Last Updated on 29 June, 2022 by Samuelsson
Since the 17th century when stocks were traded in coffee shops, to the establishment of exchange houses, and later on, the electronic exchanges, the stock market has always provided people with opportunities to grow wealth by trading the shares of various companies.
The stock market is about the most important aspect of the economy. Every country in the world depends on her stock market for economic growth. Because of its importance in growing wealth, we’ve created this guide on how to play the stock market to help you understand the basics.
In this guide, you will learn the following:
- What the stock market is
- Common securities in the stock market
- How the stock market works
- The different types of stocks to trade
- Different ways to play the stock market
- How to analyze the market: technical and fundamental analysis
- How to invest in stocks
- Stock market tips for investors and traders
- Examples of people who became rich through the stock market
So, let’s begin!
What Is the Stock Market?
The stock market refers to a collection of buyers and sellers of shares in various companies, as well as the exchanges or marketplaces where the shares are traded. A share is a unit of ownership (and possibly, voting right) in a company which can be traded on the stock exchanges.
Although the term stock exchange is sometimes used to refer to the stock market, a stock exchange is simply an organized marketplace where shares are transacted, while the stock market encompasses all the marketplaces — including the electronic exchanges — and the market participants in a country or region.
For example, the U.S. stock market consists of all the stock exchanges in the US, such as the New York Stock Exchange (NYSE), the Better Alternative Trading System (BATS), Nasdaq, and many others, as well as all the investors and traders who participate in the buying and selling of shares.
The stock market is very important in the nation’s economy because of the following reasons:
- It provides companies and businesses with a cheap way to raise capital to finance their various projects.
- It offers individual investors the opportunity to buy into the ownership of a company and grow their wealth as the company grows.
- It also provides individual investors with a ready market where they can sell their shares to raise cash for personal needs.
But how did the stock market come about?
A Brief History of the Stock Market
Even though there were semblances of the stock market in the 12th to 16th century in France, Italy, and Belgium, those markets only traded in government securities and not company stocks. The first company to sell its stock to the public was the Dutch East India Company in 1602 when it released its shares on the Amsterdam Stock Exchange.
So the Amsterdam Stock Exchange, presently known as the Euronext Amsterdam, is the oldest exchange to deal on company stocks. Following the success of the Dutch East India Company in issuing its shares to the public, other companies in the neighboring regions, including London and Paris, started selling their own shares.
Investors would meet in coffee shops to buy and sell their stocks. Later on, a marketplace for stocks was built in Paris in 1724, giving birth to the Paris Stock Exchange. This was followed by the Philadelphia Stock Exchange in 1790, the London Stock Exchange in 1801, and the New York Stock Exchange in 1817.
These marketplaces initially used the open outcry system, but with the advent of the internet, most of the exchanges now employ fully automated electronic trading systems. Furthermore, the stock market now offers other financial instruments in addition to stocks.
Common Investment Vehicles in the Stock Market
Although the market is known primarily for stocks — and bears the name ‘stock’ market, share market, or equity market — other securities can be bought or sold in the market. Some of the most commonly traded securities include:
- Exchange-traded funds
- Index funds
- Mutual funds
The stock of a company is a collection of shares of the company, and a share is the unit of ownership in the company. Often times, the terms are used interchangeably. Stocks are also known as equities. Apart from entitling the shareholder to a portion of the company’s earnings and assets (in cases of liquidation), a stock may also come with the right to vote at shareholder meetings.
Based on the voting rights attached to the stock, there are two main types of stocks:
- Common stocks
- Preferred stocks
Common stocks, also known as voting shares, equity shares, or ordinary shares, are the type of stocks that give the shareholder the right to vote during general meetings on matters of corporate policy and board membership. However, holders of common stocks receive dividends only after the preferred stockholders have been paid. And in a case of liquidation, they’re the last to receive proceeds of the company’s assets.
Preferred stocks (preferred shares) do not offer the stockholder voting rights, but the holders are paid dividends first before the ordinary shareholders. The same is true for the proceeds of liquidation. Companies can structure their preferred shares differently, but the common types include:
- Prior preferred stocks — which carry the highest priority
- Preference preferred stocks
- Convertible preferred stocks — which can be converted to a predetermined number of the company’s ordinary shares anytime the stockholder wants
- Cumulative preferred stocks — with accumulated dividends if not paid
- Non-cumulative preferred stocks — dividends can’t accumulate
- Participating preferred stocks — which may offer the holder extra dividends if the company achieves better financial results
- Putable preferred stocks — which carry a ‘put’ right
Exchange-traded funds (ETFs)
An exchange-traded fund is a collection of securities — such as stocks, bonds, commodities or a mixture — that trade on a stock exchange, just like a stock. So an investor can buy a share of an ETF the same way he can a share of an individual stock. The share price of an ETF fluctuates throughout the day as investors buy and sell the security. And the price represents the net asset value (NAV) per share.
