New To Options Trading? Here’s How Not To Make A Fool Of Yourself

 Anytime nonprofessional investors are part of a major investment trend, Wall Street’s commentariat warns that surging stock prices will soon fall from grace faster than Jerry Falwell Jr. But what really annoys them are the masses horning in on the action.

Sneering at the newly minted Robinhood and Reddit hordes trading options on stocks like Apple (ticker: AAPL), Peloton Interactive (PTON), and Microsoft (MSFT) doesn’t do anyone any good. I prefer to share some tips on how best to play the game.

Consider this an options trader’s primer aimed at helping the increasing number of investors who are learning one of Wall Street’s greatest secrets: Options can help you better navigate the stock market.

• Have an investment thesis. Know why you are doing what you are about to do. Focus on events like earnings reports or product launches and try to figure out how the underlying stock might react.

• Use your opinion on the stock to decide whether you will buy or sell a call or put option. Don’t delude yourself into thinking you have an educated view of options contracts until you have traded for a few years and understand how the stock and options markets work with each other.

• Focus on options that expire in three months or less. The sweet spot for many investors is about 30 to 45 days, which is enough time to benefit from time decay (more on that later) and for your stock thesis to work itself out without paying top dollar.

• Before you buy or sell options, divide the contract’s implied volatility by 16. This will tell you what the options market thinks the stock will do each day through expiration. If the call has an 80% volatility, the call is priced as if the stock will move 5% each day until expiration. If you think the stock will move more, buy the contract, If you think it will move less, sell the contract. The Rule of 16 is a powerful tool.

• Good trading is about understanding events and how they are packed into your expiration. Understand everything that could happen to move the stock during your chosen expiration cycle, such as earnings reports, and anything that could move the entire market, like Federal Reserve meetings, elections, and economic reports.

• Options contracts lose a little value each day. Time decay, or “theta,” is a powerful force that can be monetized by options sales. It’s also the reason that many investors try to trade options that expire in under a month. No one wants to pay a time premium, which you can think of as the inventory carrying cost for owning options.

• If you are thematically confident on a stock but unsure on the timeline, many institutions buy options that expire in a year or more to rent exposure to the stock. If the stock goes up, the call goes up. If the trade fails, options always cost less than the associated stock, which means that options, when well used, help investors limit risk.

• Don’t be a pig. If you make 50% or more on your initial trades, take profits. If you make 100% or more, definitely take profits. If you are so convinced that the market is wrong and you are right, take out your initial invested capital so you are playing with house money.

• Be afraid of excess leverage. Options contracts represent 100 shares of stock. Don’t trade 10 contracts if you cannot afford to cover 1,000 shares of stock. All tyros should trade one or two contracts at a time until they develop some mastery of basic trading rules. Never trade “naked” contracts that aren’t covered by cash or stock.

• Simplicity is everything. Avoid strategies with many moving parts. Many seasoned options traders focus on hitting singles and doubles, creating significant income for themselves. Master buying a call and put and selling a call and put, and then consider spread strategies. Optionseducation.Org is a free site that will help you learn more.

When in doubt, remember: Bad investors think of ways to make money. Good investors think of ways to not lose money.

Email: editors@barrons.Com

How To Buy Stocks

To buy stocks, you’ll first need a brokerage account, which you can set up in about 15 minutes. Then, once you’ve added money to the account, you can follow the steps below to find, select and invest in individual companies.

It may seem confusing at first, but buying stocks is really pretty straightforward. Here are five steps to help you buy your first stock:

1. Select an online stockbroker

The easiest way to buy stocks is through an online stockbroker. After opening and funding your account, you can buy stocks through the broker’s website in a matter of minutes. Other options include using a full-service stockbroker, or buying stock directly from the company.

Opening an online brokerage account is as easy as setting up a bank account: You complete an account application, provide proof of identification and choose whether you want to fund the account by mailing a check or transferring funds electronically. (We have a full guide to opening a brokerage account here.)

How do you find a broker that’s worthy of your dough? To compare options, review NerdWallet's full list of the best brokers for stock trading, or use the search tool below to find the right match for your investing style. (Article continues below tool.)

2. Research the stocks you want to buy

Once you’ve set up and funded your brokerage account, it’s time to dive into the business of picking stocks. A good place to start is by researching companies you already know from your experiences as a consumer.

