An idiots guide to investing

Hi,

Part 5 - Hedging

Okay, a short entry coming up today on the art of "hedging", which gives rise to the term "Hedge funds". Strictly speaking of course, this little foray into explaining hedging isn't actually going to be practically useful to the average private investor who's reading this guide looking for a step-by-step guide to investing, but hey, its a topical subject and the concept is a brilliant one to get your head around.

Right, to demonstrate hedging, I think an example should suffice: Lets say that this sinusoidal curve is actually the graph for a stock. and now lets assume that we are currently at the coordinates (pi, 0) with the graph heading upwards. Now we can see that the graph is moseying along nicely in a fairly regular pattern so can assume that this will continue. So what a normal person would do at this point normally is to buy in and then sell as the graph reaches its peak.
But a hedge fund is much cleverer than that. they want to make a profit without betting on hunches, so they hedge their bets by buying the stock as well as shorting the stock at the same time...
[What is "shorting"!!? I hear some of you scream. This process will be explained properly at one of the more advanced points in the guide, but suffice to say for now that all it means is that a person who holds a "short" contract on a stock will profit if the stock goes down in price.]
...But all this will mean is that they will continue along without profit or loss as the longing (buying with the expectation of a rise in price) and shorting of the stock will cancel each other out. Ah, you would think that but hedgeys are cleverer than that. They wait until the two respective long and short positions reach their maximum value, then sell them.
So at the peak at the top, the long value will be at its peak profit, and the short position will be at its peak loss - so they close out their long position at the peak, and as the graph declines to a trough again, they wait...and when it gets to the trough, their "short" position is now in profit, so they close that out here too. In other words, it didn't matter where the stock went, the hedgey's were in profit.


This is just one example of hedging. It comes in many shapes and sizes, but the principle is the same - and its a principle we need to engrave on our hearts. ALWAYS THINK THAT YOU WILL BE WRONG AND PLAN FOR THE WORST.
If you do that...well can it get worse than the worst that could happen? of course not, so if you prepare for that, you will survive.

Okay, and now for my recommended book to buy for this week...

Fear, Greed and Panic: The Psychology of the Stock Market (Finance & Investments)

Fear and greed are the things that drive the market, infact some people go as far as to say that the market is actually not a reflection of value but of the human emotions of fear and greed. Those graphs are actually mapping humanity at its worst in other words. Self awareness is vital for success in the market. Its actually less about skill, than about being in control of yourself and keeping your nerve. So buy that book!

The Guide so far:

1. The basic introduction

2. Choosing a stock

3. the tools of the trade

4. managing risk

5. hedging (this post)



My new trading book that takes you through money-making step-by-step:
http://economicsguide.blogspot.com/2010/05/why-i-wrote-trading-guide-to-sell-then.html

An idiots guide to investing on the stockmarket - part 3

I've not been posting for a long time, what with exams, novel writing and stuff, but now with an entire 13 months stretching melodiously ahead of me, I thought I'd write a proper little guide, an "idiots guide to investing on the stock market" if you will, which could actually be useful to someone out there. And if you get stuck about something I say, please don't hesitate in posting a question! I'll reply pretty promptly, seeing as though I'm on the computer editing my novel most days anyway.

Okay, the first few part of my guide can be found at my earlier posts, and the second one, starting to expound on how to choose stocks - here.

Before I start, I would just like to point out that I've been investing for roughly a year now, and been managing my own investment fund, which is in profit - so I do have some basic expertise. I correctly predicted the bottom of the recession in late summer, and predict a minor slump (or drawback if you will) in September, after which things will once again rise and get better...hopefully. 


Right, first of all, I would recommend a few simple steps to take before you embark on your dream of earning millions on the stock-market:

1. Start reading and watching business news, politics news, and international news VERY carefully. An investment opportunity lies behind pretty much every news story you can think of. "Stabbed boy dies - Hospital sued for negligence". There, we're looking at investing in a company that sells stab-proof vests, lawyer firms that specialise in NHS claims, and perhaps policing related investments (as the Government might make a knee-jerk announcement to increase police etc.) so a company that supplies the police force is going to be profitable. START THINKING LIKE THAT.

2. Buy a  few good books that give a basic overview of the stock-market. This one is a good one called "Investing in stocks and shares: a step-by-step guide": Investing In Stocks And Shares 6e: A step-by-step guide to making money on the stock market, and is the first book I read when i started, and it really is a treasure-trove of information. Then once you have read that, move onto books such as this: The Complete Idiot's Guide to Technical Analysis (Complete Idiot's Guides (Lifestyle Paperback)) This book goes into quite extensive detail about basic reading of a graph. Then once you have read that, read "The Truth About Markets by John Kay", and "Undercover Economist" by Tim Hartford,  which are an excellent - and light - general introduction to economics - which is the main discipline you have to understanding the stock-market. (Links to the books are in the sidebar.)


3. Buy the Financial Times a few times a week, and read their analysis, because its very useful to read the words of people who understand the markets much better than you and I, and it also helps with the whole MINDSET thing that I keep hammering on about.

4. Save up until you have £1000 to invest, or at least £500 - anything lower than this is just gambling  - unless of course you invest in a fund - but more about this later. Suffice for now to say that this is called "diversification of risk", which an incredibly cool title, and when you understand the concept, you too will become from amongst the cool and initiated.

5. Once you have a bit of an idea about what you're doing, register with a website that allows you to open a practise account, and trade with them for a bit, to really get your eye in and hone your skills a bit more. I use Share.com, and they do a practise account for free...so try that out. Alternatively, there's loads of other websites that offer the same facility.

6. To invest, you have three weapons: 1) a general knowledge of the market, economics, and the world, 2) a specific knowledge of the company you want to invest in i.e. is it in loads of debt? 3) technical analysis of the companies stock charts. Some people lean to one of the three, and I lean towards the third approach, rigorous technical analysis. To get your eye in for the whole graph-reading situation, I would advise that you spend about a month or so trading on this website. This site is actually for foreign-exchange trading (and that's a whole different kettle of fish) but the technical analysis is very heavy here, and the practise you get here can easily be carried across and applied to stock-market trading.

7. Finally...be enthusiastic about it all! No-one has ever fully understood the market, and no-one ever will, but people can slowly become competent over the years, and this is a long process that you are embarking upon. You will need energy and enthusiasm to continue. So if I were you, just like exercise trainers tell enthusiastic beginners, "don't do too much and burn out all your enthusiasm", because then you won't ever experience the thrill of calling a stock correctly and watching it rise.

In the next post I will explain that oh-so-cool concept of "diversification of risk", and why investing is a rich man's game.

My new trading book that takes you through money-making step-by-step:

http://economicsguide.blogspot.com/2010/05/why-i-wrote-trading-guide-to-sell-then.html