Stock Trading: What It Is and How It Works - NerdWallet (2024)

What is stock trading?

Stock trading means buying and selling shares in companies to try to make money on price changes. Traders watch the short-term price changes of these stocks closely. They try to buy low and sell high. This short-term approach sets stock traders apart from traditional stock market investors, who are in it for the long haul.

Trading stocks can bring quick gains for those who time the market correctly. But it also carries the danger of big losses. A single company's fortunes can rise more quickly than the market, but they can just as easily fall.

“Trading isn’t for the faint of heart," says Nathaniel Moore, a certified financial planner at AGAPE Planning Partners in Fresno, California. "Don’t take the risk and invest money if you need it."

If you do have the money and want to learn trading, online brokerages have made it possible to trade stocks quickly from your computer or smartphone.

But before you dive in, you should make sure you know how the stock market works. You should also read up on the best apps for trading stocks, and how to manage your risk.

Types of stock trading

There are two types of stock trading: active trading and day trading.

Active trading is when an investor who places 10 or more trades per month. They often use strategies that rely heavily on timing the market. They try to take advantage of short-term events (at the company or in the market) to turn a short-term profit.

Day trading means playing hot potato with stocks — buying and selling the same stock in a single trading day. Day traders care little about the inner workings of the businesses. They try to make a few bucks in the next few minutes, hours or days based on daily price swings.

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 mix of low-cost index funds to achieve 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. That's a 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 yet. It just gives you the option to do so once you’re ready.

2. Set a stock trading budget

Even if you're great at trading stocks, putting more than 10% of your portfolio in an individual stock can be risky.

"If all of your money’s in one stock, you could potentially lose 50% of it overnight," Moore says.

If you want to invest, he says, you could start by saving $200 a month. When you get to $1,000, you could invest $500 of that. Consider the $500 you're not investing like a parachute. You might not need it, but it's there if you do. Other do's and don’ts include:

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 app to place your stock trades. You'll be shown several options for order types. These dictate how your trade goes through. We go through these in detail in our guide for how to buy stocks. These are the two most common types:

4. Practice with a paper trading account

"Try investing in the market without putting money in the market yet to just see how it works," says Moore.

You can do that by investing your time, he says. Pick a stock and watch it for three to six months to see how it performs. You can also learn the market via the paper trading tools offered by many online stock brokers. Virtual trading with stock market simulators lets customers test their trading skills and build up a track record before putting real dollars on the line.

5. Measure your returns against a fitting benchmark

This is good 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 S&P 500 index (often used as a proxy for “the market”). It could also be Nasdaq composite index (for those investing primarily in technology stocks). Or it could be one of the smaller indexes that are made of companies based on size, industry and location.

Measuring results is key. If a serious investor is unable to outperform the benchmark (something even pro investors struggle to do), then it makes sense to invest in a low-cost index mutual fund or ETF. That's a basket of stocks whose returns closely align with 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. 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 value for years. That's a good argument for treating active investing as a hobby and not a get-rich-quick scheme.

How to manage stock trading risks

Wherever you fall on the investor-trader spectrum, taking things slowly, ignoring 'hot tips' and keeping good records can help you do it safely.

1. Lower risk by building positions slowly

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 exposure to price swings. Moore says you can also look into high-dividend stocks, which pay out a portion of earnings to investors, and ETFs, which allow you to spread your risk out among multiple companies.

2. Ignore 'hot tips'

People posting in online stock-picking forums and paying for ads touting sure-thing stocks are not your friends. In many cases, they are part of a pump-and-dump racket. That's when shady people purchase buckets of shares in a little-known, thinly traded company and hype it up on the internet.

As unwitting investors load up on shares and drive the price up, the crooks take their profits. They 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 a tax-advantaged account — such as a 401(k), Roth or traditional IRA — taxes on 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. If you've sold stocks for profit, make sure to set aside some extra cash for a larger-than-normal tax bill. Another benefit of keeping good records is that loser investments can be used to offset other taxes 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 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.

New traders should look for a broker who can teach them the tools of the trade. Some offer 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.