How to Trade
Trading is a building block of investing. It's one of those basics that is fairly easy to start but can take a lifetime to master.
There's more to it than simply buying and selling securities, though. To do well at stock trading, you need to:
- Define your goals and limits
- Know the purpose and risks of different stock trading strategies
- Understand the costs involved
Knowing how to start trading stocks and other securities is essential if you want to make your own investment decisions. Even if you don't go on to become an active trader, knowing what's involved can help you better understand your investments.
If nothing else, knowing how stock trading works can help you make the decision between whether you want to manage your own investments or have a professional do it for you.
What is Trading?
In its simplest form, trading is buying and selling securities.
Registered securities in the United States are traded on exchanges, which are public marketplaces. Those marketplaces consist of some investors who are buying and those who are selling.
Stockbrokers help match buyers and sellers at agreed-upon prices. Depending on how many buyers and sellers there are for a particular company, the stock price will move up or down.
Trading is associated most with active investment strategies. These can either involve long-term fundamental investing or short-term day trading. But before you start trading stocks, you need to figure out a framework for your investment decisions.
What Are Your Trading Goals and Limits?
To navigate the world of stock trading successfully, start by clarifying the route you'll take. This means determining how much money you can afford to put at risk, how many different securities you'll need to buy and what types of trades you should be placing.
To define your trading goals and limits, ask yourself the following questions:
- Are you just looking to capture individual opportunities in specific stocks, or do you want to put together a fully diversified portfolio made up of dozens of investments?
- How much risk are you prepared to take? Specifically, how much money can you afford to lose, and how much should you keep in safer types of investments?
- Are you picking investments that you expect to do well over the long run, or are you gambling on guessing short-term price changes correctly?
Answering these questions about your goals and limits helps define how you approach trading. It's a foundational step that can eliminate some of the trial and error that plagues beginning investors.
Stock Trading Strategies
Learning about the purpose and risks of stock trading strategies is another way to decide what fits best for your investing goals. Compare two of the more widely known approaches, long-term investing and day trading, to appreciate how they differ:
Market prices fluctuate just about every day but will generally rise over time for companies that are successful.
Because of this, if you're trying to invest in companies based on the quality of their business models, you need to be in it for the long term.
After all, it can take time for a company's business strategies to work out. Also, it may take a while for the marketplace to realize which companies are going to be the winners in their industries.
In the context of long-term investing, trading is a way to capture the opportunities you identify as the most attractive.
Once you've done the analysis to pick stocks, knowing how to trade allows you to get the companies you've identified. Being able to trade decisively and efficiently enables you to take advantage of price drops that can turn a good company into a real bargain.
Also, there's more to investing than just buying stocks. A successful investment often entails selling at the right price, and knowing how to trade can help you make that happen.
What is Day Trading
As noted above, market prices fluctuate all the time. Day trading is a strategy that attempts to take advantage of those short-term fluctuations.
There are various systems for how to day trade, but they're all generally based on two things:
- Trying to guess the relatively small moves stocks make throughout the day, and
- Making a high-enough volume of trades to turn those small price changes into a decent return.
The many small changes that occur in a stock's price throughout the day are more or less random. Because of that, day trading has more in common with gambling than it does with fundamental investing.
Worse, day trading is a form of gambling in which the odds are stacked against you. This is because there's a cost to trading, especially at the high volumes entailed in day trading.
Finally, the other thing to know about day-trading is that it's a high-intensity, time-consuming pursuit. This is because it involves closely monitoring a variety of market indicators that change constantly throughout the day.
So, if you're looking for a risk-taking activity that will keep you on the edge of your seat all day long, day trading might appeal to you. However, it's not a way to make fundamentally sound investments for the long term.
How to Trade Stocks
Whether you're investing for the long term or gambling on making a quick buck through day trading, knowing how to be precise when making stock trades is crucial to implementing your decisions correctly.
Making good trades involves deciding what type of order you want to place and knowing what instructions to give when placing it.
Types of trades
Trades can be for buying or selling a stock, but how you buy or sell can also make a difference.
One choice you have is between limit orders and market orders:
- Limit orders
A limit order means you're setting a price that you won't go beyond. For buys, that means setting a price cap that you won't pay more than. For sells, it means setting a price floor that you won't sell below.
A limit order won't be completed if the stock does not meet your price.
