Yesterday, I made a definitive statement about trading and investment.
I argued that the most critical factor in any position is your exit strategy.
I stand by this.
When and how you sell is the first thing you should consider before clicking the “Buy” button.
I didn’t say that entering a position isn’t important. Instead, I argued that the result is more important than the first move.
That said, how you buy a stock is extremely important.
So, before you dive into a new position and click the “Buy” button, give me a few more minutes of your time.
I want to discuss two of my favorite ways to buy into a stock.
Successful Buying Strategy No. 1: Limit Orders
Every day, would-be investors place orders at their brokerage and make a mistake.
They buy the stock at the “market” price. This is the price that the seller wants.
If you are just buying a stock at today’s market price, you’re likely paying more than you should.
Each stock has something called a “bid-ask” spread.
The “bid” is the highest price that a buyer is willing to pay for a stock, option, or other asset at a given moment. The “ask” is the lowest price that a potential seller is ready to meet.
Sometimes, these spreads are small. I am taking a look at spreads right now from TDAmeritrade.
Today, the bid for Apple stock at 10:30 a.m. was $131.59. The ask was $131.60.
That means the spread was a penny.
Other times, there are wide spreads. Take Citizens Bancshares (CZBS), a small community bank in Atlanta. Its bid was $12.75, while its ask was $12.85 earlier today. That is a 10 cent difference.
[If you’re looking for the bid and ask spread, you can find it on the screen of a brokerage account or locate it using Yahoo! Finance.]
If an investor buys the stock at the market price, it will fill at the ask price. So in the case of Citizens, you’d pay a premium due to this spread.
So, what should you do instead?
Set something called a buy limit order.
A buy limit order is an order to purchase a stock at the desired level or better. You can set this order level to execute at any time a seller agrees to meet your price. The best part is that you can keep this order open as long as you want and wait for it to fill.
Setting a limit order can ensure that you’re not paying the market or ask price. This can save you a few percentage points on your position if your order is filled.
Limit orders do not require any exposure to options. You can set them in your online broker’s order channel. Also, there are no additional fees associated with this buying strategy.
Successful Buying Strategy No. 2: Cash-Secured Puts
A second way to ensure that you can pay the price you want for the stocks you want to own is by selling cash-secured puts..
A put option contract gives the owner of a stock the right, but not the obligation, to sell a stock at a specific price on or before the contract’s expiration date and gives the seller of the contract the obligation to buy, should the agreed-upon strike price be met.
I’ve outlined the use of cash-secured puts in a previous issue of TradeSmith Daily. But it bears repeating. When you sell cash-secured puts to someone who owns the stock, you are choosing your entry point.
We mentioned Apple earlier. The stock traded above $131 today. It has been on a remarkable run over the last few months. And some investors might think that its current price is too expensive.
On Thursday, the Oct. 15, 2021, $110 put traded at $1.54 per contract. Since every put contract consists of the rights for 100 shares, you would receive $154 (100 times $1.54) for every contract you sell. Your broker will hold the necessary capital in reserves if you do need to buy the stock (why it’s called a “cash-secured” put).
If the stock falls under $110 by Oct. 15, the seller may execute the contract and sell the stock to you. In this situation, you would keep the $154 in the premium you received, and you will have purchased 100 shares of Apple at the price you chose.
But there’s a bonus. What if the stock falls to $115 and never reaches that $110 level by the expiration date? In this case, you get to keep the premium. And you can potentially sell new put contracts later to generate income and choose your next entry price target.
Other Ways to Invest and Trade
As you know, there are other ways to buy into a stock. For example, you can engage in position sizing and dollar-cost averaging over time. But if you’re engaging in these practices, keep buy limit orders and cash-secured puts in mind as you build your positions.
It’s your money, and those bid-ask spreads are an easy way for investors to exploit would-be buyers. But, always remember, the point of any market is ultimately to sell at a profit.
That’s why you need to constantly be aware of the advantages that sellers have. For example, eliminating the risk of the bid-ask spread will help you improve your returns over time.
We’ll talk more soon about supply chains, inflation, and what’s coming down the pipeline in the second half of 2021.