A detailed guide for how to invest in the stock market for beginners. A comprehensive review of the stock market and tips to begin investing.
Last month, the stock market and dropped over 37% at the lowest point of the COVID-19 pandemic and has continued to be volatile, going from record highs to record lows just about every other day.
While no one can predict the exact low point of this declining period in the market, some stock market experts are saying that we are getting closer to what might be a bottom to the market decline and that it might be a good time to start evaluating whether or not some of the stocks out there would be low enough to be considered an attractive buy.
Now I know that type of rhetoric might peak a lot of interest in prospective buyers in the market, so if you are in that camp of people that are looking to make an entry into this market — especially those of you that are new to investing — I wanted to provide you guys this resource so that you could have a firm foundation on how the stock market works and an understanding of how to execute the trades that you want.
My hope is that this article gives you the basic understanding upon which you can build further knowledge and then start your trading journey after you’ve done enough research and feel comfortable.
So, with that, let’s get into it.
How to Invest in the Stock Market
So in this beginner’s guide to the stock market, I’m going to go over 3 main topics:
1) First, I’m going to define what an individual stock is and explain how the stock market operates.
2) Secondly, I’m going to talk about how we, as retail traders, interact with the stock market (i.e. how do we buy and sell stocks and other securities).
3) Lastly, I’m going to talk about the 3 most common types of securities that are offered in the stock market — Equities, Bonds, Derivatives. If you don’t know what those are right now, don’t worry — just keep reading because I’ll go over each of those different types of securities, later on.
So with that, let’s begin with what a stock is and how it works within this large, convoluted thing called the stock market.
To explain what a stock is, I think the best way, would be to just tell you guys a quick story about my imaginary friend, Bob.
This is Bob — and he’s always dreamed of opening up his own coffee shop.
So over the course of a few years, Bob saved up $50k and opened up a small shop in his neighborhood. His coffee shop was an instant hit and his customer base started to grow and grow as the years went by. Bob soon realized that he needed a much bigger coffee shop to accommodate all of his new customers and quickly started to plan for an expansion to his business. He wanted to renovate his current shop to put in a second coffee bar and have twice the seating capacity that he has now — and so Bob figured out that he needs another $100k to make this happen.
But with all of his profit currently being reinvested into his current operations, there was no way for bob to carve out the extra $100k he needs for this expansion. So Bob has a couple of options — he can go to the bank and get a small business loan for the $100k, but that means he’ll have to go through all of the efforts to get approved and also pay back the loan with heavy interest. Or he could fundraise for the money that he needs by issuing small shares of ownership in his company through something called a stock.
A stock — basically gives outside investors a chance to buy and own a small piece of a business in exchange for their funding. In this example, let’s say Bob decided to trade away 5% of his business ownership by issuing stocks to raise the $100k. So, as a result, Bob prepares to release 500 shares of stock in his coffee shop business for $200 apiece.
Now in order for the public to find and purchase these shares of stock in Bob’s coffee shop, there has to be an open market where Bob can present these shares and for people to bid on them and purchase them. This would be the stock market — an open marketplace where buyers and sellers of stocks and other equities come together, to exchange and transact on different shares of public companies.
Now let’s say Bob offered the 500 shares of Bob’s Coffee shop in the open market and they were purchased by 4 different groups of buyers:
- A fellow coffee enthusiast picks up 100 shares
- A Wall Street investor picks up 200 shares
- Bob’s mom decides to support him by picking up 50 shares
- And lastly, a local investment firm picks up 150 shares
This now gives bob the $100k he needs for his coffee shop expansion and gives these investors part ownership in this thriving and growing business.
Now fast-forward — let’s say years have passed, and the expansion of Bob’s coffee shop drew in even more customers and his business grew even bigger and bigger — making him more successful and simultaneously making stock in his company even more profitable. Now, this gives his investors a greater return on their funding and everyone is happy.
Great story right?
That’s exactly how the majority of the companies in the stock market operate — they start off as small businesses that reach a certain size & operational maturity and then get to a point where they need more funding. And that’s when they decide to issue stocks in the open stock market, through a process called an IPO, or an initial public offering. Now not every company and every IPO story turns out as profitable as Bob’s coffee shop, but the process of listing on the exchange and buying and selling stock is pretty much the same.
Now, let’s talk a little bit more about the stock market itself.
First, in the US, the three most popular stock exchanges (or stock markets) are the following:
- New York Stock Exchange — abbreviated: NYSE
- The National Association of Security Dealers Automated Quotation System — or otherwise known as the NASDAQ
- And the American Stock Exchange — or better known as the AMEX.
Across these top 3 stock exchanges, there are over 6,000 different company stocks listed and in aggregate they represent over $30 Trillion dollars worth of value within the securities.
Now when trading commences within these exchanges, it’s important to note that for every stock transaction, there is always a buyer and a corresponding seller. And on each respective side, there is a bid (which is an offer from a buyer to buy a particular stock at a certain price) and an ask (which is an offer from a seller to sell a particular stock at a certain price) and only when the bid and ask prices match — does it result in a sale. So at any given time, there are hundreds of millions of open orders in the stock market, but only millions of transactions occurring at once.
