shares because they think that those future prospects are poor. Or they might just be selling so that they can buy their own private jet and Maui estate.

If you bought 1 share of Coca-Cola for $40 when it IPO'd in 1919 and held on to it, your position would currently be worth more than $15 million (assuming that you used all dividends that the stock paid you to buy more shares).

So we buy 100 shares of the stock at 47.48, and immediately sell one August 48.00 call option for 1.30. 100 shares of the stock costs us $4,748 (no commissions are charged if we use Robinhood.com). By selling an August 48.00 call option, we are giving someone the right to buy our 100 shares of XYZ stock from us at 48.00 anytime before the option expires in mid-August. In exchange we get to pocket $130. We sold the call option for 1.30 and each call option is based on 100 shares of stock, so we multiply 1.30 by 100 to get $130. We get to keep this $130 no matter what happens to the stock. We are also entitled to any dividends that the stock pays while we're holding it. If the stock is above 48 (the strike price of our call option) near expiration, the stock will be taken away from us at 48.00 and $4,800 will be deposited into our account (100 shares times 48.00). We paid only $4,748 for the stock, so that gives us a profit of $52 on our stock ($4,800 minus $4,748). Add that to the $130 that we pocketed from the call option, and you'll see we'll end up making $182. You'll notice that in this example, we sold something (a call option) that we didn't already own. Don't worry about this for now.

By now you've probably realized that this type of trade is called a "covered call." You are short a call, but you are "covered" against a big loss by simultaneously owning the stock. For every call that you want to sell, you'll need to buy 100 shares of the underlying stock to make this work.

Write down these “5 Commandments” on a sticky note and put it on your computer screen: Don’t buy stocks that are hitting 52-week lows. Don’t trade penny stocks. Don’t short stocks. Don’t trade on margin. Don’t trade other people’s ideas.

Has a company that you own just reported some really bad news? If so, remember that there is never just one cockroach. Bad news comes in clusters.

Never buy a stock after you have seen the first cockroach. When a stock goes down a lot, it can affect the company's fundamentals as well. Employee and management morale will deteriorate, the best employees may leave the company, and it may become more difficult for the company to raise money by selling shares or issuing debt.

a penny stock might appear to be liquid one day, and the next day, the liquidity dries up and you are confronted by a $2 bid/ask spread. Or the bid might completely disappear.

shorting stocks is clearly an advanced and risky trading strategy. Don’t try it until you’ve been trading for at least 5 years, and you have the financial stability to withstand a freakish upwards move in a stock. And never short a penny stock. It’s just not worth it.

Trading on margin is thus a form of leverage: it amplifies the performance of your portfolio both on the upside and the downside.

Let me start by reminding you of one of the most important truths about the stock market: Reaction to the news is always more important than the news itself. And so, by extension: Reaction to an earnings report is always more important than the earnings report itself.

Whenever you keep hearing about a risk in the financial news, it is most likely already priced into a stock, or the stock market as a whole.

George Soros: "It's not whether you're right or wrong that's important, but how much money you make when you're right and how much you lose when you're wrong."

John Maynard Keynes: "Markets can remain irrational longer than you can remain solvent."

Dennis Gartman: "The markets will return to rationality the moment that you have ...

Jim Rogers: "I just wait until there is money lying in the corner, and all I have to do is go over there and pick it up. I do nothing in the meantime. Even people who lose money in the market say, 'I just lost my money, now I have to do something to make it back.' No, you don't. You should sit there until you find something."

Paul Tudor Jones: "Don’t be a hero. Don’t have an ego. Always question yourself and your ability. Don’t ever feel that you are very good. The second you do, you are dead. My biggest hits have always come after I have had a great period and I started to think that I knew something."

Buy the strongest stocks that keep moving up. Add to your winners, get rid of your losers, and don't get too greedy. Trading is actually quite simple. It's just not easy.