Stock Trading Basics
- Last Updated: Friday, 24 April 2020
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.
Buying and Selling Stocks
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.
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 stock, or stocks, they are responsible for managing. The NYSE trading floor, and all the people that make trading a reality, is quite a sight to behold. That is why pictures of the stock exchange floor often appear in the newspaper.
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.
Role of the Stockbroker
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 market, and the investor, with essential services. The more personalize this service is for an investor, the higher the commission charged. For example, stockbrokers that answer the telephone and make trades on an investor's behalf might charge $30.00 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.
Some of the more notable "electronic" brokers 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.
Buying and Selling a Stock
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.
Making Money Trading Stocks
Let's assume that 3M releases some good news, and the stock market has reacted rationally by increasing their value for 3M to $80.00. At that price point, the investor decides to take their profits and sell their shares of 3M stock. They call their broker and complete the transaction by selling 20 shares of 3M at $80.00. The $1,600.00 in cash from the sale is placed back into the investor's account. Once again, the broker charges their standard fee of $30.00 for the trade. At the end of the day, the investor now has $425.00 + $1,600.00 - $30.00 or $1,995.00 in their account.
But wait a minute, the investor purchased 3M at $77.25 and sold it at $80.00. They started with $2,000.00 in their account and now have $1,995.00. The investor thought they were making money trading stocks, not losing it!
Unfortunately, the investor paid $60.00 in trading / broker commissions. In this example, those fees had a significant impact on the total return on this investment.
Impact of Commissions on ROI
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.
In fact, mutual funds are a great choice for investors that don't have a lot of money right now, or individuals that want to start out slowly without putting a lot of resources at risk. Mutual funds allow investors to instantly create a diverse portfolio of stocks in a very efficient manner. It's important to always research options before making an investment decision.
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