On this website, we tend to focus a lot on the Forex market, and that’s because it’s very profitable if you follow the right steps. However, we’re not crusaders for the Forex market, only interested in providing exciting and profitable investment opportunities, so we have to talk about the stock market.
The stock market provides a wonderful investment platform, and it has indeed made many individuals billionaires. In this post, we’re going to touch on some of the bare basics you need to know if you’re interested in stock trading, and by the end you will be ready to dive in.
What you need to know
The key to becoming profitable in any trade is to learn all about it first, so let’s start there, the basics:
What are stocks?
A stock, share or equity is basically a piece of a company; owning that piece means that you are entitled to that company’s earnings and assets. Companies offer stocks for several reasons, but mostly to bring in money for expansion, growth, research, or any other objective the company’s owners think might make more money. Inasmuch as you may own a stake in a company, individual traders like you and I don’t have much of a say in the way a company is run, which simply makes us speculative traders.
Companies first offer stocks through an IPO (initial public offering), this is referred to as the primary market. Afterwards, shareholders can freely buy or sell their stocks, creating the secondary market where they can trade between one another without directly involving the company. Combining all companies in the world, you can see how there are so many stocks to be bought or sold in the secondary stock market, and this is where most of us take part.
The initial price of a stock at the IPO is determined by an underwriter who values the company based on its earnings, growth and investor confidence. From this initial price, the value of a stock varies depending on the number of people buying or selling the stock. It is simply determined by the law of demand and supply, because a trade requires someone willing to buy and another to sell.
Let’s use an example to show exactly how it works – a company named, say, MNK has an IPO at $10 per share and thousands of individuals buy the stock. Sometimes, all the shares offered in an IPO are bought, let’s assume all of MNK’s shares are bought. Market forces determine that a huge number of buyers will cause the price of a commodity to rise, so the shares of MNK rise to $15 due to demand, and some of those buyers will want to offload the shares and make a profit. At the same time, those who didn’t get in at the IPO will want to buy some of MNK shares, creating the buyer-seller relationship.
The stock price of MNK will rise again after good news, like the release of positive earnings reports, and there will be more buyers wanting to get in than the sellers willing to let go of their shares. This push and pull is what determines the stock price of a company, and it goes on every day depending on how traders feel about the company – market sentiment.
Unlike the Forex market which is decentralized, all stock trades are carried out through an exchange. This exchange is basically a central location where buyers and sellers of stocks meet to decide on the price they are willing to accept. The earliest stock exchanges were formed in the 19th century and individuals would make the trades personally without the involvement of a broker. Over time, more companies were formed and there became a need for brokers since individuals could no longer make trades directly.
The modern exchange is exemplified by the trading floor with lots of traders shouting into their phones. These are traders who represent big companies placing millions of dollars’ worth of trades, the rest of us have to go through a broker linked to the same exchange.
When to buy or sell a stock
Now that you know the basics, this is the big question, and also the most important as it is the difference between becoming the next Warren Buffet or getting kicked out of your home. Fortunately, information about publicly traded companies is, well… public. All publicly traded companies are required by law to publish their quarterly earnings, which means they must inform the public about their profits or losses every 3 months.
That right there is the biggest clue on whether to buy or sell a stock – profits. Obviously, you want to buy the shares of a company making a profit and sell those of a company making a loss, but it’s a bit more complicated. How do you tell whether a company is making enough profits? After all, if Apple made a $1 million profit, you wouldn’t want to buy Apple shares, right? Because that would be too little for such a huge company. This means that there are other perspectives to look at, not just the fact that there is a profit.
The price to earnings ratio is calculated through the division of the current share price and the earnings per share (EPS). The P/E ratio is used to determine how much an investor is willing to pay for every dollar earned. In the above example of MNK company, suppose that after a year the shares were still selling at $15, the P/E ratio would be 2 (15, the current share price, divided by 5, the EPS since it was first offered at $10). In general, the lower the P/E ratio, the better that company is performing. However, this metric is most effective for companies that operate in the same industry.
Return on invested capital (ROIC)
This metric is used to determine a company’s income relative to its debt; a good company is that which has a higher ROIC meaning that it makes more profits than it takes on debt. The formula for ROIC = [(net income - dividends) / (debt + equity)].
