Guide to Stock Trading
Introduction to stock trading
The stock market is a designated market in which the stocks of publicly listed companies are traded in a secure and controlled environment. Companies that offer their stock for sale to interested outside parties (who would be called investors in the company) give up a portion of the ownership of the company in the form of shares in exchange for funds from the investors. Shares offer an attractive investment opportunity to investors because it allows them access to potential profits or dividends without having to take on the high risk of entering into business themselves, and offering stocks is an attractive fundraising opportunity for companies because they can raise the funds they need to fuel future growth or other business plans.
An efficiently functioning stock market is considered essential to economic development as it gives companies access to capital from the public. Companies list shares of their stock on an exchange and investors can purchase those shares and then can participate in trade amongst themselves on what are called stock exchanges (which will be covered in more detail below). The stock market as a whole tracks the supply and demand of these shares. Supply and demand are important determinants of the price at which shares will be bought or sold on the stock market.
Primary and Secondary Markets
The stock market can actually be divided into two distinct parts: the primary market and the secondary market. The primary market is where a company’s shares are offered and sold for the first time by the company to the public. This market is usually dominated by larger investment institutions such as investments banks and hedge funds. The secondary market, on the other hand, is where traders trade these stocks amongst themselves without the initial company being a direct participant in that trade.
WHAT IS A STOCK?
A stock (also called a share or equity) is a term used to describe an investment in a company. Stocks essentially represent ownership shares in a company. It represents a claim on the company’s assets and earnings. An individual who acquires a company’s shares is referred to as a shareholder or stockholder and can claim a part of a company’s assets and earnings should the company have to dissolve. Owning shares also gives shareholders the right to vote in stockholder meetings, receive dividends if they are distributed, and sell their shares to other traders on the secondary stock market as described above.
Common Stock and Preferred Stock
There are two common types of stocks: common stock and the preferred stock. The holders of preferred stock are, by law, entitled to receive dividend payments before they are distributed to other shareholders. Common stockholders, on the other hand, can only exercise their voting rights in corporate decisions. However, depending on the number of shares they have, individual investors usually have a minimal influence on voting. Nevertheless, all stockholders enjoy limited liability whereby they are not legally liable for outstanding payments if the company goes bankrupt.
WHAT IS AN ETF (EXCHANGE-TRADED FUND)?
ETFs, or Exchange Traded Funds, are baskets of securities that resemble index funds. However, the difference is that they can be bought and sold during the day through brokerage firms on a stock exchange just like regular common stock. They provide investors with a convenient way of purchasing an extensive collection of securities in a single transaction. They also offer the benefit of a stock with the diversification of a mutual fund. ETFs are provided on every conceivable asset class, ranging from traditional investments to alternative assets such as currencies or commodities.
A few different types of ETFs include:
- Market ETFs
- Alternative Investment ETFs
- Sector and Industry ETFs
- Foreign Markets ETFs
- Actively Managed ETFs
- Exchange traded notes.
- Bond ETFs
- Commodity ETFs
- Style ETFs
- Inverse ETFs
ETFs offer investors several advantages compared to other funds. These include:
- Investors can buy and sell ETFs at any time of the day.
- ETFs offer lower fees, although brokerage service commissions do apply.
- ETFs are more tax-friendly as investors have better control when it comes to paying capital gains tax.
- Because ETFs are traded like stocks, investors can place a multitude of orders such as limit orders, stop-loss orders, buy on margin, etc. on ETF trades.
- ETFs offer much better liquidity than many other investment types.
WHAT IS A MUTUAL FUND?
Deciding on which equities to invest in can be a pretty daunting task for a new investor. Creating your personal portfolio can be extremely difficult, not to mention extremely risky for the uneducated. Mutual funds exist solely for this purpose: to help the small or individual investors access professionally managed portfolios of securities such as bonds, stocks, and other assets. A mutual fund refers to a collective pool of cash collected from many investors that are then used by professional investment managers for investment in various equities. An average mutual fund holds a collection of different stocks or securities. Therefore, if you purchase a share at a mutual fund, you are buying the performance of the mutual fund’s portfolio. Thus, the overall value of the mutual fund depends on the performance of the equities contained therein.
