Stock Trading: An Introductory Guide

stock market

Investing and trading are two very different ways of approaching financial markets.

The goal of investing is to gradually build wealth over time through the buying and holding of stocks, bonds, and mutual funds. Investments are often held for a period of years, or even decades, taking advantage of perks like interest, dividends, and stock splits along the way. While markets inevitably fluctuate, buy-and-hold investors will “ride out” the downtrends with the expectation that prices will rebound and any losses will eventually be recovered.

Trading, on the other hand, is characterized by the more frequent buying and selling of stocks and commodities, with the goal of generating returns that outperform buy-and-hold investing. While investors may be content with a 10 to 15% annual return, traders might seek a 10% return each month. Traders profit when they buy at a lower price and sell at a higher price within a relatively short period of time.

Unlike buy-and-hold investors, they must make profits within a specified period of time, and often use a protective “stop loss order” (more on this later) to automatically close out losing positions at a predetermined price level.

Traders typically buy stock for the following reasons:

  1. A trader senses a price movement (through technical analysis, market/sector news, etc).
  2. A trader is interested in profiting from a price movement and, most likely, selling and moving on to another stock.
  3. A trader has no real interest in the company behind the stock other than it is in the right place at the right time.

A trader’s “style” refers to the timeframe or holding period in which stocks or commodities are bought and sold. Traders generally fall into one of four categories:

Position Trader: positions are held from months to years
Swing Trader: positions are held from days to weeks
Day Trader: positions are held throughout the day only with no overnight positions
Scalp Trader: positions are held for seconds to minutes with no overnight positions

Traders often choose their trading style based on factors like account size, amount of time that can be dedicated to trading, level of trading experience, personality, and risk tolerance.

The wise trader has an escape plan in place to prevent small losses from becoming big losses. The trader has no emotional attachment to the stock, so getting rid of the loser at a predetermined point is a simple choice.

As a general rule of thumb, many traders find that selling a stock when it has fallen 7% or 8% is a good way to keep losses small. If they set their sell level higher, they are in danger of letting a normal market fluctuation trip their sell signal, only to see the stock and market rebound.

Problems arise for the stock trader when they decide they really like a stock and don’t want to part from it so easily. In other words, they’ve quit being traders and become investors.

What Are Stocks?

A share of stock is the smallest unit of ownership in a company. Initially, stocks–also called “equities”–are sold by the original owners of a company to gain additional funds to help the company grow. This is called the Initial Public Offering. The owners basically sell control of the company to the stockholders. After the IPO, the shares can be sold and resold on the stock market.

If you own a share of a company’s stock, you are a part owner of the company. You have the right to vote on members of the board of directors and other important matters before the company. If the company distributes profits to shareholders, you will likely receive a proportionate share.

One of the unique features of stock ownership is the notion of limited liability. If the company loses a lawsuit and must pay a huge judgment, the worst that can happen is your stock becomes worthless. The creditors can’t come after your personal assets. That’s not necessarily true in private-held companies.

Over time, stocks have outperformed cash and bonds; this takes into account depressions, world wars, and other world changing events. Stocks automatically adjust for the inflation of the currencies.

In the United Kingdom, Republic of Ireland, South Africa, and Australia, “stock” can also refer to completely different financial instruments such as government bonds or, less commonly, to all kinds of marketable securities.

Different Types of Stock

There are two main types of stock: 1) common stock and 2) preferred stock.

1. Common Stock

Most of the stock held by individuals is common stock. Common stock represents the majority of stock held by the public. It comes with voting rights, as well as with the right to share in dividends. When you hear or read about “stocks” going up or down, you are learning about common stock.

Another benefit of common stocks is that they are, for the most part, highly liquid. Small and/or obscure companies may not trade frequently, but most of the larger companies trade daily creating an opportunity to buy or sell shares.

