What is Stock Trading?

by Andrew McGuinness  //  jan. 22, 2018

A brief history of stock trading

In the 12th and 13th century there were some early attempts in trading debt and government securities, but the formal stock markets appeared five hundred years later. In 1600, the Dutch East India company was the first company to issue bonds and shares to the public. It was often traded on the Amsterdam Exchange.

The modern stock exchanges: London Stock Exchange and New York Stock Exchange, were formed in 1801 and 1817 respectively. The London exchange was the main stock market for Europe, while the NYSE for America and the world, and due to no competition in America, the NYSE was most influential at the time.

Today almost every country has their own stock exchanges. Stock markets are everywhere in the world and there is no doubt that stock trading is of great importance for the financial world.

After dominating the stock market for three centuries, NYSE got its true competitor in 1971 when Nasdaq exchange was created. Nasdaq was different from the other stock exchanges as it didn’t have a physical location, but a network of computers that executed all trades electronically. This gave Nasdaq an advantage over their competitors. In 2007 NYSE merged with Euronext and became NYSE Euronext – the first transatlantic stock exchange.

But stock trading didn’t go smooth throughout history. There were many market crashes that left individual investors and companies bankrupt.

These are the largest market crashes in the history of modern stock markets:

  • Black Thursday of 1929. This was the most devastating market crash in the history of the United States. It signaled the beginning of the Great Depression that affected the whole world.
  • Stock market crash of 1973-1974. This market crash followed the fall of the Bretton Woods system. It affected all major stock exchanges in the world, and most of all the United Kingdom.
  • Black Monday of 1987. The crash began in Hong Kong, but soon spread to U.S. and Europe.
  • Dot-com bubble of 2000. This was an economic bubble and a period of high speculation with the use of internet by business and consumers. During this time, many internet-based companies were found and many of them failed.
  • Stock market crash of 2008. The largest financial institutions in the U.S. were overexposed to the packaged sub-prime loans and credit default swaps, and this was the reason for the market crash, which turned into a global economic crisis.

What is a stock?

A stock is a type of security that represents ownership in a company, and entitles the owner to a share of the company’s profits. Firms issue shares of stock when they need financial capital, which is usually required for new investments. If the firm is publicly held, its stock is sold to the public.

The stocks can be:

  • Preferred stock. This is a special asset class that has preference in dividends and preference in assets (in case of liquidation). Preferred stock holders have no voting rights.
  • Common stock. This asset class dividend only after the preferred stockholders have been paid. Common stock holders may vote for the Board of Directors, and with that, exert control over managers.

In United Kingdom, Australia, and South Africa, a stock can refer to government bonds as well.

What is the difference between stocks and shares?

All shares form a stock, and the stock of a firm is partitioned into shares. They represent a fraction of ownership. A company may declare different classes of shares, with different value, privileges, or rules.

What are stock offerings?

When a company issues stocks to the public for the first time it is called Initial Public Offering (IPO); This turns the firm into a public company. IPOs are usually used to raise capital and to become a publicly-traded company. The downside of going public is the cost of the entire process (legal, accounting, and marketing), and the fact that certain information is disclosed to the public, which can benefit the competitors.

When a company that already has publicly-held stocks issues new shares it is called a Secondary Stock Offering. This second offering does not benefit the company in any way; these are usually privately held shares (by directors, or other insiders) who may want to diversify their portfolio. This new issue must be registered with the Securities and Exchange Commission (SEC).

Until 2009 the United States was the leading issuer of IPOs, but since then, China has become the largest issuer in terms of total value.

What are stock derivatives?

Any financial derivative that has value dependent on the price of a particular stock is called a stock derivative. The main derivatives on stocks are futures and options. The stock options are the most popular, but also the riskiest stock derivatives.

What is a stock exchange?

A stock exchange is the place where the organizations and individuals trade stocks, bonds, or other securities. The exchange acts as an intermediary, which simplifies the clearing and settlement of trades. They can also provide payment of income and dividends. The exchanges establish rules and procedures for safe and fair method of determining stock prices and provide a medium for trading stocks.

For someone to trade a certain stock on a stock exchange, the stock has to be listed there in the first place. However, there is no obligation for a stock to be traded on an exchange or to be listed there. Also, only brokers who are members of an exchange can trade there.

Today’s markets use electronic networks, which give advantage to traders in speed and reduced cost of transactions, and everyone with an internet connection and a computer can trade through a broker on a stock exchange.

The roles of a stock exchange are:

  • Raising capital. Through public offerings, limited partnerships, venture capitals, firms raise funds for new investments.
  • Company growth. This can be achieved through acquisitions, acquiring assets, or even merger with other companies.
  • Sharing profit. Stock exchanges sometimes provide dividend payments to shareholders.
  • Government capital rising. This is achieved through selling bonds by the government to private entities, mostly banks.
  • Economy barometer. Through the price of stocks, the entire health of the economy can be observed (whether it be depression or expansion).