An alternative if you want to make sure the trade happens is a market order.
- Market orders
A market order means that you will trade for whatever price the security happens to be at.
Placing a market order may mean paying a little more to buy a stock or getting a little less when you sell. On the plus side, a market order has a greater chance of being completed than a limit order.
Another choice of trade types you have is between a day order or a good-till-cancelled order.
Sometimes a trade cannot be completed right away. This is especially true if you've placed a limit order and the market price doesn't meet your limit.
- Day orders
A day order means that your trade request is only in place on the day you make it. If the trade does not get completed, it is cancelled.
- Good-till-cancelled orders
A good-till-cancelled order remains in place for as long as it takes to complete the trade.
A good-till-cancelled order can be helpful if you are determined to hold out for a particular price, no matter how long it takes. However, there is a risk that a good-till-cancelled order may remain in place for so long that you lose track of it by the time it can be completed.
A day order gives you a chance at the end of each day to evaluate why a trade didn't get completed and possibly change your price limit or other instructions the following day.
Placing an order
When placing an order, you need to give a series of specific instructions:
- Whether it is a buy or sell order
- The number of shares you'd like to trade
- Whether it is a limit or a market order
- If it is a limit order, you need to specify the price limit
- Whether it is a day order or a good-till-cancelled order
- The stock symbol - this is very important because some companies have similar names but the stock symbol helps make sure you trade the right one
One advantage of online trading is that online brokerage platforms often allow you to see a preview of your trade once you've entered your instructions. That allows you to look everything over before you commit to the trade.
Cost of Stock Trading
There is a cost involved in trading, and the type of cost has evolved over the years.
Traditionally, brokers charged a commission based on the number of shares you were trading. The bigger your trade, the more expensive the commission would be.
With the popularity of online trading in the 21st century, many brokers switched to flat-rate commissions. With these, you would pay the same rate on every trade, regardless of the size of the trade. This is a great deal for large trades, but not necessarily for smaller ones.
Competition among online brokers is so intense that some now offer $0 commission trades. However, this doesn't mean you don't pay anything to trade.
In a market exchange, there is a difference between what buyers are willing to pay for a stock (the bid price) and what sellers are willing to take for a stock (the ask price). That difference is known as a spread, and brokers can make money from the spread between bid and ask prices.
That spread adds to the cost of trading. Another cost is regulatory fees that are assessed on trades. In particular, these can represent a burdensome percentage of small trades.
What Does It Mean to Short a Stock?
Normally, you would sell a stock only after you already own it. However, it is possible to agree to sell a stock you don't yet own. This is known as shorting a stock.
When you short a stock, you agree to provide it to the buyer at the agreed-upon price sometime in the future. To fulfill that agreement you'd have to buy the stock at whatever the price happens to be in the future, and sell it at the price you agreed on when you shorted the stock.
Selling short is a bet against the stock's price. If the price goes down, you get to buy it for less in the future and then turn around and sell it at the higher price a buyer agreed to previously.
If the price goes up, though, you'll have to buy the stock for more than you agreed to sell it for. This guarantees a loss.
There are two reasons why short selling is a very risky strategy. One is that stock prices have generally risen over time, so you are going against the trend when you bet on a stock's price to go down.
The other risk is that, because there is no limit to how high a stock's price can go, there is no limit to how much you can lose when you short a stock.
How to Trade Options
Rather than buying or selling a stock, you can acquire an option to buy or sell a stock at some time in the future.
These options specify a price at which that future trade can take place, and have a time limit for how long you have the option.
A put is an option to sell a stock sometime in the future at a prearranged price. A call is an option to buy in the future at a prearranged price.
You would buy a put option to bet against a stock and a call option to bet it will go up.
The notable risk of trading options is that if the stock does not meet your target price before the option expires, you lose the entire value of your investment.
Alternatives to Trading
This article provides just an introduction on how to trade. Trading can be extremely complex, requiring both expertise and a major commitment of time.
If you are unsure that trading is for you, there are still other ways to invest:
- A mutual fund lets you buy a share of a professionally managed portfolio very efficiently
- A robo-advisor can assemble a portfolio of different funds for you based on your goals
- A Registered Investment Advisor can manage a customized portfolio for you
All investing pretty much starts with trading. However, you have a choice as to whether you want to take on that task yourself or delegate it to a professional.