How Do
You Buy and Sell a Stock?
According to
an old Wall Street saying, a stock is worth what an investor is willing to pay
for it. True enough, buyers determine a stock's price. After learning new
information about a company, investors will choose if they are willing to pay
more or less for a stock, thus, pushing share prices up or down. Simply put,
supply and demand decide a stock's price. The supply is the number of shares a
company has issued to the public. The demand is investors' desires to buy shares
from current owners. Investors will purchase a stock if they think they will
make a profit.
One of the first steps to becoming a successful investor is knowing how to buy
and sell a stock. You will make
many trades as an investor, and the process involves steps that seem to happen
within minutes. Here are the steps
for buying and selling a stock:
| Steps of Buying and Selling Stocks | |
| Buyer | Seller |
| Joe decides to invest in the stock market. | Shirley decides to sell 100 shares of AT&T (T). |
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| Joe has done some research and decides AT&T's share price is at an attractive level. He gets a quote online at $35. | Shirley get a quote on AT&T online for $35. |
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| Joe gets on his online broker account and sends in a market order of 100 shares for T. | Shirley logs in to her computer and clicks the sell button for 100 shares of AT&T. |
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| The two online brokers send their orders to the floor of the NYSE. Joe's order gets to the buying brokers and Shirley's order gets to the selling brokers on the NYSE Trading Floor. | |
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| At the trading post of the NYSE, a specialist who handles AT&T makes sure the transactions are executed fairly and in an orderly manner. | |
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| The two floor brokers compete with other brokers on the Trading Floor to get the best price for their customers. The brokers representing Joe and Shirley agree on a price. | |
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| After the trades are executed, the specialist's workstation send notice to the brokerage firms and the ticker tape. | |
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| The transaction is reported by computer and appears within seconds on the ticker tape displays across the country and around the world like those seen on the bottom screen of CNBC live or the quotes on StocksQuest 20 minutes later. | |
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| Within three days, both Joe and Shirley are sent confirmations of their trades from their brokerage firms. | |
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| Joe settles his account within three business days by submitting payment through his online account. | Shirley's trade is also settled in three business days. Her account will be credited with the proceeds of the sale of stocks, minus any applicable commissions. |
Investors
can take advantage of six basic types of buy and sell orders:
Note that our stock market game supports only market orders.
Market
Order:
A market order is buying or selling a
stock at whatever the market price is. With
the rapidly-changing market, prices can change quickly, and the price you get
the stock at may be different from price at which you placed the order.
A market order will always go through, but the results may not be to your
liking.
Limit
Order:
A limit order is buying or selling a stock at a specified price or better.
For example, you can place a limit order to sell 100 shares of Pfizer at
$30. If the
shares price rises as high as $35, your shares will be sold at $35, and you will
make an extra $500 profit.
However, if the price goes as high as only $29, the order will not go
through and your shares will not be sold.
Stop
Order:
A stop order, also known as a stop-loss order, is buying or selling a stock when
it reaches or exceeds a specified price.
If you buy a stock at $50 but fear it will drop too low, you can place a
stop order to sell that stock at $40.
If the stock drops to $37, your order would be executed as soon as
possible. It
would become a market order but you would have to sell for even less than $37 if
the stock is dropping fast.
Stop-limit
Order:
A stop-limit order is buying or
selling as stock when a stock goes above a set price.
For example, you may put a stop-limit order to buy a stock at lower than
$75 but once it gets above $70. However,
if the share price goes from $70 to $78, your order may not get executed.
Day
Order:
A day order is buying or selling a
stock at a set price but is good for only the day you placed the order.
The order is canceled if it is not executed before the close of the day.
All orders are day orders unless the investor specifies another time
period, usually a month.
Good-till-canceled
Order (GTC): A
GTC order is buying or selling a stock but with no specific time period.
It has no set expiration date until the order is fulfilled or executed.
Buying
stock on margin means buying stock with money borrowed against the stocks in the
same account. These stocks, or
collateral, guarantee that you can repay the loan, otherwise, your stockbroker
has the right to sell your stocks (collateral) to repay the borrowed money. He can sell your stock if the share price drops below the
margin requirement, at least 50% of the value of the stocks in the account.
Buying on margin works the same way as borrowing money to buy a car or a
house using the car or house as collateral.
Moreover, borrowing is not free. Your
broker usually charges you 8-10% interest.
