How Stock Trading Works

Stock trading involves either buying a certain amount of a company’s stock, called going long, or borrowing a certain number of shares from a broker, with the hope that the price will decline and one can buy the shares later and repay the loan to the broker, called going short.

While owning stock does represent fractional ownership in a company, that in itself isn’t the goal of buying stock, unless you are looking to buy enough of it to take over a company. This is something that is limited to the biggest players in the market, and is far from something that individual investors would even dream of, so owning the company isn’t on the agenda for them.

How Stock Trading WorksWhat we are looking to do with these shares is to make money from the purchase, to make a profit, and therefore when we trade we essentially make bets that certain things will happen which will lead to profits for us, whether that’s through capital accumulation, dividends, or both.

There are several steps involved here, and it doesn’t just start when you click on a trade with your broker and it gets filled. One must start out with a plan, what one is looking to achieve with one’s stock trading.

Coming up with a good plan is not as simple as it may appear. You need to decide more here than I’d like to make some money trading stocks. There are a number of factors to consider here.

How much money you are able or want to devote to stock trading is perhaps the most fundamental one. It’s not just what you start out with that you need to figure out, you also need to decide how much you are willing to commit further to the project, if any.

Risk Appetite

Your objective is of course to make money from the deal, but there are a number of different strategies that can be used here depending on what you’re really looking to do. It’s always a matter of how much risk you want to take on, and this is the next thing that must be decided when formulating any good trading plan.

Risk and reward tend to be inversely correlated, so while everyone wants to make as much money as they can from trading, shooting for more return means that you will encounter a higher level of risk. Risk can be managed to a certain extent, but the type of strategy you’re going to be using is going to influence things as well.

Many a trader has overestimated his or her ability to manage risk, and then discovered later that the risks were higher than they had imagined, and their skill in managing it turned out to be less effective than they believed.

Stocks are an asset class that by its nature involves less risk, and often quite a bit less risk, than most other asset classes. With some asset classes, you can lose your entire investment in a matter of hours or even minutes if you are not careful. This doesn’t mean that these trades are by nature undesirable, but they certainly may be for a lot of investors who don’t have anywhere near the risk appetite that is required to trade them.

Leverage plays a big role in this, and some types of trades can be highly leveraged, like forex or contracts for difference, and others, like options, may be leveraged by their very nature. Stocks though have strict caps on leverage which is generally 2:1, and one does not have to borrow at all to trade stocks if one does not want to.

Certain stocks are riskier than others of course, and some investors may want to stick with these less risky and less volatile stocks, while others may want to engage in more risky trades.

Once one has decided upon how much risk they are willing to take on, and have factored this in to what their overall objectives of trading will be, the next decision becomes which stocks to trade.

Stock Selection

From among the types of stocks you’re looking to consider, in order to decide which ones to buy, or which ones to short if you’re looking to do that, the next step is deciding on which one or ones to trade, and when.

There are a lot of different stocks in the market and there is also a number of things that you want to be looking at when deciding between them. The skill level employed by retail traders ranges from buying stock because they like the company, to trading on hunches, to trading on company news, to adding in some basic technical indicators, to a sophisticated system based upon a combination of analytics, skill, and experience.

In all cases, there is a belief that a certain stock play will represent a profitable opportunity for the trader or investor, over a certain timeframe. Part of the plan that we devised included what our expectations are as far as how long we expect to hold on to the stock, and this will matter a lot.

As a general rule, very long-term stock plays tend to be less risky, based upon historical data at least. Over a period of several decades, as long as the stocks chosen are ones with a solid history of success that can be well expected to continue into the distant future, these stocks do tend to go up with the market.

So once you take out the normal market volatility, which holding for such a long period has at least served to do in the past, then one may reasonably expect a good return over time, not a great one mind you but a solid one.

If an investor is looking at shorter time periods or wants a better return than this, they are going to have to use a different strategy, one that comes with more risk. This will involve timing the market for stocks more, to seek to take advantage of swings in momentum over shorter periods of time, anywhere from minutes to several years, depending on the strategy.

Placing Your Order

In order to trade in stocks, you will need to go through a broker, who places your trades for you. Stocks are traded in lots of 100, and  it’s always best to buy or short stocks in even lots of 100.

The price of a stock may be a factor in deciding which ones to trade, as you’re going to need to want to devote enough money to trade at least 100 shares of the stock you are considering.

In order to trade stocks, you’re going to need to open an account with a broker. Full service brokers, those who provide advice as well as the ability to trade, used to be the only way to do this at one time, but nowadays a lot of people trade through online brokers and make their own decisions, called a self-directed trading account.

Let’s say you want to buy 100 shares of XYZ, and you place an order to buy with your broker. You may either specify the price you want to pay, called a limit order, or instead place a market order, in which you’ll have the trade executed as quickly as possible at the prevailing price of the market for the stock.

Stocks are quoted as bid and ask prices, and since you’re looking to buy here, you’ll be paying the ask if you submit a market order. You could instead place a limit order, but limit orders can be quite problematic.

Your order might just be ignored, or worse, the market may move and leave you behind. Let’s say you engage in two trades, one that goes up while you’re placing the order, a good-looking trade, and one that goes down, one that you end up wishing you had not bought.

If you place a limit order below the ask, you won’t get filled with the good trade, but you will with the bad trade, and therefore this strategy can easily work against you.

As well, if the market leaves your limit order behind, and you still want it, you’ll now have to chase it, and hopefully this time you’ll use a market order. If not, and you place another limit order, this one can be left behind as well, and you will either abandon the trade, missing out on the opportunity, or end up chasing it, with the result being that you paid too much for it.

This applies both to very short-term trading and longer term as well, as you never want to pay too much for a stock, even though this is an even bigger deal with shorter term trades due to their smaller objectives, where you may miss the trade altogether with a limit strategy.

Your trades get sent to the market where they are handled by market makers, who are intermediaries which hold inventories of stock and make a little off of their trades, and it’s best to leave the market making to the market makers and not try to do this yourself, which is what limit orders try to do.

With some more thinly traded stocks, it might make sense to place a limit order, so it’s not that this is a strategy you never want to consider, but with stocks which have a lot of trading volume, the kind that traders tend to focus on, it can be a questionable practice.

Once it’s time to exit the position, and you need an exit strategy as well, you simply place a trade to close your position, either selling it or buying it to close a short position. At this point, the net amount, either up or down, plus the commission, will be reflected in your account balance.

To recap, to trade stocks you need to decide how much you want to commit to trading or investing overall, decide how much risk you want to take, and decide your objectives. You then need to select your stock plays accordingly, and also come up with a good plan on what you want the trades to do for you and when your trade would become invalid, the point where it did not work out as planned, and is off course enough to get out of the position.

If everything goes right, you will achieve your objective in making money. There is a lot to this though, but the good thing is, each trade is a learning experience, or should be, and as you gain more and more experience in trading.

John Miller

Editor, MarketReview.com

John’s sensible advice on all matters related to personal finance will have you examining your own life and tweaking it to achieve your financial goals better.

Contact John: john@marketreview.com

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