fbpx

How Do the Stocks Work? Your Guide to Stock Market Basics

I f you aren’t experienced in investing, you might be asking, ‘how do the stocks work?’ As a beginner, you can start with this guide to understand what exactly stocks are and how to buy and sell them on the public stock market. We’ll also explore why stocks are such an important component of meeting financial goals like saving for retirement.

Key Takeaways:

  • Purchasing stock gives you a share of a company’s profits but also its losses.
  • When you invest in stock, you can take advantage of interest and dividends, profit from price increases, and even enjoy voting rights.
  • You can buy stock through an online stockbroker exchange, but review the associated fees before joining a trading platform.
  • Holding stock shares for at least five years increases the likelihood that you will receive a generous return on your investment.
  • You have to pay taxes on stock market profits but can offset the taxes by deducting capital losses.
  • You can also invest in the stock market through your 401(k) or individual retirement account, buy stocks directly from a company, or invest in your company’s employee stock program.

What Are Stocks?

When you buy a stock, you are actually buying a share in a company. As the company earns profits, the value of your stock increases. If you own a stock that pays dividends, you will also receive a portion of the company’s profits through either cash dividends or share repurchases. Reinvesting your stock market earnings allows you to build compound interest, which facilitates the exponential growth of your initial investment.

A company ‘goes public,’ or decides to issue shares of its stock for sale on public stock exchanges, to raise money for expansion and new initiatives. Most companies issue two main types of stocks: common stock and preferred stock. Common stock provides shareholders with voting rights, while preferred stockholders have voting rights as well as preferential treatment for dividends and in the event of a liquidation.

Stock markets originated in 16th-century Europe, popping up in trading cities like London, Amsterdam, and Antwerp. However, these stocks were more similar to bonds than modern stock since they did not offer equity. The concept moved to America when the Philadelphia Stock Exchange opened in 1790, followed by the New York Stock Exchange in 1792.

In the United States, stock exchanges must meet the ethical guidelines of regulatory organizations. These include the Financial Industry Regulatory Authority (FINRA) and the National Association of Securities Dealers (NASD).

Stock Classifications

The most common ways to categorize stock are by sector and market capitalization. The Global Industry Classification Standard is used to classify stocks by 11 industry sectors:

  • Materials.
  • Energy.
  • Industrials.
  • Consumer staples.
  • Consumer discretionary.
  • Information technology.
  • Financials.
  • Health care.
  • Communication services.
  • Real estate.
  • Utilities.

Market cap, or market capitalization, is the number of a company’s outstanding stock shares multiplied by the current trading price of a single share. Companies with a market cap of at least $10 billion are considered large-cap stocks. Medium-cap stocks have a market cap of $2 billion to $10 billion, while small-cap companies have a market cap of at least $300 million but less than $2 billion.

Benefits of Investing in Stock

Some of the advantages of investing in the stock market include:

  • Shareholder voting rights for the companies in which you own stock shares.
  • The ability to sell stock for a profit if it rises in price.
  • The right to receive periodic shareholder payments called dividends that some companies offer.
  • An average return on investment of 10%, adjusted to about 7% or 8% after considering inflation.

Drawbacks of Investing in Stock

While it’s great to own stock in a growing company to profit from that growth, remember that you also share a company’s losses if the stock price declines. This will result in a decline in the overall value of your stock portfolio. Because stock prices change all the time for plenty of different reasons, investing in the stock market carries inherent risk.

The Process of Trading Stock

Image via Flickr by David Blaikie

Most investors trade stock on a brokerage firm’s online trading platform. Here, you buy shares from another investor instead of directly from the company. You can also sell stock to other investors seeking shares on the platform, which links directly to the major stock exchanges, like Nasdaq and the New York Stock Exchange in the United States.

To become eligible to trade, you have to open an account with the brokerage firm. Typically, you can transfer money from your bank account to your brokerage account when you’re ready to purchase stock.

When you buy a stock, you offer a bid. This expresses the highest amount you’re willing to pay per share. The seller, in turn, responds with an ask, which is usually higher. The buyer and seller must bridge this so-called bid-ask spread to make a deal — meaning the seller goes down in price or the buyer comes up.

Most online broker platforms have resources and tools that can help you make smart trades. These often include a company’s financial details, performance history, and other types of analysis. If you’re looking to buy stock from a specific company, you can look up its ticker symbol to find it on the trading platform.

When you make a stock trade, you must also pay a commission to your broker as well as a transaction fee. When choosing an online broker, review the fees carefully to ensure that you aren’t overpaying for your trades or for specialized tools you don’t need.

Throughout the trading day, stocks change in price based on supply and demand. If only a few people want to buy certain shares, they drop in price. If traders are clamoring for shares in another company, the price of those shares goes up as demand exceeds supply.

Holding stocks for years or even decades helps mitigate the risk associated with the stock market. Usually, despite the market’s regular price fluctuations, portfolio values rise over time. You can also decrease risk by diversifying your portfolio, which means holding various types of stock shares and financial assets with different risk levels from various economic sectors.

To track the activity of the stock market or a specific asset, traders review the activity of a market index. These indexes — most notably the Standard and Poor 500 or the Dow Jones Industrial Average — consist of a selection of companies used to represent the stock market as a whole.

Tax Considerations

If you sold stock this year, you have to pay taxes on the profit. If you had the shares for at least a year before selling them, the profit is subject to federal long-term capital gains tax on a sliding scale of 0% to 20% based on your income (usually 15%). If you sell shares that you have owned for less than a year, your regular tax rate applies. Dividends are also taxed.

Don’t forget to deduct the expenses you incurred while selling the stock, such as fees and commissions. You can also deduct losses you suffer in the stock market from your capital gains, including up to $3,000 from your income if your losses exceed your gains.

Other Ways To Buy Stock

B esides buying stock from a broker, you can invest in the stock market in a few other ways. You might already own stock if you contribute to your company’s 401(k) or another retirement plan. These plans often include mutual funds, which contain a selection of stocks, bonds, and assets.

If you want to invest in a specific company, you can check if they allow you to buy shares from them directly. This may or may not be a better deal than buying the shares through a broker, so be sure to read the details carefully before you decide what to do.

Additionally, your employer might offer stock options or even let you negotiate stock as part of your salary. Again, review the details to make sure you can’t get a better deal on shares through your own broker.

Another alternative to the traditional stock market is over-the-counter bulletin boards (OTCBB), which are less regulated than traditional stock exchanges. As a result, they carry a much higher level of risk. Companies that do not meet the criteria to qualify for the NYSE or Nasdaq often trade on these smaller OTCBB exchanges, so they do not need to prove their value or profitability to shareholders.

While investing in stocks can seem overwhelming at first, most traders manage to avoid risk by holding shares over time. Attempting to make quick profits, on the other hand, may result in significant financial loss. In general, it’s important to do your research and fully understand the market before you start investing in stocks.

Author: Jason Bond

Jason taught himself to trade while working as a full-time gym teacher; his trading profits grew eventually allowed him to free himself of over $250,000 in student loans!

Now a multimillionaire and a highly skilled trader and trading coach, Over 30,000 people credit Jason with teaching them how to trade and find profitable trades. Jason specializes in both swing trades and in selling options using spread trades, which balance the risk of selling options. Jason is Co-Founder of RagingBull.com and the RagingBull.com Foundation which donates trading profits to charity. So far the foundation donated over $600,000 to charity.

How to Trade Stocks Online in 7 Easy Steps

I nterested in investing in the stock market? Online trading has made the market more accessible than ever, making it a great way to get started. It’s relatively easy, transactions are fast, and you can make trades and monitor your investments from the convenience of your home.

Don’t jump into the market blindly, however. Do your research so you can be an educated investor. Follow these steps to learn how to trade stocks online:

  1. Choose a broker.
  2. Open an account.
  3. Research stocks.
  4. Choose a trade order.
  5. Practice paper trading.
  6. Make your first trade.
  7. Set a strategy you can stick to.

1. Research and Choose a Broker

Image via Flickr by ota_photos

Online brokers act as the medium between those buying and selling stocks. They typically charge a small fee or commission to make your trades and manage your funds.

The internet is home to a wide range of online brokers that cater to different types of investors and trading styles. If you’re new to online trading, you’ll want to find a brokerage that’s easy to use and has the resources to guide your investment decisions. Look for an online broker that does the following:

  • Maintains a reputable name. To avoid scammers, stick to trading platforms with established names and reputations, such as TD Ameritrade or Merrill Edge.
  • Has good customer support and educational resources.
  • Has an easy-to-use interface for your trading method of choice (e.g., app or website).
  • Fits your budget. Some brokers require a minimum account balance or amount of money to start an account. In addition, take into consideration the broker’s fee structure based on how you plan to use your account.
  • Has good cybersecurity measures in place to protect your financial information.

Online brokers offer many other services ranging from live broker advice to complex investments. Take your time researching online brokers so you can select one with the best tools and format for your budget and needs.

2. Open an Account

Once you decide on an online broker, it’s time to open an account. To do so, you must answer a list of personal and financial questions for tax purposes and to prove that you can afford to invest your money. You’ll need to provide information such as your contact information, employment status, income, government-issued ID, and Social Security number. Then, you will need to decide what type of account you want to open:

  • Cash Account: A cash account functions like a checking account. The amount of money you have in your cash account dictates how much you invest at any given time. You must have enough funds to buy the stock you want in its entirely.
  • Margin Account: A margin account is more like a loan. You can borrow money from the brokerage to fund your stock purchase but will need to pay interest on that borrowed money, and your existing stock (securities) serves as collateral. While riskier than a cash account, a margin account gives you greater investing power.

The last step before you can officially open your account is to deposit money into it, which you can do via check, wire transfer, or holdings transfer.

3. Research Stocks

Thousands of stocks exist in the U.S. and international markets. Choosing which ones to invest in can be intimidating, but your brokerage should provide plenty of resources to help. Look for company analyses, earnings and SEC reports, financial filings, risk ratings, and recent news. Read reports and recommendations from proven experts. Then, to get started, select just one or two that you’d like to invest in.

When first learning how to trade stocks online, you might feel more comfortable buying exchange-traded funds (ETFs). An ETF is a group of securities rather than an individual stock. They’re often less risky and can allow you to invest in and understand an entire industry or index.

4. Choose a Trade Order

You can place different types of trade orders, depending on your investing style, when buying and selling stocks online. The most basic and common types are:

  • Market Orders: These allow you to buy a stock immediately at the current market price, which fluctuates constantly.
  • Limit Orders: These allow you to set the price you want to buy the stock at, and the transaction only occurs if the stock reaches that figure or lower.

Once you’ve mastered how to trade stocks online using these simple orders, you can branch out into more complex strategies, including stop-loss, stop-limit, all or none, immediate or cancel, fill or kill, good ’til canceled, day, take profit, margins, and more.

5. Practice Paper Trading

If you want to get a feel for online trading without risking any money, start by paper, or virtual, trading. Many online brokers have a stock market simulator that allows its account holders to make trades using different strategies based on a theoretical market environment.

Paper trading allows you to familiarize yourself not only with trades and market trends but also with the platform and software you’ll be using to make actual trades. Experiment with trade types and buying decisions, learn what works and what doesn’t, and hone your investing style and strategy. Once you feel confident enough to play with real money, start trading online.

6. Make Your First Trade

You can begin trading stocks online as soon as the funds are in your account. Note that you might see a delay while the transfer processes before the money lands in the account. Then, select the stock you want to buy, get a real-time stock quote to confirm its current price (often available through your online brokerage), choose a trade order type, and place it. The process on your chosen trading platform might look like this:

  • Click the ‘Trade’ button.
  • Select which action you want to take: ‘Buy.’
  • Indicate the number of shares you want to buy.
  • Set the price you’re willing to pay per share.
  • Select your order type (market, limit, etc.).
  • Set a time frame for that order. You can indicate whether you want the order to remain active until the end of the day, a certain date, or indefinitely until you cancel it.
  • Preview your order for accuracy and to determine its final cost.
  • Place the order.