Don’t let the deluge of data and real-time market gyrations overwhelm you as you conduct your research. Keep the objective simple: You’re looking for companies of which you want to become a part owner.

Warren Buffett famously said, “Buy into a company because you want to own it, not because you want the stock to go up.” He’s done pretty well for himself by following that rule.

Once you’ve identified these companies, it’s time to do a little research — here’s how.

Start with the company’s annual report — specifically management’s annual letter to shareholders. The letter will give you a general narrative of what’s happening with the business and provide context for the numbers in the report.

After that, most of the information and analytical tools that you need to evaluate the business will be available on your broker’s website, such as SEC filings, conference call transcripts, quarterly earnings updates and recent news. Most online brokers also provide tutorials on how to use their tools and even basic seminars on how to pick stocks.

To learn more about evaluating companies for your portfolio, see NerdWallet’s feature on how to research stocks.

3. Decide how many shares to buy

You should feel absolutely no pressure to buy a certain number of shares or fill your entire portfolio with a stock all at once. Consider starting small — really small — by purchasing just a single share to get a feel for what it’s like to own individual stocks and whether you have the fortitude to ride through the rough patches with minimal sleep loss. You can add to your position over time as you master the shareholder swagger.

New stock investors might also want to consider fractional shares, a relatively new offering from online brokers that allows you to buy a portion of a stock rather than the full share. What that means is you can get into pricey stocks — companies like Google and Amazon that are known for their four-figure share prices — with a much smaller investment. SoFi Active Investing, Robinhood and Charles Schwab are among the brokers that offer fractional shares.

Many brokerages offer a tool that converts dollar amounts to shares, too. This can be helpful if you have a set amount you’d like to invest — say, $500 — and want to know how many shares that amount could buy.

4. Choose your stock order type

Don’t be put off by all those numbers and nonsensical word combinations on your broker's online order page. Refer to this cheat sheet of basic stock-trading terms:

For buyers: The price that sellers are willing to accept for the stock.

For sellers: The price that buyers are willing to pay for the stock.

The difference between the highest bid price and the lowest ask price.

A request to buy or sell a stock ASAP at the best available price.

A request to buy or sell a stock only at a specific price or better.

Stop (or stop-loss) order

Once a stock reaches a certain price, the “stop price” or “stop level,” a market order is executed and the entire order is filled at the prevailing price.

When the stop price is reached, the trade turns into a limit order and is filled up to the point where specified price limits can be met.

There are a lot more fancy trading moves and complex order types. Don’t bother right now — or maybe ever. Investors have built successful careers buying stocks solely with two order types: market orders and limit orders.

Market orders

With a market order, you’re indicating that you’ll buy or sell the stock at the best available current market price. Because a market order puts no price parameters on the trade, your order will be executed immediately and fully filled, unless you’re trying to buy a million shares and attempt a takeover coup.

Don’t be surprised if the price you pay — or receive, if you’re selling — is not the exact price you were quoted just seconds before. Bid and ask prices fluctuate constantly throughout the day. That’s why a market order is best used when buying stocks that don’t experience wide price swings — large, steady blue-chip stocks as opposed to smaller, more volatile companies.

A market order is best for buy-and-hold investors, for whom small differences in price are less important than ensuring that the trade is fully executed.

If you place a market order trade “after hours,” when the markets have closed for the day, your order will be placed at the prevailing price when the exchanges next open for trading.

Check your broker’s trade execution disclaimer. Some low-cost brokers bundle all customer trade requests to execute all at once at the prevailing price, either at the end of the trading day or a specific time or day of the week.

Limit orders

A limit order gives you more control over the price at which your trade is executed. If XYZ stock is trading at $100 a share and you think a $95 per-share price is more in line with how you value the company, your limit order tells your broker to hold tight and execute your order only when the ask price drops to that level. On the selling side, a limit order tells your broker to part with the shares once the bid rises to the level you set.

Limit orders are a good tool for investors buying and selling smaller company stocks, which tend to experience wider spreads, depending on investor activity. They're also good for investing during periods of short-term stock market volatility or when stock price is more important than order fulfillment.

