Are you new to the world of investing? Do you have money set aside to invest in the stock market but don’t know where to begin? Do you watch the financial news on TV but have no idea what they are talking about? This article, How To Invest In Stocks, seeks to educate new investors just like you. To learn more about investing, select an subject from the table of contents to read more about each individual topic.
Opening a Brokerage Account
The first step is to open a brokerage account. Charles Schwab, TD Ameritrade, Robinhood, Fidelity, and Vanguard are the five most popular online brokerage firms for individual investors. Be on the look out for promos for opening a new account, such as commission-free trades and deposit bonuses.
Your other option is to open an account with a full service broker. A traditional full service brokerage firm, such as Morgan Stanley or Edward Jones, will provide investment advice and financial planning services in addition to handling your stock trades.
After opening an account, it is time to do some research. Figure out what your financial goals are and which companies you will invest in. Consider local businesses you already know and understand. Read about each company you are considering, including their quarterly and annual reports. Large companies will often have a link at the bottom of their website which leads to their corporate page. This area of their website will have information for shareholders including a corporate profile, stock information, press releases, and other shareholder tools.
Stock Market Indices
Indices are the price of a group of stocks which are quoted to give investors an overall view of how the market is moving. They can also be used by the financial media as a barometer of how the economy is performing overall. While the performance of a particular index may not reflect that of an individual stock you are interested in, it does give you an indication of the sentiment of other investors in the market. The composition and weighting of each index varies which can make it difficult to compare when investing in different markets so it is important to understand how the index is constructed.
Some investors use an index as a benchmark to judge how their portfolio is performing. While this is a widespread practice, the index performance does not include any costs for transactions or holding shares and is calculated using mid prices. A portfolio made up of the same shares as the index would not give identical performance. The vast majority of indices do not factor in dividends paid and if these are reinvested each year the actual portfolio value would be increased.
The Dow Jones
The most widely used index in the USA is the Dow Jones Industrial Average [official site] or DJIA. This index is made up of thirty very large companies which are weighted by price and then adjusted by a current average divisor. The divisor is used so that when the component companies are changed the index retains continuity; however this is a rare occurrence with less than seventy changes in over a hundred years of the index. According to Dow Jones,
The Dow Jones Industrial Average played a role in bringing about this tremendous change. One hundred years ago, even people on Wall Street found it difficult to discern from day to day whether the wider stock market was rising, falling or treading water. Charles Dow devised his stock average to make sense out of this confusion. He began in 1884 with 11 stocks, most of them railroads, which were the first great national corporations. He compared his average to placing sticks in the beach sand to determine, wave after successive wave, whether the tide was coming in or going out. If the average’s peaks and troughs rose progressively higher then a bull market prevailed; if the peaks and troughs dropped lower and lower, a bear market was on.
It seems simplistic nowadays with the array of market indicators in the public eye, but late in the nineteenth century it was like turning on a powerful new beacon that cut through the fog. The average provided a convenient benchmark for comparing individual stocks to the course of the market, for comparing the market with other indicators of economic conditions, or simply for conversation at the corner of Wall and Broad Streets about the market’s direction.
The mechanics of the first stock average were dictated by the necessity of computing it with paper and pencil: Add up the prices and divide by the number of stocks. This application of grade-school arithmetic, while creative, is hardly useful more than a century later. But the very idea of using an index to differentiate the stock market’s long-term trends from short-term fluctuations deserves a salute. Without the means for the ordinary investor to follow the broad market, today’s age of financial democracy (in which millions of employees are actively directing the investment of their own future pension money and as a result are substantial corporate shareholders) would be unimaginable.
Following the introduction of the 12-stock industrial average in the spring of 1896, Mr. Dow, in the autumn of that year, dropped the last non-railroad stocks in his original index, making it the 20-stock railroad average. The utility average came along in 1929 (more than a quarter-century after Mr. Dow’s death at age 51 in 1902) and the railroad average was renamed the transportation average in 1970.
