21:5 Financial Network

Biblically Responsible Investing and Financial Coaching

Trading Handbook

Successful DIY Investors Need to Know the Tools of the Trade

 

Managing your own brokerage account may feel overwhelming, but it isn’t so complicated when you understand the terminology and how processes work. Trading is a major part of managing an account, so we hope to present trading terminology and processes in a simple, practical way. It is well worth the effort for an investor to be self-directed. Learning how to trade effectively can save an investor large amounts of their invested dollars that would otherwise be paid to someone else in management fees. That being said, let’s get started.

Each brokerage firm has a slightly different user interface for making trades and managing an account, but they all have the features to get the job done well. When an investor opens an account and transfers money into it, the brokerage firm will hold the deposit in a cash fund or money market fund. They are both considered a cash position, and pretty much all of your stock, ETF, or mutual fund purchases and sales will flow out of and into the money market/cash fund. A money market fund is not FDIC insured but keeping money market funds stable is of utmost importance to our national economy. Money market funds pay interest, but people rarely open a brokerage account just to hold a cash position in a money market, so let’s discuss the details of how to buy and sell securities effectively.

 

Implementing a Stock and/or ETF Portfolio

Orders to buy or sell stocks and ETFs are put into effect as soon as an investor places them, and they will be filled depending on the type of order placed (more on that to follow). Unless an investor is using Motif Investing® or another brokerage firm that enables him or her to buy partial shares, stocks and ETFs must be purchased in whole shares. You have to do some simple calculations in order to figure out how many shares you can buy with the money you have available to trade.

Example: Suppose that an investor has a total account value of $50,000. They want to allocate 5% of their portfolio into XYZ Company which is trading at around $43.50 per share. The investor needs to calculate how many shares of XYZ Company he or she can buy. So he or she finds 5% of $50,000 (which is $2,500) and divides that amount by $43.50 (which is approximately 57.47 shares). The investor needs to round down in order to avoid overspending on the purchase, so he or she places an order for 57 shares of XYZ company. 

Before the trade order is confirmed, the brokerage firm should show the investor the total cost of the purchase, including trading commissions and fees, as well as any warnings that might pertain to the trade. 

There are a few other costs related things to consider when placing any order for stocks or ETFs. If the amount of money is limited in the money market, the investor should account for the trading commission when figuring how many shares to buy. The investor may also want to raise the share price by a few cents in the calculation to account for a possible price change between figuring the number of shares to buy and actually placing the order. From our example, subtracting $10 for the trading fee and raising the share price to $43.60 makes the share calculation 57.11 shares. The extra considerations didn’t reduce the amount of whole shares the investor can buy, but sometimes they could reduce the number by a share or two. 

Once the investor has found how many shares he or she wants to buy, then he or she needs to determine what type of order to place.

 

Order Types

Placing a securities trade is similar to buying or selling any other product in an open air market. The first question is, “Do I want to haggle over price or not?” On the upside, there is no salesperson, per se, trying to influence your opinion. If you just want to buy a security at the asking or market price, then place a market order. If you want to haggle, place a limit order.

 

Market Order

A market order is an order to purchase or sell a security immediately at the best available price.

The advantage of market orders is that the trade will be executed immediately. The disadvantage of market orders is that they have to execute immediately at the prevailing price. Markets are volatile, and sometimes the price of securities can move against an investor, leaving the investor with an execution that results in a lower (or higher) amount than expected. This is the tradeoff for wanting orders to be executed immediately.

A market order is the rough equivalent of walking into a furniture store, seeing the sticker price, and saying, “I’ll take it.” Unfortunately, in the securities world the sticker price fluctuates regularly. This might be the rough equivalent of seeing the sticker price on a piece of furniture increase between the time you say you will take it and when you actually get it out the door. The actual price you pay is the sticker price at the moment the credit card is swiped through the reader or you sign the check.

 

Limit Order

A limit order is an order to purchase or sell a security at a specific price set by the investor. Imagine walking into a furniture store and seeing a piece of furniture that you like. It will probably have a tag on it with an asking price, but you make your own offer instead. The salesperson can accept or reject your offer, but you set the price you are willing to pay. This is the equivalent of a limit order. In the world of securities trading, prices fluctuate regularly so your limit order might not execute immediately. As the price changes over a period of time, your limit order might execute later. As long as your offer still stands, the furniture salesperson might call you back later and accept your offer after all. 

If a limit order is a buy limit order, it will be executed at the stipulated price or better.

For example, if a limit order is placed to buy 20 shares at $9.50 per share, it has to be filled at a price of $9.50 or lower.

If a limit order is a sell limit order, it will be executed at the stipulated price or better.