Mutual funds are one of the most popular investment vehicles in existence today as they offer additional security, low risks, and diversification at affordable prices. They are operated by professional portfolio managers who specialize in earning capital gains or income from the funds they invest on behalf of their clients. However, due to their high fees and the fact that most mutual fund managers cannot beat the performance of the S&P 500 benchmark, they are slowly dying in popularity.
Every mutual fund has a particular purpose, investment strategy, or style. For instance, some mutual funds only invest in blue-chip companies, while others invest in start-up businesses. All in all, a mutual fund is collective, and each stockholder benefits or loses in equal proportion, while the expenses of the mutual fund are shared by everyone in similar proportion.
Some examples of mutual funds include:
- Open-end funds
- Close-end funds
- Load funds
- No-load funds
DIFFERENCES BETWEEN ETFS AND MUTUAL FUNDS
Both Mutual Funds and ETFs are investment vehicles that bundle securities to provide diversified portfolios to investors. Despite this similarity, these two funds are marked by several differences. These differences include:
- ETFs can be traded just like common stocks, and their prices can rapidly change. However, orders for Mutual Funds can be made during the day, but the actual trade doesn’t happen until the market closes.
- ETFs are structured differently and often have low portfolio turnover. Therefore, investment gains on ETFs are usually taxed more delicately than capital gains realized on mutual funds.
- ETFs typically require investors to pay small trading fees. However, compared to mutual funds, ETFs never have heavy load or management fees. Therefore, they typically cost less.
- ETFs are passively managed. ETFs represent indexes which are entire markets or market segments. Therefore, ETF managers tend to do minimal trading of securities in the ETFs themselves.
WHAT IS A MARKET INDEX?
A market index is a metric that is used to denote the performance of a group of stocks or other investments from a section of the stock market. Some market indexes are intended to indicate the overall performance of the stock market, while others only track a part of a particular stock set by monitoring changes over time. For instance, if a specific market index rises one level or one percentage, that means that that specific group of stocks has increased in value and has become more attractive to investors.
Examples of market indexes include the Standard & Poor’s 500 index, the Dow Jones Industrial Average (DJIA), the Nasdaq Composite Index, amongst others. The S&P 500 Index is computed by combining 500 large-cap U.S. stocks into one index value. The DJIA, on the other hand, measures 30 shares traded on the Nasdaq and the NYSE (New York Stock Exchange). Both these indicate the financial health of the companies included in the index.
These indexes help investors track changes in market value over long periods of time. For instance, if the DJIA index drops and continues to decline for more than a month, an investor may conclude that some of the companies in the index are performing poorly. Therefore, if he or she owns stock in some of the companies tracked by the index, the investor may resort to reassessing their portfolio and look for better companies to invest in.
Stock Market Indexes to note:
- $SPX (S&P 500 Index)
- $INDU (Dow-Jones Industrials 30 Index)
- $COMPQ (Nasdaq Composite Index)
- $RUT (Russell 2000 Index)
- $VIX (CBOE Volatility Index)
WHAT ARE STOCK SECTORS?
The stock market consists of thousands of shares offered by a multitude of companies. These shares are separately placed in sectors. These sectors are essentially broad classifications based on a few key characteristics. Within each industry, there are numerous sub-sectors. According to the GICS (Global Industry Classification Standard), there are 11 designated stock sectors, including:
- Basic Materials
- Information Technology
- Consumer Staples
- Consumer Discretionary
- Real Estate
Each stock that investors invest in will be placed in a specific sector from the list above. Moreover, a diversified portfolio will usually hold stocks across multiple sectors, if not all of them. This diversification helps investors mitigate the risks of unsystematic risks caused by factors affecting specific companies or industries in a sector. The above sectors are further divided into two sectors: the defensive sectors, and the cyclical sectors.
