How Stock Trading Works

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.
Stock Trading: How to Begin, How to Survive

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Stock trading involves buying and selling shares in companies in an effort to make money on daily changes in price. 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 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. Financial advisors generally don't recommend people invest in individual stocks unless they have money they could afford to lose.

You don't have to work on Wall Street to learn stock trading. Online brokerages have made it possible to trade stocks quickly from your home computer or your 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.

What is 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.

» Read more: How to day trade

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.

» See NerdWallet’s ranking of the best stock brokers for beginners

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TradeStation

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Fees and minimums:
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  • $0 account minimum.
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2. Set a stock trading budget

Even if you find a talent for trading stocks, allocating more than 10% of your portfolio to individual stocks can expose your savings to too much volatility. But this isn’t the only rule to manage risk. 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 like 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 virtual trading account

There’s nothing better than hands-on, low-pressure experience, which investors can get via the virtual trading tools offered by many online stock brokers. Paper trading 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 Hail Mary for quick riches.

» Interested in stock research? Read our review of Morningstar

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.

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 folks 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. 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.

Frequently asked questions

NerdWallet has reviewed and ranked online stock brokers based on which ones are best for beginners. This list takes into consideration the stock broker’s investment selection, customer support, account fees, account minimum, trading costs and more.

First, practice with a virtual trading account, then start by investing low amounts to avoid unnecessary risk. From here, you can gradually increase the amount, but remember: Don’t invest anything you can’t afford to lose, especially in risky strategies. Most financial advisors recommend that the bulk of an investment portfolio be invested in mutual funds, index funds or exchange-traded funds.

Yes, as long as the share price is below $100 and your brokerage account doesn’t have any required minimums or fees that could push the transaction higher than $100. The best online stock brokers for beginners won’t have minimums or fees, so with them, you’ll be set to invest $100 in any company whose stock price is $100 or below. Some brokers also allow you to purchase fractional shares, which means you can buy a portion of a share if you can’t afford the full share price.

The main difference is how frequently you buy and sell stocks. Traders buy and sell more frequently, while investors typically buy and hold for the long term. Learn more about stock trading vs. investing here.

Normal trading hours on the New York Stock Exchange and the Nasdaq are 9:30 a.m. to 4 p.m. Eastern time on non-holiday weekdays. However, there are also premarket and after-hours sessions — not all brokers allow you to trade during these extended-market hours, but many do. Learn more about after-hours trading here.

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