For example, if a limit order is placed to sell 20 shares at $10 per share, it has to be filled at a price of $10 or higher.

Limit orders ensure that an investor receives at least a certain amount for the transaction. This provides investors with some protection against volatile price movements of securities. The disadvantage of limit orders is that the order may not execute. If nobody is willing to buy (or sell) at a specific price, the order may not be filled. The tradeoff for buying or selling at a particular price is that the order may not execute at all.

 

Stop Orders and Stop-Limit Orders

A stop order allows the investor to set a price or a percent of gain or loss that a stock or ETF must reach to execute the order. A stop order or stop-loss order triggers a market order when the stop price is reached.

Example A: Suppose the current share price of XYZ company is $20 per share. Suppose you don’t want to buy at this price, but you would buy if the share price ever falls to $16 per share. You can place a stop order now at $16 per share, and if the share price reaches that price point, your order will execute as a market order.

A stop order is similar to a limit order, except that reaching stop price triggers an order while a limit price sets the actual purchase or sale price. There is a difference in meaning that sounds like it would produce the same result when it might not. A stop order triggers a market order, which as we look back at the definition of a market order, means that an order will execute immediately once the stop price is reached. However, the stop order does not guarantee a particular price for the trade. If XYZ reaches $16 per share and immediately jumps back to $18 per share, a stop order might mean that you will buy XYZ at $18 per share. If you care more about the buying price than simply triggering an order execution, using a limit order would better accomplish that goal.

A stop-limit order can incorporate both aspects of triggering an order and setting an acceptable price. For a stop-limit order, the investor sets two prices. The stop price essentially activates the limit order. The limit price sets the price at which the stock or ETF will buy or sell. Why would an investor use this?

Example B: Let’s suppose that you own ABC Company and its current price is $40 per share. You want to protect your profits if the price falls to $35 per share, but you don’t want to get less than $33 for the sale. If you set the stop price at $35 per share but set the limit price at $33, and the stock falls to $35, then the order would become a live sell-limit order. The order may be filled at a price of $33 or higher. If the stock price falls below $33 before the order is filled, then the order will remain unfulfilled until the stock price rises to $33. If the share price remains steady at $40 or continues to rise, then you would hold your shares – allowing you to reap more gains.

 

Trailing Stop and Trailing Stop-Loss Orders 

These types of orders combine three features that allow an investor to place a preemptive order and have the order execute without having to monitor the stock or ETF on a regular basis. For this order, the investor sets a stop price that activates an order. The investor also sets a trailing price or percent such that if the share price rises or falls to it, the order will execute. The trailing aspect of the order means that the trailing price or percent moves favorably as the share price changes. As with any other stop order, once the trailing price is reached a market order is triggered. For a trailing stop-limit order, once the trailing limit price is reached, a limit order is executed. (A market order executes immediately and guarantees a trade, but not a price. A limit order guarantees a specified price, but a trade may or may not execute). 

Example: To illustrate, let us say that you own a stock whose price is $50 per share. You would like to sell the stock if the price reaches at least $55, but you would like to ride the increase in price for as long as it continues to rise and capture more gains. Now suppose the price increases to $70. If you originally placed a stop-limit order with a limit price of $55, then the share price would have to fall back to $55 in order to execute a sale. However, if the price reaches $70, you probably don’t want to lose the additional gains between $55 and $70 per share. A trailing stop-limit order resolves this for the investor. Suppose you set a trailing limit at 5%. As the share price increases, your limit price increases with it and always trails the maximum share price by 5%. Once the share price hits a maximum of $70 per share, your 5% trailing limit means that a limit order would execute if the price falls to $66.50. 

The trailing limit price rises as the share price rises for a sell order, but it stays the same once the share price falls from its maximum point. The trailing limit price falls as the share price falls for a buy order, but it stays the same once the share price rises from its minimum point.

 

Day Order

The order is to be fulfilled during the trading day. U.S. markets regularly open at 9:30 a.m. and close at 4:00 p.m. A day order will expire at the close of the markets on the day the order is placed.

  

Good Til Cancelled (GTC)

The order remains active until it is either rescinded by the investor or fulfilled. GTC orders are usually set to expire 30 to 90 days after the order is entered so that investors don’t forget about them.

GTC orders allow investors to place trades at orders at specific price points (limit orders) until they reach an expiration date, are executed, or are cancelled. For example, an investor going out of the country for a while may choose to enter GTC Stop Limit orders on his account at 10% below the purchase price. If the stock market sells off while he is away, the orders may execute to limit further losses on his account. Because of this, the investor does not have to constantly monitor the stocks in his account.

 

Immediate or Cancelled (IOC)

The order must be fulfilled immediately, in part or in whole, or it is cancelled. Filling a large order is sometimes difficult, so this designation avoids having the order filled at a wide variety of prices.

