It is possible that you already have a decent grasp with stock market basics, in which case you might be able to skip this section and move on to the next.

Keep in mind, however, that even if you are a seasoned pro, there could still be some fundamental principles that could use some brushing up. Worse yet, you could be a victim of the "everybody knows" syndrome (this is when no one ever explains a common term because it is assumed that "everybody knows" what it means, and the term remains undefined). The point is that it may be beneficial to study the present section, even if you are a veteran.

All About Stock Trading

The concept of investing in a business venture is as old as business itself. In the purest scenario, an investor supplies the capital needed by a business concern, and in return, the business concern grants the investor an ownership stake in the business, or shares. The total number of shares that a company will issue is essentially arbitrary (it can be any number that the people who are forming the company have agreed upon), as well as the price each share is worth (which is also arbitrary, depending on the amount of cash the company needs to raise).

Let's say, for instance, that you and a few of your friends want to start a new company, and you need to raise $100,000 of capital to do so. After tapping all personal resources, you and your friends have raised $25,000, so you still need to raise an additional $75,000 to start the company. One way to raise the $75,000 is to offer shares of the company to other people. In this case, you decide to divide the company into 1,000,000 shares, each share being worth $0.10 (ten cents) each. You and your friends own 250,000 of those shares (from your $25,000 investment), and you offer 750,000 shares to anyone who wants to invest, at $0.10 each share, with the intention of raising the additional $75,000.

Under these types of arrangements, all parties are hoping that the business will grow in value as sales are generated, the company expands, etc. If so, the value per share should grow along with the company, and if all goes well, each shareholder will get a return on the investment. A return on such an investment might come to a shareholder in the form of dividends (distributed company profits), or from selling the stock to someone else, or from selling the company outright.

The Public Company

The $100,000 example given above illustrates a small, private offering (private in the sense that the company's shares were not offered through an official market like the New York Stock Exchange(NYSE)). A larger corporation may offer a portion of its stock to the general public. This type of stock offering is called an Initial Public Offering (or "IPO"). Fundamentally, there is no difference between the IPO arrangement and the private offering used in the above example, except an IPO is subject to a strict set of rules and regulations. Also, IPO offerings typically raise hundreds of millions—or even billions of dollars of capital.

Public offerings are sold through securities dealers ("brokers"), who in turn sell to the "public" (their clients), and from that point forward, the stock is officially traded in one of the large, public exchanges, such as the New York Stock Exchange, or the NASDAQ exchange.

Hence, the primary difference between private and public stock is the accessibility the public has to the company's shares. To purchase public stock, you could go to any broker and buy shares; to purchase private stock, you would have to locate an existing shareholder yourself, and pay the shareholder personally.

One-Shot IPO

A point that requires reiterating is that when you buy stock from a broker, the money goes to a shareholder who is selling the stock; not one penny goes to the company that originally issued the shares. The single exception to this is when a company makes a secondary offering, usually to raise more cash. But even with the secondary offering, once those secondary shares are sold, no additional cash goes to the company when the company's stock is traded on the exchange.

The significance of this point is more psychological than practical. Sometimes, an inexperienced investor will think that the company is being "supported" by purchasing shares (or boycotted by refusing the buy any shares), whereas the company never sees one cent of the proceeds.

There is, of course, an indirect relationship between a stock's value and the stock's underlying company. There are other factors, such as a company's capitalization value, which is purely measured by the company's recent stock price. Hence, in fairness to investors who feel they are supporting a company by buying its stock, there is an element of truth to such "support"—if the stock price is affected by purchasing the shares. But the point being emphasized above is that the company receives no cash from the stock exchange after the Initial Public Offering or a secondary offering.

Trading Stock

Trading differs from investing when you consider that quick trading relies on the fluctuations of the stock value itself. Investing, in its purest form, relies on the growth of the company that has issued the stock.

For instance, let's say that Joe Investor purchases 1,000 shares of a company's Initial Public Offering for $10 per share. Joe is thinking that this is an excellent investment since the company is expected to grow by a factor of 20 during the several years. If this pans out, his initial $10,000 investment will be worth approximately $200,000. Now let's say that the word gets out about this company, its future looks quite promising, and suddenly everyone wants "in." Because of the high demand for the stock, it is driven up to $20, then to $40. Other investors notice the new "hot" stock issue, and in a mad buying frenzy, its price is driven up to $100 within a matter of months, or even weeks or days.

What just happened? The company hasn't changed, it hasn't made one penny, and it has hardly had a chance to even get off the ground. Yet, Joe's initial $10,000 investment is now worth $100,000! If Joe wanted to, he could sell his shares right now for a 10-to-1 gain rather than wait for many years to (maybe) realize his goal of a 20-to-1 gain. Unless he has some sentimental reason to hold the shares, Joe will probably sell.

In this case, Joe has made a trade—trading the stock for cash. His profit, while large, did not result from the underlying company's success, but rather his profit is purely the result of speculation about the company. Additionally, those who bought Joe's shares could, in turn, sell to someone else, again, another trade.

