Individuals new to the concept of investing often want to start trading stocks, but don't understand where to begin. This article is structured to be a simple introduction to stock trading basics. We'll explain what takes place when trading a stock, and what to look out for when calculating the return on investment.
Stock trading is a misleading term since stocks are not really traded. The term describes the activity associated with buying or selling stocks. Like most financial markets, the stock market is very efficient and follows the laws of supply and demand in a fairly consistent manner.
In general, whenever an investor wants to sell a share of stock, there is always someone ready to buy that share, at the right price. The stock exchanges throughout the world bring order to the trades that take place each day, making sure that buyers and sellers can quickly find each other.
Let's take a quick look at the steps involved when buying and selling a stock.
Choosing a Broker: The first step is to decide on the level of personalized service needed. Once this has been determined, an account is established with the broker, and money is deposited into the account. In this example, let's assume an investor has deposited $2,000.00 into a personal account.
Conduct Stock Research: It's now time to complete any stock research. In this example, the investor has decided to purchase 20 shares of 3M Company at $77.25. Because the investor is new to stock trading, they've decided they need more personalized service, and call a broker over the phone to place the order.
Stock Order Issued: The broker places the order, and the trade completes at $77.25. The broker takes 20 x $77.25, or $1,545.00, from the investor's account to pay for the stock, and also charges a $30.00 fee as a commission. The account now has a cash balance of $425.00 plus 20 shares of 3M stock. The shares in the account are held in "street name." This means there is no physical stock certificate to touch or hold. If you are interested in starting small, we have prepared a list of the best stocks under $2.
Understanding the Stock Market
Here are explanations of some of the core aspects of the stock market.
Market Fluctuations
Market fluctuations are one of the main reasons stock market trading works and allow traders to profit from selling their stocks.
Stock prices can be impacted by factors like company performance, economic conditions, investor sentiment, geopolitical events, and market dynamics like supply and demand. These factors can influence the perceived value of a company and its future prospects, causing stock prices to rise or fall.
The continuous buying and selling of stocks by investors and traders in response to these factors lead to market fluctuations.
Bear vs Bull Markets
To identify profitable trade opportunities, traders constantly monitor market fluctuations to determine whether prices are going up or down.
One of the tools traders use to assess the market's direction is market indexes. Market indexes, such as the S&P 500, Dow Jones Industrial Average (DJIA), and Nasdaq Composite, provide a snapshot of the performance of a specific group of stocks.
These indexes serve as benchmarks for the overall market performance and are commonly referenced to understand whether the market is in a bear or bull phase. Depending on the general direction market fluctuations are heading towards, markets can be up (bullish), trendless, and down (bearish).
In bull markets, traders adopt strategies focused on buying stocks with the expectation of price appreciation, aiming to profit from upward trends and market optimism.
When the market is trendless, traders may find it challenging to identify clear opportunities for profit, and they may choose to wait for a clearer market direction before making significant trading decisions.
In bear markets, traders often adopt strategies focused on selling stocks or taking short positions to profit from the downward trends and declining prices.
Diversification
While stock price movements create profitable opportunities, they also present one of the biggest risks associated with stock trading, known as the market or systemic risk.
Market risk refers to the potential for overall market conditions to impact the value of investments. It arises from factors that affect the broader market, such as economic downturns, geopolitical events, changes in interest rates, or even widespread investor sentiment.
The best way to mitigate market risk is through diversification.
Diversifying one's portfolio refers to spreading investments across multiple types of stocks, sectors, and geographical regions. The rationale behind investing in a diverse mix of stocks is that they all may behave differently in response to market conditions.
In simple terms, diversification bets on the idea that while some investments may experience downturns, others may remain relatively stable or even perform well. This would allow traders to offset losses in one area with gains in another.
Types of Stock Trading
There are various approaches to stock trading, each with its own characteristics and strategies. Some trading types prioritize generating short-term profits from frequent trades, while others focus on long-term investment strategies.
Let’s have a look at some of the most popular stock trading types.
Short-Term Trading
The following trading styles involve shorter-term trading approaches where traders aim to profit from the price volatility within a specific time frame.
Day trading – Day traders aim to take advantage of short-term price fluctuations by buying and selling stocks within a single trading day. They focus on technical analysis and utilize leverage to amplify potential gains.
Swing trading – Swing traders hold stocks for a few days to several weeks, aiming to profit from price swings within an established trend. They rely on technical analysis and market indicators to identify entry and exit points.
Scalp trading – Scalpers execute numerous trades throughout the day, aiming to profit from small price movements. They focus on capturing short-term profits by entering and exiting trades swiftly, often within seconds or minutes.
Momentum trading – Momentum traders aim to capitalize on stocks that are experiencing upward price momentum. They identify stocks with strong price trends and high trading volume, seeking to ride the momentum for short-term gains.
Long-Term Trading
On the other hand, the following types involve longer-term investment strategies, focusing on long-term trends and generating income or seeking growth in the value of the investments.
Position trading – Position traders hold stocks for an extended period, ranging from weeks to years. They aim to identify long-term trends and invest based on fundamental analysis, paying less attention to short-term price fluctuations.
Income investing – Income investors focus on stocks that generate regular income through dividends or interest. They seek out stable companies with a history of consistent dividend payments and prioritize generating a steady income from their investments over short-term profit.
Value investing – Value investors look for undervalued stocks compared to their intrinsic worth. They analyze fundamental factors such as earnings, assets, and market position to identify stocks that may be priced below their actual value. The goal is to buy these stocks at a discount and hold them until the market recognizes their full potential.
Growth investing – Growth investors seek stocks of companies with high growth potential. They focus on companies expected to grow above average compared to the broader market or their industry peers. Growth investors are willing to pay a premium for stocks with the anticipation of future capital appreciation.