At first, the average was published irregularly, but this changed with the daily publication in The Wall Street Journal, which began on Oct. 7, 1896. In 1916, the industrial average expanded to 20 stocks; the number was raised again, in 1928, to 30, where it remains. Also in 1928, the Journal editors began calculating the average with a special divisor other than the number of stocks, to avoid distortions when constituent companies split their shares or when one stock was substituted for another. Through habit, this index was still identified as an “average.”
Using such large, frequently traded stocks provides an important feature of the Industrial Average: timeliness. At any moment during the trading day, the price of the Dow Jones Industrial Average is based on very recent transactions. This isn’t always true with indexes that contain less-frequently traded stocks. The Dow Jones Industrial Average is the most-quoted market indicator in newspapers, on television and on the Internet. Because of its longevity, it became the first to be quoted by other publications. This practice became habit when Wall Street earned at least a mention in the general news each day, and habit became tradition when the post-World War II bull market commanded the nation’s attention. The Industrial Average became the indicator to cite if you were citing only one. Besides longevity, two other factors play a role in its widespread popularity: It is understandable to most people, and it reliably indicates the market’s basic trend.
The S&P 500
The Dow Jones Industrial Average is only a small snapshot of the market and an investor may be interested in far more than thirty companies. A wider index for the US market is the Standard and Poor’s 500 [official site] or S&P 500 which includes five hundred companies listed on the New York Stock Exchange. The index is weighted by market capitalization which means that a small company cannot distort the price of the index. For the more specialized investor there are indices covering individual sectors and the popular Russell 2000 Index [official site] which covers smaller companies.
Widely regarded as the standard for measuring large-cap U.S. stock market performance, this popular index includes a representative sample of leading companies in leading industries.
The S&P 500 Index always contains 500 companies… New companies will only be added when there is a vacancy. S&P’s Index Committee, which is responsible for the overall management of the S&P Indices, looks at the company’s market value, industry group classification, capitalization, trading activity, financial and operating condition before making a decision to list it. Companies are removed from the S&P 500 Index for four major reasons: merger with (or acquisition by) another company, financial operating failure, lack of representation, or restructuring.
General Guidelines for Adding Stocks to the S&P 500 Index:
1. Market Value: The S&P 500 is a market-value weighted index. (See the top portion of this page for current market value levels.)
2. Industry Group Classification: Companies selected for the S&P 500 represent a broad range of industry segments within the U.S. economy.
3. Capitalization: Ownership of a company’s outstanding common shares is carefully analyzed in order to screen out closely-held companies.
4. Trading Activity: The trading volume of a company’s stock is analyzed on a daily, monthly, and annual basis to ensure ample liquidity and efficient share pricing.
5. Fundamental Analysis: Both the financial and operating condition of a company are rigorously analyzed. The goal is to add companies to the Index that are relatively stable and will keep turnover in the Index low.
6. Emerging Industries: Companies in emerging industries and/or new industry groups-industry groups currently not represented in the Index-are candidates for the Index as long as they meet the guidelines listed above.
General Guidelines for Removing Stocks from the S&P 500:
1. Merger, Acquisition, LBO: A company is removed from the Index as close as possible to the actual transaction date.
2. Bankruptcy: A company is removed from the Index immediately after Chapter 11 filing or as soon as an alternative recapitalization plan that changes the company’s debt/equity mix is approved by shareholders.
3. Restructuring: Each company’s restructuring plan is analyzed in depth. The restructured company as well as any spin-offs are reviewed for Index inclusion or exclusion.
4. Lack of Representation: A company can be removed from the Index because it no longer meets current criteria for inclusion and/or is no longer representative of its industry group.
The Russell 2000
For the more specialized investor there are indices covering individual sectors and also the Russell 2000 Index [official site] which covers smaller companies. Of the largest 3000 companies in the U.S. stock market, the Russell 2000 includes the smallest 2000 of those 3000. It is the most popular index for small-cap companies.