There several types of ETFs based on the underlying assets:
- Bond ETFs: They involve government bonds, municipal bonds, and corporate bonds.
- Industry ETFs: These are funds that track a specific sector, such as financial services (XLF), biotech (BBH), energy (XLE), etc.
- Index ETFs: They track some major market indexes, such as the S&P 500 Index, Dow Jones Industrial Average, Russell 2000, Nasdaq 100, etc. For example, SPDR S&P 500 (SPY) and iShares Russell 2000.
- Commodity ETFs: These ones include commodities, such as oil (USO), natural gas (UNG) or gold.
- Currency ETFs: foreign currencies like the Euro or British pounds.
Being a basket of securities, an ETF offers an investor a diversified portfolio and are known to carry low brokerage commissions. You can buy an ETF through an online broker or a traditional broker.
A mutual fund is a managed investment fund that collects money from many investors to invest in securities, such as stocks, bonds, money market instruments, and others. The investors can range from retail to institutional investors, and the fund is managed by a professional fund manager.
A share of a mutual fund represents a fractional investment in different asset categories the fund has in its portfolio. Unlike ETFs, mutual funds don’t actively trade on the exchanges, and an investor can only buy them after the market hours at its net asset value per share.
Depending on the asset category in a mutual fund, it can be categorized into the following:
- Stock mutual fund: This type of fund is mostly invested in common and preferred stocks of different companies.
- Index mutual fund: Also called an index fund, this type of fund tries to mirror the major stock market indexes, such as the S&P 500, in its portfolio composition.
- Bond mutual fund: This type of fund invests principally on government, corporate, or municipal bonds.
- Hybrid mutual fund: Here, the fund is invested equally in various stocks and bonds.
- Money market fund: The funds in majorly invested in money market instruments, such as treasury bills.
An index fund is a type of mutual fund or exchange-traded fund that seeks to track a particular market index. The index tracked may be a broad market index, such as the S&P 500, Dow Jones Industrial Average, Russell 2000, to mention but a few. So there are basically two types of index funds:
- Index mutual funds: Here, there’s a fund manager that picks and allocates funds to different stocks to mirror the intended index. Being a mutual fund, the fund doesn’t trade actively on an exchange during the day. It can only be bought after the market hours and can be bought directly from the fund.
- Index ETFs: These types trade actively on the exchanges, and the shares can be bought like a stock. The management fee is very small compared to the other type of index fund.
By providing a broad market exposure, an index fund is inherently diversified. Additionally, both types of index funds are cheaper than building a diversified portfolio made of individual stocks or investing in traditional mutual funds. That is, index mutual funds have lower management fees than the actively managed traditional mutual funds because a fund manager doesn’t need to research before picking stocks in index mutual funds.
Comparing the Common Types of Securities in the Stock Market
|Stocks||ETFs||Mutual Funds||Index Funds|
|Fund manager||No||No||Yes||Index mutual funds have fund managers, but index ETFs don’t.|
|Minimum initial investment||None||None||$1000||Depends on the type: $1000 for index mutual funds and no minimum investment for index ETFs|
|Risk||Riskier||Less risky||Less risky||Less risky|
|Expense||Brokerage fees||minimal||More expensive||Depends on the type|
|Where to buy||Stock exchanges||Stock exchanges||Directly from the fund||Depends on the type: Index ETFs can be bought from the exchanges.
Index mutual funds can be bought directly from the fund
|Time to buy||Market hours||Market hours||After the market hours||Depends on the type — market hours for index ETFs and after the market hours for index mutual funds|
How the Stock Market Works
The stock market provides an enabling environment for investors and companies to transact in a fair, transparent, orderly, and efficient manner. It provides a secure and regulated business atmosphere that operates under well-defined rules, which are enforced by a regulatory agency.
The stock market brings different participants together in the business of buying and selling shares and serves both as a primary market and secondary market for stocks.
Serving as a primary market means that the stock market allows companies to issue some of their common shares to the public for the first time — a process known as the initial public offering (IPO). Through the IPOs, companies can raise funds from investors to finance their different projects.