It's important to note that these approaches have varying degrees of risk and require different levels of knowledge and experience.
Traders often choose a strategy that aligns with their financial goals, risk tolerance, and trading preferences. Additionally, traders can combine methods or adapt their approach based on market conditions and individual stock opportunities.
Stock Exchanges
Investors and traders buy stocks and shares on multiple stock exchanges like Nasdaq and the NYSE to benefit from the company’s financial success. They can either hold on to their stocks and benefit from capital appreciation and dividends or sell them at a higher price.
All stock exchanges where the buying and selling of stocks and shares occur collectively form the stock market.
Stock Exchange Floor
The floor of the New York Stock Exchange is the picture that most people have in their minds when they think of trading stocks. That's because the NYSE still uses a physical exchange floor, where the ‘market makers’ use handheld terminals, overhead monitors, and hand gestures to complete their transactions.
The NYSE depends on these specialists, or market makers, to match buyers with sellers. They also ensure that a robust market exists for the stocks they’re responsible for managing. The NYSE trading floor is quite a sight to behold, which is why pictures of it often appear in the news.
Electronic Exchanges
Unlike the NYSE, the NASDAQ is a completely electronic exchange. The NASDAQ uses a sophisticated network of computers to match buyers with sellers of stock. This makes electronic exchanges very fast, with almost instantaneous confirmation of stock trades.
Electronic exchanges give many investors an added feeling of control over their trades. But either method, exchange floors or electronic exchanges, still requires the use of a stockbroker.
Stockbrokers’ Role
Individuals do not have direct access to the stock market. Stockbrokers are used to make sure the exchange rules are enforced, and that all stock traders have the funds necessary to complete their transactions.
So, whether an investor is day trading or calling a broker over the telephone, the stockbroker provides the investor with essential services. The more personalized this service is, the higher the commission charged.
For example, stockbrokers that answer the telephone and make trades on an investor's behalf might charge $30 or more to complete a single transaction. This is a generalization, and the actual fee structures will vary with the dollar amount or number of shares traded.
There are also electronic brokers that allow investors to make online trades through an account established with their companies. These businesses use sophisticated computer networks to send buy and sell orders to the correct stock exchange. Electronic brokers typically compete for clients based on price, or low commissions, not personalized service.
Making Money Trading Stocks
An investor starts with $2,000 in their account and purchases 20 shares of a company called 3M at $77.25. They’re charged a broker fee of $30 for the trade, leaving them with $425 in their account.
Let's assume that 3M releases some good news, and the stock market has reacted rationally by increasing its stock value to $80. At that price point, the investor decides to profit by selling their 3M shares.
They call their broker and complete the transaction by selling 20 shares of 3M at $80. The $1,600 from the sale is placed back into the investor's account. The broker charges their standard fee of $30 for the trade. At the end of the day, the investor has $1,995 ($42+ $1,600 - $30) in their account.
Considering they sold their stocks at a higher price, the investor thought they were making money, not losing it. However, they paid $60.00 in commissions. In this example, those fees had a significant impact on the total return on this investment.
The above example serves as an important lesson in stock trading basics that needs to be carefully considered before investing in the market or choosing a broker. Make sure the impact commissions will have on investments is completely understood. In the above example, the initial investment of $1,545.00 carried with it $60.00 in commissions. A total of 3.88% of the investment was paid to the broker.
To lower the impact of commissions on the return on investment, either larger trades (more money), or brokers with lower commissions are needed. Alternatively, investors can get started in the market with no-load mutual funds.
Investing vs Trading Stocks
Although most people use the terms investing and trading interchangeably, as illustrated above, they are not quite the same thing.
Trading relies on more frequent buying and selling of stocks to generate short-term profits from market fluctuations, while investing involves a long-term approach focused on building wealth over time.
As a result, traders focus their attention on short-term price movements, technical analysis, and market indicators, while investors focus on fundamental analysis, company financials, and industry trends to make informed decisions.
Which one is harder?
Even though both trading and investing require knowledge, skills, and experience to be successful, most would agree that trading is the more complex of the two.
Trading can be very challenging due to its short-term nature and the need for quick decision-making. Traders constantly monitor the market, analyze price charts, and react swiftly to market movements. It requires discipline, risk management, and the ability to handle the stress of rapid trading.
Investing, on the other hand, requires patience, a deep understanding of fundamental analysis, and the ability to identify undervalued stocks or long-term growth prospects.
Which one is more profitable?
Regarding profitability, it’s a bit more difficult to make a definitive statement.
Trading can potentially generate quick profits from frequent buying and selling, taking advantage of short-term market fluctuations. However, it also comes with higher risks, including the possibility of significant losses.
Investing, while aiming for long-term wealth accumulation, may not provide immediate profits but can offer steady and consistent returns over time. It allows investors to benefit from compounding growth, dividends, and overall market appreciation.
Ultimately, the choice between trading and investing depends on an individual's goals, risk tolerance, time commitment, and personal preferences.
Risk-tolerant individuals may find success and fulfilment in trading, while risk-averse individuals may prefer the more patient and long-term approach to investing.
Before You Start Trading
Trading can be an exciting and potentially profitable venture, but it's important to approach it with caution and proper preparation. Here are the top 10 considerations beginner traders need to know about before they start trading.
Prioritize education and research
Create a trading plan
Start with a demo account
Choose a reliable broker
Learn effective risk management
Start small
Be disciplined
Embrace continuous learning
Practice risk control
Seek professional advice if needed
Remember, trading involves risk, and there are no guarantees of profits. It's important to approach trading with a realistic mindset, understanding that both gains and losses are possible. Only invest what you can afford to lose, and always prioritize your financial well-being and long-term goals.
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