Frank Russell Company produces a family of 21 U.S. equity indexes. The indexes are market cap-weighted and include only common stocks domiciled in the United States and its territories. All indexes are subsets of the Russell 3000 Index, which represents approximately 98% of the investable U.S. equity market.
Determining Index Membership: Rank the U.S. common stocks from largest to smallest market capitalization at each annual reconstitution period. Top 3,000 stocks become the Russell 3000 Index. Largest 1,000 stocks become the Russell 1000 Index. Next 2,000 stocks become the Russell 2000 Index.
Other markets have their own range of indices and for the global investor the most widely followed are the FTSE 100 [official site] for the London Stock Exchange and the Nikkei 225 [official site] for the Tokyo Stock Exchange. The FTSE 100 is weighted by market capitalization but the Nikkei 225 is not. Other indices around the world have even more differences so it is essential to study the composition of the index before using it as a tool for investing.
When looking to begin investing, one of the problems faced is being able to diversify the portfolio enough to protect against the risk of a single stock failing. Opinions on the minimum number of companies to hold stock in can vary, but most experts advise a mix of between twenty and forty companies. Once the costs of commissions and the amount of time required is taken into account, it may not be possible to invest in such a diverse way.
An alternative method is to buy shares in funds that exist for the purpose of holding shares in many different companies. By pooling your money with that of other investors, this gives you the advantage of an investment in a much wider range of companies than you would normally be able to invest in on your own. In addition, there may well be cost savings as commission rates tend to be lower when trades are made in high volumes. However, investment funds will have fees to pay for the management of the fund that are not present when investing directly.
Another advantage of an investment fund is that some not only diversify across different stocks, but across the other asset classes as well. This level of diversification helps protect the investor against a fall in equities as a whole and would be hard to achieve when investing directly without a large portfolio.
Types of Funds
Mutual funds, exchange traded funds (ETFs), and real estate investment trusts (REITs) are examples of investment funds. There are many different types of investment funds and not all are traded on the stock exchanges. Usually the closed end funds tend to be the ones listed on the exchanges as they have a set number of shares available like any other listed company. These shares are bought and sold like any other and usual transaction charges will apply. There will also be a spread between the buy price and sell price and this will vary depending on the size and popularity of the fund.
Active and Passive
Investment funds can be either actively or passively managed. Actively managed funds will have a professional manager to select the stocks that provide a good return. Passively managed stocks aim to replicate the performance of a particular index by buying stocks in a way that replicates the index. A good manager will aim to outperform the index although not all managers will consistently achieve this. There is no guarantee that an actively managed fund will give a better return than a passive fund that tracks an index. Generally, the management fees for a passively managed fund will be much lower that an actively managed one.
Buying shares in a fund does mean that you are handing over some control of your portfolio. It is important to choose a fund where the manager has a similar attitude to risk to you. Investors who have a preference for investing in ethical or socially responsible companies will want to find a fund that only invests in these companies. For those with very strict criteria or looking for high risk investments there may not be a suitable fund, and stock picking may be more appropriate.
Exchange Traded Funds
The most popular type of investment fund is the Exchange Traded Fund, or ETF. ETFs generally hold a basket of stocks that track an index or follow an investment strategy. An ETF is traded on the stock market just like the shares of a publicly traded company are.
For each of the before-mentioned indices there exists multiple ETFs. The most traded ETF for the Dow Jones Industrial Average is the SPDR Dow Jones Industrial Average ETF Trust (DIA) and for the S&P 500 it is the SPDR S&P 500 ETF Trust (SPY). For the Russell 2000 the ETF most used is the iShares Russell 2000 ETF (IWM).
Value investing is the term used for a strategy based on holding an undervalued stock for a longer period of time rather than participating in short term speculation. The main principle in value investing is to find stocks which will appreciate in value to provide a good return over time. This can either mean a company which is currently undervalued or one where you feel the company is likely to grow in the future. This potential is referred to as the value in the stock by investors.