Defensive Sector Companies
Companies in the defensive sector usually don’t suffer as much in a market downturn. These sectors include the utilities and consumer staples because these are things that people tend to buy and consume regardless of how well or poorly the market is doing. They usually provide a balance to portfolios and offer protection in a failing market.
Cyclical Sector Companies
Companies in the cyclical sector react to a multitude of market conditions that cause them to fluctuate up and down. Sectors in the cyclical sectors also move independently of each other. While one sector is doing well, another may be experiencing a downfall.
LARGE-CAP STOCKS VS. LOW-CAP STOCKS
Public companies are generally classified into three different market-cap categories. Market cap in this context is short for market capitalization, which is a way of measuring a company’s size. It is usually calculated by multiplying the number of shares issued by the company with the current share price.
The three categories by which companies are categorized by market cap include:
- Large-Cap Stocks
- Mid-Cap Stocks
- Small-Cap Stocks
Large-cap stocks are stocks in companies that are worth $5 billion or more. These are companies that are generally very stable, well-established, and have a strong market presence. Their stocks tend to be less volatile and less-risky. Examples of such companies include Apple, Amazon, and Google. Large-cap stocks are also referred to as blue-chip stocks.
Low-cap stocks, on the other hand, are companies that are valued at less than the $2 billion threshold. They are usually young companies that have significant growth potential and are often companies in the development stage of their lifecycle or are startup companies. They tend to have low revenue and a small number of employees. Therefore, small-cap stocks tend to be risky as they are more volatile than large-cap stocks.
The differences between large-cap stocks and low-cap stocks are as follows:
- Small-cap stocks are younger. Therefore, they offer greater potential gains in share price and a higher return for investors. Large-cap stocks, on the other hand, are often so expensive that it can be challenging for them to achieve massive growth.
- Large-cap stocks are less risky since large-cap companies usually have a proven track record over many years, not to mention a broad mix of products. Small-cap stocks, on the other hand, are riskier, since small-cap companies can become short on resources, and their management teams may be short on experience.
- Large-cap stocks can provide better access to dividends since large-cap companies offer dividends as an incentive for investors to purchase shares. Small-cap companies, on the other hand, often retain their earnings instead of paying out dividends in order to be able to fuel company growth.
Shares, equity, and stocks are words that are used interchangeably. Shares are usually issued by a public company and are sold to investors for cash in an IPO or float (see No. 17 below for more details on stock floats). After this initial sale, the shares are then traded on the stock market. Shares are generally considered to be good long-term investments, and there are two ways in which an investor can make money from shares:
- Capital gains: realized by selling shares for more than how much they were purchased for.
- Income: these are regular payments received in the form of dividends and represent a share of company profits.
Furthermore, shares can be classified into two broad categories:
- Authorized shares: these shares comprise the number of shares a company’s board of directors may issue.
- Issued shares: these shares comprise the number of shares that are provided to shareholders and are counted for purposes of ownership.
TYPES OF ORDERS
There are three common types of orders. They are:
- Market Orders
- Limit Orders
- Stop Order/Stop-loss orders
A market order is an order to purchase or sell a security (which is a stock or a share) immediately. This type of order offers the guarantee that the order will be executed. However, it doesn’t guarantee the execution price. Market orders typically execute at or near the current bid for a sell order, or at or near the current ask for a buy order. Market order offers a variety of benefits, such as:
- You can get the stock at any time.
- You can buy large numbers of shares without a lot of difficulty.
- You have higher chances of filing your order.
- You can get them in less liquid stocks.
The only downside to market orders is that there is the potential of having to pay higher prices than necessary as market prices react to your buy or sell order and rise or fall accordingly (a phenomenon known as ‘slippage’).
