There is a lot to learn when you first begin your journey into stock trading. With so much information available, many beginners tend to miss some important pieces.
What Beginner Traders Should Know
This list of 8 things beginner traders need to know includes some not so obvious yet, vital information. After reading this article you may have some “ah-ha” moments. It’s also a great refresher for seasoned traders and investors.
This information should help improve your trading knowledge and possibly prevent you from making some serious mistakes.
1. Limit Your Watchlist to Just a Few Stocks
There are over 6,000 listed companies available for trading in the U.S. stock market. The NYSE has 2,800 companies and the NASDAQ has 3,300 at the time of this writing. That, my friend, is a lot of stocks to choose from. It’s tempting to build a large watchlist of many different companies, ETFs, commodities, etc.
Beginners tend to watch way too many different stocks because they don’t want to miss out on the action. If your watchlist is overcrowded, you’re doing yourself a disfavor. The more stocks you watch, the more time you’ll need to devote to researching the company and charts. Trying to keep up with tons of different industries and stocks will quickly turn into a major headache.
There isn’t a set number you should keep in your watchlist, but the fewer the better. Try to hone in on a specific industry or commodity. Become an expert in a certain area and only watch a few stocks. You’ll be able to trade with more confidence if you focus in on a smaller area.
One the greatest traders of all times Jessie Livermore said: “It is much easier to watch a few than many.” Do yourself a favor, keep it simple and don’t overfill your watchlist.
2. Stay Away From Leveraged ETFs
Trading leveraged ETFs is not for beginners and is a sure-fire way to destroy your portfolio. Just like regular ETFs, they track the returns of a specific index. They then crank up the returns 2x or 3x using leverage from options.
Each leveraged ETF will have an inverse that shorts the same index. There are bull and bear ETFs for almost every index like the S&P 500, oil, tech, financial sector, etc.
Getting double or triple the returns sounds like a dream come true, right? So why would you want to avoid these? Well, the returns diminish in the long run due to “daily asset rebalancing.” The ETFs must continually sustain its leverage ratio to deliver the 2x or 3x returns. If it goes down, it locks in losses at the end of every trading day by selling off some of its assets.
Just look at the long-term chart at leveraged ETFs and you’ll see why they are a loser’s bet. They also have higher management fees and expense ratios than unlevered ETFs. These financial products are best left for experts or advanced day traders and not someone that’s just learning to trade.
3. You Don’t Need to Trade Every Day
I get it. You are excited and eager to place some trades! That’s great, but, developing patience and discipline is a major key to trading success. Trading every day, just to trade, is a common mistake that many advanced and newbie traders make.
If you trade out of boredom instead of opportunity, you’ll likely make more losing trades than winners. Each time you place a trade it’s like sending your money out to war. You only want to risk your dollars if you are confident enough they will return in victory. If you don’t feel like there are any great setups to trade on then sit on your hands. Sounds easy right? It is actually much harder than it sounds.
You may want to place a trade but decide not to because the opportunity doesn’t sit right. The next day you watch it play out like you thought and wish you had made that trade! It’s painful but it’s part of the game. If you get emotional and trade out of spite, you’ll likely burn your portfolio to the ground. Stay patient and remember that the market will always be there.
4. Understand What the PDT Rule Is (Pattern Day Trader)
I’ve seen countless traders get marked as a pattern day trader and have no idea what is going on. The pattern day trader rule says you must maintain equity of $25,000 in your brokerage account to have unlimited day trades. If you have less than $25K (which majority of beginner traders do) you are limited to no more than three-day trades in a five-trading day period.
Most brokerages will keep track of your day trades for you, but you’ll need to pay close attention. If you go over the day trade limit you’ll likely get marked as a pattern day trader. Once you are flagged as a pattern day trader, you’ll need to bring your account balance to $25k or your account will get restricted for 90 days. After the 90 days, your account will reset back to normal.
Your account will only be restricted from the brokerage you used while getting flagged. So, you can trade on another brokerage account until the 90 days is up. It’s best to avoid this entirely just by closely monitoring your day trades if you have less than $25k.
Another option is to trade with a cash account, this will allow unlimited day trades without having to have $25k. However, cash accounts require that funds settle (2 business days) before you can use them to trade again. The PDT rule flat out sucks, but make sure you understand it or else you can end up in a mess.
5. Volume Matters
Liquidity or volume is the amount a security is traded during a given period of time. Volume is very important for a lot of different reasons. A beginner that is trading in short time frames should stick with stocks that have a high average volume.
If there are a lot of people trading a certain stock, you will be able to easily sell or buy it. Volume is important when investing for the long-term, but not as much. If the stock has low-volume, the bid-ask spread is likely to be wide.
This means a buyer could be asking $35 and a seller may be asking $50 while the stock is trading at $40. If you want to buy/sell the stock right then, you’ll lose out due to the large bid-ask spread.
Volume is also used to gauge movement in stocks. If a stock if making a large move up but the trading volume is low, an investor should be wary that the move is false. This is also the case for a large move down.
There isn’t an exact amount of volume you should be looking for because it depends on a lot of factors. As a beginner, however, you’re best to steer clear of stocks trading under 500,000 average volume.
6. The Risks of Penny Stocks Outweigh the Benefits
Penny stocks, also known as micro-cap stocks, are shares of companies that trade for less than $5 per share. Beginner investors get hooked on these stocks because of their low share price and potential to skyrocket.
While some of these low-priced stocks can turn into ten-baggers, most of them are complete garbage that will sink your portfolio. You are much better off avoiding penny stocks in the long run. The risk simply outweighs the benefits, especially if you are just learning how to trade.
Most penny stocks have very low trading volume and are often susceptible to pump and dumps. Don’t fall for the get rich scheme that many penny stock traders push. It’s extremely rare to get rich from trading penny stocks, you’ll probably have better odds at a casino.
7. Don’t Forget About Taxes
Yep, if you make a profit you will need to pay taxes. Of course, when it comes to taxes in the U.S. things are not so simple. Beginner traders can find themselves in a tax mess at the end of the year if they don’t understand the basics.
You will want to get familiar with short-term and long-term capital gains tax. If you make a substantial profit, set some aside to pay taxes (look up your specific tax rate to find out how much). If you end up with losses that offset your gains you can write-off up to $3,000.
Many traders fail to remember a tax rule called the “Wash-Sale Rule.” The rule comes from the wonderful IRS and it prohibits you from claiming losses for the sale of a security.
Luckily, it is easy to avoid a wash sale. If you sell for a loss, do not buy the same or identical security for 30 days. If you do rebuy the same stock you sold for a loss in less than 30 days after selling it, then it is deemed a wash sale.
You will have to add the loss to the cost of the newly purchased security. Read more about the wash-sale rule here.
There are different tax stipulations on specific assets as well. If you trade a lot, you’ll likely want to reach out to a tax professional near the end of the year. If you are confident in doing your taxes yourself, you can do it for free using Free Tax USA (affiliate link).
8. Always Do Your Own Research
This is the most important thing beginner traders need to remember. Always, always, always do your own research. Don’t be lazy. Don’t take someone for their word. It’s your capital at stake, take the time to do your own due diligence. Even if the trade doesn’t work out, at least you’ll only have yourself to blame.
You will learn a lot more if you do your own research before making a trade. The internet and social media are full of trading gurus that seem to never lose money. There is nothing wrong with getting the opinion of other traders or hearing out their thesis on a security. Just don’t blindly follow them without taking the time to look into things yourself.