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.
- What is stock trading?
Stock trading involves buying and selling shares in companies in an effort to make money on daily changes in price. Traders watch the short-term price fluctuations of these stocks closely and then try to buy low and sell high.
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This short-term approach is what sets stock traders apart from traditional stock market investors who tend to be in it for the long haul.
While trading individual stocks can bring quick gains for those who time the market correctly, it also carries the danger of substantial losses. A single company's fortunes can rise more quickly than the market at large, but they can just as easily fall.
“Trading isn’t for the faint of heart," says Nathaniel Moore, a certified financial planner and a certified kingdom advisor 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, the best apps for trading stocks, and how to manage your risk.
Types of stock trading
- 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 an individual stock can expose your savings to too much volatility.
"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 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. We go through these in detail in our guide for how to buy stocks, but 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 and 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 monitor 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 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 a certain 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 get-rich-quick scheme.
- How to manage stock trading risks
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. 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.
2. Ignore 'hot tips'
People posting in online stock-picking forums and paying for sponsored ads touting sure-thing stocks are not your friends. In many cases, they are part of a pump-and-dump racket where shady people 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. If you've sold stocks for profit or made money from selling stocks, make sure to set aside some extra cash for a potentially larger-than-normal tax bill. 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.
- 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 higher 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.
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 (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.
great ! you have explained it very well. looking for more content like this.
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