This is an order to purchase or sell a security at a specific or better price. For example, a buy limit order is an order that can only be executed at the specified limit price or lower. A sell limit order is an order that can only be executed at the limit price or higher. Placing limit orders helps buyers and sellers guarantee a certain price for the sale or purchase of their desired stock, share, or security.
Stop Order/ Stop-Loss Order
A stop order is an order to sell or buy a stock once the price of the stock reaches a specified price. This specific price is known as the stop price. Such orders are entered at a stop price above the current market price. Investors use buy stop orders to limit losses or protect profits on a stock that they have sold short. A sell-stop order, on the other hand, is entered at a stop price above the current market price. It’s used by investors to limit a loss or to protect a profit they have earned.
In this way, market orders offer the guarantee that stocks can be bought or sold at whatever the price in the market is, while a limit order guarantees that an investor will purchase or sell stock at a price they want. If neither condition is met, these orders are canceled at the end of the day.
LEVEL 1 AND LEVEL 2 QUOTES
Level 1 and Level 2 quotes are two different types of trading screens leveraged in stock trading. Some of the information displayed on the screens are the same, such as the stock’s last trading price, the current bid, the daily high and low, and the trading volume. There are, however, a few differences between them.
Level 1 Quotes
Level 1 Quotes provide most of the information that the average investor would want on a stock or share. However, they do not include more advanced data points, the kinds that may be of interest to expert traders, such as the market depth information that is found in level 2 quotes. Level 1 quotes essentially show the bid, offer, and volume information that is commonly provided for free on sites such as Google Finance or Yahoo Finance.
Level 2 Quotes
Level 2 quotes take things a step further by offering and providing a behind-the-scenes view of all the real-time action currently in play in the market and where it’s from. Level 2 quotes usually show:
- The current bid and offers of individual market makers (people setting up and executing trades in the market).
- Who the market makers are for each stock.
- Information on when each market maker trades shares.
- Which collection of shares by each market maker are trading the lowest and highest at any given time.
- How many shares per collection are being traded by each market maker.
The added features of Level 2 quotes enable a trader to determine the magnitude of buy and sell orders at different prices and where most orders are concentrated among the market makers. Knowing how many people are buying or selling a stock or share at a specific price is a very valuable investment data point that can be leveraged to execute better and perhaps more profitable trades by professional investors.
WHAT IS SHORT-SELLING AND HOW DOES IT WORK?
Novice and inexperienced traders often stick to the objective of buying stocks low and selling them when prices are high. However, another strategy, known as short-selling, can be equally profitable. Short-sellers typically borrow shares of stock they don’t own and sell those shares at current market prices. Their goal is to eventually re-buy the same stock shares at a lower price and then return the borrowed shares to the lender.
Short-sellers usually hope that they can profit from the difference between the earnings from the short sale and the value of buying back the shares in a strategy known as short-covering. Short-selling can be used for both speculation or hedging purposes. Hedgers usually use short-selling to protect their gains or mitigate losses in a portfolio. Speculators use short-selling to capitalize on a potential decline in a specific security or the broader market.
Margin trading refers to the activity of using borrowed funds from a broker to purchase additional securities while using your securities as collateral. All assets and personal guarantees are held as assurance that the debt will be repaid no matter what the outcome. Margin trading is a double-edged sword: it could either significantly magnify gains or burden a trader with devastating losses. Therefore, because of the high amount of risk that margin trading carries, it can only be executed in a special account known as a margin account.
While margin trading is a quick way for a trader to make some quick cash, it is an activity that’s reserved for the trade-savvy and high-net-worth investors who are comfortable with such risks. Margin trading is especially significant in a favorable bull market, but it may work unfavorably in a bear market. When used correctly, it can be highly profitable. However, it still represents debt, and all debts must be paid off in the long-run.
