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How to invest in the stock market

When the bear market hits...
When the bear market hits...

Ah yes. It’s about time I talk about one of my favorite things to do – invest in the market. It is something that not everyone can do, or knows how to do. I just want to share some of my thoughts and experiences about it so far.

I started investing in November 2008 – around the time the financial crisis happened. I recognized a great opportunity then to invest because the markets were all down as a result of global economic malaise at the time that the next great depression was happening. All the major indexes were down to their 1998 levels and it was a good time to get in. Fast forward a year or so later and we can see that all the indexes have gained 30-60% from then and the DJIA is hovering between 10,000 and 11,000.

Investing in stocks is something that many people are afraid to do. They are afraid of risk or losing money in case a company goes bankrupt. Or what if the stock price goes down and I lose a lot of value? I’d like to take a quote from Winston Churchill who said that ‘Pessimists see the difficulty in every opportunity and Optimists see the opportunity in every difficulty‘. Investing in stocks need not be a daunting task. A lot of people think you need to be really knowledgeable about finance, or you need a lot of capital. Neither. Much of it is common sense and I started my portfolio with a measly $1000 in savings.

The basic premise of the stock market is to make profit and/or earn money. You can do this two ways: buy common stock and hope that it goes higher and then sell it at a profit. This is the most common way. Or you can buy preferred shares and hold it long term and make income from dividends. I would suggest the latter if you have a lot of cash handy. The main goal of a company is to be profitable. Once a company is profitable the stock generally goes up and assuming you have bought it at a lower price you can sell it to make profit, buy more of it hoping it goes up more or hold it to see how much it goes up. I’ve taken a pretty standardized routine of buying stocks now. I’ve invested for over a year, learned the good and bad and generally this way has worked for me. During all of 2009 I have yet to have a month where I have had a net loss. Last month was the first month I ever actually had a net loss for my investments, and it was mostly due to a stupid glitch with my brokerage. You want to know how I invest? Here’s how I invest (keep in mind that I’m a short term investor):

Look at which companies are currently profitable and can sustain their profit margins. If a company has a product or service that can be differentiated from its competitors that’s a good sign. If a company is in an emerging market, like China, that’s a good sign because there’s room for growth. A prime example is Sirius XM Radio (NASDAQ:SIRI). Back in Nov 2008 this stock was trading at $0.25/share. Now if you look at it Sirius XM has a good product: it’s the sole provider of satellite radio. It also increased subscribers year after year and more car manufacturers were offering it in their cars. In addition, this stock was so cheap that it had very little room to fall. So it’s a good investment. And if you look at the quotes for SIRI now, you’d see that it’s trading at more than $0.90 a share, that’s almost 4x the price it was back when I first invested in it. If a stock’s value seems cheap for what it is, then that’s a good deal. Two other stocks I would like to call attention to are Baidu (BIDU) and Ctrip.com (CTRP). These two Chinese stocks are at the top of what they do, in terms of market share, revenue, etc. Baidu is the leading search engine in China and because of China’s nationalistic spirit, I doubted that Google was going to surpass it (turns out they pulled out completely). Baidu was trading around $120/share back in February 2009. This is an incredibly attractive price for a stock that had such a huge potential for growth (online advertisement, search deals w/government, etc). And currently Baidu is trading at around $430/share. This is likely to sustain for a few more years because of its dominance of the Chinese market and to benefit from its growth. Next, Ctrip.com is the leading provider of travel service in China. This is another potential segment for growth because as middle class Chinese move up benefiting from China’s growth, they have more purchasing power allowing them to spend more on such things like travel. In addition, Ctrip provides both international and domestic flights. Again when you have a company that is in an emerging market and said company dominates its competition (EPS, Revenue, etc) then you have a winner. Ctrip’s value went from $17/share back in March 2009 to $76/share last month before it split. Again more than 400% gain.

After analysis of the stock and purchasing x shares of y company, there’s the thought: what if the stock falls? There’s two things I would in this case. Stocks fall for a number of reasons: a) Stock fell because earnings report b) Stock fell because of increased competition c) Stock fell because the market fell. In case a) and b) I would suggest selling the stock depending on how bad it was. If it’s not expected to return to profitability anytime soon, it’s gonna tie up your portfolio which you could be using to purchase better deals. In a worst case you should hold it because a) and b) tend to have longer term repercussions on the stock’s value. On the other hand, if it’s c) there’s one thing I would do: invest invest invest and/or average down. When those bearish days hit and the Dow drops 100+ points you know that’s a good time to buy. Because usually it doesnt mean anything about the company, it’s mostly a market reaction of investor fears and as Warren Buffet says ‘be greedy when others are fearful and be fearful when others a greedy‘ these down drops are typically temporary and the stock typically goes back up once the market recovers.

Making profit. I tend to have a general rule about stocks. If I make more than $100 on a stock, I sell it. Sure it means I lost out on the opportunity to make more money but some profit is better than nothing and it builds up. If a stock is really high then I would use a stop limit to lock it in. Limit orders are also a nice way to ensure that you buy low and sell high. But one rule in general is that the most profit tends to be made longer term. In fact if I had held alot of my stocks I invested in before until now I would’ve been 10x richer at least… but for those with short term thinking like me, locking in little profits a bit at a time helps too. In general, limit your risk by knowing when to sell and when to hold.

Three things to think about: How to purchase a stock, what do to if a stock falls, and when to make your profit. Stocks aren’t really as complicated as some people make it out to be.

Here’s some tips in general for making a profit on the market in the long run:

1) Be a contrarian: Buy stocks when others sell, and sell stocks when others buy. This can be very hard to do, but remember that once a stock is oversold – it will reach a certain point where it will look cheap to value investors and thus go back up, what goes down must come back up. Same thing when it’s high. When everyone is buying, it reaches a certain point where it looks too expensive, and then people will sell, and it will go down. It’s hard to tell where the peaks and bottoms are, but don’t try to time the market, just try to get a good idea of what’s happening to the stock.

2) There’s no software in the world that can make profit consistently: Don’t be sold on certain programs that can make money, because it’s impossible that it can make profit all the time; if it did, then everyone would be using it, and whatever gains would be gone, because if everyone bought or sold the stock, then the opportunity for profit disappears and the software is useless.

3) Use Limit, Stops, and Limit Stops: Limits are executed when the stock goes above a certain limit price, stops are executed when the stock goes below a certain price, and limit stops are executed when the stock is above a limit price, and below a stop price. Use these two tools to trade stocks because they are very useful. For one thing, buying at market may not guarantee you the price you want. Limits are usually used to maximize profit, and stops are usually used to minimize loss. With these tools, you know what price your stock is going to be bought/sold at, giving you more control over it. Using them helps exercise your patience (below):

4) Have foresight and patience, take advantage of human irrationality: Do not panic about a stock. There are a lot of times where certain common sense scenarios don’t get processed by investors right away. Example would be, when Ford Motor Company (NYSE:F) was trading about $1 in Dec 2008, Ford declined to take bailout funds from the US government. One would think that the stock price would be higher given that Ford didn’t need a bailout – you would expect Ford to be doing pretty well – now Ford is trading at around $16, and making billions in profit. Wasn’t this expected?
Baidu Inc (NASDAQ:BIDU) was at about $46 in Jan 2010, then news that Google would exit China’s market was revealed and Baidu shares went up – thing is, it didn’t go up enough to account for just how much profit Baidu could make. The average investor could realize that the shares were still undervalued and bought some – because now, Baidu is trading at $110, over 100% gain.
Shares of Home Inns (NASDAQ:HMIN) and Ctrip.com (NASDAQ:CTRP) didn’t go up substantially until after the Shanghai Expo was already underway. Given that these were huge Chinese travel stocks, one would think it obvious that these companies should be making a huge profit – and they did. Point is, it takes time for people to absorb the information. If one has patience, they could use this delayed reaction to make some profit.
Another curious thing that occurs, is that whenever an announcement is made, or IPO is made, it takes a few hours after the opening for the news to absorb. The stock could then keep going up or down depending on the nature of the news. Humans make irrational decisions sometimes, they overreact to news, and they take time to absorb information. Take advantage of human nature, and you can make profit.

5) Use fundamental and technical analysis: Fundamental analysis is looking at the company’s balance sheets. Technical analysis is looking at the trends. You should make use of both. If a stock is trading below it’s 50 day moving average, and it’s balance sheets are still solid, then that’s a good prospect for a buy. If a stock is trading on high volume above it’s 100 day moving average, and it’s trading at a high EPS, then it’s being heavily bought on speculation, and should be sold soon. Use both types of analysis to your advantage, it can tell you a lot about whether investors are behaving irrationally or overreacting (see previous point).

6) Generally, do not short a stock: Shorting a stock means potentially unlimited losses, as that stock could go up over 100%, that’s why I highly recommend against it. I have personally never made money by shorting a stock. Stocks have natural tendencies to go up because people want to see the companies do well, and companies want to make profit. Only in an extreme bear market would I ever consider shorting a stock, and/or terrible news for the company has been revealed (ie. BP oil spill, Goldman Sachs charged with fraud, etc). When you buy a stock, the worst that could happen is that the stock goes bankrupt and you lose all your money that you invested – but no more than that. If you want to hedge your position, buy gold or exercise options instead (below).

7) Make use of options: Options can be very useful if one uses it well. Never buy/sell an option by itself, it’s a huge risk, and you could potentially end up in a naked position. However, you can use options in combination’s and/or together with stocks to hedge your position. There are two types of stocks: blue-chip stocks (ie. General Electric, Apple, Microsoft) that trade on a large market cap (over 50 billion), those stocks tend not to move a lot and are generally not risky. Small and medium cap stocks are stocks with a market cap of a few hundred million to a few billion, and these stocks are more volatile and risky, but with potentially higher returns. There are certain option strategies that can be used with both:
Small/Medium cap stocks with bullish indicators: Bull Spread (buy a call option at one price, and sell a call option at a higher price), Straddle (buy a call option and buy a put option), Strap (buy two call options, and buy a put option).
Small/Medium cap stocks with bearish indicators: Protective Put (buy the stock, and buy put options on it), Bear Spread (sell a call option at one price, and buy a call option at a higher price), Straddle (buy a call option and buy a put option), Strip (buy two put options, and buy a call option).
Large cap stocks: Covered Call (buy the stock, and sell call options on it) , Butterfly Spread (sell two call options, buy a call option at a lower price, and buy a call option at a higher price).

8) Do not day trade: Day trading is basically gambling; you are betting that the stock will go up, and if it doesn’t, then you’re screwed. Not worth it. It’s just as risky as naked options trading. If the stock goes the wrong way, then you are losing potentially all your money.

That’s basically all for now, I am still learning as I invest, and will add to this article as I go along. I hope this has been useful for the majority of you.