Aside from raising the initial funds from the market, listed companies also enjoy the following benefits:
- The opportunity to raise additional funds by issuing more shares in the future
- Greater visibility
- The possibility of using listed shares to pay for business deals like acquisitions
- The ability to set up employee stock options plans which can attract more talented employees
As a secondary market, the stock market provides a marketplace where the existing shareholders can sell their shares to other investors to raise cash for personal use. So in the secondary market, stocks trade without the direct involvement of the underlying companies.
The Participants in the Stock Market
There are different players in the market, with each player performing a specific role. Here are some of the players:
Corporations: These are the companies whose stocks are listed on the market. They have a duty to make important information that concerns their business activities available to the public.
Investors: They are the ones that bring the funds to buy stakes in the publicly traded companies. Investors often hold their shares for a long time.
Traders: These are short-term operators, frequently buying and selling shares to benefit from short-term changes in stock prices.
Stockbrokers: They are the middlemen between the traders or investors and the exchanges. Stockbrokers help investors/traders to buy or sell stocks.
Portfolio managers: These are professional investors who are paid by inexperienced investors to manage their portfolios.
Investment bankers: They help the corporations to list on the market or perform other business deals like mergers and acquisitions.
Custodians: These ones help in holding customers’ securities for safekeeping.
Market makers: They help to maintain liquidity in the market by posting bid and ask prices and maintain an inventory of shares.
Roles of the Stock Market
The market means different things to different participants, but generally, it performs the following roles:
Ensuring Fair Transactions
It is the role of the exchange to efficiently match the buy orders with the appropriate sell orders. So the market ensures that transactions are carried out in a fair and transparent manner by making sure that buyers and sellers have instant access to the market data that help their trading decisions.
The market matches the buyers with the sellers together, so it helps to maintain adequate liquidity. Although it’s not the role of the market to tell investors what to trade and when to trade, it has a duty to ensure that all willing investors have access to whatever they want to trade and that orders are fulfilled without delay.
Ensuring Efficient Pricing Mechanism
There’s a mechanism for ensuring the proper pricing of a financial instrument. Although several factors can affect the price, it all boils down to the demand and supply of that security. So the market allows the normal market forces to determine the price, without manipulation of any sort.
Providing an Enabling Environment for All Types of Players
The players in the stock market, such as investors, speculators, traders, scalpers, hedgers, and market makers, participate differently in the market. The market should be able to accommodate all of them, allowing them to operate seamlessly so as to ensure an efficient market.
Ensuring the Validity of Transactions
The market makes sure that all market participants are verified and play by the established rules and regulations to ensure accountability and prevent cheating. Fraudulent practices, such as insider trading, should never be allowed — all entities must be made to adhere to the rules of the game.
Regulating the Listed Companies
The market and its regulators have a way of monitoring the activities of the companies listed on the exchanges. The listed companies are mandated to report their quarterly earnings timely and also supply the market with other information pertaining to their business activities, such as acquisitions, change of directors, etc. This way, the investors will have all the necessary information for making their investment decisions.
Why Stocks Move: The Effect of Supply and Demand
The price of a stock is affected by the imbalance in the demand and supply of that stock. There must be a willing seller and a willing buyer for a transaction to take place. So if there are more willing buyers than sellers, the stock’s price will go up. On the other hand, if there are more sellers than buyers, the price will go down.
Let’s break this down.
Some buyers place orders at certain prices they’re willing to buy the stock at. Similarly, some sellers place orders at prices they’re willing to sell. A stock’s current price is represented by the bid and ask prices — which are the highest of any of those buy orders and the lowest of any of the sell orders respectively.
A transaction happens when a seller accepts the bid price or a buyer accepts the ask price. If there are more buyers than sellers (more demand), there will be buyers who are willing to accept the ask price, and by taking out all the orders at the current ask price, the price will go up to meet more sell orders at a higher ask price. This way, the demand is driving the price up.
Conversely, when there are more sellers than buyers (more supply), some sellers will be willing to accept the current bid price, and by doing that, move the price down to the next buy orders which are bidding at a lower price. So the price effectively trends down.
Factors That Affect the Demand and Supply of a Stock
There many factors that can affect the demand of a stock. Some of them include:
- any news about the company
- the company’s financial reports, such as earnings, revenues, and sales
- the general state of the economy
- changes in interest rates
On the other, the supply of a stock will be affected if:
- the company buys back its stocks
- the company issues new shares
- there’s a spinoff
- negative information is released about the company
How is the stock market regulated?
Every country has a financial body tasked with the job of regulating the country’s stock market. In the US, the stock market is regulated by the Securities and Exchange Commission (SEC).