Buying on margin can double your gains in a rising stock market, also known as a bull market. For example, IBM is trading for $100 a share and you pay $50 cash per share and borrow $50 from your broker for the stock. If the share price of IBM rises to $150, you will earn 100% on your investment (150-100) / 50 (but not quite because you must deduct the interest paid to your broker). If you pay $100 per share for the stock, your gain will only be 50%, (150-100) / 100.
On
the other hand, buying on margin can double your losses when the stock market is
down, also known as a bear market. Once
again with IBM, trading for $100 a share, if it goes down to $50 and you pay
cash, your losses will be 50% (100-50) / 100.
But if you pay for the stock with $50 cash and $50 borrowed from your
broker, your losses will be 100% (100-50) / 50.
Also, you must pay your broker for interest on the borrowed money.
Even worse, if you can’t pay the money, you will get a margin call and
your broker will sell your shares at a depressed price.
To
help offset losses in a portfolio with stocks bought on margin, you should also
buy stocks that will withstand market drops.
Otherwise, you will constantly get margin calls during a bear market.
Worse yet, some brokerages can sell your stocks without notifying you
first. Moreover, if they do call,
you may sometimes not be able to pay because they will have already sold some of
your shares before you can get the money to them.
Basically,
a stock option allows you to buy or sell a specified number of shares
of a stock at a specified price. Two types of options exist: call
options and put options. Buying a call option lets you purchase a set
number of shares of stock at a predetermined price until it expires.
Put options differ only in that they let you sell rather than buy
stock. If you think the price of a stock will go up, you can buy a call
option to increase your profits. If you think the price will go down, a
put option will help you make money. Options
can multiply profits immensely but they involve a high degree of risk.
If Intel stock does not go up past $100 by October, your option expires
worthless and you lose $1000 whereas if you bought stock that went down
by October, you can hold onto the shares and still make money if it
goes up again in the future. With call options you lose all the money
you put in based on the assumption that the stock would go up. 
For
example, if Intel stock trades at $90 a share and you think it will go
up by October, you can buy an Intel October 100 call for $10. That
means you pay $10 per share for a call option to buy Intel stock at
$100. Since contracts are traded in quantities of 100 shares, you pay
$1000 (the premium) for this option expiring in October. If the stock
goes up to $120 by October, you can exercise your options-that is, buy
100 shares at $100 and sell them at $120 for a gain of $2000. Since you
pay only $1000 for the options, you will make a profit of $1000. If you
were to buy $1000 worth of Intel stock rather than $1000 worth of call
options, the share will be worth only $1333 in October. That's a gain
of only 33% compared to 100% from the option. How
Do Options Work?
Call
Option
Put
Option
Buyer
Hold Long
Seller
Write Short
Buyer
Hold Short
Seller
Write Long
With a put option, you can profit if the stock declines in value. If you believe Intel stock will go down by October, you can buy an Intel October 80 put at $10, assuming Intel stock is currently trading at $90. This put option gives you the right to sell 100 shares of Intel at $80 a share until it expires in October. Now, if the stock drops to $60 by October, you can exercise your put option by buying 100 shares at the market value of $60 and selling them at $80 for $2000. If, however, the stock does not go below $80 by the time your option expires, you lose $1000. Buying put options on your stock can help protect your investment from sharp drops in value. For example, if you own Intel stock and buy put options as above, you can still sell at $80 to minimize your loss.
You can also write call or put options. That is, you can sell options to people who want to buy them. The writer of an option gets the premium the buyer paid for it. If you write a call option for Intel and the stock goes down, you get to keep the premium. If the stock price increases and the buyer exercises the option, however, you must buy the stock at the market price and sell it at a lower price. You could potentially lose an unlimited amount if the stock goes up. Writing call options can also help you make extra money on your own stock.
For example, let's say you write an Intel October 100 call for $10 and you own 100 shares of Intel. You get $1000 immediately-if the stock does not go over $100, you get to keep the premium. If the stock goes up over $100, you will have to sell your 100 shares of Intel to the buyer at $90. By writing a call option you lessen your losses if the stock goes down, but lose out on potential gain if your stock goes up past $100.
Investing in stock options requires a complete understanding of their risks and potential rewards. If you decide to enter the world of option investment, be sure you know how to use them wisely and effectively-though you may profit immensely, you can lose everything if you are careless.
Short
selling means selling a stock you don’t
own. To make more sense, you borrow
shares of a stock to sell short from your broker or from another person’s
account in hopes that the share price will drop.
