What to know before you buy stocks

E*TRADE from Morgan Stanley


Before you place a stock order, there are several important things you may want to take into account. 1. Have a well-considered opinion on the stock. 2. Know your exit point. 3. Consider how the trade will affect your portfolio.

Three steps to prepare for a stock trade

Placing a stock trade is about a lot more than pushing a button and entering your order. It's important to be prepared before you open a position and to have a plan for managing it. Let's take a look at a few things you might want to consider before placing that trade.

1. Have a clear and considered opinion about the stock you're planning to trade as well as the broader markets.

Typically, your opinion will be based on the strategies you use to analyze securities and markets. There are many methods and criteria for analyzing stocks, and they generally fall into two categories: fundamental analysis and technical analysis.

One technical strategy, for example, is to follow the money. What does that mean? Markets are made up of buyers and sellers. By charting price trends, you may be able to determine which group is currently in control, or driving the price of the stock. If buyers are in control, you might want to be a buyer. If sellers dominate, you might not want to buy, or you might want to sell a long position you already hold.

2. Know when to get out if the trade isn't going your way and when to take your profit if it is.

To help understand when it’s time to close a position, keep these things in mind:

Managing downside risk is one of the most important and overlooked aspects of trading. Determining when to cut your losses is just as essential as understanding when to lock in your gains.

Consider creating a simple risk management plan before you place your trade and using a stop order to enforce it. The stop will get triggered automatically if the stock moves against you and hits your predetermined target price. If you wait until you already hold the stock before setting a loss target, your emotions could lead you to hold it too long and take an even bigger loss. Note, this is just one of many strategies used to hedge the risk of an investment, and you should choose the one which best suits your own portfolio management strategy.

If your trade is working in your favor, you'll need to figure out when to take a profit. While it's impossible to predict the future, you can use charts, technical indicators, fundamental analysis, and other tools to help you determine your exit point. As with risk management, discipline is key. Setting a trailing stop order can help you counteract your own possibly unrealistic profit expectations while still allowing room to run if the stock continues to rise.

3. Take a look at how it would affect the balance of your portfolio.

If you open the position would it increase your concentration in a particular sector or industry? That could set you up for big losses if the market turns against you. To avoid this, you may want to look for opportunities in other sectors or industries.

These three principles aren't the only useful guidelines to prepare for a trade, but they're a good starting point any time you're thinking about investing in a stock.

What to read next...

There are many adages in the trading industry. A few of them are: “Buy low; Sell high”; “Nobody ever went broke ringing the cash register”; and “Bears and Bulls make money, but Pigs get slaughtered.” Interestingly, there is a motif underlying all of these sayings, and it has to do with managing risk.

In this video, we'll answer the question, “What is fundamental analysis?” Learn how this process can help you evaluate the economic health and financial performance of the companies in which you may want to buy or sell stock.

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