This is the fundamental difference between investing and trading—at least in theory.

Is Investing Really Trading?

Investing is considered to differ from trading in that the investor is depending on the company's value to appreciate, whereas the trader is expecting the stock itself to appreciate. However, the difference between these two perceptions is paper thin, and today, the terms investing and trading are used almost interchangeably.

The lone distinction between the two terms is time. One is "investing" if the buyer of stock intends to hold on for a long period of time; one is "trading" if the stock is held for a very short period of time. This distinction is important—more from a philosophical point of view than from a technical one.

For whatever reason, the activity of "trading" is considered politically incorrect in many circles. Some anti-trading advocates go so far as to imply gambling addiction and other questionable morality is associated to "trading." Yet, in today's market, every stock purchase is, in fact, a trade. Unless one is participating in an Initial Public Offering, not one penny of a stock purchase goes into the company, so one isn't really investing at all. They are all trades, albeit some of them with longer time spans than others.

The Real Difference

In spite of its social taboo, trading differs from investing only in technique. Both the trader and investor share the same goal—to profit. While convincing arguments can be constructed for both techniques, the point is that moral implications about trading should not be a factor and need not be part of the debate. Long-term investing advocates are quick to point out that many people have lost fortunes in day-trading and other forms of stock market "gambling." On the other hand, the trader can equally argue that sticking with a company for the long haul, can be equally as deadly (which became painfully obvious to millions of investors who held on to sinking technology stocks or dot-coms that went bust throughout the years 2000-2002).

In truth, successful trading demands a skill not unlike any other profession that requires precision. In the hands of a skilled surgeon, a heart transplant goes smoothly; the attempted procedure performed by a novice might be fatal. Stock trading is no exception.

Personally, I have no fixed rule about time. I may hold a stock for five minutes or five months. All that matters is that I maximize profit and minimize losses. It surprises me that this simple concept is somewhat of a "new" idea. Both the investor and the day-trader have a very fixed idea about time. The investor is in for the long haul, through thick and thin, while the day-trader specializes in split-second, stress-driven trades, by definition. I find it odd that neither of these approaches consider maximizing profit. Rather, they emphasize time as a primary strategic component.

Although an alien idea to many, consider the following strategy: To own a stock as long as it is rising and not own it otherwise. In volatile markets this will look like day trading. In steadier markets it will look like investing. It’s really that simple.

All About the Exchange

When a corporation goes public, that means that the stock trades on one of the public stock exchanges. What that basically means is that anyone who has the money can purchase shares of the company's stock through brokers, banks, and other financial institutions.

A stock exchange is basically a central location where public stock is exchanged. By exchanged is meant exchanging money for stock, and vice versa. In other words, the stock exchange is the central location where people buy and sell stock from each other.

The two major exchanges that exist in the United States are the New York Stock Exchange (abbreviated as NYSE), and the NASDAQ (which stands for National Association of Securities Dealers Automated Quotations). There are other smaller exchanges (such as the American Stock Exchange), and there are various electronic exchanges (computerized exchanges where buyers and sellers meet electronically through the Internet, etc.). For the purposes of trading, we will deal only with the NYSE and NASDAQ exchanges.

Thousands of stocks are listed on the major exchanges, and literally billions of shares trade hands every day. Many of these stocks are relatively unknown, trading only a handful of shares each day, while other popular, big-name stocks can trade as many as a hundred million shares or more during any one session. Trillions of dollars flow through these markets!

The Middleman

Unless you have multi-millions to trade, or have special clearances and other connections, it is unlikely that you would be able to trade directly with traders on the floor of a major exchange. What you would do instead is go through a securities broker. This is essentially a "middleman" between you and the major exchanges.

The securities broker takes your order to buy or sell stock, and he contacts the exchange to perform the actual trade. The broker essentially has arrangements with the major exchanges to perform these transactions. Furthermore, the broker is able to group all stock orders into larger transactions, a block of shares that is acceptable to the exchange.

For instance, let's say that you want to buy 50 shares of IBM. Assuming that you were even allowed on the NYSE floor at all, the traders wouldn't even consider an order this small. The broker, however, might receive 300 orders for 50 shares of IBM, and as a result, can present a 15,000-share trade to the exchange.

Brokers make their money by charging their clients a commission to perform the trade. The amount that you will pay for a commission depends on the broker, and the commission system used may vary (some charge a flat fee for each transaction, while others charge a percentage of the trade, or a price-per-share for the trade).

Types of Brokers

In the "old" days, brokers had nice offices that you could visit personally, or call on the phone to make a trade. With the advent of the Internet, however, online brokers (places where you can trade on the web) have become the trading medium of choice. Actually, the old style broker—the type that you see in movies that you call on the phone—still exists today. They are often called full service brokerages, and they include big names such as Merrill Lynch, Salomon Smith Barney, etc. Unfortunately, their reputable names and full service also equate to very large commission fees.

