The stock market can be a confusing place for the uninitiated. Financial news is often saturated with bemusing buzzwords; tales from the trading floor of treasury stock, stated value, and retained earnings often mean nothing to the average investor. But for those looking to trade stocks, understanding and applying such concepts is key to profiting from this asset class.
Done right, trading stocks can be an effective way of accumulating wealth, and a well-chosen, balanced stock portfolio could be a ticket to a stable passive income. Read on for a beginner’s guide to trading stocks, and we’ll help you turn the jargon into actionable knowledge.
Getting started in stock trading: Main talking points:
- What is the stock market and how does stock trading work?
- How does an investor make money trading stocks?
- What does it take to start trading stocks?
- How do you pick the right stocks to trade?
- Things to consider before trading stocks
What is the stock market and how does stock trading work?
Being a confident stock trader or investor involves getting to grips with the basics of the market and how stock trading works.
What is the stock market?
The stock market is where shares are bought and sold by individual and institutional investors. In the modern era, the process is conducted electronically through major stock indices such as the Nasdaq 100, FTSE 100 and DAX, each of which represent the performance of a basket of constituent stocks.
These stocks are tracked by the market index to come up with a value for the index based on weighted market capitalization methodology. This means that a large movement in the price of a single large stock can influence the index on which it is listed.
What are stocks?
Stocks are effectively the ownership certificates of a given company. They are issued by a business to raise capital for growth, and they fluctuate in price depending on the company’s performance. They can be listed on the stock market (public) or may only be available to private investors (OTC or over-the-counter stocks). Commonly traded stocks include Boeing, Xerox and Apple, the latter of which is traded on the Nasdaq 100, Dow Jones and the S&P 500.
Events such as product launches, a new CEO appointment, and earnings announcements are all instances that can move a stock’s price and influence your choice of stock. More of these factors are discussed in the ‘How do you pick the right stock’ section below.
Shares on the other hand refer to the proportional ownership of a stock in one particular company. For example, owning 50,000 shares of a company with 1 million outstanding shares would give an investor a 5% ownership stake.
How are stocks traded?
When it comes to approaching stocks, there is an important distinction to be made between trading and investing.
A trader makes money by speculating on securities over a shorter timeframe. Often, traders will focus on technical patterns using methods such as scalping and day trading, often using short-term timeframes such as ten-minute charts.
With online trading platforms traders can monitor the stock’s performance along with their entry and exit prices.
An investor can make money trading stocks essentially through purchasing the asset, often via a brokerage account, and holding it over a longer timeframe. During this period, (s)he may look to receive dividends and interest, as well as benefit from long-term increases in value, culminating in the sale of the stock(s).
This ‘buy and hold’ strategy may involve holding a stock for at least five years. Focusing on a ‘total return’ means that interest, dividends, distributions and capital gains are all taken into account when calculating the payout from a given stock.
How to begin trading stocks
The easiest way to start trading or investing in stocks is through a trading platform/online brokerage account, which can be set up simply with proof of ID and a choice of funding method. Finding a low-commission broker is important for more active traders as they will naturally pay more commission than those trading at a lower volume.
Investors should also decide whether to go for individual stocks or mutual funds. Individual stocks, as mentioned above, represent a share of the corporation, while mutual funds pool a range of stocks, with managed funds looking to outperform the market and exchange-traded funds or ETFs tracking an index.
Get started in stock trading: A Checklist
- Establish trading goals
- Choose the right broker
- Research key companies
- Keep a diversified portfolio
- Practice risk management
How do you pick the right stocks to trade?
When it comes to picking the right stocks, it’s worth going for companies you’re already familiar with, then consider factors which help to determine the chances of its price rising. These factors include:
- Financial health of the company: What does the company’s balance sheet look like? Have revenues and profits been increasing in recent years? How much debt does it have? Is it driving efficiencies?
- Innovation levels: What new products or expansion plans are in the pipeline? How does it stack up against rivals in terms of satisfying its customer base? Is it well placed to pivot and address new market demands?
- Dividends: If a company is paying a dividend, are they increasing it? How often is a dividend paid?
- Price and valuation: Is it undervalued? To get a better picture of this, you can go by a price-to-earnings ratio, or P/E. A P/E of 15 is considered ‘cheap’. However, it may be cheap because of slower growth. Try and identify the ‘cheap’ stocks that figure to be positive in as many of the above areas as possible. You can also assess the fair value of a company by calculating total assets on its balance sheet, minus depreciation and liabilities.
- Liquidity: Liquidity refers to the stocks that have sufficient trading volume to allow traders to enter and exit positions straightforwardly. Making sure you choose liquid stocks can ensure you enter and exit at the price you want. Examples of liquid stocks as of 2019 include ExxonMobil, General Electric and Alibaba. Read more on stock market liquidity for a detailed picture.