Now that you know this — a question you might have is: what determines the actual price at which a stock transaction occurs? Well, for this explanation, I need to show you guys a quick visual on supply and demand. So let’s make this a very simplistic example — say I have 5 sellers currently with open asks for stock in Bob’s coffee shop — which means I have 5 people interested in selling this stock at the prices show here.
And let’s also say that I have 4 buyers with bids for this same stock — at the prices shown above. Now, as you can see here — there is no instance where the bid and the ask prices match, therefore, no sale is occurring at the moment.
But let’s say that one of those buyers (we’ll name him Mark), visited Bob’s coffee shop the other day and absolutely loved the brand new flavor of coffee that was just released there. Mark thinks that if Bob keeps release new and innovative coffee drinks like this one, his shop will skyrocket in popularity — even more than it is now. And this experience really motivated him to become a shareholder in Bob’s company — so Mark decides that he wants to get in on Bob’s business today — regardless of the price. So he raises his buy order to the lowest ask price on the market — and boom, a match has occurred and a stock transaction was executed.
And that’s generally how that works, in any given day there is usually a higher pressure from either the demand or the supply side that affects the bid and ask prices to make them match.
Oh, and by the way, your know-how in a stock ticker, the price of the stock keeps flashing up or down, in green or red every fraction of a second? That is the price in which the last sale, the most recent transaction occurred. So when you watch a ticker symbol change prices, you’re actually witnessing real live trades going through every fraction of a second.
I know this was a very high-level, simple example of how a stock transaction occurs — but imagine this example with millions of more bids & asks, and all of this happening within milliseconds across the internet, millions of times per day — THAT pretty much describes how the stock market works each day.
So, to recap, let’s summarize what we’ve learned so far:
– Small businesses release stock, into the stock market, as a way to raise capital for themselves through a process called an IPO.
– A stock is a small share of ownership in a company, in exchange for capital funding.
– The stock market is an open marketplace where buyers and sellers come together to trade securities
– A stock transaction always involves a seller and a buyer — and occurs when the bid and ask price matches.
Cool — now that you have the basics down. Let’s talk a bit more about how we, as a retail trader, interact with the stock market. So let’s say that you are ready to start trading — Where do you begin? What do you need to do first? Well — the very first thing you need is an avenue for engaging with the stock exchanges so that you can place orders and buy and sell these different securities — and as a retail trader, that typically means you need an account, at a brokerage firm.
So what’s a brokerage firm? Brokerage firms are companies that provide access to the stock market by acting as middlemen between sellers and buyers in the stock exchanges. At a simple level, they offer access to the listings of the securities in the exchanges, their prices and fulfill buy and sell orders on your behalf to execute your trades — and of course, they also provide an account for you to hold your purchased securities in.
There are a lot of brokerage firms out there and they all come with their own unique advantages and disadvantages. Here is a comparison chart of just a few of the more popular ones.
My favorite happens to be Etrade — not only do they have free transaction fees like everyone else, but I think their pro trading platform is the probably the most nimble and robust out of all of the ones I’ve use — but at a foundational level, all brokerages have the same capabilities to engage the market, so which one you use should just be a matter of your own preference.
So once you create an account, you can use the platform’s tools to research the stocks you want to buy. Most brokerage firms have detailed company profiles, robust charts and expert analysis to help you pick the right investment security for you. Now, once you’ve selected the stock you want to purchase, it’s now time to buy — which means you need to be aware of the different types of orders types available for you to use.
Different types of orders types:
Here are the 5 most common order types that you can use to purchase or sell your securities.
1) Market order
This basically is an order to buy/sell your shares of stock at the most current ask price in the market. Placing a market order guarantees the fastest execution because it purchases or sells your shares at whatever the going price is at that current moment. If you want to buy/sell a stock immediately regardless of the price — this is the order type you want to use.
2) Stop order
The second-order type is a stop order type, which is a standard market order that is triggered & activated when the price action hits a certain specified stop price. What I mean by this is — let’s say the stock price of Bob’s coffee shop was steadily dropping and you wanted to buy it when it hits $150. So if you place a stop order for one share of Bob’s Coffee shop at a stop price of $150 — once the stock hits $150, your stop order transforms into a regular market order, and it purchases your share at the next available ask price. Same thing happens when you use a stop order to sell your stock — except in reverse. So let’s say bob’s coffee shop stock was steadily on the rise and you wanted to sell it when it hit $300. So when you place a sell stop order at $300, once the price hits $300, it turns into a regular market order and sells at the next available bid price.