The SEC is an independent federal agency whose mission is to protect the investors, maintain a fair, orderly, and efficient market, and facilitate capital formation. It enforces the rules in the market to ensure that the investors are treated fairly.
The Differences Between Penny Stocks and Normal stocks
Penny stocks are quite popular among new trades, since they trade at low prices and often experience wild swings, both to the upside and to the downside.
To understand how they differ from normal stocks, it’s important to explain what a penny stock is.
A penny stock is a stock that trades at less than $5 per share. Although in the past, penny stocks were considered stocks that traded for less than $1 per share, the SEC has recently modified the definition to include all stocks that trade below $5 per share.
Unlike the normal, well-capitalized stocks which trade on the popular exchanges, such as the NYSE, Nasdaq, and others, most penny stocks trade via electronic over-the-counter (OTC) marketplaces, such as OTC Bulletin Boards (OTCBB) or privately owned Pink Sheets. These are not regulated exchanges, and bear higher levels of risk.
Furthermore, penny stocks differ from normal stocks in the following ways:
Penny stocks, generally, don’t have adequate liquidity. They trade only a few thousand (or less) shares each day, and that is why institutional investors don’t invest in them — there will be no one to take the other side of their trades when they want to sell.
On the other hand, normal stocks that trade on the big exchanges trade large volumes each day, so the issue of liquidity does not often arise. Both retail and institutional traders can buy and sell the stocks with relative ease.
Closely related to liquidity is volatility. Because of the lack of liquidity, penny stocks are highly volatile. With a relatively small volume, the price can jump up or down depending on the direction of the trade. So the stocks usually show outrageous price swings on the chat, making technical analysis more difficult and less accurate.
Normal stocks, on the other hand, have normal volatility because more traders are involved and the volume is high enough to prevent wild price spikes most of the time. The charts of normal stocks therefore might be easier to analyze with technical analysis methods.
Because there are fewer traders involved in penny stocks, the bid-ask spread can get extremely wide, worsening the excessive volatility in the stocks. Additionally, the widened spread increases the cost of transaction as a percentage of the stock price.
In normal stocks, the spread is usually not that high, and more importantly, it is quite stable. Because the normal stocks trade at higher prices, the cost of transaction as a percentage of the stock price is very small.
The majority of penny stocks don’t trade on well-known exchanges like the NYSE — which are tightly regulated by the SEC — so they don’t get the attention of the stock market regulators. The OTC marketplaces where they trade have little or no listing criteria or minimum standard. Nobody demands financial reports or quarterly earnings.
Conversely, normal stocks must meet certain criteria before they are allowed to list on the standard exchanges. And listed companies are required to timely release their financial reports and quarterly earnings. In addition, they must make available to the public other important information concerning their day-to-day business activities. Failure to adequately inform the public is met with suspension from the market.
Many of the companies behind the penny stocks are new and relatively unknown. Generally, these companies don’t have a good track record, and some may not even have any track record at all —some are even close to bankruptcy. This lack of historical fundamental data — like earnings, revenue, and sales — makes it difficult to fundamentally analyze the stocks.
The opposite is the case for normal stocks. Because of tight regulation, there’s a wealth of information about normal stocks. Just go to the companies’ websites; you will have more than you need for your analysis.
Penny stocks often have less actual value than they’re made to appear when you see them on the news for one reason or the other. Most of the time, their prospects are exaggerated. The promoters know what they’re doing; they have their interest.
Normal stocks, on the other hand, have less need for exaggerated promotions, as you can get the necessary fundamental information online to calculate their real value. Moreover, many analysts follow these stocks and usually discuss those things.
Penny stocks exist mostly for speculative purpose, as the companies behind them have little or no available information about their operations, resources, revenues, and management. The companies may not even have proven products.
Although there’s speculation, normal stocks are relatively less speculative. They are genuine companies that do genuine business and gradually grow their revenues and earnings. The share prices often reflect growth in the underlying companies, so the changes in the stock prices are rarely excessive.
Manipulations and scams
Because of the lack of liquidity, the resultant high price volatility, and lack of regulatory oversight, penny stocks are highly prone to manipulations and scams. One popular strategy the fraudsters employ is the pump and dump scheme — the scammers would acquire large long positions in a penny stock and then promote (pump) the stock to lure investors; once investors rush to buy the stock, they sell (dump) their shares and move on.
Normal stocks are relatively liquid and less volatile so they are less liable to this type of scam. Moreover, they’re highly regulated.
Some brokers don’t allow their client to trade penny stocks. The brokers that permit penny stocks often charge higher commissions for such trades.