When selecting the stocks you would like to invest in it pays to take the time to fully understand the company itself as well as the share price. If you understand the products or services a company provides and the markets it operates in then not only will you have a better idea of whether to buy, but you will also be more likely to know how events may affect the price once you hold the stock.
Before buying a particular stock you should be clear about why you think there is value in the stock. Ideally you will be able to quantify this in terms of share price before committing to a purchase. The value should be greater than the sum of the share price, the spread and all dealing costs if you are going to make a purchase. If you are unsure about a stock it can be worth waiting a short while to ensure your predictions are starting to come true. While this can mean you pay a slightly higher price if you do eventually buy, it can also save you the loss if the predictions are not correct.
When you find the stock you are going to purchase it is a good idea to set yourself a minimum and maximum price that you are comfortable with the stock reaching. The minimum price is so that if you have picked a company whose fortunes suffer you can minimize the loss you are going to experience. The maximum is so that you can take the profits if prices rise before anything else happens. As you are holding these stocks for a while, these limits will need revising from time to time to ensure you are not caught out.
Value investing is popular with large institutional investors and pension funds so you will have competition to find opportunities; however, the returns can make the hard work worthwhile if you get it right. One extra benefit of holding stocks for the long term is that many companies pay dividends each year as a share of the profits. These can be used to make further investments so that your portfolio grows even more over time. Before reinvesting all the money make sure you have made provision for any tax due as this will be counted as income for the year.
Vanguard Value ETF (VTV) [official site], iShares Russell 1000 Value ETF (IWD) [official site], and the iShares S&P 500 Value ETF (IVE) [official site] are three of the most frequently traded ETFs for value stocks.
Anyone who is considering investing in the stock market will hopefully be aware that the share price of individual companies can go up and down, as can whole sectors of the market or sometimes the whole market can go down in value. There are a large number of factors that can influence the share price of a company.
Supply and Demand
The share price of a company is effectively the limit of what an investor is prepared to pay for it. If investors are confident that the stock of a company is undervalued, demand will increase and the price will increase until those investors who own the stock feel the price is worth selling at. At this point supply and demand will balance out and the price will stabilize until something happens to convince investors to increase demand again. The reverse of this is where supply is greater than demand and those wishing to sell have to lower their price until demand increases.
Market Bubbles and Crashes
Not all investors study financial reports and some buy shares simply because the prices are increasing and they feel they are bound to increase more. When the prices are increasing like this it is known as a bubble. When the bubble inevitably bursts, shares return to a value based on the profitability of the company. A large bubble can affect whole sectors or even the whole market in an extreme case. The reverse of a bubble where investors are selling and prices drop below their logical price is known as a crash.
The individual fortunes of a company are mainly measured in terms of the profit it makes and the possibility for future profits. Listed companies have to provide reports of their profits publicly, commonly called earning reports, and it is common to see big moves in prices if the reported profits are different to those expected.
Other Factors the Company
Other factors that can affect the price include key directors joining or leaving the company, contacts being won or lost and rumors of a takeover or merger. New product announcements, patents filed for new inventions, and collaborations with other companies can also cause the share price to increase or decrease.
As well as the fortunes of the individual company, the fortunes of the sector as a whole are likely to affect the price. Investors and the financial press group companies into sectors such as construction or aviation. A change in the demand for their sector, or the raw materials and commodities they rely on, can move the prices of all the companies in the sector.
Wider economic activity can have an effect on the share price of a company even when it is not directly affected. In a recession when people have less money to spend, and are concerned about the risks of investing in the markets, the demand for the stock of a company can be reduced which will push the price down. Large nationwide and global events can also cause a similar effect. For example when the New York Stock Exchange opened for the first time after 9/11, the whole market suffered one of its worst ever losses in a day. Natural disasters can also cause drops in share prices because of concerns over likely price increases in commodity and raw materials. Government policy and perceived policy changes including upcoming elections can also affect prices where conditions for a business is likely to change.
Investment ratios are of benefit to investors comparing stocks as they provide ways of comparing different share prices. While there is a large amount of financial numbers and statistics available, there are five main ratios which most investors study before making investment decisions.
Earnings per share, or EPS, is one of the most widely followed ratios and is published in the company’s accounts. EPS is calculated by taking the total profit which would be attributable to ordinary shareholders and dividing this by the total number of ordinary shares in issue. The profit figure used is the profit after tax and any preference dividends have been satisfied. EPS gives investors a good indication of the overall profitability of the company because it is unlikely that all of the profits will be distributed as dividend in any year.
Price to Earnings
If you divide the current share price by the EPS of the share you get the Price to Earnings ratio. Price to earnings is another widely followed ratio particularly when comparing the stocks of companies in the same sector. The ratio is seen as an indicator of how well valued the company is by investors. A low ratio can indicate an undervalued company or a company that will not likely grow much further. A higher ratio suggests that investors are more optimistic about the company’s profitability in the future. Another way to think about price to earnings is as the number of years it will take the company to earn the same profit as the price of the shares.
Dividend Yield is the ratio of the return on investment in the share. The yield is simply the dividend per share divided by the share price, expressed as a percentage. This can be used to compare the return on holding a stock to another share or type of investment. Dividend yield can be used to give an estimate of the return in future, although there is no guarantee that dividends will continue to be paid at the same rate.
Dividing earnings by the dividend will give the investor the Dividend Cover of the company. This is simply the number of years the company could pay the same rate of dividend for out of this year’s profit. A high number in this ratio suggests the company is holding a large amount of the profit back to reinvest in the business. This is not necessarily bad news for investors as this can generate growth in the company which will increase the share price.
The fifth ratio investors take into account is Net Asset Value Per Share. This is the total of a company’s assets minus its liabilities, divided by the number of shares in issue. It is the theoretical price shareholders would receive if the company stopped trading and all assets were sold. This is best used when comparing stocks in the same sector, such as real estate. Most companies will be valued at much more than their net asset value due to the additional value of goodwill and future orders.
Hidden Costs of Investing
One of the most common mistakes new stock market investors make is failing to fully appreciate the costs involved in investing. While some of the costs can be minimized by selecting the right broker, it is important to understand all costs so that your profits are not reduced, or worse still, turned into losses.
The first thing to consider is the difference between the buying and selling price of the shares. There will always be a difference between the price you can buy for and the price you would receive when you sell.
The difference between the two is known as the Spread and this varies by the company and also can vary among brokers. Normally the more actively traded stocks have the smallest spread and smaller niche companies have much wider spreads. It is important to factor the spread into your calculations because once you buy a stock it needs to increase by the spread before you are breaking even. When you look at share prices online there is only a single price. This is simply the the most recent amount the stock was traded for.
Some stockbrokers will charge a commission for buying or selling stocks on your behalf. Commissions are normally a percentage of the total transaction costs and may include stepped rates or a minimum charge. As their operating costs are lower, online brokers tend to have the smaller charges, but you do need to shop around to get the best deals. Remember that you will be charged to both buy and sell stocks so you will be paying commission twice over the course of the deal. Brokers that have zero commissions still must charge you for regulatory fees, known as the SEC or FINRA fees.
A few brokers also charge a subscription or management charge for holding the shares for you. Again the price varies between brokers and some do not make any charge, although these will normally have higher fees for transactions. In order to work out the best deal for your individual circumstances, you will have to estimate the size and number of transactions you plan to make. It can seem a chore to do this research but many brokers charge a high fee for transferring your holding to a new broker so it pays to get this right first time.
Finally, once you have invested in the stock market and made your profit the government will tax you on it. In the USA the tax is straightforward: any income, whether from dividends while you hold the stock or as a capital gain when you sell it, is taxable as income and needs to be declared on your return. Any losses can be used to offset the liability on the gains. Beware not all markets are the same; for example if you buy shares on the London stock exchange there is a tax of 0.5% on all transactions paid to the UK government. If you do plan to invest in overseas markets, it pays to make sure you understand the tax situation of each county first.
