Learn how to use stop and limit orders and why reading financial statements could be important for buy/sell/hold analysis.
Traders just starting out are often excited about getting into the market. But before doing so, it's important to understand factors that can influence decisions on when to buy, sell, and hold on to stocks for max growth and to limit losses.
There's no way to know exactly what a stock or asset will do for sure because its price can be impacted by many factors, ranging from broader market conditions to its own business performance. While there's not one specific strategy that's best for everyone, professional traders do have several "rules" they follow when considering their investment moves, such as establishing entry and exit points and assessing fundamental factors.
Individual traders can develop their own way of buying and selling after learning more about these general principles.
An entry point is the price level where a trader buys or "enters" a position, while an exit point is the price a trader sells or "exits" the position. Ideally, you want to determine your entry and exit points in advance to provide a clear strategy toward minimizing risk and maximizing returns. Establishing entry and exit points will also help you avoid making decisions based on emotion.
Many traders try to establish an entry point to try to maximize gains. While some are very long-term buy-and-hold investors, others think it's also important to determine when to cut losses if a stock's value is declining.
Some traders may find it feels natural to hold on to underperforming assets and wait for their value to rebound, but this can be a mistake if the asset continues to decline. While some professional traders do adhere to a buy-and-hold strategy, many set a clear plan for buying and selling.
Traders commonly use stop and limit orders to help maximize gains and minimize losses. Instead of constantly monitoring the price movements of your investments, you can establish stop or limit orders so you can enter or exit according to your plan. A limit or stop order dictates how much stock to buy at a certain price or once it reaches a certain price. So, you can set a limit or stop order for higher or lower than the current market value to try to time your trades in a way that minimizes your losses or maximizes your gains. Market value is the current price of the stock.
Stop and limit orders work differently, and traders have different goals with each. But they act as constant monitors of price movements, giving traders a reprieve from doing it manually.
With limit orders, a trader's goal is to buy or sell a security at a particular price. For example, if a stock's market value was $65, a trader who wants to buy it may set a buy limit order at $60 if that's considered their ideal entry point. Similarly, if a trader wants to sell that stock, they may set a sell limit order of $70 if that was their planned exit point.
Stop orders are generally used more as a defensive strategy to minimize losses. To avoid missing out on a potential opportunity if the stock continues rising in value, a trader may set a stop order at a point well below the current price. But if that stock is expected to trade lower, the trader may want to try to minimize losses with a tighter stop order that might be close to or just below the current price.
Stop and limit orders are designed to trigger when the trader's pre-designated price is reached. So, in the case of the trader setting a $70 sell limit order, the stock would sell automatically when the stock reaches $70. Or, if there's a stop order under the current price, the stock would automatically be sold once it hits that price.
In the sell example, the limit order helped the trader know when to sell as the price increased, while the stop order helped the trader determine when to sell as the price decreased. That is the key difference between a limit and a stop. Certainly, if a stock is at $50 and one trader places an order to sell "if" it increases to $60 and another trader places an order to sell "if" it falls to $40, those traders have two very different mindsets. But that's not the only difference.
It's also important to understand the risks associated with both order types. For one thing, a limit order guarantees the limit price or better. But on the downside, it might never get filled. Stop orders are usually intended to exit a stock position if the price tumbles. Should that happen and the stock price hits that stop, it then becomes a market order and competes with everyone else's order to get filled.
There's no guarantee your order will fill at the exact price you've set. If you set a stop order to sell at a certain level, you might actually end up selling the stock slightly or in some cases dramatically below that level.
Another risk of stop orders is their automatic "bail out" feature, which can be good news or bad news. If a trader sets a sell stop at $60 and the price falls to $35, then stopping out, even if the $60 "triggered" stop fills at a lower price, looks like a good thing. But things could turn out differently. For instance, if you bought a stock at $65 and set a stop at $60, the stock might go down to $59 and be sold, and then jump back to $70.
As you consider when to buy, sell, and hold stocks, you most likely want to learn about the financial strength of a company, something many fundamental analysts do. One way to do that is through the company's financial statements, which the Securities and Exchange Commission (SEC) require publicly held companies to file quarterly. Financial information can be found on the SEC's website and usually on the Investor Relations page of the company's website.
Financial statements are a treasure trove of information. To simplify your review, focus on several key figures, such as the company's revenue or sales and how it compares to its past performance. Are the company's sales increasing or decreasing? If sales are rising, is that growth slowing or gaining momentum? Look at the company's guidance for revenue or sales, which reveals how it expects to perform in the future.
Cash flow offers insight about a company's liquidity. Many professional traders consider it the foundation of a company's financial health and factor it into their decisions when determining whether a particular stock might be a good investment. If more money is coming into a company than the company is paying out, then it has a positive cash flow, which is generally a good sign. However, if the company is paying out more money than it's receiving, its cash flow turns negative. An increasing negative cash flow, say, in consecutive quarters, could be a red flag.
Potential traders might also want to familiarize themselves with a company's earnings per share, gross margins, and any dividends and share buyback programs before deciding whether to buy a stock.
Traders often use technical analysis to evaluate an asset's past price trends and patterns shown on charts as a rule for buy, sell, and hold decisions.
Technical analysts generally believe broader economic factors have already been factored into a share's market price. Other traders may rely more heavily on looking at fundamentals such as information found in statements. Instead of scrutinizing outside influences and financial statements, technical analysts take a more visual approach, looking at trading patterns to anticipate future stock movements that might help determine the best time to buy or sell.
Chart patterns are a key part of technical analysis. A chart can provide an at-a-glance summary of historical prices, including highs and lows, that can reveal trends. Professionals use different chart patterns in different ways to look for trendlines over a certain time period.
Technical analysts may also look at indicators such as trading volume and moving averages for clues on when to buy, sell, or hold. Trading volume is the amount of shares being traded. When trading volumes are higher, some traders believe that might indicate stronger momentum behind the stock's movement.
Moving averages, such as a 50-day moving average or a 200-day moving average, smooth out price changes by averaging prices over a given time frame. A 50-day moving average would average the closing prices of the previous 50 days. With these numbers, you can see moving average trends as you do price trends. When the moving average has been rising, the stock is in an uptrend, and when the moving average has been declining, it's in a downtrend. Keep in mind, trends on charts, even those that have been in place for a long time, are still a backward-looking view. A trend can change at any time.
Traders have a lot to consider when buying and selling stocks, but professionals rely on several key pieces of information when making decisions. New traders can get started by slowly building their knowledge and developing an investing strategy that considers their goals. Learning about a company's earnings reports and price trends can be a good first step in determining whether an asset would fit with your investment goals.
Ultimately, it's up to each trader to determine which strategy and which investments are in their best interest based on factors such as their time horizons and risk tolerance.