There are no brokers’ issues when it comes to normal stocks.
The Benefits of Trading Penny Stocks
As you can see, the differences we discussed showed penny stocks in the negative light. But there may be a few benefits of trading penny stocks, and here are some of them:
- Potential winners of tomorrow: Not all stocks trading below $5 per share are hopeless; there are many good companies with good management, consistent earnings growth, and excellent products that are trading below the $5 benchmark.
- High return potential: Because they’re trading at such low prices, the upside potential for good companies are very high when they’re eventually discovered. And a lucky investor who spots a good company can make great returns from small investments.
- Fast moves: Sometimes, the moves in penny stocks occur very fast — within hours or a few days — so money can be made in a relatively short time.
Different Ways to Play the Stock Market
There are many different ways to play the stock market, but they can be broadly grouped into two main categories:
Active trading is the act of buying and selling stocks to profit from the frequent up and down swings in price movements. Active traders can trade in either direction — long or short. They believe that they can time the market and capture the various trends in the market, making significant profits in the process. In other words, the aim of active trading is to beat the market.
Traders often analyze the price charts to identify potential trading opportunities. Although some of them may also study the stock’s fundamentals, they often tend to rely heavily on technical analysis of the price and volume charts.
Depending on how long they’re willing to hold their positions and the type of price trends they try to capture, active trading can be categorized into:
In addition to these categories, you could divide all traders into two more categories regardless of trading style:
- Algorithmic Traders
- Discretionary Traders
Algorithmic traders execute their systems with the help of a computer, and may do other things while their computer trades for them. The laborious task of finding strategies to trade can be done anytime, which means a lot of freedom for the trader!
At The Robust Trader, we believe algorithmic trading is superior to discretionary trading irrespective of that trading form you’re into. We recommend that you read our guide to algorithmic trading to find out more!
Now, let’s cover the different types of trading styles!
Scalping is the quickest styles an active trader can adopt. It involves exploiting the various price changes that occur throughout the day. Each trade usually lasts from a few seconds to a few hours.
A trader who uses this style is called a scalper. Scalpers monitor price movements in the shortest possible timeframes, such as the 1-minute to 10-minute timeframes and even the tick charts. Most scalpers base their trading on technical analysis alone.
However, some scalpers may try to profit from the higher price volatility that occurs when important news — such as earnings — is released. When trading based on technical analysis, scalpers may use oscillator indicators, such as stochastic and relative strength index (RSI), which closely follow price swings.
Because they try to capture little price movements, scalpers often use the four-to-one leverage available to intraday traders to maximize profits. While profits can quickly compound if a scalper uses an effective exit strategy to minimize losses, overtrading and over-leveraging associated with this style of trading makes it extremely risky.
In addition, scalping incurs heavy commissions because of the huge number of transactions.
This is a style of trading where a trader buys and sells (or shorts and covers the short) a stock within a single trading day. In other words, the position must be closed before the market closes for the trading day. A day trader often tries to profit from the predominant price trend of the day.
So if the trader thinks that the stock will trend up for the day, he goes long, and if his analysis indicates a downtrend, he goes short. Most of the time, a day trader relies on technical analysis but may also be mindful of important news releases to avoid price gapping against his position.
Day traders’ favorite timeframes for analyzing a stock are lower timeframes like the 15- and 10-minute charts. Some may also use a higher timeframe, like 4-hour bars and daily bars, to ascertain the direction of the predominant trend.
Most day traders use margin leverage: brokers often allow 2:1 leverage, but some may permit up to a maximum of 4:1 leverage. Although leverage can enhance profitability, it increases the risk of huge losses.
Because of the number of transactions involved, commissions can easily add up.
Swing trading is a type of trading style where the trader tries to profit from short-term price swings. This type of traders normally holds their trades from a few days to a few weeks, as they try to milk the short-term trends. For most swing traders, spotting price patterns and using technical indicators to find trading opportunities is how to play the stock market.
However, they may also make use of fundamental analysis to select the stocks to trade and then use technical analysis to determine when to make a trade and the direction of the trade. Their aim is to identify price reversals early enough and ride the next price swing.
Most swing traders analyze their charts on the daily timeframe to find trading setups and then some choose to go to the 1-hour timeframe to select the best entry. They may also check the weekly timeframe to gauge the state of the long-term trend.
Although swing traders don’t trade as frequently as day traders or scalpers, their volume of transaction is still high when compared to position traders or investors, so they incur higher trading costs. Furthermore, the fact that their trades can last for several days may expose them to the risk of overnight price gaps.