2. Preferred Stock

Despite its name, preferred stock has fewer rights than common stock, except in one important area: dividends. Companies that issue preferred stocks usually pay consistent dividends and preferred stock has first call on dividends over common stock.

Investors buy preferred stock for its current income from dividends, so look for companies that make big profits to use preferred stock to return some of those profits via dividends.

In addition to the two main types of stocks, there are many different groupings of stocks, also referred to as types. The stocks are grouped according to the characteristics of the companies that issued them. These different groupings meet the varying needs of stockholders.

In the context of market capitalization (the total stock market value of the company), for instance, there are three different groupings:

1. Small cap stocks: these have a market cap of $2 billion or less. They are likely to grow quickly, but are riskier.
2. Mid cap stocks: these have a market value of between $2-$10 billion.
3. Large cap stocks: these have a market cap of $10 billion or more. They grow more slowly, but are not as risky.

How Stocks Trade

There are two basic ways exchanges execute a trade: 1) on the exchange floor and 2) electronically.

1. Exchange floor

An exchange floor is the platform where most trading is done face-to-face. This is also referred to as a listed exchange. The most prestigious exchange in the world is the New York Stock Exchange (NYSE). The “Big Board” was founded over 200 years ago in 1792 with the signing of the Buttonwood Agreement by 24 New York City stockbrokers and merchants. Currently the NYSE, with stocks like General Electric, McDonald’s, Citigroup, Coca-Cola, Gillette and Wal-mart, is the market of choice for the largest companies in America. The two other main financial hubs are London, home of the London Stock Exchange, and Hong Kong, home of the Hong Kong Stock Exchange.

In Australia, there’s the ASX.

A simple trade on the exchange floor of the NYSE might go as follows:

  1. You tell your broker to buy X shares of a stock at market.
  2. Your broker’s order department sends the order to their floor clerk on the exchange.
  3. The floor clerk alerts one of the firm’s floor traders who finds another floor trader willing to sell X shares of the stock.
  4. The two agree on a price and complete the deal.
  5. The notification process goes back up the line and your broker calls you back with the final price. The process may take a few minutes or longer depending on the stock and the market. A few days later, you will receive the confirmation notice in the mail.

2. Electronically

The second type of exchange is on a virtual platform, called an over-the-counter (OTC) market, of which the Nasdaq is the most popular. These markets have no central location or floor brokers whatsoever. Trading is done through a computer and telecommunications network of dealers. The Nasdaq is home to several big technology companies such as Microsoft, Cisco, Intel, Dell and Oracle. The Nasdaq is a serious competitor to the NYSE.

On the Nasdaq, brokerages act as market makers for various stocks. A market maker provides continuous bid and ask prices within a prescribed percentage spread for shares for which they are designated to make a market. They may match up buyers and sellers directly, but usually they will maintain an inventory of shares to meet demands of investors.

Individuals can also trade electronically. The cheapest way is to set up an online account. With your bank details and a debit card, you can start trading almost immediately. Though electronic trading facilitates greater control of online investing by putting the individual one step closer to the market, you still need a broker to handle your trades, since individuals don’t actually have access to electronic markets. Your broker accesses the exchange network and the system finds a buyer or seller depending on your order.

There are dozens of online stockbrokers, all charging different fees. Watch out for sites that charge higher fees if you trade bigger sums.

Here’s what happens once you select a broker:

  1. Select the stock name you want and receive an indicative price quote.
  2. Choose the amount you want to spend, and deal. You’ll get a real-time quote and have around 15 seconds to execute the deal. The money is cleared from your online account. Obviously you can only deal with the amount of money you have deposited with the share dealer.

Buying Stocks

There are two main ways to purchase stock: 1) using a brokerage and 2) using DRIPs & DIPs

1. Using a Brokerage

The most common method to buy stocks is to use a brokerage. Brokerages come in two different styles: full-service and discount. Full-service brokerages claim to offer expert advice and can manage your account for you. They are also more expensive. Discount brokerages offer little in the way of personal attention but are much cheaper.