- Volatility: Volatility refers to the stocks with the highest potential for significant price movement. Choosing a volatile stock can be risky, but can also provide real opportunities. Read more on stock market volatility to discover how.
You also need to consider how the stocks fit within your portfolio of other assets such as forex and commodities. For example, you may want to go purely for strong capital gains with growth stocks, or add in greater security with dividend stocks or defensive stocks. This will depend on your wider investment/trading goals. For more on these types of stocks, see our FAQ section below.
4 Things to consider before trading stocks
Before getting started in stocks, you should have an idea of your goals, how much money they want to risk, an understanding of their trading style and how to diversify their portfolio.
1. What are my goals?
How long do you expect to tie up your cash? What are your plans for the money? Is there a chance you’ll need the funds before your investment has a chance to appreciate? For example, if you’re saving for retirement, investing in stocks may be a good choice as that’s a long game. But if you want to work up a deposit for next year’s house purchase, you might want to trade the stocks over the short term instead, or consider a different asset.
2. How much money do I want to risk?
Consider how much money you have to trade or invest. A prudent amount might be 5% of your annual earnings, but everyone is different. When it comes to risk, the more knowledge you acquire of industries and companies within them, the better prepared you’ll be for the inevitable market swings.
3. Can I keep my emotions at bay?
Managing your emotions when trading is of paramount importance. When trading stocks, you will be faced with a slew of market information over the course of your investment – much of it unhelpful. Can you filter out the rumors, speculation and noise, and avoid letting FOMO impact your stock trading decisions? Can you manage your emotions and stay true to your initial reasons for buying the stock? Also, you will naturally have stocks that don’t perform to your expectations. Can you deal with losses, and if you do need to exit your position, will you know when to do so?
4. Is my portfolio diversified?
A diversified portfolio might mean owning/trading stocks in a variety of companies, across numerous sectors, to protect against adverse events. You may also want to consider other assets such as bonds, forex and commodities.
Stock market basics FAQs
Why is the stock market important?
The stock market is important for businesses, individuals and economies. It allows businesses to raise money for growth and to spread their risk. It allows investors to potentially make returns on their capital and increase their wealth, and it allows the economy to benefit from domestic and international cash injections. The stock market is also a measure of economic performance; its trends can help people understand cycles, how businesses are doing, and make predictions for future policy. Stock market performance is also linked with that of pension funds and other assets.
Read more on the stock market and the economy.
What is the difference between a stock trader and an investor?
A stock trader will look to speculate on an asset over the short term, which may be as short as minutes, whereas an investor will be aiming for more of a ‘buy and hold’ strategy designed to see an appreciation of the stock’s value over several years, as well as take dividends.
Why choose stocks over bonds?
While stocks represent an ownership stake of a company, bonds are a type of loan issued by a company or government that pays investors interest on top of the debt. Bonds are considered less risky than stocks. However, naturally, they also generally return lower yields.
What are the main types of stock?
Three main types of stocks are growth stocks, dividend or yield stocks,and defensive stocks, each with different characteristics to understand.
- Growth stocks are shares bought purely for the goal of capital growth. Companies will reinvest profits rather than pay dividends, meaning investors’ only route to profit is through capital gains. This makes growth stocks inherently risky. However, while capital losses may be incurred, the payoff from stocks that are expected to grow fast can make this risk worthwhile.
- Dividend stocks, or yieldstocks, pay regular (usually quarterly) dividends to company shareholders. That means if a company pays an annualized dividend of 10 cents per share, it will pay a quarterly dividend of 2.5 cents a share.
- Defensive stocks will provide a constant dividend regardless of the state of the wider stock market. These will be companies with reliably high demand for their products and services no matter what the state of the economy; industries such as healthcare, consumer staples and utilities. This makes them ideal to trade during recessions, but may not be the best choice for general bull markets.
What are the best stocks for beginners?
The best stocks for beginners, as mentioned, will often be companies they know and understand, so it’s wise to research the stocks you are familiar with. Some of the most popular stocks are Facebook, Google parent company Alphabet, Amazon and Nike, which have all seen three-digit percentage five-year returns. For traders more interested in the short term though, the stocks are all liquid, meaning there is sufficient volume of buyers and sellers to ensure you enter or exit a position at the price you want and avoid slippage.
How many shares should a beginner buy?
The number of shares a beginner should buy is a common question, but it’s best to focus on total share value rather than the share count. Your money should be divided between stocks across a variety of companies for a diverse portfolio.
Further reading on stocks and global stock market indices
Understanding the stock market means grasping the fundamental factors that can move it. Read our guide to the stock market and interest rates, and explore a rich history of major financial bubbles and events that sent shockwaves through the financial world.