At this point, the broker will try to purchase your chosen stock at your given price within that time frame. If you choose a market order, it should execute immediately (though it might still take time to find a seller and process the trade). If you choose a limit order, it won’t execute until the stock reaches your asking price. Remember that the U.S. stock market trades from 9:30 a.m. to 4 p.m., so while you can place orders all day and night, they only execute during market hours.

If and when your trade goes through, you’ll officially become stock owner.

7. Have a Strategy and Stick to It

O nline trading can be a rollercoaster of excitement and emotions. To avoid getting caught up in the action and potentially make hasty and costly investment decisions, have a strategy ahead of time. Set personal limits as to how much you will invest and at what price. Decide how far you’ll let a stock’s value fall before you sell it. After all, a timely exit can prevent major losses. Take advantage of trade orders that will help you stick to your strategy. Stop-loss orders, for instance, will automatically sell your stock if it drops to a price you’ve set.

If you want to be a savvy and successful online trader, research and follow the market regularly. Take advantage of your online brokerage’s resources, read financial articles and books, follow news sites, sign up for tutorials and workshops, and find a mentor with market knowledge.

Read charts, keep tabs on stock price fluctuations, and build an online trading strategy based on your observations and research. Try your strategy out with paper trading first, which will allow you to assess your results and make adjustments before risking your own money. Once you’ve got a solid handle on how to trade stocks online, you can diversify and build a robust portfolio.

Author: Jason Bond

Jason taught himself to trade while working as a full-time gym teacher; his trading profits grew eventually allowed him to free himself of over $250,000 in student loans!

Now a multimillionaire and a highly skilled trader and trading coach, Over 30,000 people credit Jason with teaching them how to trade and find profitable trades. Jason specializes in both swing trades and in selling options using spread trades, which balance the risk of selling options. Jason is Co-Founder of RagingBull.com and the RagingBull.com Foundation which donates trading profits to charity. So far the foundation donated over $600,000 to charity.

Bear Put Spreads: Everything You Should Know

A s you delve further into stock market investing, you’ll find that you run into new lingo all the time. Many of these phrases, such as bear put spread, describe specific investment strategies and techniques that you may be able to incorporate into your trading strategy. Today, we’ll take a deep dive into bear put spreads and how you can use this method to potentially increase your trading profits.

Key Takeaways

  • Bear put spreads are trading strategies designed to take advantage of the slow decline in the price of a stock or asset.
  • A bear put spread consists of one long put, or option, with one short put. These put options have different strike prices but the same expiration date and underlying asset.
  • Bear put spreads limit the investor’s maximum profit as well as his or her maximum risk.
  • A bearish market on a general decline provides the best environment for a bear put spread.
  • Time decay, volatility, and changes in the underlying stock price all affect the outcome of bear put spreads.
  • The advantages of bear put spreads include the chance to increase potential profits and reduce costs while minimizing risk.
  • Bear put spreads can result in a significant loss if you fall victim to early assignment without a plan to exit your position.
  • Understanding the indicators of a bear market will allow you to put a bear put spread strategy into action.

What Are Bear Put Spreads?

Image via Flickr by investmentzen

With a bear put spread, the investor identifies an asset with a slow, steady price decrease and tries to profit from that decline. The term ‘put’ refers to a put option. With this technique, you pay a premium price to reserve the option to sell a certain stock at a certain price (the strike price) before a certain date. As a stock price drops, the put option grows in value. ‘Spread’ refers to the difference between an asset’s lowest asking price and its highest bid price.

You may also hear a bear put spread called a debit put spread or a long put spread.

When you place a bear put spread, you make one short put and then one long put for the same underlying stock or asset and the same expiration date. The long put should have a higher strike price than the strike price you set for the short put. This type of spread is called a vertical spread.

Let’s look at an example. You think XYZ stock will decline in the coming days and weeks. The current share price is $66. You buy a $50 put option for $2 and sell a $60 put option for $4. To break even, you need XYZ stock to fall below $58 per share. The further the stock price falls, the larger your profit on this put spread.