At one time, only the wealthy could afford a broker, since only the expensive, full-service brokers were available. With the internet came the explosion of online discount brokers. Now, nearly anybody can afford to invest in the market.

2. DRIPs & DIPs

Dividend reinvestment plans (DRIPs) and direct investment plans (DIPs) are plans by which individual companies, for a minimal cost, allow shareholders to purchase stock directly from the company. Drips are a great way to invest small amounts of money at regular intervals.

What Causes Stock Prices To Change?

Generally, the price of a stock is determined by supply and demand. For example, if there are more people wanting to buy a stock than to sell it, the price will be driven up because those shares are rarer and people will pay a higher price for them. On the other hand, if there are a lot of shares for sale and no one is interested in buying them, the price will quickly fall.

Because of this, the market can appear to fluctuate widely. Even if there is nothing wrong with a company, a large shareholder who is trying to sell millions of shares at a time can drive the price of the stock down, simply because there are not enough people interested in buying the stock he is trying to sell. Because there is no real demand for the company he is selling, he is forced to accept a lower price.

Once a stock moves out of the IPO stage and into the open market, there are a number of factors that go into setting the price. The shifting of the market, political trends, and industry news influence whether there are more buyers or sellers for a particular stock in the market at any one time. Every day the market opens, it’s a clean slate. Stocks that were flying high yesterday may not get off the ground today.

Understanding supply and demand is easy. What is difficult to comprehend is what makes people like a particular stock and dislike another stock. This comes down to figuring out what news is positive for a company and what news is negative. There are many answers to this problem, and just about any investor you ask has their own ideas and strategies.

Understanding Stop Loss Orders

When your stock’s price drops, a stop loss order on file with your broker can help ease the pain. A stop loss order instructs your broker to sell when the price hits a certain point. The purpose of the stop loss is obvious: you want to get out of the stock before it falls any farther.

A stop loss order works like this: You tell your broker you want a stop loss order at a certain price on the stock. When and if the stock hits that price, your stop loss order becomes a market order, which means your broker sells the stock at the best market price available immediately.

If the stock is trading at $30 per share and normally doesn’t fluctuate more than $1-$2, then a stop loss order at $26.50 might be reasonable.

Take the pharmaceutical giant Merck, for example. When studies linked usage of its popular drug Vioxx to an increased likelihood of heart attacks and stroke, Merck pulled the drug off the market.

As soon as Merck made the announcement, its stock dropped dramatically. By the end of the day, the stock was down almost 27% or over $11–taking billions of dollars in company value along with it.

The stock opened around $45 the day of the announcement. If you had a stop loss order in for $40, it would have triggered very soon after the announcement. When the market hit your $40 price, your stop loss order became a market order, meaning your broker sold the stock at the best current price. That may not have been $40.

If you do ask for a stop loss order, here are some important points to remember:

  1. Be careful where you set your stop loss points. If a stock normally fluctuates 3-5 points, you don’t want to set your stop loss too close to that range or it will sell the stock on a normal downswing.
  2. Stop loss orders take the emotion out of a sell decision by setting a floor on the downside.
  3. If you plan to be out of touch from the market, on vacation for instance, put stop loss orders in so you have some protection against an unexpected disaster.
  4. Stop loss orders don’t guarantee against losses. When disaster strikes a stock, it may fall so fast the best you can hope for is to come out close to you price.

How to Read A Stock Table/Quote

table

Columns 1 & 2: 52-Week High and Low – These are the highest and lowest prices at which a stock has traded over the previous 52 weeks (one year). This typically does not include the previous day’s trading.

Column 3: Company Name & Type of Stock – This column lists the name of the company. If there are no special symbols or letters following the name, it is common stock. Different symbols imply different classes of shares. For example, “pf” means the shares are preferred stock.

