Stock trading is a form of investing that prioritizes short-term profits over long-term gains. It can be risky to dive in without the proper knowledge.
Not everyone who buys and sells stocks is a stock trader, at least in the nuanced language of investing terms. Depending on how frequently they buy and sell stocks, most fall into one of two camps: traders or investors.
The caricature of the trader is that of the frenzied Wall Streeter in front of monitors and scrolling tickers, buying and selling throughout the day. Investors, on the other hand, are typically in it for the long haul, buying at regular intervals and selling much less frequently — or not at all, at least until retirement.
Stock trading isn’t always what you see on the floor of the New York Stock Exchange, though, and it’s possible to get started from the comfort of your couch. But you’d better know what you’re doing before you place your first trade.
What is stock trading?
Stock traders buy and sell stocks to capitalize on daily price fluctuations. These short-term traders are betting that they can make a few bucks in the next minute, hour, day or month, rather than buying stock in a blue-chip company to hold for years or even decades.
There are two main types of stock trading:
Active trading is what an investor who places 10 or more trades per month does. Typically, they use a strategy that relies heavily on timing the market , trying to take advantage of short-term events (at the company level or based on market fluctuations) to turn a profit in the coming weeks or months.
Day trading is the strategy employed by investors who play hot potato with stocks — buying, selling and closing their positions of the same stock in a single trading day, caring little about the inner workings of the underlying businesses. (Position refers to the amount of a particular stock or fund you own.) The aim of the day trader is to make a few bucks in the next few minutes, hours or days based on daily price fluctuations.
How to trade stocks
If you're trying your hand at stock trading for the first time, know that most investors are best served by keeping things simple and investing in a diversified mix of low-cost index funds to achieve — and this is key — long-term outperformance.
That said, the logistics of trading stocks comes down to six steps:
1. Open a brokerage account
Stock trading requires funding a brokerage account — a specific type of account designed to hold investments. If you don't already have an account, you can open one with an online broker in a few minutes. But don’t worry, opening an account doesn’t mean you’re investing your money quite yet. It just gives you the option to do so once you’re ready.
2. Set a stock trading budget
Even if you find a talent for trading stocks, allocating more than 10% of your portfolio to individual stocks can expose your savings to too much volatility. But this isn’t the only rule to manage risk. Other do's and don’ts include:
Invest only the amount of money you can afford to lose.
Don’t use money that’s earmarked for near-term, must-pay expenses like a down payment or tuition.
Ratchet down that 10% if you don’t yet have a healthy emergency fund and 10% to 15% of your income funneled into a retirement savings account.
3. Learn to use market orders and limit orders
Once you have your brokerage account and budget in place, you can use your online broker's website or trading platform to place your stock trades. You'll be presented with several options for order types, which dictate how your trade goes through.
Market order: Buys or sells the stock ASAP at the best available price.
Limit order: Buys or sells the stock only at or better than a specific price you set. For a buy order, the limit price will be the most you're willing to pay and the order will go through only if the stock's price falls to or below that amount.
4. Practice with a virtual trading account
There’s nothing better than hands-on, low-pressure experience, which investors can get via the virtual trading tools offered by many online stock brokers. Paper trading lets customers test their trading acumen and build up a track record before putting real dollars on the line.
Several of the brokers we review offer virtual trading, including TD Ameritrade and Interactive Brokers.
5. Measure your returns against an appropriate benchmark
This is essential advice for all types of investors — not just active ones. The bottom-line goal for picking stocks is to be ahead of a benchmark index. That could be the Standard & Poor’s 500 index (often used as a proxy for “the market”), the Nasdaq composite index (for those investing primarily in technology stocks) or other smaller indexes that are composed of companies based on size, industry and geography.
Measuring results is key, and if a serious investor is unable to outperform the benchmark (something even pro investors struggle to do), then it makes financial sense to invest in a low-cost index mutual fund or ETF — essentially a basket of stocks whose performance closely aligns with that of one of the benchmark indexes.
6. Keep your perspective
Being a successful investor doesn’t require finding the next great breakout stock before everyone else. By the time you hear that XYZ stock is poised for a pop, so have thousands of professional traders and the potential likely has already been priced into the stock. It may be too late to make a quick turnaround profit, but that doesn’t mean you’re too late to the party. Truly great investments continue to deliver shareholder value for years, which is a good argument for treating active investing as a hobby and not a Hail Mary for quick riches.
» Interested in stock research? Read our review of Morningstar
How to survive stock trading
Wherever you fall on the investor-trader spectrum, these four tips for how to trade stocks can help ensure you do it safely.
1. Lower risk by building positions gradually
There’s no need to cannonball into the deep end with any position. Taking your time to buy (via dollar-cost averaging or buying in thirds) helps reduce investor exposure to price volatility.
2. Ignore 'hot tips'
WallStreetHotShot4721 on the EZMillion $ Trade forum and the folks who pay for sponsored ads touting sure-thing stocks are not your friends, mentors or bona fide Wall Street gurus. In many cases, they are part of a pump-and-dump racket where shady folks purchase buckets of shares in a little-known, thinly traded company (often a penny stock) and hit the internet to hype it up.
As unwitting investors load up on shares and drive the price up, the crooks take their profits, dump their shares and send the stock careening back to earth. Don’t help them line their pockets.
3. Keep good records for the IRS
If you’re not using an account that enjoys tax-favored status — such as a 401(k) or other workplace accounts, or a Roth or traditional IRA — taxes on investment gains and losses can get complicated.
The IRS applies different rules and tax rates and requires the filing of different forms for different types of traders. Another benefit of keeping good records is that loser investments can be used to offset the taxes paid on income through a neat strategy called tax-loss harvesting.
4. Choose your broker wisely
To trade stocks you need a broker, but don’t just fall for any broker. Pick one with the terms and tools that best align with your investing style and experience. A higher priority for active traders will be low commissions and fast order execution for time-sensitive trades. See our picks for the best online platforms for active traders/day traders to learn more.
Investors who are new to trading should look for a broker who can teach them the tools of the trade via educational articles, online tutorials and in-person seminars Other features to consider are the quality and availability of screening and stock analysis tools, on-the-go alerts, easy order entry and customer service.
No matter what, the time spent in learning the fundamentals of how to research stocks and experiencing the ups and downs of stock trading — even if there are more of the latter — is time well spent, as long as you’re enjoying the ride and not putting any money you can’t afford to lose on the line.
