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Trading stocks may sound glamorous, but behind the scenes it’s actually a lot of hard work and can involve extensive research. While it’s not always easy, new investors can take a number of steps to begin investing successfully, including finding a style that works to grow their portfolio over time.
If you’re looking to trade stocks, one of the first things you’ll want to consider before getting started is to figure out what type of trader you want to be:
- Are you an investor looking to buy and hold stocks, potentially for years?
- Or are you looking to exchange shares more frequently, perhaps over a few weeks or even over the course of a day (perhaps making you a day trader)?
Traders are those individuals who are in the market looking to take advantage of short-term price moves and score a relatively quick profit, while investors look to profit on the ongoing success of the company behind the stock over the longer-term.
Why trade stocks?
People trade stocks for one reason: to make money. In order to profit, they need stocks to fluctuate — and the more they move, the better. Stocks are one of the most volatile assets in the public markets — much more than the staid asset class of bonds – so they offer a lot of potential to move. Savvy traders can make money both when a stock rises and when it falls.
Stocks aren’t as volatile as options, however, and that’s one reason that options have become a very popular security to trade as well. However, stocks are more forgiving. That is, unlike options that can lose all their value over a short time, stocks tend to retain much of their value. So stocks hit a sweet spot – enough movement to be profitable to trade, but not too much to be utterly ruinous.
How to trade stocks
Before you start trading, you’ll want to put some thought into why you are trading and the strategy you’d like to employ. Here are some things to think about before you dive in.
1. Decide which kind of trader you want to be
Are you a trader looking to actively manage your way to more wealth? Or are you an investor, looking to profit from the long-term appreciation of stocks? Of course, you could do a little of both: keep most of your portfolio (say 90 percent) in stocks, while you use a little bit to trade.
The approach you choose will determine:
- Your stock ideas
- Your typical holding period
- Features you’ll need from a broker
- Tax impacts
It’s also important to note that most traders lose money, so you must have a clear grasp of your goals and process before you begin. On the other hand, investors who buy and hold a broadly diversified basket of stocks (such as the Standard & Poor’s 500 index) may enjoy the long-term appreciation of the stock market with minimal work each year.
2. Identify your process
So you’ve decided you want to trade stocks – what kind of strategies are you going to use?
- Are you going to be a scalper, trying to get a few pennies on every trade?
- Are you going to only buy stocks or are you also going to short-sell them?
- At what point will you cut losses and realize gains?
- Are you going to do swing trading, trying to ride a longer up or down move in a stock?
- Or will you be a day trader, trading in and out of a position in a day or two?
Those are just some of the many questions you may want to ask yourself as you begin trading. Many different approaches can work, and you’ll need to find one that works for you and your temperament.
The list of questions for those who want to invest is shorter, however, and less varied:
- How long do you want to be invested? Do you need the money soon?
- What level of risk are you comfortable with?
- Do you want to buy stocks (more risky) or funds (generally less risky)?
- How much money do you want to invest and how much can you add over time?
While investors may need to answer a few other questions, the list is much less detailed than for traders.
3. Set up your brokerage account
Choosing a broker will depend on your trading approach. Here are some broker features to consider for different types of strategies.
- Traders – If you’re trading, you may want to consider brokers that offer charting capabilities to help you spot opportunities or those that have low costs, since you’ll likely be making a lot of trades.
- Investors – If you’re investing, you might opt for a broker that’s a little bit pricier, but that offers more research, since you want to find the best long-term picks.
- Funds – If you’re investing in funds, you might want to find a broker that offers a wide selection of commission-free ETFs or no-transaction fee mutual funds.
- Beginners – If this is your first time setting up a brokerage account, you might want to select a broker that’s known for providing a high level of customer support. Good customer support will be able to guide you through various questions, as well as resolve issues. Some brokers also offer excellent educational resources (articles and videos) on their site that can get you up to speed on the broker’s features and tools.
When you’re opening an account, you’ll want to have at hand your financial information, including your bank details. The broker will ask for your income range, your overall assets and other personal questions. You should be able to open most accounts within about 15 minutes, and may not even have to immediately fund the account — though it’s usually a good idea.
Above all, let your style direct the brokerage you select. Here are the best brokers for beginners.
4. Find trade ideas
Before you make a trade, you first have to know what to trade. A good brokerage can help with that, as can any number of subscription stock newsletters and even some free sites.
If you’re a trader, your broker may provide ideas for you, or you may have to do your own research to find interesting set-ups. That can mean analyzing lots of stock situations, for example, stocks at 52-week highs or lows, to see if they look like they’ll continue trending. Your broker should support your approach with charting capabilities and other technical studies.
If you’re an investor, the broker may also provide research, such as reports on the company’s business and prospects for the future. But you can also turn to third-party research, some of which has an excellent track record. You’ll need to develop investing ideas on your own, though the broker may provide some ideas to kick off your hunt for stock riches.
Whether you’re trading or investing, you’ll also want to consider when it may be best to sell a position. For traders, you’ll often sell when the stock hits a certain price, either a gain or loss. That may also be the case with investors, though they may also hold a stock indefinitely, riding a high-flying stock for decades with no intention of ever selling.
5. Execute the trade
Once you’ve found what you’re going to trade, then it’s time to execute the trade. Make sure you know your basic order types, though most brokers have more complex options than just these two:
- Market order: A market order will execute at whatever the best price is at the time you place the order. That is, if you place a market order to buy a stock, you will buy at the lowest asking price currently. If you place a market order to sell a stock, you will sell at the highest bidding price.
- Limit order: With a limit order, you specify to the broker what price you want to get on the trade. If the broker can get that price or better – a higher price for sells or a lower price for buys – then the trade will be executed.
One important point to remember with these order types is that you’re beholden to the market when you place a market order. You’re going to get whatever the prevailing price is. That’s not likely to cost you anything on large, highly liquid stocks, but you may spend or lose more money if you use a market order for smaller, less liquid stocks.
Finally, once you own the stock, you can carefully watch for when you want to sell, or you can be less attentive if you aim to hold the stock for years. In fact, investors might relish when a stock drops because it may offer an attractive price to buy the stock.
How to protect your portfolio
Trading is difficult to succeed at, because there are many ways to screw it up. Whether trading or investing, here are some important tips to keep you from blowing up your portfolio.
1. Manage risk
Every time you lose money, it’s like a loss of future earnings potential, and that’s why it’s absolutely vital to keep from losing money. Of course, many trades will be losers. Traders who want to live to trade another day should know how to manage risk so that they don’t bleed cash when they do make a bad trade. So that’s why one of the first rules of trading is to cut losses before they turn into big losses and then into catastrophic losses. You won’t get a catastrophic loss if you always sell when you’re down 3 percent, for example.
By taking a loss early, you can prevent it from becoming crippling to your portfolio. Ultimately, that means you may be taking many small losses in order to prevent that massive loss. Psychologically it’s tough to take a loss — even a small one — but risk management is the most important skill a trader can have.
2. Diversify your positions
Diversification is another form of risk management, and it has the potential to increase your total returns, too. Whether you’re a trader or investor, it’s important not to have all your money in just one or a few investments. By diversifying across multiple investments – think 10 or 20 or more – you drastically reduce the chance that one position will hurt your portfolio. Plus, diversification helps to smoothen your returns over time versus a few (volatile) stocks dictating your returns.
3. Stay away from pump-and-dump schemes
As you’re starting to trade or invest, you’ll want to be wary of hucksters promising quick returns. Often these frauds will post about some unknown penny stock on an internet message board, hoping to lure novice traders. Unfortunately, the goal of these schemes is to move the stock price higher with a quick burst of hype followed by insiders selling the stock to take advantage of the run-up. That’s why they’re called “pump-and-dump” schemes.
Trading is hard work, and no one knows with certainty how a stock is going to perform. But traders can make it easier on themselves by only buying and selling legitimate companies.
4. Practice virtual trading
Many brokers allow you to trade virtually or with “paper money,” so that you can test and refine your skills before you go out into the market with real money. You can sign into the broker and trade exactly as you would normally, without incurring any penalties for being wrong. Then when you’re ready for the real thing, you can switch back and give it a go.
As you practice, however, track your performance so that you have an accurate gauge of how you would do in reality, not just rely on your subjective impression. Have you gained or lost money on your transactions? How did you react? And don’t forget that you’ll probably trade much differently when your real money – and your emotions – are on the line.
When you first begin trading or investing, it can seem overwhelming, but the biggest step is just getting started. Then you can find a style that fits you and your temperament. Those who want to invest for the long term and put less effort into their investments can practice buy-and-hold investing, while those who live for an exciting trade can become traders. One beautiful thing about the market is that you get to choose the style that works for you – and many styles can be successful.
Note: Bankrate’s Brian Baker contributed to an update of this story.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.