Calculating Maximum Profit

To find the maximum possible profit from bear put spreads, subtract the lower strike price from the higher strike price, then subtract commissions and other costs of the spread. For example, if you have a put option with a $200 strike price and one with a $175 strike price, the maximum profit is $25 per share minus commissions and fees. You would receive the maximum profit from a bear put spread when the stock’s value is equal to or lower than the short put when the option expires.

Understanding Maximum Risk

With bear put spreads, you can only lose the premium cost of the spread, plus associated fees and commissions. This occurs if you hold the option until it expires and the stock price exceeds the strike price of the long put at that time, which renders both puts valueless.

Using Bear Put Spreads

This type of strategy works best in a generally bearish market. The atmosphere to profit from a bear put spread is best when the value of the underlying asset is declining as the option closes in on its expiration date.

When you establish a bear put spread for an asset, you set yourself up for one of three potential outcomes when it expires:

  • If the value of the stock falls below the lower strike price, assign the short put and exercise the long put.
  • If the value of the stock falls between the two strike prices, create a short position and exercise the long put.
  • If the value of the stock rises above the higher strike price, the option expires without value.

Factors That Influence Bear Put Spreads

Investors using these spreads should be aware of these factors that can impact their value.

Stock Price Chance

The price of a bear put spread goes up as the underlying stock goes down and rises when the price of the underlying stock falls. Traders call this concept net negative delta, where delta describes the inverse relationship between the option price and the stock price. This relationship is usually roughly proportional.

Volatility

This concept measures the amount an asset’s price fluctuates as a percentage. Assets with higher volatility tend to have higher option prices. However, the design of a bear put spread shields the deal against the impact of volatility. This type of minimal impact is known as near-zero vega in the trading world.

Time Decay

As the expiration date of an option approaches, its time value may decrease. Investors call this concept time decay or erosion. The impact of time decay on bear put spreads varies based on the difference between the strike prices and the stock price:

  • When the stock price approaches or exceeds the long put price, the option value decreases as expiration approaches as follows.
  • When the stock price approaches or drops below the short put price, the option value increases as expiration approaches.
  • Time decay is negligible when the stock price falls between the short put and long put prices.

Advantages of Bear Put Spreads

With bear put spreads, you spend less than you would to purchase only the higher strike put while increasing your chances of a higher profit percentage. This reduces your overall risk level. You can also reduce your costs if you sell the lower put. Traders can access the potential profit of short-selling a stock without the nearly unlimited possible loss associated with that strategy.

Disadvantages of Bear Put Spreads

As with any option, the person who purchases the option can be obligated to fulfill it if an early assignment occurs. This risk prevails when the underlying stock or financial asset is subject to major news, such as a dividend issue, acquisition, or merger. U.S. traders who buy an option can exercise it on any business day, requiring the option holder to immediately fulfill the obligation without the ability to control timing. You must be able to tolerate this risk to experiment with bear put spreads and other short options.

Usually, only the short put in a bear put spread carries a risk of early assignment. This may occur with a put that’s in the money with a time value below its dividend value. If this red flag occurs, you can either keep the long put open and close the short put or sell the long put and buy the short put to get out of the position unscathed.

When a short put is assigned early, you must buy the stock and either exercise your long put or resell the stock on the market. However, this could result in additional commissions and fees. An early assignment could also trigger a margin call, which means the value of your brokerage account falls below the required minimum.

Understanding bear put spreads can help you diversify your portfolio and hedge against risk. Now that you have the basics, keep an eye out for a bearish environment that’s right for this type of strategy.

Author: Jason Bond

Jason taught himself to trade while working as a full-time gym teacher; his trading profits grew eventually allowed him to free himself of over $250,000 in student loans!

Now a multimillionaire and a highly skilled trader and trading coach, Over 30,000 people credit Jason with teaching them how to trade and find profitable trades. Jason specializes in both swing trades and in selling options using spread trades, which balance the risk of selling options. Jason is Co-Founder of RagingBull.com and the RagingBull.com Foundation which donates trading profits to charity. So far the foundation donated over $600,000 to charity.