If it does, you can buy back the shares and pocket the difference from
the borrowed price as profit. When
you short sell, you don’t receive a stock certificate, no papers change hands,
and the lender is not identified. Short
selling has many drawbacks but can produce high profits if the share price
declines.
Short selling can be very risky, and you
will benefit only if the share price drops.
When you short sell, the amount will show up on your account, but it
doesn’t receive any interest or dividends and the money cannot be used.
Even worse, if the company declares a dividend, you must pay the person
who loaned you the shares because that person no longer owns the stock, but you
don’t really own the shares either. Often
times, your broker will make you use other stocks in your portfolio as
collateral in case the share price rises and you don’t have enough money to
buy back the shares. Your broker
can sell shares of your stock to make sure you can return the shares to the
lender.
Although short selling has many
disadvantages, investors still short sell because they can make large profits if
the share price drops. For example,
Internet Capital Group (ICGE) dropped from 100 to 30 within the past two months.
If you short sold 100 shares of ICGE at 100 and bought it back at 30,
your profits would be (100-30) * 100 = $7,000.
Investors usually buy stocks if they believe the share price will rise,
but short selling is available to those who think the share price will drop.
As you
probably guessed from the name, after-hours
trading
means buying and selling securities after the market closes at 4:00 P.M. Eastern
Standard Time. Until 1999, only
large amounts of shares among professionals could be traded after hours.
Most of the trading was restricted to electronic trading networks (ECNs),
including Instinet and Island ECN. Unfortunately,
individual investors could not trade, and some felt they deserved the same
rights as professionals. Now, the
Nasdaq and New York Stock Exchange (NYSE) have expanded their trading hours to
everyone in addition to numerous online brokers such as Schwab, E*Trade, and
Datek Online.
After-hours
trading gives investors extra opportunities to make profitable trades since
late-breaking news often affects share prices.
Sometimes, information is released after the market closes.
However, when trading after hours, the volume is considerably lower than
during normal hours. The stocks are
not as liquid, so your orders may take longer to be fulfilled or may be more
difficult. With fewer buyers and
sellers, there will be fewer market makers;
thus,shares
will be sold at a lower price and bought at a higher price since there will be
fewer people to find the best prices, the exact opposite of the ideal situation.
Because stocks traded after hours are concentrated on a small volume,
they are more volatile than those in regular hours.
Of
course, the more popular stocks are quite liquid but when trading after hours,
you might not be able to buy or sell large amounts of a lesser-known company. Luckily, Nasdaq is allowing only limit orders after hours in
order to guard investors from extreme volatility during after-hours trading.
After-hours
trading also gives investors less time to evaluate news that a company releases
after the market closes. Major
companies such as Microsoft and Intel often make important announcements after
hours, but now investors can still make trades according to the news.
Positive news could overwhelm supply and cause people to be less
reluctant to sell. Share prices
could skyrocket but quickly drop as the number of sellers increases.
Day
trading is
buying a stock and holding it for a day, whether the share price is up, down, or
unchanged. Day traders usually buy
large quantities of a stock, wait for the share price to increase, and sell the
stock once it starts to fall. They
buy large amounts in order to make profits from a small increase in the share
price. Successful day trading
requires speed in order to get in and out of a stock at the right price.
Day
traders need advanced equipment to buy and sell stocks quickly and make their
trade before the next investor. This
extra money can cut into your gains if the stock doesn’t go up considerably. Unfortunately, most day traders aren’t that lucky.
They have to compete with professionals, who have much more experience.
Most of the time, you won’t be able to get your order in before them.
Day traders have to be extremely fast in analyzing and evaluating a
change in the share price. One little slip when typing the order and you could lose a
lot of money.
Day
traders also suffer from lack of discipline and emotional influences.
The investors don’t handle losses very well and may hold onto a stock
if it goes down in hopes that the share price will rise again.
Often times, the share price goes even lower.
Likewise, day traders often get greedy if the share price rises.
They think the share price will rise even more, and they can make even
more profits. However, the share
price may drop, causing their gains to become losses.
You
shouldn’t become a day trader unless you have the right equipment and enough
knowledge about a particular. Researching
a company thoroughly is necessary for successful day trading. Moreover, day trading should be for only experienced,
disciplined investors. True day
traders won’t hold onto a stock for more than one day.
Also, if you’re not careful when doing day trading, you could lose
money faster than at casinos. But
for those who don’t lose considerably in their first year, you usually don’t
make real profits until another year or even longer.