Efficient Market Hypothesis
The efficient market hypothesis was developed in the 1960s by Eugene Fama as a development on the Random Walk Theory which suggested that stock market prices could not be predicted. The hypothesis is the basis of much of the financial research and further theory that has been put forward since and is a good starting point in investment theory for the new investor.
The basis of the hypothesis is that in an open and efficient market, prices rapidly adjust to any new information and are based on all available information. This means that the prices for each stock should always be a correct reflection of their intrinsic value. Any new information would quickly be acted upon before investors could profit from the knowledge.
The efficient market hypothesis is split into three forms: strong, semi-strong, and weak. Weak form efficiency is concerned with only past data and proposes that by looking at historical data alone, it is not possible to make a return by outperforming the market. Semi-strong form efficiency also includes all publicly available information such as financial reports, and strong form efficiency includes private information which would constitute insider dealing.
There have been numerous studies into all three forms of efficient market hypothesis. There is a large amount of evidence to support weak form efficiency where markets are efficient, however the case is less convincing where semi-strong efficiency is concerned. Strong form efficiency has been disproved which is why insider trading is illegal and breaches are prosecuted so vigorously.
For the investor this is especially relevant as historic share price information is very easy to acquire and draw conclusions from. Weak form efficiency has shown that just studying the past performance of a particular stock will not be enough to make a good return.
Another factor to consider is the efficiency of the market in question. Large stocks which are traded in high volumes have more people studying the information and so the stock should be efficiently priced. Less popular stocks and those listed on the stock exchanges in emerging markets often have less people carrying out the research and the efficiency is potentially lower which increases the opportunity for returns that beat the market.
If efficient market hypothesis is correct in all cases, then it is not possible for a stock picker to consistently beat the return of the market overall. While the hypothesis has not been conclusively proved in all forms it has led to an increase in popularity of index tracking funds as it suggests that the lower costs of these would offer better value than actively managed funds. The investor has to decide if they prefer to spread their investments around to replicate the whole market or to look to find an opportunity where there is enough inefficiency in the market for them to make a higher return.
Most investors will look to diversify their portfolio in order to reduce the effect of one company dropping in price. This is always a good idea, but will have very little difference if the fortunes of the companies you invest in are directly linked.
The financial term for this is correlation and assigns a value to how closely the two share prices follow each other. Correlation is not necessarily limited to the share prices of individual companies and it is possible to look at the correlation of different sectors or indices as well. While the use of correlation cannot completely guard against a major global crisis it should certainly help protect you from the effects of one share price dropping.
If two companies are so closely linked that their share prices move in an identical way and amount, then they have a correlation of 1. If their businesses are arranged so that one only gains when the other loses and vice versa, then their correlation would be -1. In reality this is very rare, and they will be somewhere between the two. It is possible for there to be no link at all between the fortunes of the two companies in which case we simply say there is no correlation.
The ideal is if you can find companies with negative correlation so that if one stock is losing value this will be canceled out by the other gaining. These can sometimes be hard to identify, but a good place to start is with companies who depend heavily on a particular commodity and the suppliers of that commodity (for example an oil company and a transport company). These could have negative correlation because a rise in the price of the commodity is good for the supplier, but increases costs for the customer.
An alternative is to select companies with little or no correlation between them. While they will not necessarily cancel each other out there will be a much lower risk of one event having a dramatic event on the performance of your overall portfolio.
There is a mathematical formula for working out the exact correlation for those that are comfortable with statistical analysis, but there is also a shortcut to this. The easiest way is to plot the two share prices on a graph and see what the relationship between the two prices is. There are many websites which will do this for you just by selecting the stocks and the time-frame you would like to consider. It is then just a case of comparing the peaks and troughs. Remember that correlation is only one factor in selecting which stocks you are going to invest in. It is still important to ensure that you are buying stock in a company that you feel will increase in value and not just because it has a negative correlation to another stock in your portfolio.