While "full service" brokers may be suitable for long-term investing, or even financial advice, these are unusable for high-action trading. For one thing, the speed of execution is too critical to rely on a broker that you would have to call on the phone, or contact in any way other than a split-second Internet connection. For another, commissions are usually much higher with full service brokers. Online (Internet) sites are very competitive, and most of them offer relatively cheap commissions.

How the Market Moves

 

When I became interested in stocks many years ago, one of the mysteries of the market was how stock prices move, or how they are determined. How does a stock price "move" up or down? Who determines these prices? I had many similar questions, yet no one ever answered them. It is one of those "everybody knows" items, something that was assumed, rarely explained.

 

The Grand Auction

 

Simply stated, stock prices move up or down by virtue of a continuous auction, with such prices purely determined by how much anyone is willing to pay for a stock, or how little anyone is willing to sell a stock. The way it works is like this. Imagine of 5 people wanted to sell 100 shares of IBM, and another 5 people were looking to buy 100 shares of IBM. Now imagine if each of the sellers wrote down the lowest price they are willing to sell for, and turned their asking prices into a third party to hold.

 

The buyers, on the other hand, turn in their bids with the highest price they are each willing to pay for the shares. The third party, receiving these bids and offers, sorts them out by price. He then presents the lowest offering price from all 5 sellers, and the highest bid price from all 5 buyers. For the sake of discussion, let's say that the bids and offers for IBM break down as follows.

 

 

The example shown for IBM is a simple one, yet this is literally what occurs at the stock exchange. At any given moment, many people put up stock for sale, and others put up offers to buy; you can think of it as a sophisticated, ongoing auction.

 

Now let's see what happens when stock is actually bought or sold. Suppose you decide you want to buy 100 shares of IBM stock, so you go through your broker to buy the shares at the current price. In this case, the "current price" is the $79.00 price at the top of the seller's list, as shown in the top-right column above. Your broker buys the $100 shares for $7,900, and what happens now gets interesting: The 100 shares at $79 are no longer available (because you just bought them). Hence, the table instantly changes to the following.

 

 

Notice what just happened: the best selling price for IBM has now "moved" from $79 to $82. Quite literally, your purchase just bumped the price up for IBM a couple of dollars. If someone else buys 100 shares at the "current" (best) price, the table would change again, as follows.

 

 

To the inexperienced eye, IBM has magically "moved" from $79 a few minutes ago to $90.75. Of course, most stock quotes only show the top bids and offers (the top line of the table above, if you will), so it appears that the prices just changed in some mysterious fashion.

 

Naturally, it works the same way on the other side, when someone wants to sell IBM, only in this case, the price "moves" down. Using the original chart, let's say you want to sell 200 shares of IBM. Currently, the "best" bid for your shares is $78.50 (it is the most anyone is currently willing to pay for IBM), and there are 100 shares available. The next best price is $78.25, also 100 shares. You tell your broker to go ahead and sell 200 shares, and this knocks the top two positions off of the table.

 

 

Notice that the price of IBM being bid has now "plummeted" from $78.50 down to $67.50. This is because you just sold to the top two bidders, and those shares are no longer available. The next price down—$67.50—takes over as the best bid.

 

This whole cycle, a stock's best bids and offers on both sides of the aisle, and the trades that pick off the top items, is the sole reason why prices "move" in the market.

 

What Shows in a Stock Quote

 

One reason that newcomers don't fully understand how prices move is that they usually don't see all the stock offers that are happening behind the scenes. Instead, a stock price is usually quoted with the top prices—one for the bid (the best price anyone is willing to pay), and the ask (the best price anyone is willing to sell). The resulting quote simply looks something like the following.

 

 

Usually, a stock quote only reports the current bid (the highest price anyone is willing to sell for), the current ask (the lowest price anyone is willing to sell for), and last (last price the stock traded for). If you came along and bought all shares up for sale at the current "ask" price, it would make way for the next seller in line, which effectively bumps "up" the price.

 

Becoming a Bidder

 

In each of the examples given above, it is assumed that you go through your broker and buy or sell at the "current" price levels for the stock. But you can tell your broker to put in a limit order, which effectively places your bid or ask price on the list. In our previous example, you bought or sold at the "current" price, which is called a market order. But if you place a limit order, your sell or buy offer goes on the list, sorted by price.

 

In the case of the above table for IBM, for instance, let's say that you want to sell 100 shares, but you want to "undercut" the top price of $79.00. You would put in a limit order for 100 shares of IBM at, say, $78.95. After your broker puts in the offer, the table changes as follows.

 

 

If anyone out there is willing to buy your shares at $78.95, the transaction occurs, and your shares are removed from the list.

 

Naturally, it works the same way on the other side. If someone decides they are willing to pay more than the best bid price ($78.50), they could put in a bid for, say, $78.75, at which time the table changes again.

 

 

Hence, prices "change" — and the market moves.

 

Tools of the Trade