There are additional conditions you can place on a limit order to control how long the order will remain open. An “all or none” (AON) order will be executed only when all the shares you wish to trade are available at your price limit. A “good for day” (GFD) order will expire at the end of the trading day, even if the order has not been fully filled. A “good till canceled” (GTC) order remains in play until the customer pulls the plug or the order expires; that's anywhere from 60 to 120 days or more.

While a limit order guarantees the price you’ll get if the order is executed, there's no guarantee that the order will be filled fully, partially or even at all. Limit orders are placed on a first-come, first-served basis, and only after market orders are filled, and only if the stock stays within your set parameters long enough for the broker to execute the trade.

Limit orders can cost investors more in commissions than market orders. A limit order that can't be executed in full at one time or during a single trading day may continue to be filled over subsequent days, with transaction costs charged each day a trade is made. If the stock never reaches the level of your limit order by the time it expires, the trade will not be executed.

5. Optimize your stock portfolio

We hope your first stock purchase marks the beginning of a lifelong journey of successful investing. But if things turn difficult, remember that every investor — even Warren Buffett — goes through rough patches. The key to coming out ahead in the long term is to keep your perspective and concentrate on the things that you can control. Market gyrations aren’t among them. What you can do is:

Make sure you have the right tools for the job. NerdWallet’s list of the best stockbrokers can help you identify the right brokerage account for you.

Be mindful of brokerage fees. These can significantly erode your returns.

Consider also investing in mutual funds, which allow you to buy many stocks in one transaction. Here's our list of the best brokers for mutual funds.

FAQs about buying stocks

1. What are some cheap stocks to buy now?

It’s important to note that the price of a stock doesn’t tell you everything you need to know about a company you’re considering investing in. Price reflects how much investors are willing to buy or sell the stock for — not the intrinsic value of the company, nor the direction in which the company’s stock price is headed. Just because a stock is “cheap” doesn’t mean it’s a good buy.

That said, there are ways to find stocks that may be undervalued. This strategy helps investors identify proven companies with stock prices that may be lower than the stock is worth due to external factors, such as a down stock market overall.

2. How do I know if I should buy stocks now?

The truth is, you’ll never know if it’s exactly the right time to buy stocks. However, if you’re investing for the long term (say, more than five years), then the time to buy stocks is as soon as you have the money available. Even if the market falls soon after investing, you’ll have plenty of time to make up those losses. And the only way to guarantee you’ll be a part of any stock market recovery and expansion from the beginning is to be invested before the recovery starts.

3. What are the best stocks for beginners?

NerdWallet strongly advocates investing in low-cost index funds. However, if you’d like to add a few individual stocks to your portfolio (we suggest allocating no more than 10% of your portfolio to individual stocks), beginners may want to consider blue-chip stocks in the S&P 500. These are among the country’s most stable companies with a proven track record of delivering long-term returns for investors. These include companies like Microsoft, Amazon, Johnson & Johnson, Home Depot and AT&T.

4. How much money do I need to buy stock?

If you open a brokerage account with no account minimums and zero transaction fees, you could start investing with just enough to buy a single share. Depending on the company, that could be as little as $10 (though remember that cheap stocks don’t necessarily make good buys).

Some brokerages even allow you to buy fractional shares, meaning if you only had $100 to invest, you could buy a portion of a stock like Google, which has long traded for more than $1,000 a share. Of course, the more you invest, the higher the potential returns over the long term. Use our investment calculator to see how compounding returns work.

5. Are stocks and shares the same thing?

For the most part, yes. Owning “stock” and owning “shares” both mean you have ownership — or equity — in a company. Typically, you’ll see “shares” used to refer to the size of an ownership stake in a specific company, while “stock” often means equity as a whole. For example, you might hear investors say, “I bought 10 shares of Apple,” or “I have stock in Apple, Facebook and Amazon.”

6. How many shares should I buy?

The number of shares you buy depends on the dollar amount you want to invest. If the share price is $50 and you have $500 you’re willing to invest, you could purchase 10 shares. However, if your brokerage doesn’t allow fractional trading and the numbers aren’t that clean, you’ll have to round down. If the stock price is $51 and you have $500 to invest, you’ll only be able to purchase nine shares, as 10 shares would cost $510.