Correlation should be done over a timescale of several years if possible and certainly a minimum of one year. You need to consider that companies do evolve and change their focus so the correlation of the two companies may change over time.
Initial Public Offerings
Initial public offerings, or IPOs as they are commonly known, are essentially the first time a company offers its shares for sale to the public. The IPO changes the status of the company to a public listed company so that the shares can openly be sold on the stock markets. The sale of new shares is known as the primary market and the money raised is going directly to either the company or its private owners. Once the IPO is completed the shares are traded on the stock exchange between investors; however, this is known as the secondary market and the rising share price is mainly benefiting the investors rather than the company.
In nearly all cases the IPO will be handled by an investment bank or a syndicate of banks on behalf of the company. The investment bank will act as the underwriter for the deal and is hired to ensure enough funds are raised. While they will sell to individual investors, they will be actively targeting the large institutional investors in order to complete the process in a smaller number of transactions and guarantee enough volumes to satisfy the company. It may well be necessary to have a trading account with a participating bank or broker before being offered shares of the IPO.
Many IPOs will be smaller or newer companies and considered a riskier investment because of this. The initial public offering of Facebook, which raised sixteen billion dollars, has raised the profile of IPOs and may well increase demand in similar offerings. The offer price will be set in advance of the offering which does give an investor time to research and decide if the shares are likely to provide a healthy return. The difficulty for investors who have not bought stock through an IPO before is that there is no historic share price data to consider. The investor will have access to much of the information on the company which is supplied as the prospectus by the investment bank. To protect investors the prospectus must be cleared by the Securities and Exchange Commission.
Some riskier investors look to make very quick profits by investing in IPOs where the share price is likely to rise. Some share prices have risen dramatically following the initial offering, especially where the demand is high. Both the price and the number of shares in the offering are fixed in advance so this demand can create a rapid rise on the day of the offering.
What is day trading? Day trading is a term that refers to very short term investing. The investor may hold a position for only minutes, or in extreme cases seconds, but in any case all trades are settled before the market closes for the day. While day trading can be risky, closing all trades removes the risk of markets opening in a different position while traders cannot exit a position.
The main principle of day trading is to predict the way the market is likely to move and take a position in order to profit from the movement. Day traders can profit from either a rising or falling price by taking advantage of derivatives. These include instruments that allow traders to sell stock they don’t own in the hope they can buy it cheaper later, or to agree a price for a future purchase which they hope will give them a discount for the stock at that point. These strategies can be high risk as if a price moves in the opposite way the trader still has the liability to complete the trade which can give them a large loss.
Stocks are not the only market for day traders; foreign exchange and commodities are also commonly used. Most day traders will have a specialized area of interest and will tend to wait for the opportunity in their market rather than trying to cover everything.
Because the potential for share price movements in a short time frame are lower most day traders will use very large volumes of stock in order to make the returns they want. This does increase the potential for losses as well as the potential for gains. Some will also use borrowed money to make the investment, which is known as trading on margin, but this will still need to be repaid if they make a loss. A day trader will not necessarily need to hold the full price of the stock to make the trade but they will always need to be able to cover any losses if the market moves against them.
There are a wide range of techniques used by day traders to identify the opportunities for trades. The largest driver of share price fluctuations during the day is the news, and day traders will have a close eye on any reports coming out. Beyond this, individual strategies place importance on a wide range of factors and information available. Some large traders will even use algorithms that spot opportunities and make the trades based on predefined parameters.
Day trading can provide big returns for experienced investors and in a much shorter timescale than with value investing. The technique does mean that the trader has to be watching the market full time when they have positions open. It will also require quick access to recent stock market news and a broker that can fulfill orders near instantly when required. It is always worth remembering that when the potential for returns increases, the potential for losses tends to increase as well.
Our goal with this article is to provide the average individual investor with the knowledge to confidently invest in the world’s equity markets. Whether investing for the short or long term, it is important to understand the risks and costs when investing in stocks.