What to trade?
This question could be answered in many different ways – stocks, bonds, options, futures, stock options, options on futures, forex options, etc. … which are different types of tradable instruments. However, I choose to answer the question very differently, but, I’ll give you the reason for my answer below.
The short answer to the above question is only trade liquid instruments!
Let me explain this apparently cryptic statement. In the above line, ‘liquid instrument’ refers to any traded item that is traded in sufficient quantities to make it easily tradable. This item could be stocks, options, futures, forex, etc (or any item really).
The reason for only trading liquid instruments is to minimize the likelihood of one of the major sources of losses that an investor or trader faces – that is the difference in the bid-ask price of an item. We will delve into this topic some more in the ‘How to trade’ section, which will detail how to find liquid instruments. But for now, here’s the explanation (with an example) of what this is and why it matters.
Explanation of ‘The Spread’ (a.k.a. the bid-ask spread)
Any marketplace is made up of both buyers and sellers. The price the sellers wish to sell at is the ‘Ask’, and the price the buyers wish to buy as is the ‘Bid’. The ‘Ask’ is always higher than the ‘Bid’ because the seller wants as much as s/he can get, and the buyer wants to pay as little as s/he can pay. In any marketplace, there is always negotiation, and the final price (sale price) reached will be somewhere between the two prices. When there are more buyers, they tend compete and raise the bid in an effort to get the item being sold. Similarly, when there are more sellers, they tend to compete and lower the price in an effort to sell their item. Thus, the ‘Bid-Ask’ difference (spread) tends to get smaller as the number of buyers and sellers increase.
Why it matters
The spread basically is the loss you would incur if you decided to sell the item you bought a minute after you bought it (‘‘buyer’s remorse’’).
For a stock or option, we can calculate the instantaneous percentage loss we would have by determining what % of the stock/option price the spread represents; for course, the smaller the better.
Incidentally, the spread always increasing ‘after hours’, which is why it is never a good idea to buy with a ‘market order’ after the market closes, especially if buying illiquid stocks/options. Over the next few weeks, I will add some real-life examples to show why this matters.