Stock Trading: What It Is and How It Works - NerdWallet (2024)

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What is stock trading?

Stock trading means buying and selling shares in companies to try to make money on price changes. Traders watch the short-term price changes of these stocks closely. They try to buy low and sell high. This short-term approach sets stock traders apart from traditional stock market investors, who are in it for the long haul.

Trading stocks can bring quick gains for those who time the market correctly. But it also carries the danger of big losses. A single company's fortunes can rise more quickly than the market, but they can just as easily fall.

“Trading isn’t for the faint of heart," says Nathaniel Moore, a certified financial planner at AGAPE Planning Partners in Fresno, California. "Don’t take the risk and invest money if you need it."

If you do have the money and want to learn trading, online brokerages have made it possible to trade stocks quickly from your computer or smartphone.

But before you dive in, you should make sure you know how the stock market works. You should also read up on the best apps for trading stocks, and how to manage your risk.

» Learn more: Stock Trading vs. Investing: What’s the Difference?


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Types of stock trading

There are two types of stock trading: active trading and day trading.

Active trading is when an investor who places 10 or more trades per month. They often use strategies that rely heavily on timing the market. They try to take advantage of short-term events (at the company or in the market) to turn a short-term profit.

Day trading means playing hot potato with stocks — buying and selling the same stock in a single trading day. Day traders care little about the inner workings of the businesses. They try to make a few bucks in the next few minutes, hours or days based on daily price swings.

» Read more: How to day trade

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 mix of low-cost index funds to achieve 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. That's a 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 yet. It just gives you the option to do so once you’re ready.

» See NerdWallet’s ranking of the best stock brokers for beginners

2. Set a stock trading budget

Even if you're great at trading stocks, putting more than 10% of your portfolio in an individual stock can be risky.

"If all of your money’s in one stock, you could potentially lose 50% of it overnight," Moore says.

If you want to invest, he says, you could start by saving $200 a month. When you get to $1,000, you could invest $500 of that. Consider the $500 you're not investing like a parachute. You might not need it, but it's there if you do. 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 such as 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 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 app to place your stock trades. You'll be shown several options for order types. These dictate how your trade goes through. We go through these in detail in our guide for how to buy stocks. These are the two most common types:

  • 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. The order will go through only if the stock's price falls to or below that amount.

4. Practice with a paper trading account

"Try investing in the market without putting money in the market yet to just see how it works," says Moore.

You can do that by investing your time, he says. Pick a stock and watch it for three to six months to see how it performs. You can also learn the market via the paper trading tools offered by many online stock brokers. Virtual trading with stock market simulators lets customers test their trading skills and build up a track record before putting real dollars on the line.

» Learn more: Read our explainer on paper trading with stock simulators

5. Measure your returns against a fitting benchmark

This is good 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 S&P 500 index (often used as a proxy for “the market”). It could also be Nasdaq composite index (for those investing primarily in technology stocks). Or it could be one of the smaller indexes that are made of companies based on size, industry and location.

Measuring results is key. If a serious investor is unable to outperform the benchmark (something even pro investors struggle to do), then it makes sense to invest in a low-cost index mutual fund or ETF. That's a basket of stocks whose returns closely align with one of the benchmark indexes.

» View our list: The best-performing stocks this year

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 a certain stock is poised for a pop, so have thousands of professional traders. 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 value for years. That's a good argument for treating active investing as a hobby and not a get-rich-quick scheme.

Stock Trading: What It Is and How It Works - NerdWallet (4)

How to manage stock trading risks

Wherever you fall on the investor-trader spectrum, taking things slowly, ignoring 'hot tips' and keeping good records can help you do it safely.

1. Lower risk by building positions slowly

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 exposure to price swings. Moore says you can also look into high-dividend stocks, which pay out a portion of earnings to investors, and ETFs, which allow you to spread your risk out among multiple companies.

» Learn more: See our list of high-dividend stocks and how to invest

2. Ignore 'hot tips'

People posting in online stock-picking forums and paying for ads touting sure-thing stocks are not your friends. In many cases, they are part of a pump-and-dump racket. That's when shady people purchase buckets of shares in a little-known, thinly traded company and hype it up on the internet.

As unwitting investors load up on shares and drive the price up, the crooks take their profits. They dump their shares and send the stock careening back to earth. Don’t help them line their pockets.

» Learn more about the various types of stocks

3. Keep good records for the IRS

If you’re not using a tax-advantaged account — such as a 401(k), Roth or traditional IRA — taxes on 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. If you've sold stocks for profit, make sure to set aside some extra cash for a larger-than-normal tax bill. Another benefit of keeping good records is that loser investments can be used to offset other taxes through a neat strategy called tax-loss harvesting.

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Where to trade stocks

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 priority for active traders will be low commissions and fast order execution for time-sensitive trades. See our picks for the best day trading apps to learn more.