Column 4: Ticker Symbol – This is the unique alphabetic name which identifies the stock. If you watch financial TV, you have seen the ticker tape move across the screen, quoting the latest prices alongside this symbol. If you are looking for stock quotes online, you always search for a company by the ticker symbol. If you don’t know what a particular company’s ticker is you can search for it at: http://finance.yahoo.com/l.

Column 5: Dividend Per Share – This indicates the annual dividend payment per share. If this space is blank, the company does not currently pay out dividends.

Column 6: Dividend Yield – The percentage return on the dividend. Calculated as annual dividends per share divided by price per share.

Column 7: Price/Earnings Ratio – This is calculated by dividing the current stock price by earnings per share from the last four quarters. For more detail on how to interpret this, see our P/E Ratio tutorial.

Column 8: Trading Volume – This figure shows the total number of shares traded for the day, listed in hundreds. To get the actual number traded, add “00” to the end of the number listed.

Column 9 & 10: Day High and Low – This indicates the price range at which the stock has traded at throughout the day. In other words, these are the maximum and the minimum prices that people have paid for the stock.

Column 11: Close – The close is the last trading price recorded when the market closed on the day. If the closing price is up or down more than 5% than the previous day’s close, the entire listing for that stock is bold-faced. Keep in mind, you are not guaranteed to get this price if you buy the stock the next day because the price is constantly changing (even after the exchange is closed for the day). The close is merely an indicator of past performance and except in extreme circumstances serves as a ballpark of what you should expect to pay.

Column 12: Net Change – This is the dollar value change in the stock price from the previous day’s closing price. When you hear about a stock being “up for the day,” it means the net change was positive.

Are You a Bull, Bear, or Farm Animal?

Wall Street is a zoo of bulls, bears, and farm animals, constantly struggling against one another for a leg up in the market. Which type of investor are you?

The Bulls

If a person is optimistic and believes that stocks will go up, he or she is called a “bull” and is said to have a “bullish outlook.” A bull market is when everything in the economy is great, people are finding jobs, gross domestic product (GDP) is growing, and stocks are rising. Picking stocks during a bull market is easier because everything is going up. But because bull markets can’t last forever, they can sometimes lead to dangerous situations if stocks become overvalued.

The Bears

If a person is pessimistic, believing that stocks are going to drop, he or she is called a “bear” and said to have a “bearish outlook.” A bear market is when the economy is suffering, stock prices are falling, and recession is on the horizon. Bear markets make it tough for investors to pick profitable stocks. One solution to this is to make money when stocks are falling using a technique called “short selling.” Another strategy is to wait on the sidelines until you feel that the bear market is nearing its end, only starting to buy in anticipation of a bull market.

Chickens and Pigs

Chickens are afraid to lose anything. Their fear overrides their need to make profits, so they turn only to money-market securities or get out of the markets entirely. While it’s true that you should never invest in something over which you lose sleep, you are also guaranteed never to see any return if you avoid the market completely and never take any risk.

Pigs are high-risk investors looking for the one big score in a short period of time. Pigs buy impulsively and invest in companies without doing their homework. They get impatient, greedy, and emotional about their investments, and they are drawn to high-risk securities without putting in the proper time or money to learn about these investment vehicles. Professional traders love the pigs, as it’s often from their losses that the bulls and bears reap their profits.

The bottom line when it comes to stock trading is to do your research. Read everything you can, and constantly try to learn about the market. Even once you’ve begun trading, you will need to continually keep up with market developments and research in the industries in which you invest. You even need to keep up with your company’s competitors.

Read the company’s annual report, as well as the one they file with the SEC. This will give you important information about where the company might be going, and hint at possible problems on the horizon. Read reliable sources of investment information, like Standard and Poor’s reports, the Wall Street Journal, Bloomberg or Forbes.

Take time to get to know the market. Watch as stocks rise and fall, and observe the sorts of things that evoke market reactions. When you feel like you understand how the market works, then you can get your feet wet.