Stock market basics and what you need to start trading
Read this post later? Download the e-book!
Read this post later? Download the e-book!
Are you already trading with stocks?
If yes, or if you invest in an index fund regularly instead of buying and selling, then you might want to skip this article. But if you are curious what trading stocks is about, and what stock markets are, then this article is for you.
After years of trading stocks, I got used to the “market language” and I do not spend much time thinking about the basics. However, it took me a long time to learn all that stuff… and you might wonder, how come?
Thanks to the Internet, everybody can browse around and figure things out by themselves, right?
And yes, that is certainly true. 20 years back or so, the main problem was to find information. Today the problem is different…
Now there is so much information available that we need to filter and find the one that matches what we are looking for – and that can be a daunting task.
There are thousands of websites that churn out information at an ever-increasing rate. It’s overwhelming! That’s why I decided to write this article with the focus on two things:
1) Stock market basics, i.e. what are stocks, what are stock markets and how people make money by trading on the markets?
2) What a beginner needs to know to start with trading
Let’s dive right in!
Stock market basics
Let’s figure out what stocks are in the first place, and how they are made available to everybody who wants to buy them.
…basically, a piece of paper that after its purchase makes you a partial owner of the company that issued this stock.
It has a certain price and it gives its current owner certain rights (e.g. voting on whether the company CEO did a good job, etc.).
Here’s an example.
Creating stocks for investors
Imagine you have a friend who started a business.
It could be anything – a restaurant, a kiosk that sells newspapers, a software company, a cleaning services company, etc. He or she spent money, time and a lot of hard work to make this company a success.
And it’s a success – it’s growing fast and all earned money is put back into the company to make it grow even faster. More clients mean more products need to be manufactured and sold, or more people need to be hired and paid to do the work.
At some point your friend needs more money – either to grow the company or to retire ?.
He decides to sell part of his company by issuing stocks. He hires a finance expert to come up with a number – how much his company is worth today.
Let’s say the estimated company value is 10 million Dollars.
That’s a good feeling! After years of turning and reinvesting every penny, your friend now feels quite well off!
Your friend wants to sell 40% of his company (so he remains the majority shareholder), i.e. he wants to get 4 million Dollars from issuing stocks.
He creates 400,000 stocks and he offers them at $10 each. That’s the IPO – the “initial public offering”.
How money is made with stocks by investors
You believe in your friend’s business and you decide to buy 100 stocks for a total of $1,000.
Your friend sold all the issued stocks and uses the $4,000,000 to grow the company. Because of his business success, demand for the stocks is high and the price increases from $10 to $20 over the next 12 months.
At this point you decide to sell because you need money for other endeavors. You sell all of them and you get $2,000 from the sale, i.e. you gained $1,000.
That is a gain of 100%!
Not bad for one year return (and not working like a donkey)! Just compare that to a savings account… how much would you get after depositing $1,000 for a year?
So, one way (and the most common way) to make money with stocks is to buy them at a low price and sell them at a higher price.
Such gains are called “capital gains” because the value of the amount you invested increased.
Another way to make money with stocks is to buy them to earn dividends.
Dividends are payments that are made by the company to stock owners on a regular basis – like an interest payment of a savings account.
But there is no obligation for a company to do so. In fact, many companies that are growing do not make such payments. Instead, they prefer to re-invest the money into the business.
How to buy and sell stocks
Once stocks have been sold to the public, they are traded on stock exchanges, like the New York Stock Exchange, or the NASDAQ.
While everybody can buy and sell stocks, usually only stock brokers can trade at exchanges – so you would need to ask a broker to do the buying and selling for you (for a transaction fee).
You might have seen pictures of stock exchanges where brokers and traders are standing on the trading floor, frantically waving hands, shouting to make the next deal.
It’s not like that anymore. Nearly all trades are done electronically. In fact, approximately 90% of all trades are done by computer algorithms instead of humans!
For individual traders, online brokerages make the trades.
It’s straight forward:
- decide which stock you want to buy,
- create a buy order on your broker’s website (or app) and
- the stock will be purchased for you and kept in your stock portfolio until you sell it again.
How to get an online brokerage?
Signing up with an online brokerage is similar to opening a bank account.
You fill the forms (usually directly online), attached required documents, and once your application is approved you can transfer funds from your regular bank account to the broker account and start trading.
Bull and bear markets
You might have heard the term it’s a bull market. That’s one of those “market language” things ?.
A bull market is a time period where most stocks prices are trending up, i.e. most prices increase over time.
A bear market is the opposite of a bull market – it’s a time period where most stocks are declining in price.
In general, it is good to buy stocks during a bull market – with many stocks increasing in price over time, your odds of increasing the capital you invested are good.
But what to do in a bear market? It depends on your trading strategy.
If you are in it for the long run (say, 20 years or more), then you might continue to buy stocks and sit it out.
Once the bear market period is finished, a new bull market will eventually start. On average, bull markets are longer lasting than bear markets, so in the long run, the returns are positive. But it is very stressful to see the value of your portfolio decline over extended periods of time.
Another option is to sell your stocks and retain your capital in cash until the next bull market comes.
A third option is to short-sell stocks.
That’s a practice where you sell a stock that you do not own (you must borrow it for a fee) and then buy it back at a lower price.
It’s an advanced strategy that comes with additional risks, but it can help a lot with growing and/or protecting your capital during market declines.
Stock Market Indexes
You probably have heard about the Dow Jones, or the NASDAQ composite, or the S&P-500 index. These are market indexes. A market index is a mathematical construct that is used to represent the general market climate.
Let me explain:
- Pick 100 stocks of companies that are worth more than $500 million (you could use Google Finance to get such a list).
- Write down each stock price
- Sum up all 100 prices
- Divide the summed-up number by 100 (i.e. calculate the average price)
- Write down this number next to today’s date
- Repeat every day and mark each result on a Price-Date chart
And that’s it. You made your own market index!
You cannot buy a market index, as it is not a stock. It’s a collection of stock prices that are juggled together to track the market.
But you can buy mutual funds that track market performance. These are called index funds.
If market indexes are declining, then the market might be in a bear market period – and if they increase, it’s a bull market.
Trading and investing techniques
It is said that there are as many trading strategies as there are traders.
That should not be too surprising – we all have our opinion on what the future will bring, and our opinion differs from others to some degree.
But it is possible to categorize mainstream ideas about trading and investing. I am looking at two very different ways to trade and invest:
- Value Investing
- Technical Trading
Let’s look at each separately:
The value investor is someone who does research about a company’s business fundamentals and decides based on those if he should buy a stock or not.
Past earnings, future forecasts, revenues, costs, future potential, R&D spending, CEO and management team, etc. Based on the findings, he will determine if a stock is either undervalued or if it is at a fair price and has great future growth potential. In each case he might decide to buy stocks and hold onto them for a very long time.
The technical trader is someone who only looks at stock price history. In his opinion, all information that is worth knowing about a company is already reflected in its stock price.
If he uses a trend following strategy, he will look out for stocks that show a potential uptrend and buy them.
If the trend reverses, he will sell and look for new and better opportunities. There is no long-term commitment to a stock, only price trends.
There is no rule that says you need to choose between the two.
Myself I am a bit of both. Some stocks I buy because I believe in the future potential, maybe because of a disrupting new technology (think about 3-D printing, Artificial Intelligence, electrical cars), or because I think they sell something that will continue to grow the company for years to come.
For other stocks, I might decide purely based on price trends whether to buy or to sell. It really depends on your own ideas and your investment strategy.
Now let’s look into what you need to know to get started with trading!
What you need to get started
Trading stocks to grow your wealth is much easier today than it was 15 years ago.
In fact, thanks to recent web developments and disruptive brokerage start-ups, access to the world of trading is easy and, most importantly, cheaper than before.
What you need (in a nutshell) is:
- A trading strategy – i.e. a plan!
- Funds to invest
- A trustworthy and cheap online brokerage
Failing to plan is planning to fail – or so the saying goes. And it’s very true when dealing with investments (not just in the stock market but for any type of investment).
Luckily, I got you covered! In the next few sections, I will walk you through the parts of making a plan to succeed in the stock market.
Making an investment plan
My basic plan has four parts. There can be more, but these are the most important ones.
Decide on your strategy first
Your overall trading strategy should contain stuff like your financial goals, available funds, and general trading styles. Think about them and write them down.
That is the most important part to start with!
It will determine how much you want to put aside to invest, as well as how you will trade. Both are largely determined by your personal lifestyle.
If you have a job that takes most of your time, as well as other obligations (don’t forget to have fun and spend time with family!), then the time you can spend with trading will be limited.
That’s not a problem – you can adjust your trading style to your lifestyle. But first, it’s important to be aware of such limitations.
If you would choose a trading style that requires you to spend several hours in front of a screen, staring at flickering numbers and charts, while you have a family and a job to take care of also, then you will fail.
Instead, choose a trading style that matches your lifestyle.
With a trend following strategy, you can automate a lot when trading, minimizing time once your trading system is up and running. It can work with spending less than one hour per week.
Other trading types, like day trading, require much more time (at least several hours per day).
Another important part of your strategy is how much you are willing to invest, i.e. your available funds. I do not recommend starting stock trading with less than $10,000, and better with more than $25,000.
The main reason is trading fees.
While today’s fees are quite low, they will still eat away your capital – and the lower your capital, the stronger the effect of fees. I will write more about that in a later section.
How to select which stocks to buy
You will find endless ideas about the current “hot stocks” on the Internet. Everybody seems to have great knowledge about the future! 🙂
But here is the thing:
How high do you think is the financial risk for the person giving the tip-off?
Will a wrong forecast hurt him? Because suggesting buying a stock means that he or she is suggesting the price of that stock will increase in the future.
If there is no penalty for being wrong, then how much can you trust such forecast?
Do you know how often the forecast was correct? Can you find something like a “forecast result history”? Chances are… nope. Such thing does not exist.
Instead of listening to the endless business news and hot stock tips, use a stock selection system that has been used successfully for decades. There are plenty and the ones that work best are the ones that are the simplest.
One example is the breakout system. It works like this:
- Go through a list of your favorite stocks (your personal shortlist)
- Check for each stock if it has reached new price highs over the last 3 – 6 months
- If yes, mark it as a potential buy candidate
- If no, ignore it until your next review.
Here is how such stock price history might look like:
Once you decided which stock(s) to buy, creating the buy orders is easily done through your online broker.
Lesson 4 of my free stock trading course is all about how to select stocks.
Knowing when to sell a stock
Most beginner traders assume that choosing the right stock is the most important thing to be successful.
However, what good is investing in a great stock if you do not cash in at some point?
Many companies who once were great investment opportunities are today either bankrupt or are just a shadow of their former self (just think about Blackberry… or Nokia).
That’s why it is essential to decide when to sell and use these gains to invest in new opportunities.
A “knowing-when-to-sell-plan” is called the Exit Strategy.
There are many different ones, and it will depend on your trading strategy which one to choose.
- If you plan to hold on to a stock for a long time, your exit strategy could be “sell only if the price falls by 25% or more” (from its highest recent price).
- If you do not mind selling the stock at the first sign of a price decline, you might have the same strategy, but reduce your price decline tolerance to 10%.
Whatever your strategy will be, keep in mind the golden rule of stock traders:
Keep the winning trades and sell the losing trades.
One of the deadliest beginner mistakes is to sell a stock after a little gain and hold on to stocks that keep falling, assuming they will recover in the future.
Hope is not a strategy in trading!
The most important part of your trading strategy though is the part where you protect your capital.
This is called “risk management” or “money management”.
There are many ways to reduce risks when trading stocks. Many of them work just as well for any other investment.
You probably heard the age-old wisdom: “Don’t put all eggs in one basket”.
This risk reduction strategy is known as Diversification. When trading with stocks it is relatively easy to do; instead of using your entire capital for buying stocks from a single company, buy stocks from 10 or 20 different companies – just buy less from each.
Why does that work, and how does it protect your investment?
Let me explain by making an example based on an industry we all know a bit about… the movie industry.
Imagine… that we want to invest in upcoming movies.
We love going to the movies, but we know that some movies are better than others. Some make a lot of money (the blockbusters), while others, despite good critics, become box office flops.
If we would invest all our money in a single movie, it could either be a great deal, or a major disaster, or anything in between.
Sure, we could do some smart filtering, e.g. choosing a movie with a famous director or actor – that might increase our odds a bit, but is no guarantee for success. There are plenty of movies with famous actors that did not break even!
So, making a highly accurate forecast is not possible.
Instead, we diversify our investment. We choose 10 movies and spend 10% of our capital as an investment for each (the rest is financed by other investors).
We know that a few movies will become blockbusters, many movies will at least not lose money, and some will become the inevitable flops.
After the year is over, we check the results of our (10) investments:
From the 10 movies in which we invested, only 4 made more money than just breaking even.
The other 6 investments were essentially losses, with the worst one only returning 10% of what we invested (definitely a box office flop!).
And yet… when summing it all up, we grew our capital by 16%.
That does not sound like much considering that one investment, the blockbuster movie, returned four times the invested amount. But there was no way of knowing this beforehand.
Had we invested all our money in a single movie, it could as well have been the box office flop, leaving us with only 10% of our invested capital – essentially bankrupting us.
That’s the power of diversification.
There is much more to risk management than diversification – I cover this in detail in my Stock Trading 101 course.
Use a system approach
All the above parts of the investing plan are important – but it only works if applied consistently.
Stamina and patience are the hallmarks of successful traders. It helps a lot to build a system around your investment plan. My own system has two parts:
1) A set of written down rules
2) A set of spreadsheets that track what I am doing
And that’s it. No fancy software needed.
The trading rules are like written down goals, just more specific. Here are some examples of my own trading rules:
- Before buying a stock, decide what is the “bail-out” price, i.e. the price where I say, “that trade did not work out… better get out!” (this is called the “Stop Price”).
- After buying a stock, immediately create a sell order for the decided Stop Price.
- Never shift the Stop Price downwards.
- Don’t watch CNBC or other business news.
- Never risk more than 1% of total portfolio value per trade.
- Don’t trade if on an emotional rollercoaster.
- Don’t make more than 1 trade per day, and not more than 3 per week.
And there are much more. It’s a good practice to print them out and keep them in sight of your desk.
On the spreadsheets, I am keeping track of my trading. Which stocks to watch, which ones are currently in my portfolio and which ones I sold. Below is an example how such a spreadsheet could look like.
In my trading course, I explain in detail how to build your own trading system, including all spreadsheets and how to use them.
What to do about breaking your own rules
It’s easier said than done not to break your own rules.
In fact, it is extremely tempting to break your rules. Even after years of trading, I am still doing it, too.
More often than not, breaking trading rules is costly. It is rare that I break a rule and the outcome is that I make more money. But how to deal with it?
The important thing is to recognize that you broke a rule. Usually, we know when we break rules. So instead of not breaking the rule, do something else…
Document it. Write it down in your tracking sheets that you broke a rule, and which one. It’s just between you and your trades, nobody else will know about it.
Why is it so important to document it? It’s not about making you feel bad about it! It’s about improving your system. Let me explain:
When breaking a trading rule, there are 3 possible outcomes:
- You make more money. In that case, you should change your rules to adopt that new way of doing things.
- You lose more money. In that case, stop doing this unless you want to go bankrupt.
- Nothing happens. In that case, drop the rule because it seems to have no impact whatsoever.
Keep in mind that a single occurrence is not enough to establish if you should change or abandon a trading rule. But if you notice that after 10 – 20 trades there is a difference… then you might be onto something.
Funds for your investments
Apart from having a plan, you will also need funds to invest. That’s a big topic, but if asked to strip it down to essentials, I would suggest these two things:
First, it should be enough. How much is enough, and why does it matter?
Let’s start with the WHY. Two words: transaction costs.
If you buy and sell stocks from 50 companies over one year, you create 100 transactions (50 to buy and 50 to sell). If each transaction costs $5, then your yearly trading fees are $500. If you start with a capital of $5,000, then 10% of your capital is spent on transaction costs. Ouch!
With a long-term average market growth of 7%, that’s a sure-fire way to lose money.
If your trading fees take large chunks out of your capital then you need to change strategy.
You can either reduce costs (there are low-cost online brokers, I use one who charges me between $1 and $2 per transaction), or change strategy altogether.
Instead of trading stocks, buy and hold index funds.
The performance will be similar to what the market does (and it is rare to outperform the market), costs are low, and the number of transactions is low, too.
Second, don’t use funds that you depend on in your daily life.
Don’t use funds that you parked for your upcoming rent or mortgage payments, children’s education, etc.
The problem is not so much that you could lose them (the risk obviously exists), but it’s a psychological thing. Trading with such “reserved” funds causes tremendous stress and pressure – and trading when under emotional duress is always a bad idea.
To sum it up about funds: use at least $10,000 (and better more than $25,000) as funds when investing in stocks. Otherwise, consider making regular payments into a low-cost index fund.
Finding an online broker you can trust
There are many online brokerage firms available, and their fees and offers vary widely. My main criteria when looking for one are:
- Is it a trustworthy firm?
- Are the costs low?
Costs vary over a wide range, even after filtering out the dodgy ones. The reason is their added services. Many companies offer a trading software package “for free”.
But guess what… it’s not free – developing such software is costly and you pay for it through trading fees and sometimes other hidden costs.
The question is: do you need a complex trading software?
I used such software before, and I loved it. But it did not improve my trading performance (I figured that out later) and transaction costs were a killer…
So, my personal preference is to use a broker that executes transactions reliably and at low costs. I do not care about their trading software at all.
And there you have it… my wrap up of what you need to get started with trading.
If you want to give stock trading a try, or if you already trade and you like to improve your trading performance, have a look at my Stock Trading 101 course. It’s free and full of actionable, easy to implement tips and tricks to create your own, personalized trading system.
Browse by Topics
What to Invest In
Make the most out of investing by starting early.
Stock Trading 101
From Novice to Profitable Investor in 8 simple steps.
Reduce your Risks
Dramatically improve your trading performance with the Slash Formula.
Get this post as e-book:
Click on the image or button below to get the file.
This article has over 4,000 words. Download the e-book version to read it as PDF.
It includes two chapters:
- What stocks are
- How to get started with stock trading