7. How will I know when to sell stocks?

If you’re purchasing stocks, you should be comfortable not touching your money for at least five years. That’s due to stock market volatility — it’s possible the value of your shares will go down before going up. You could consider selling your stocks if you need cash and they’ve risen in value, but doing so means you may pay capital gains taxes on the sale, and miss out on future gains over time.

Perhaps what’s more important is to consider when not to sell stocks. When the market is falling, you may be tempted to sell to prevent further losses. This is widely recognized as a bad strategy, as once you sell, you’ll lock in the losses you’ve incurred. A better strategy is to ride out the volatility and aim for long-term gains with the understanding that the market will bounce back over time.

8. How do I buy stocks online without a broker?

In recent years online brokers have made it extremely easy for beginners to sign up for and use their services. For most new investors, an online brokerage account will be the easiest way to get into the stock market.

But if you’re still keen to start investing without a broker, look for companies that offer a direct stock plan, which lets you purchase shares directly from the company for a low fee or no fee at all. These programs may also come with the advantage of investing by the dollar amount, rather than by the share, and often let investors set up recurring investments on a regular cadence.

Another way to buy stocks without a broker is through a dividend reinvestment plan, which allows investors to automatically reinvest dividends back into the stock, rather than taking the dividends as income. Like direct stock plans, though, you’ll have to seek out the companies that offer these programs.

Three Traits To Look For In A Starter Stock (and One To Avoid)

So you've opened a brokerage account, funded it, and are ready to find your first investment. It's easy to be overwhelmed by the hundreds of publicly traded companies out there. Not only is the sheer number of companies difficult to wade through, but the idea of making money fast is incredibly tempting.

Unfortunately, when you buy a company with the goal of doubling your investment in the short term, you are less of an investor and more of a gambler. These short-term plays are often incredibly risky, subpar businesses, and will ultimately burn you. Companies like these tend to appear incredibly cheap, and with good reason.

While different parts of a portfolio can accommodate more risky investments, a starter stock should be held for the long term -- at least three to five years, or preferably longer. Your first company should be a cut above the rest, something to be proud of, but where do you start? Be on the lookout for these three traits: 

Image Source: Getty Images

1. Global trends will lift them higher

A starter stock should benefit from global trends into the future. NextEra Energy (NYSE:NEE)is a utility and wholesale power company that generates its electricity from renewables such as wind and solar. NextEra stands to benefit from the same trend (a push for renewable energy) that has steadily weakened ExxonMobil (NYSE:XOM), a company once seen as a prime candidate for any portfolio. You can rest easy when holding onto a starter stock with decades of growth ahead.

2. Recurring revenue

Recurring revenue is generated when a company sells to a client repeatedly, turning customers into cash cows year in and year out. Because companies who implement this model have a clear ability to determine future revenue, many of them are able to pay out dividends. Businesses with strong levels of recurring revenue can provide a level of safety for an investor's portfolio.. 

For example, NextEra Energy's electrical utility customers pay them month in and month out as residents tend to have little or no choice in electrical utility providers. This is very different from the commoditized model of ExxonMobil's gasoline -- which means customers will go wherever the gas is cheapest. The ability for repeat business is another instance where NextEra has Exxon beat.

3. A leader in its industry

A great starter company has a distinguished track record of innovation, marking it as a leader in its field. Companies that pivot with the times become the trendsetters of their industries, which in turn generates value for shareholders. A true leader is more than just the biggest company -- it's the one most willing to grow. 

Back to our comparison: Exxon may have great name recognition, but it loses once again to NextEra. For example, scientists have known of global warming for decades, yet Exxon has made no fundamental changes to its business. By comparison, NextEra Energy started shifting more of its power portfolio toward renewables. Shareholders will continue to benefit from NextEra's ability to capitalize on opportunities early.

Don't limit yourself to bargain hunting

When starting to invest, it's easy to get sucked into a subpar company that is trading for a discount, but don't focus on the bargain bin. I love NextEra Energy as a starter company, but it is by no means cheap. However, it has earned that extra valuation due to a long runway for growth from global trends, strong recurring revenue, and a demonstrated ability to adapt. In the words of Warren Buffet, "it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." Ultimately, you could do far worse than heed the words of the Oracle of Omaha.