SEC RESTRICTIONS ON DAY-TRADING
Day trading refers to buying and selling a security within a single trading day. It’s an activity usually performed in foreign exchanges (FOREX) and stock trading. Traders who conduct day trades are often well-funded and educated and they utilize high amounts of leverage and short-term trading strategies to make profits on small movements in highly liquid currencies or stocks. The U.S. SEC (Securities and Exchange Commission) has imposed certain restrictions on the day trading of U.S. stocks.
Day traders are required to maintain an equity balance of at least $25,000 of personal capital in their trading accounts. This restriction prevents ‘pattern-day traders’ from operating. Therefore, to regularly day-trade stocks in the U.S., a day-trader needs at least $25,000 in their trading account. If a trader doesn’t have the required $25,000 equity balance and has been classified as a pattern day trader, then they will be prevented from making day trades until they increase their equity balance to $25,000.
Brokers and FINRA (Financial Industry Regulatory Authority) consider a pattern day trader as someone who buys or sells any security on the same day within a marginal account four or five times during any continuous five-day period. Moreover, if a trader exceeds their allowed margin, then the trader will be issued what is called a margin call since their deposited capital begins to drop because of a losing position.
WHAT IS AN IPO?
An IPO (Initial Public Offering) is the very first sale of stock issued by a company to the public. Before a company conducts an IPO, the company is considered private and generally has a small number of stockholders, most of whom are usually early investors and professional investors. The public in this context refers to any individual or investor who wasn’t involved in the early stages of the company and who has an interest in buying the shares of the company at a later point in time.
Public companies are those that have sold at least a portion of their shares to the public for trading on stock exchanges. This is primarily the reason why conducting an IPO is referred to as going public. An IPO helps the company raise and collect a great deal of capital for it to grow and expand. Some of the largest IPOs include the Alibaba Group IPO of 2014 where the company raised $25 billion. The American Insurance Group (AIG) also conducted an IPO in 2006 and raised a staggering $20.5 billion.
The benefits of an IPO include:
- It increases the company’s exposure, public image, and prestige, all of which can boost the company’s sales and profits.
- Going public helps the company attain and retain better management staff and employees.
- It’s the best option for raising a tremendous amount of cash for the company in a short amount of time.
- An IPO gives the company a lower cost of capital.
The cons of an IPO include:
- The loss of control and the rise of agency problems brought about by new shareholders who can control the company via the Board of Directors.
- Increased legal or regulatory issues and risks such as private securities class action lawsuits.
- The company is required to disclose financial, tax, accounting, and other business information to the public.
- Competitors, customers, and suppliers can use this information, which is required by law to be public, for their own personal gain at the expense of the company
HOW DOES MARKET NEWS IMPACT STOCK MARKETS AND EARNINGS?
Negative news will often cause individuals to sell their stock. Negative news such as a bad earnings report, economic and political uncertainty, unexpected and unfortunate events, and poor governance all create selling pressure, which will lead to a decrease in stock price. Positive news, on the other hand, translates to individuals wanting to buy more of a particular stock. Positive news such as new products and acquisitions, positive economic and political indicators, good earnings reports, and increased corporate governance will lead to an increase in stock prices. This translate into buying pressure, which will lead to an increase in stock price.
These changes take place as changes around the world affect the economy and stock prices. For instance, a news report of a rise in energy costs can lead to lower sales, which leads to lower profits and therefore, lower stock prices. A terrorist attack can also lead to a downturn in economic activity and subsequently, a fall in stock prices. News of natural disasters such as a potential hurricane could cause utility stocks to depreciate, but the same news could cause insurance stocks to rise depending on the projected damage.
News Catalysts to Note:
- Earnings Reports
- New Product Announcements
- Mergers or Acquisitions
- Analyst Revision
- New Government Legislation
- Something as simple as a tweet by the CEO
Popular News Websites:
- Yahoo Finance
- Seeking Alpha
- The Street
- Brokers typically have a news feed as well
WHAT IS STOCK FLOAT?