Popular stock exchanges

Each exchange competes with the others for business. They all have specific listing requirements, like market cap, sales, and so on. If a company meets the listing requirements, but later does not, it can be de-listed. Once listed, a company is assigned a trading symbol, called a ticker symbol; these symbols can be three letters for shares traded on NYSE, or four to five for those traded on Nasdaq.

The ten largest stock exchanges by market capitalization in 2017 are:

Name

Market Cap

Number of listed companies

New York Stock Exchange (NYSE)

$19,923 billion

2400

NASDAQ

$6831 billion

3058

London Stock Exchange

$6817 billion

3041

Tokyo Stock Exchange

$4485 billion

2292

Shanghai Stock Exchange

$3986 billion

1041

Hong Kong Stock Exchange

$3325 billion

1866

Euronext

$3321 billion

1299

Toronto Stock Exchange

$2781 billion

1524

Shenzhen Stock Exchange

$2285 billion

1420

Frankfurt Stock Exchange

$1766 billion

3769

What is a stock index?

A stock market index is a measurement of value of a section of the stock market, based on the prices of selected stocks (a weighted average). Its use is mostly for describing the market by investors and managers, and to compare returns on specific investment.

There are many types of indexes (also called indices). Some are classified as world indexes, others as national, then regional, and specialized, which track performance in specific sectors of the market.

Popular stock indexes are:

  • Dow Jones Industrial Average
  • Standard and Poor’s 500
  • NASDAQ 100
  • Russell 3000

Many mutual funds and exchange-traded funds (ETFs) attempt to track the index. Index funds own a group of stocks that make up a portfolio.

What is a stockbroker?

A firm that executes buy and sell orders by individuals or organizations through a stock exchange for a fee is called a stockbroker or a brokerage firm.

In the past, owning stocks was meant for the wealthiest people at the time. But now, with the access to internet and online brokerage firms, everyone can own a share of a listed company on a stock exchange.

At the beginning of the 20th century, stockbrokers emerged as intermediaries between investment bankers and the public. Brokers studied companies and their financial health, monitored the price at the comfort of their offices, and basically served as financial advisors. Eventually, as technology progressed, brokerage firms expanded, and stock trading was simplified.

Today, there are four types of stockbrokers:

  • Full-service brokers. They offer stocks, mutual funds, bonds, options, and futures trading, they give investment advice, retirement plans, tax tips, and more. That is why this type of brokers have the highest commissions and fees. They are also known as wire houses. These are the largest and most influential entities on Wall Street (firms like Merrill Lynch, Morgan Stanley, Goldman Sachs).
  • Discount brokers. They offer stocks, mutual funds, bonds, options, and futures trading, and give almost no investment advice. Basically, they just execute trading orders. That is why they have lower commission and fees compared to full-service brokers. Many experienced traders choose to do their own research, so discount brokers are a good choice for them.
  • Deep-discount brokers. They offer stocks, bonds, options, and futures trading, with no investment advice. This type of broker has even lower commissions than discount brokers.
  • Online brokers. They offer stocks, bonds, options, and futures trading, with no investment advice, but they have enough files to educate the trader. Many online brokers, which target the small individual investors, are deep-discount brokers.

How to start trading stocks?

To begin trading on the stock market, a trader would need to open an account with a brokerage company.

These are some of the best online brokers to trade on the U.S. market:

Every one of these brokers have their own proprietary trading platforms and offer their own research.

What is the difference between cash trading and margin trading?

Today, most brokers offer margin accounts. This means that the broker borrows money to the trader and gives them more leverage to buy more stocks than the trader could afford with their own money in the account. For the trader to borrow money, they need to have a margin, or a deposit, used as a collateral in case of losses. However, the trader is not obliged to trade on margin. Instead, they can pay in full for the purchased stocks.

How to buy and sell stocks?

The goal of buying stocks is to profit with the increase in price of the particular stock. This is also called going long. Buying stocks has limited risk as the price of a stock cannot go below zero.

Selling stocks comes in two forms: if the trader already owns the stock and wants to sell it; and the second form is shorting the stock. The goal here is to profit from the drop in price of the stock. The process of shorting stocks goes like this: the trader believes that a certain company (XYZ) is doing poor and that their stock price will start to drop (let us say, from current price of $10); The trader borrows 1000 stocks from the broker at the price $10,000 and sells them on the market. All they have to do now is wait for the price to drop; The price has now reached $8 per share. Let us say that the real owner of those 1000 stock has had enough losses and wants to sell their XYZ shares at the current price of $8. The broker notifies the trader that they have to return the 1000 shares, so the trader buys 1000 shares from the market for $8,000 and returns them to the broker and profits the difference between $10,000 when they sold the stock on the market and $8,000 when they purchased the stock. The losses in shorting can occur only if the price goes up. The risk in shorting stocks is unlimited, as the price can rise indefinitely.

Types of orders

Since the stock market is less liquid than the currency market, and the orders executed are referring to a specific number of shares, there are a number of order types that give exact trading directions. Those are:

  • Stop orders. When the market reaches a certain price, the trade is executed. These can be buy stop and sell stop orders.
  • Limit orders. This gives a specific maximum buying or minimum selling price. They can be limit buy or limit sell orders.
  • Market orders. These are most common, executed at the current price. They can be buy and sell orders.
  • Good till canceled orders. This type of order remains until executed or canceled by the trader. They are usually placed further from the price.
  • Day orders. They must be executed during the day or get canceled at market close.
  • Immediate or cancel orders. These have to be executed in whole or part as soon as opened. The parts that don’t get executed are canceled.

What is technical analysis in stock trading?

Technical analysis uses historical price in attempt to forecast future price with the use of technical studies, price charts, indicators, and other tools. It is based on the theory that market prices exhibit repetitive patterns that can be tracked and then recognized before they are repeated. Technical analysis in stocks is basically the same as with other financial instruments.

What is fundamental analysis in stock trading?

In stock trading, fundamental analysis refers to the research that uses economic and production data to determine a company’s value. For this purpose, the trader uses information such as: balance sheets, income statements, earnings reports, assets, products and services.

What is value investing?

Value investing is a trading strategy where investors are more interested in a certain company and their tangible assets. They are constantly on the lookout for undervalued companies and value stocks.

To select a value stock, they look at the company’s balance sheet, subtract liabilities from asset, and then they compare the result to the current market price. This doesn’t mean that the stock has to be cheapest to be a value stock, but rather something that other investors have failed to see.

What are dividends?

A dividend is quarterly payout that some companies make to their shareholders. However, the company does not guarantee this payment; eventually, they may decide to stop paying out.

Many traders often overlook dividends in their decision making. They usually think of it as a small dollar amount that is not important. The dividend yield is a good means for comparison between companies in the same industry. For example, two companies have similar fundamental value, but one of them pays 2 percent yield, while the other 4 percent. This makes choosing a company easier.

Largest public companies

Of all the thousands of listed companies on the stock exchanges worldwide, these are the largest ten based on market capitalization by the third quarter of 2017:

Name of the company

Ticker symbol

Market capitalization

Country

Apple Inc.

AAPL

$791,700 million

United States

Alphabet Inc. (Google)

GOOGL

$664,550 million

United States

Microsoft

MSFT

$568,965 million

United States

Amazon.com

AMZN

$459,435 million

United States

Berkshire Hathaway

BRK.A

$451,840 million

United States

Alibaba Group

BABA

$436,850 million

China

Tencent

TCEHY

$405,000 million

China

Facebook

FB

$399,946 million

United States

ExxonMobil

XOM

$348,248 million

United States

Johnson & Johnson

JNJ

$347,497 million

United States

Advantages of trading stocks vs currencies

Some traders prefer stocks to currencies as they have the following advantages:

  • Ownership. The trader actually owns a share of a certain company.
  • Dividend yield. Based on shares owned, the trader receives a good revenue stream.
  • Large number of companies to choose from. The trader can pick the best-performing companies to trade.
  • Diversification. The trader can move their funds based on current economic conditions either for safety or higher-profit.
  • Low risk of fraud. Unlike forex brokers, where a number of them are unregulated, the online stock brokerages that offer trading in the U.S. are regulated by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA).
  • Historically, they have offered the best returns over time. Stock trading may not offer high return every month, but in the long run they have proved to be a solid investment.
  • Limited risk. If a trader owns a stock they can only lose the money invested in it. In forex, there is no limit to how far a currency price can go.

What are the risks of trading stocks?

Risk in trading comes in many forms. In stock trading it can be:

  • Inflation risk. This type of risk affects all investments, not just stocks. For stock investments to be viable, the rate of return has to be higher than the rate of inflation.
  • Market risk. This type of risk refers to the constant market changes in the price of stocks.
  • Opportunity risk. This is the risk that makes a trader miss on better opportunity than their current investment.
  • Loss of money. Stock prices can change and if a trader uses higher leverage, it can result in losses.
  • Liquidity risk. If a stock price drops, there may be no one to sell to.
  • Business risk. Difficulties that a company faces will affect their stock price.

Conclusion

Historically, stocks have outperformed every other investment in the long run. This makes stock trading one of the best and highly-lucrative trading ventures that many people choose to opt in. Unlike other financial derivatives where traders make bets on something intangible, in the stock market, the trader actually owns a piece of the company, and sometimes even receives dividends for it. This is a good option for value and long-term investing strategies, although day traders participate in this market as well. However, for a trader to be profitable in stock trading they first have to develop a decent risk tolerance and then educate themselves in technical and fundamental analysis.





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