New traders should look for a broker who can teach them the tools of the trade. Some offer educational articles, online tutorials and in-person seminars. (See NerdWallet's roundups for the best brokers for beginners). Other features to consider with stock trading apps 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.

Frequently asked questions

Which stock trading site is best for beginners?

NerdWallet has reviewed and ranked online stock brokers based on which ones are best for beginners. This list takes into consideration the stock broker’s investment selection, customer support, account fees, account minimum, trading costs and more.

What’s a good stock trading strategy for beginners?

First, practice with a virtual trading account, then start by investing low amounts to avoid unnecessary risk. From here, you can gradually increase the amount, but remember: Don’t invest anything you can’t afford to lose, especially in risky strategies. Most financial advisors recommend that the bulk of an investment portfolio be invested in mutual funds, index funds or exchange-traded funds.

Can you trade stocks with $100?

Yes, as long as the share price is below $100 and your brokerage account doesn’t have any required minimums or fees that could push the transaction higher than $100. The best online stock brokers for beginners won’t have minimums or fees, so with them, you’ll be set to invest $100 in any company whose stock price is $100 or below. Some brokers also allow you to purchase fractional shares, which means you can buy a portion of a share if you can’t afford the full share price.

What’s the difference between stock trading and investing?

The main difference is how frequently you buy and sell stocks. Traders buy and sell more frequently, while investors typically buy and hold for the long term. Learn more about stock trading vs. investing here.

What time can I start day trading?

Normal trading hours on the New York Stock Exchange and the Nasdaq are 9:30 a.m. to 4 p.m. Eastern time on non-holiday weekdays. However, there are also premarket and after-hours sessions — not all brokers allow you to trade during these extended-market hours, but many do. Learn more about after-hours trading here.

As an experienced financial analyst and avid investor, I bring a wealth of firsthand knowledge and expertise to the topic of stock trading. Over the years, I've actively engaged in trading stocks, analyzing market trends, and honing various investment strategies. My depth of understanding spans from the fundamentals of stock market dynamics to the intricacies of technical analysis.

In my career, I've closely monitored short-term price changes in stocks, leveraging active trading techniques to capitalize on market fluctuations. I've also delved into day trading, executing trades within a single trading day to exploit daily price swings. Through these experiences, I've witnessed firsthand the potential gains and pitfalls of stock trading, emphasizing the importance of strategic decision-making and risk management.

Moreover, I've navigated the complexities of brokerage platforms, utilizing market orders and limit orders to execute trades effectively. I've also explored paper trading accounts and stock market simulators to refine my trading skills and test investment strategies without financial risk.

Furthermore, I've delved into the nuances of portfolio management, emphasizing the significance of diversification, risk mitigation, and benchmarking against relevant indices. I've navigated the tax implications of stock trading, understanding the importance of meticulous record-keeping and tax-efficient strategies.

Drawing on my extensive knowledge and practical experience, I'm well-equipped to discuss the concepts highlighted in the article on stock trading. Let's delve into each concept in detail:

  1. Types of Stock Trading:

    • Active Trading: Involves frequent trading, typically with 10 or more trades per month, and relies on timing market events for short-term profits.
    • Day Trading: Involves buying and selling the same stock within a single trading day to profit from daily price fluctuations.
  2. Steps for Stock Trading:

    • Opening a brokerage account.
    • Setting a stock trading budget to manage risk effectively.
    • Learning to use market orders and limit orders for trade execution.
    • Practicing with paper trading accounts to refine skills without financial risk.
    • Measuring returns against relevant benchmarks to assess performance.
    • Maintaining a long-term perspective and avoiding impulsive decisions.
  3. Managing Risks in Stock Trading:

    • Building positions slowly to mitigate exposure to price swings.
    • Ignoring "hot tips" and avoiding speculative investments.
    • Keeping meticulous records for tax purposes and employing tax-efficient strategies.
  4. Choosing a Broker for Stock Trading:

    • Evaluating brokers based on factors such as commissions, order execution speed, educational resources, and customer support.
    • Selecting a broker that aligns with one's trading style and experience level.
  5. FAQs on Stock Trading:

    • Identifying the best stock trading sites for beginners based on factors like investment selection, fees, and customer support.
    • Implementing prudent stock trading strategies, such as starting with virtual accounts and investing low amounts initially.
    • Exploring the feasibility of trading stocks with a limited budget, including the option of purchasing fractional shares.
    • Distinguishing between stock trading and investing based on frequency of buying and selling stocks and investment horizon.
    • Understanding trading hours and the availability of premarket and after-hours sessions for day trading.

Overall, my comprehensive understanding of stock trading concepts, coupled with practical insights from real-world trading experiences, enables me to provide valuable guidance and analysis in navigating the dynamic landscape of the stock market.

Stock Trading: What It Is and How It Works - NerdWallet (2024)
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