3) Limit order
The 3rd order type is a Limit order. Limit orders are live orders that buy or sell whenever the stock price goes lower or higher respectively than the limit order value you set. For example, let’s say that the price of Bob’s coffee shop stock was hovering over $200, but you wanted to make sure that you bought this stock at exactly $185 or below. If you put a limit order to buy at $185, the trade would only execute if there was a seller selling at $185 or below. This order type guarantees the price at which you enter your stock position, but it may take a bit longer for it to execute if the price doesn’t ever touch your limit value.
4) Stop Limit order
The 4th type is a combination of #2 and #3 called a Stop Limit Order — and it’s one of the most useful order types in the group. This one adds the trigger of the stop price, but once that price is hit, instead of turning into a market order and just buying or selling at the next immediate price, it turns into a limit order and only executes once it hits that limit price or better.
Here is an example — let’s say Bob’s coffee shop was about to release a news statement about some new plans to change their menu. And let’s say that you weren’t sure if this change in menu would be well received by the patrons or not. But if market receives this menu favorably and the stock starts to rise, you’d like to get in on the action and ride the wave up, but only if you are able to get in before the stock price goes too high — you certainly don’t want to get in at the top.
So, in this case, let’s say you place a stop-limit BUY order, with a stop price of $220, and a limit price of $240. And let’s say at the menu unveiling, the new menu was received well and the stock price starts shooting up exponentially! So it hit the stop price of $220, and but was moving up so quickly that the next available price was $260!
If you had used a regular stop order, you would get in on this one stock at a $260 per share, b/c that is the next available ask price. But with the Stop Limit buy order, you would not have executed this order, because the next available buy price was higher than the limit price of $240. You see, a Stop Limit order is the best way to control not only when but at what price you enter your position. (If you’d like to see these examples visualized, click here.)
5) Trailing Stop order
The 5th order type is called a Trailing Stop. A trailing stop means from whatever the current price is, if the stock drops either a certain dollar amount or a specific % amount, the order automatically converts to a market order and executes as fast as possible at the next available price. Here is an example of how this would work.
Let’s say, unfortunately, Bob had fallen on hard times — and as a result, he had to lay off a 1/3 of his staff. As a result, the investors got nervous and his stock price started to plummet. If you’ve set a trailing stop order to sell whenever this stock drops more than 5%, then when Bob’s coffee shop stock drops below that point, your trailing stop order would automatically turn into a market order and sell your shares as fast as possible. This order type is mostly used as a safety net to exit your positions quickly in the event of a swift market decline.
Ok — so now that we’ve covered what a stock is, how a stock market works, and how you can buy and sell securities through your online brokerage, let’s talk briefly about the type of things you can trade within the stock market.
They’re called securities — which is just a fancy way of saying tradeable financial instruments, like stocks or bonds, etc.
3 classes of securities: Equities, Bonds, Derivatives.
Equities are basically your stocks — small shares in companies that you can purchase from other traders or through an IPO. We’ve covered this type of security earlier with the example of Bob’s coffee shop. But in addition to stocks, equities also include mutual funds and ETFs, which are collections or pools of individual stocks grouped into one package. For example the ETF: SIL which is called the GLOBAL X SILVER MINERS NEW ETFis a collection of silver related company stocks that track the value of how silver is doing as a commodity within our market.
Index funds like the the Vanguard VTSMX & VTSAX that track the overall US market performance also fall within this security class. Mutual Funds and ETFs are robust topics on their own — if you’d like to read the beginner’s guide to these subjects, click here.
The second type, Bonds, are effectively loans that you give companies, which are paid back to you with interest. You see, when a company needs to raise capital but doesn’t want to go with the stock issuing route — they can go to their bank and get a loan. But because banks are pretty risk-averse — let’s say these businesses can’t get the full amount that they need from a bank loan. In that case, they’ll come out to the open market and issue what’s called a bond. And when you as an investor purchase these bonds, you are effectively loaning this business your money — and the company has an obligation to pay you back the loan amount semi-annually with interest. In this case however, it’s important to note that there is no stake in the ownership of the business, like in the case of stocks.
And the last type of security is call Derivatives. Derivatives are a little bit more advanced and complicated — so I wouldn’t recommend this security class for beginners… but basically this class includes investment vehicles like Futures, Options, Forwards, Swaps, and certain types of inverse ETFs (mainly those that have derivative components within them). It’s basically any type of security where you don’t actually own the direct underlying stocks or equities, but rather you own contracts to purchase them at certain agreed-upon conditions. In the interest of time and keeping this article at a fundamental level, I’ll cover this topic later on, in a future article.
So — I hope this gives you guys a quick overview on what a stock is, where you can buy them, and what type of securities you have the option of purchasing in the market.
Good luck out there! Remember, make sure you do as much research as you can before you invest in the market. If you dive in unprepared, the stock market can be a pretty choppy place to swim in.
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**** Disclaimer *****
The content here is strictly the opinion of Daniel’s Brew and is for entertainment purposes only. It should not be considered professional financial investment or career advice. Investing and career decisions are personal choices that each individual must make for themselves in accordance with their situation and long term plans. Daniel’s Brew will not be held liable for any outcome as a result of anyone following the opinions provided in this content.