A stock float is the number of shares that are available for the trading of a particular stock. The stock float is calculated by subtracting the number of restricted stock and closely-held shares from the number of total outstanding shares. Closely-held shares are shares that are held and owned by insiders, shareholders, and employees of the company. Restricted stock refers to insider shares that can’t be traded because of a temporary restriction such as the lock-up period after an IPO. More research on this topic should be done for full comprehension.
A company’s float is important to investors as it indicates how many shares are available to be purchased and sold by the general public.
Stock float can be classified into two: low-float stock and high-float stock.
Low float stocks indicate that the number of shares outstanding is low. Therefore, as an example, if a company has 90% institutional ownership, that leaves 10% of shares available to trade. This makes for big moves in price especially when combined with a news catalyst. However, as there aren’t many shares available, the downside is that it’s much harder to fill and get out of positions. As a result, market orders can be risky as you will most likely not get your desired fill price. This is where limit orders can come in handy.
A High-float stock, on the other hand, is a stock that has a high number of freely tradable stocks. Large companies such as Facebook usually have such kinds of stocks. Often, a company’s goodwill is measured based on the float. High-float stocks tend to be more predictable as the company’s colossal float can absorb any significant movements. Such floats could therefore be safer to trade.
VOLATILITY AND THE IMPORTANCE OF VOLUME
Stock volatility is the sudden decrease or increase in value experienced by a given stock within a given period of time. There is a relationship between the volume of a traded stock and its volatility. When a stock is bought in massive quantities, the stock’s price, or value, rises sharply. However, when the stock is sold in larger quantities immediately after, the stock value decreases sharply. This goes to show that volatility occurs when there is an imbalance in trade orders for a particular stock.
For instance, if the majority of orders for a trade order for a specific stock are all sell orders with little or no buy orders, then the stock’s value drastically falls because of the high sell pressure (which is an indication that no one wants the stock, whatever the reason may be). Therefore, the type of trading orders being received can strongly influence a stock’s volatility. Furthermore, if a company reports excellent earnings, there will be greater buy orders, and the stock will increase. However, if earnings reported are low, then the stock value will fall.
Company or industry news also tend to cause stock price volatility. Trading volume is essential as it acts as a warning as to whether a stock is on the verge of breaking into high volume or if it’s on the verge of a downside trend, which is why news, volatility, trading volumes, and the types of orders currently in place on the market are all used by advanced traders to maximize profits and reduce risks over the course of a trading day, week, or quarter.
PRE AND POST MARKET TRADING
For most novice stock traders, the stock market’s regular trading hours are between 9:30 a.m. and 4:00 p.m EST. What most beginners never realize is the fact that the stock market is also open for business before and after regular trading hours. These before and after trading hours constitute the pre-market and post-market trading hours. Unlike regular trading hours, pre and post-market trading hours have fewer traders, most of whom are likely professional traders. Therefore, trading volumes in these sessions are generally quite low.
With this in mind, we refer to pre-market trading as any transactions that take place before the conventional stock market operating timing of between 9:30 a.m. and 4:00 p.m EST. This usually happens from 4:00 a.m. to about 9:30 a.m. EST in the morning. Most times, the pre-market trading session sets the tone of the market’s movements for the day. On the other hand, post-market trading refers to any transactions that are completed after regular trading hours. Post-market trading, also referred to as after-hours trading or extended-hours trading, usually takes place between 4:00 p.m. and 8:00 p.m EST.
Pre and post-market trading provide several benefits to traders. For starters, many significant news events such as economic indicators and earnings are often released outside standard trading hours. Pre and post-hour trading sessions offer traders the opportunity and convenience of immediately executing trades based on new information now available in the market rather than waiting for the trading day to open again in order to take a position on a specific stock or portfolio.
Even with this advantage, before and after-hour trading sessions still carry a number of significant risks, such as:
- A high rate of volatility.
- Low trading volumes which make selling a tough call.
- It can be quite challenging to find a fair value for a stock.
- Since stock trading volumes are small, liquidity can be extremely thin in both sessions.