Monday, July 16, 2007

What Stock and Option Trading Strategies to Use

As anyone who has been following my articles for some time knows, I am an advocate of trading education. We work hard to earn our money and we also need to work hard to learn how to make our money work for us. If we spend the time it takes to learn how to have our money make money for us, we may create a much better quality of life for ourselves and our families. Few are willing to take the time, but for those who do, the rewards can be fantastic.

There are many strategies available to the trader that offer various degrees of risk and involve many levels of complexity. The real issue is what strategy or strategies are right for you.

The markets (or an individual stock) can only do three things: they can go up, they can go down, or they can go sideways. Depending upon your personality, you can choose to play all three directions, any two, or only one. If you are bullish by nature, you may choose to play only when markets are rising and stay on the sidelines when they are flat or dropping. Historically, markets have risen about 2/3 of the time so the bullish only trader can expect to be in the market a great deal of the time if historical trends hold true. On the other hand, if you are bearish by nature, you may only want to be involved when the markets are falling. My experience has indicated that a trader can make more money faster in a falling market, but that only occurs during a relatively small proportion of the time.

If you want to play the markets all the time, you need no more than three strategies: one for a bullish market, one for a bearish market, and one for a flat market. I don't mean to suggest that you shouldn't study and learn more than three strategies; I mean that you can make money if you only use three strategies that you have learned well and practiced. If the market is bullish, for example, you could choose to buy stocks with the intention of selling when the price goes up. You could also buy call options, or you could enter bullish put spreads for a credit, or sell naked puts, or you could enter bullish call spreads for a debit. Any of those strategies could make you money in an uptrending market or stock. Each has a different risk and each has a different potential reward.

In a bearish situation, you could sell stock short, or buy puts or enter a bearish call credit spread or a bearish debit put spread. If the market or stock is neutral or moving sideways, you could consider something like an iron condor.

Each strategy can provide profit. In some cases, the profit may be limited as in the case of spreads, but the risk also would be limited. In some cases, the risk may be limited but the profit theoretically unlimited as in buying call options. In some cases, the potential reward may be limited but the risk unlimited as in the case of selling naked calls. Your job is to find the strategy that meets your personal goals.

In my estimation, trading is not a get rich quick endeavor though it can be a get rich steady method. Like anything else, success requires a foundation in the basics. Algebra would be almost impossible to learn without a foundation in basic math. As the three little pigs learned, building a house of straw may not be the wisest course. In trading, the foundation must be built through study. Learn all you can about any strategy that interests you and then practice it by paper trading. Only after you have paper traded the strategy successfully should you put any of your hard earned money at risk.

Your rewards will depend on the effort you expend.

Bill Kraft, Editor
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