Ready to start trading stocks? Start by answering a few simple questions: Is your retirement plan humming along with regular monthly contributions (at least as much as your employer matches)? Do you have little to no high-interest rate debt? How about plenty of excess cash beyond your emergency fund?
If you check all those boxes, it may be the right time to start trading stocks. Trading stocks — actively buying and selling portions of ownership in companies — can bring you closer to your favorite corporate brands, it can make you feel powerful and, if the timing is right, there is great potential upside. However, stock trading can also be risky and incredibly difficult to do well, so it helps to be deliberate and know how trading works before you buy your first stock.
What is stock trading?
First, it helps to define a few terms. A share of stock represents a portion of ownership in a company, and trading stock is buying and selling those shares. But how you purchase stocks, and how often, will put you into one or more of the following categories:
Stock investing is owning shares of stocks. You may be invested in a portfolio of stocks through a mutual fund or index fund, hold some individual shares in a long-term retirement account or own shares of your employer’s stock.
Stock trading or active trading involves shorter-term buying and selling to take advantage of market opportunities.
Day trading means you buy and sell a single security within the same day, according to the Financial Industry Regulatory Authority (FINRA).
Pattern day trading means you conduct four or more “day trades” within five consecutive days, according to the SEC, although day traders often trade throughout the day, attempting to take advantage of any market moves. There are high barriers to entry to day trading, including the ability to maintain at least $25,000 in your account, according to the FINRA.
Pros and cons of trading stock
So why should the average investor want to trade individual stocks — or avoid them? Consider some pros and cons.
Pro. Trading stocks is exciting. Individual stocks represent companies, and trading stocks can feel like a thrilling stake in ownership of a favorite brand. As you research a company and get to know what moves its stock price, you may see patterns that help you find other companies with stock you can trade. You may not get that same sensation purchasing shares of a mutual fund.
Con. Trading stocks carries a higher risk than other types of investments. Buying a mutual fund or index fund, for instance, makes you the owner of an entire portfolio of companies, which reduces the risk of your overall investment. It’s harder to achieve the same level of diversification with individual stocks.
Pro. Stocks offer incredible potential for growth. The stock market has returned an average of about 10% per year historically, compared to around 5% annually for bonds. Individual stocks can be volatile, but can also achieve some amazing returns.
Con. A finance professor from Arizona State University recently crunched the numbers and found that most stocks are terrible investments. Professor Hendrik Bessembinder analyzed common stocks included in the Center for Research in Security Prices (CRSP) database since 1926 as long-term, buy-and-hold investments. The top-performing 4% of companies were responsible for the net gain of the US stock market since that time. The others? Most returned less than one-month Treasuries. Rather than try to select those few winning stocks, you might be better off buying the market’s performance with an index fund.
Pro. Unlike mutual funds, stocks don’t charge annual fees. Index funds charge an average 0.09% of your investment each year, just to be part of the fund. Active mutual funds take an average 0.59%, according to the Investment Company Institute. It may not sound like much, but for buy-and-hold mutual fund investors, these expenses add up over time.
Con. Stock traders pay brokerage fees when they buy or sell shares, which can also add up quickly if you trade actively. Over time, it’s possible the brokerage fees could have a similar impact on your investment as annual fund expense ratios.
How do you trade stocks?
What do you need to start trading stocks? The following will help get you started.
Excess cash. Start trading with money you can afford to lose. Because of the high-risk nature of stock trading, your first attempts may be unsuccessful or you could turn a profit early on. Avoid big bets until you’re comfortable in the market. “Think of it as Atlantic City money,” says Tom Henske, CFP with Lenox Advisors in New York. “I tell clients, if you want to do it, you should go in willing to lose half the money you invest. If losing $25,000 would be too much, then you shouldn’t invest $50,000.” Even if you’re a trading whiz, Henske says, “No single holding should represent more than 5% of an individual’s portfolio. If you have $100,000 in net worth, you should go in with less than $5,000.”
A brokerage account. Traders need an account to access and hold stocks. You can open an account through a brokerage, which can also provide access to a wide variety of bonds, mutual funds, exchange-traded funds and so on.
The type of broker you choose will depend on your needs. Large, full-service brokers offer trading advice but are sometimes known to aggressively push investments. If you’re looking for lower trading fees and a bit more freedom, an online discount broker may be more appealing. Online brokerages generally offer the same investment selection and trading capabilities. You may not get personal advice, but some online brokers offer things like third-party analyst research and tools to help compare stocks.
When comparing online brokers for stock trading, ask the following questions:
- Are there trading fees or account minimums? There are reputable online brokers offering trades as low as $4.95 with no account minimums. Some companies charge a fee per share instead. If you plan to trade more complicated investments, such as options, compare those fees as well.
- What are the trading capabilities? Some brokerages offer sophisticated investments (e.g. options, futures) and strategies (e.g. ladders, swaps). These are not for beginners, but they may of interest at some point, so compare the capabilities of different online firms to find what suits you.
- Can I get help researching stocks? From video tutorials to company analysis and data to user-friendly tools that make complex trading easy, brokerages find different ways to engage and educate investors. Take advantage of as much information as you can.
Investment ideas. One of the biggest mistakes a trader can make is to seek out “hot stocks” or buy based on investment buzz. Instead, consider the strategies, sectors or companies that are of interest to you and start to build from there. Are you looking for companies in growth mode, or value stocks that pay regular dividends? Could you build a sector-like portfolio with a handful of stocks?
If you have companies in mind, a next step is to research their fundamentals. You can get to know the company’s price-to-earnings ratio, revenue and income. Also consider the competition, the company’s importance in the market, the executive management, operational efficiency and so on. Your brokerage platform may help connect some of these dots for you.
A buy/sell strategy. Do you plan to invest a lump sum? Or buy shares at regular intervals to create substantial positions over time? What are your goals for the money? How much risk can you afford to take? These are important questions for any investor to consider.
Additionally, give some thought to how long you will hold the stock or at what price you might sell it. In general, it helps to have a long-term outlook as an investor. Sometimes, however, there are reasons to sell. If prices for a stock spike, for instance, it may make sense to move money out of it. If share prices fall, you might consider buying more shares at a discount. Whatever your strategy, it should not be driven by panic or fear caused by dips or swings in the market.
A target share price. If you have your eye on a stock at a certain share price, you can set something called a limit order, instructing the broker to buy stock when it hits a specific share price. Alternatively, a market order can be made to buy shares at whatever the current price is.
There are also tools like stop-loss orders that allow you to determine an automatic price at which to sell your stock shares. These orders come at an extra cost, so use them wisely if at all.
4 things to know before you start stock trading
- Start virtually. Some online brokers offer virtual or “paper trading” accounts that let you practice trading before investing real money. If you’re not ready to sign up with a broker, search for a free online tool that lets you track a stock portfolio.
- Beware low-quality investments. Watch out for penny stocks, also known as microcaps, which let you trade companies with very low share prices. Penny stocks might sound like great deals, but they are volatile, oversold and can be downright sketchy. And remember, it’s not just the price of the investment that makes it cheap, but the price compared to what it’s worth.
- Time in the market > market timing. Even the sharpest investor sentiment is slow compared to the market’s speed. It’s not easy to keep up. Consider a longer-term buy and hold strategy when trading stocks.
- Watch the margins. Some brokerages will allow you to pump up the number of shares you purchase by lending you the funds to do it. It’s known as a margin account, and it increases your risk because you can lose more than you have invested. The Securities and Exchange Commission has some recent guidance on margin accounts to consider before opting for this type of account.
3 simple alternatives to stock trading
Still not sure whether to start stock trading? There are simpler ways to try and make money in the market. Consider the following stock trading alternatives.
- Exchange traded funds (ETFs). ETFs trade like stocks but offer broad market diversification. You can buy in for the cost of a single share (plus trading costs), with minimal annual fees.
- Robo-advisors. These automated financial advice algorithms use your responses to a simple questionnaire to help you build a low-cost investment plan.
- Index funds in a Roth IRA. It may sound boring, but a Roth IRA offers serious tax advantages for longer-term, eligible investors. You can trade anything within a Roth, but a stock index fund is easiest and can provide the performance of the larger market at a low annual fee.
Stock trading is just one tool in a wealth-building arsenal — and not the most effective for the average investor, says Henske. “There’s so much transparency in today’s markets, it’s very hard for even a professional money manager to beat an index,” Henske says. “When you trade stock on your own, you’re saying you know more than the markets know. It’s not easy to do.”