 

All Or None (AON)

The order must be filled completely or not at all. For example, if an investor is trading 5,000 shares on an AON basis and only 4,000 shares can be filled, the order will not execute at all. There will be no partial fill. If there is insufficient supply to meet the order, the order will be cancelled at the close of the market. As this implies, sometimes orders are filled in partial increments and at different prices.

 

Other Factors to Consider for Efficient Trading

Spreads 

Spreads are an important hidden cost when trading stocks and ETFs. While the language may sound intimidating at first, it is really a simple concept. (On a side note, mutual funds do not have spreads because they trade at the NAV at the close of the market).

Think about purchasing a car for a moment. When you go to the car dealership, they list the price they are asking for it. The “ask” is the price at which the dealer is offering to sell it to you. As a savvy buyer, however, you may not be willing to pay that much. You tell the dealer how much you are willing to pay – the “bid.” How much the car is actually worth is likely somewhere in between the two figures. The “spread” signifies this – it is simply the difference between the bid and the ask. The wider the spread, the more likely you are to pay more as the buyer and/or to give up as the seller in order to close the deal. 

Stocks and ETFs work in a similar way as buying or selling a car in that they trade intraday on an exchange and investors try to negotiate for the best price they can get – whether they are buyers or sellers. When you go to place an order for a stock or ETF, you will notice the ask price (the price at which someone is willing to sell to you, the buyer) and bid price (the price at which you, the buyer, is willing to pay). The spread is the difference, and the wider the spread, the more it will likely cost you to trade the stock or ETF.

Example: Let’s imagine that XYZ stock is trading with a bid of $20.10 and the ask at $20.30. The spread is therefore $0.20. If you want to execute a trade right away, you would enter a market order. For a buy of XYZ, you would probably pay $20.30. If you wanted to sell XYZ, you would probably get $20.10. In this example, you would lose $0.20 per share in the buying and selling of the stock. Since a primary goal of investing is generating the best possible returns, losing returns in the buying and selling of securities should be avoided whenever possible. Limit orders can help to reduce the effect of spreads, because investors set their own prices and are more likely to work a favorable deal. 

Spreads tend to widen and narrow based on trading volume of the stock or ETF. If the stock or ETF is popular and trades frequently, the spreads tend to be narrow. If the stock or ETF is traded less frequently, the spreads tend to be wider. The same effect occurs with buying or selling any product. A rare baseball card will probably have a great difference between the asking price of the owner and the bid of a prospective buyer. Meanwhile, juice boxes at a grocery store are pretty much priced where any shopper would pay what is asked because of competitive prices from other stores. As a reference, stocks and ETFs could trade as few as hundreds of shares per day to as many as millions of shares per day.

 

Trading Situations for 21:5 Financial Portfolios 

21:5 Financial Network Portfolios do not operate according to a buy and hold strategy, per se. We attempt to limit the trading costs for investors by limiting the number of trades that investors need to make in order to maintain the portfolios in our newsletter. However, we seek to capitalize on overall trends in the market and trade into and out of stocks, ETFs, or, on rare occasion, mutual funds at opportune times.

The newsletter might suggest the use of certain types of orders such as stop-limit orders to limit losses if a stock or ETF selection does not work out or to allow a gain to run with a trailing stop order in place to capture returns. Every percent of loss requires a greater percent of gain to recover those losses, so 21:5 Financial Portfolios seek to limit losses and allow gains to run upward as far as possible. 

The portfolios contained in the newsletter are designed to be implemented in whole, not in part. Investors are free to use the newsletter in any way they choose, but each stock or ETF within a portfolio is meant to complement the rest of the portfolio. In a similar way, a baseball pitcher might have a strong curve ball, but that pitch is most effective when used in conjunction with the pitcher’s fastball and as part of a pitching plan that is meant to get a hitter to hit into a double play. Our portfolios are designed with a plan to accomplish their stated goals, and each part of the portfolios is meant to complement the other parts in order to reach those goals. For example, some securities within a portfolio carry high risk, but the return potential warrants the risk when those securities are paired with lower risk securities. If an investor buys the high risk securities without buying their lower risk complements, the result could be large losses.

21:5 Financial Portfolios will never include buying on margin as an investment strategy, nor will we include options trading within our portfolios. We will almost always suggest long positions, and we will attempt to diversify the portfolios among regions, sectors, and asset classes. We attempt to minimize unnecessary risk to accomplish the stated goals of a portfolio, and we make investment decisions based on greatest probability and expected values. Over time, the correct use of probability and expected value should produce the most likely outcomes. We also factor in estimated fees to the investor into the decision-making process in order to try to provide subscribers with the best possible results.

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