Introduction
Stocks are among the oldest financial markets, starting from the 1500s. We live in a highly economical society, with stocks playing a major role. Each financial instrument serves its purpose in the economy.
Crypto is helping to usher in digital money; forex is necessary for the international exchange of fiat currencies (check out this piece where we compare FX and stocks).
The issuing of stocks helps companies grow their business, and, in return, investors profit from that growth. So, understanding stock trading can help align you with a tried-and-tested investment strategy through familiar brands.
So, let’s explore stock market basics in more detail here.
What are stocks? How stock trading works
A stock (also known as equity or share) simply represents fractional ownership of a listed corporation. We generally trade stocks on stock exchanges and brokers (but it can also be privately). The concept of basic stock trading is simple.
It always involves an already profitable company (or one that shows excellent potential) looking for external funding. Stock markets are one way of raising this money for the business to expand and make more profit.
The company will first decide how much equity it will give to investors. This stake is what’s distributed to the exchange into shares priced at a certain value during the IPO (initial public offering) phase.
Shareholders expect the price to increase over time if the company performs well, among other factors. Here, they can sell some or all their shares to other investors, resulting in a profit for them. Some companies also pay yearly dividends to their shareholders, derived from actual profits.
This is, in a nutshell, stock market basics.
The exchanges are the next element to observe when exploring how to understand stocks. This is a marketplace that most companies consult to list their shares. It has a physical location that stockbrokers and shareholders can attend for trading purposes.
But, of course, you can trade online through a platform connected to the exchange. There are approximately 60 major exchanges globally. They are located across various countries like America, China, Japan, Hong Kong, India, the United Kingdom, and Australia, among others.
Here is a list of the top 10 exchanges by trading volume:
- New York Stock Exchange (USA)
- NASDAQ (USA)
- Shanghai Stock Exchange (China)
- Euronext (Europe)
- Japan Exchange Group (Japan)
- Shenzhen Stock Exchange (China)
- Hong Kong Stock Exchange (China)
- National Stock Exchange (India)
- Saudi Stock Exchange (Saudi Arabia)
- London Stock Exchange (United Kingdom)
Another popular way to trade stocks is through derivatives offered by brokers. This product derives or takes its value from an underlying asset. It’s a way of trading a market without owning the real thing.
For instance, a gold or silver derivative means you don’t take physical possession of the metal. But you can profit from the price’s up and down swings.
In the case of stocks, trading a share derivative means that you don’t own the actual shares issued by the exchange. Yet, you can make money whether its price rises or falls.
There’s more to explore with stock market basics in the next section.
The basics of trading stocks
How to understand stocks is about analysing what drives their prices. Like most markets, we have two primary types of analysis: technical and fundamental. Some traders use one exclusively or combine the two.
It’s not only the analysis that matters. Your trading style determines how long you will hold your stocks.
For example, short-term traders, like day traders, close their orders before the trading day ends. On the other hand, swing traders keep their positions open for several days or weeks. And then position traders who have a long-term buy-and-hold approach with monthly and yearly horizons.
Nonetheless, let’s look at technical and fundamental analysis in more detail.
Stock market basics technical analysis
Technical analysis (TA) is about studying patterns and indicators to predict future movements. Traders typically look at elements like the trend, momentum, support/resistance and volume on a candlestick chart.
These contribute to a trader’s decision to buy or sell a certain stock. Charts are the primary graphical representation of present and price action. So, even if you’re not using technical analysis, they are still necessary.
As with other markets, the main flaw with TA is that it doesn’t provide information on the external forces of price changes. Fundamental analysis is there to fill this gap and is a crucial part of stock market basics.
Stock market basics fundamental analysis
Experts consider TA as representing the present value of a stock. Fundamental analysis looks at factors that suggest the true or fair future price by looking at the underlying company’s financial performance, assets, market share, etc.
Also, economic and geopolitical events form part of FA. This type of analysis in stocks is multi-layered and depends on the investor’s objectives. Some prioritise industry trends as what will determine the success of a company.
For example, if a corporation is in an emerging industry, this could be enough of a reason to invest in it, despite other harmful factors.
Others will want to see a healthy balance sheet and earnings report, using that to decide whether the stock will fall or not. Regardless, while TA is geared for the short term, the impact of FA is felt in the long term.
Most common types of stocks
Now we’ll look at the different kinds of shares to fully understand stock market basics. We generally have six types of stocks (the examples we’ll provide of each relate to American companies).
- Blue-chip: As the term suggests, a blue-chip stock is the crème de la crème of shares. These are large and well-known companies with several years or decades of existence. They are industry leaders and have a strong track record of profitability.
While there is no formal criteria to determine a blue-chip stock, investors refer to the Dow Jones Industrial Average as the benchmark. Examples of blue chips include Apple, Coca-Cola, Microsoft, Nike, McDonald’s, etc.
- Dividend: A dividend (or income) stock pays dividends to its shareholders. As mentioned earlier, not all companies do this. Dividend stocks come from all industries and include well-known (like Ford) and less-popular companies (like CME Group).
- Defensive: A defensive (or non-cyclical) stock is known to maintain good performance regardless of how well the economy is doing. Businesses of these equities typically sell essential services and products, making them less likely to fail.
Defensive stocks are also known to pay dividends, another factor adding to their reliability. Examples include Procter & Gamble, Philip Morris International, Johnson & Johnson and Coca-Cola.
- Growth: As the name suggests, a growth stock is a stock that analysts anticipate will increase faster than the business or industry average. Companies of growth stocks tend to be new or have developed an innovative product/service that will offer them greater market share.
Examples include Tesla, Netflix, Spotify, Etsy, Meta Platforms, and many others.
- Cyclical: A cyclical stock (the opposite of a defensive stock) is affected by economic cycles. When the economy is at a peak, it does well; when it’s in a recession, it follows suit. Cyclical stocks consist of brands selling non-essential or consumer discretionary products.
These include car producers, hotels, restaurants, airlines, retailers, etc.
- Penny: A penny stock usually trades for less than $5 a share. These are small companies with growth potential. However, experts consider them riskier than established equities, primarily because you don’t always find them on proper exchanges. Also, they don’t have enough of a track record.
Conclusion: pros and cons of stocks
To round off our stock market basics discussion, let’s look at the benefits and drawbacks of investing in shares:
Pros
- Well-established trading/investing strategy with proven returns
- Better regulated compared to other markets
- Some stocks offer passive income in the form of dividends
- You can start with a few hundred of dollars
- Equities are linked to a growing economy
Cons
- Stocks have lower margin compared to instruments like forex, meaning more capital is needed
- There are tons of stocks, making it harder to specialise
- Slower growth compared to markets like crypto
- Needs more time in fundamental analysis research
- Limited opening hours
Ultimately, any financial market has its unique pros and cons. It is no different when learning about stock market basics. As they say, knowledge is power. The investors who remain successful are those who have studied beyond the basics of trading shares.
Still, it helps immensely to start with the simple things before moving on to the advanced stuff. So let this guide be everything you need to know about stocks in the most basic form.