Earnings per share (EPS)
The EPS shows how much of a company’s profits is allocated to each outstanding share, and can be used to determine just how profitable the company really is. To calculate EPS, take ((Net income – dividends)/outstanding shares). If the EPS is higher, it shows that the company is making enough profits.
There are plenty of other aspects to look into when deciding on a stock, such as the 52-week high and low, the dividend yield, dividends per share, trading volume, net change, etc. that all determine the strength of the stock, but we’ll look into that in a separate post.
How to trade stocks
So now you have analyzed the stocks offered by an exchange, how do you actually buy or sell the stock:
All trades must be carried out through a broker, so you need to find one that suits you depending on your situation. Some top rated Forex companies will also offer stocks as part of their services, which can be great if you want to trade both stocks and Forex. Then there are dedicated stock brokers who deal only in the stock market, and this specialty means they can give you access to many more stocks to trade. Finally, you can always have direct contact to a broker in your location who will also provide you with the access you need to the markets.
It’s really important to choose your broker carefully because they will be in charge of your money, and you should try to avoid falling for a scam.
You might not need this if you’re dealing with a local broker, since you could just call them up to place and close trades. If they are online brokers on the other hand, you might need to install their trading platform on your computer and/or smartphone. Some Forex trading platforms may also allow for stock trading like cTrader and MetaTrader 4 and even MetaTrader 5, but there are those platforms dedicated to stocks like Quik and NinjaTrader.
Some precautions before you begin trading stocks
Looking at how the stock market has made investors like Warren Buffet one of the richest people in the world, then surely it must be awesome. Yes, but with some slight caveats you need to consider first:
The stock market is far much wider than the Forex market
In the Forex market you only have less than 10 currencies to worry about like the USD, EUR, GBP, JPY and a few more others. Every other currency pair is derived from these few major currencies and it is easy to predict how the pairs will affect each other. On the other hand, the stock market is very wide and most stocks are independent of one another. This means that you have to be informed of hundreds of different stocks from all over the world that have no connection to each other.
It’s pretty daunting, I know, but it just means you have to be even more focused, dedicated and disciplined in order to succeed. The trick is to learn as much as you can from news channels, books and webinars/seminars if you want to become profitable.
Volatility and consistency
The Forex market has a lot of volatility because there are millions of speculative traders from all over the world participating. This has made it the largest market in the world with an average daily traded volume of $5.3 trillion! Looking at the chart below for the EUR/USD, you can see just how volatile this market is.
The stock market isn’t a slouch either and it does have a huge volume of trades every day, which is why stock exchanges like the NYSE have a market cap of $19.3 trillion, but there just isn’t as much volatility. Looking at the chart of Volkswagen below shows just that – for a trader, especially a day trader, this just looks unappealing.
The only major moves in the stock market come from major news announcements like quarterly reports, or in the case of VW above, a scandal. It’s not all bad news though, and this kind of stability can be very well suited for a patient swing trader uninterested in quick profits, but one who would rather invest for the future.
There’s also the problem of timing because the stock market isn’t a 24/7 market – you have to trade a particular stock when the exchange is open. This means that, in order to buy or sell a UK stock, you have to wait until the London Stock Exchange is open, which is only a brief 8-hour window. Some traders may not like this if the exchange is in a different time zone, but you can still make it work if you’re committed.
Competition between Forex brokers and the lower risks have lowered the costs of trading in the Forex market. Spreads and commissions are very low and leverage is very high, allowing traders to take part with only a small investment. You won’t get this same comfort in the stock market, because the main participants are investment banks, hedge funds and private equity firms. To participate, you will need a sizeable capital to start off with, and you can only expect a small amount of leverage from your broker. In addition, the broker is also going to deduct a commission from all your trades, and that might also be significant.
My take on stock trading
The stock market is certainly open, but it’s not meant for everyone. There are opportunities to make profits from it, but you will need to change your mindset and adapt to the different environment. For a first time trader, this won’t be too much of a hurdle and you can learn the ropes easily. If you’re a Forex trader, you will have to adjust your trading strategy and learn a few more things.
Finally, I would never advise anyone not to participate in the stock market if they wanted to, as long as you keep the precautions mentioned above in mind. If you’re a full-time trader, then I should advise you to trade the stock market part-time, or for hedging, while also trading Forex, because the volatility of the stock market may not be enough to bring you the profits you need in time to pay your monthly bills.
This is a quick video that explains the stock market in a nutshell, just to recap what we've learned: