How Online Trading Works


New York Stock Exchange See more investing pictures.
Photo courtesy MorgueFile

Legend has it that Joseph Kennedy sold all the stock he owned the day before "Black Thursday," the start of the catastrophic 1929 stock market crash. Many investors suffered enormous losses in the crash, which became one of the hallmarks of the Great Depression.

What made Kennedy sell? According to the story, he got a stock tip from a shoeshine boy. In the 1920s, the stock market was the realm of the rich and powerful. Kennedy thought that if a shoeshine boy could own stock, something must have gone terribly wrong.

Now, plenty of "common" people own stock. Online trading has given anyone who has a computer, enough money to open an account and a reasonably good financial history the ability to invest in the market. You don't have to have a personal broker or a disposable fortune to do it, and most analysts agree that average people trading stock is no longer a sign of impending doom.

­The market has become more accessible, but that doesn't mean you should take online trading lightly. In this article, we'll look at the different types of online trading accounts, as well as how to choose an online brokerage, make trades and protect yourself from fraud.

Review of Stocks & Markets

Review of Stocks & Markets

Before we look at the world of online trading, let's take a quick look at the basics of the stock market. If you've already read How Stocks and the Stock Market Work, you can go on to the next section.

A share of stock is basically a tiny piece of a corporation. Shareholders -- people who buy stock -- are investing in the future of a company for as long as they own their shares. The price of a share varies according to economic conditions, the performance of the company and investors' attitudes. The first time a company offers its stock for public sale is called an initial public offering (IPO), also known as "going public."

When a business makes a profit, it can share that money with its stockholders by issuing a dividend. A business can also save its profit or re-invest it by making improvements to the business or hiring new people. Stocks that issue frequent dividends are income stocks. Stocks in companies that re-invest their profits are growth stocks.

Brokers buy and sell stocks through an exchange, charging a commission to do so. A broker is simply a person who is licensed to trade stocks through the exchange. A broker can be on the trading floor or can make trades by phone or electronically.

An exchange is like a warehouse in which people buy and sell stocks. A person or computer must match each buy order to a sell order, and vice versa. Some exchanges work like auctions on an actual trading floor, and others match buyers to sellers electronically. Some examples of major stock exchanges are:

Worldwide Stock Exchanges has a list of major exchanges. Over-the-counter (OTC) stocks are not listed on a major exchange, and you can look up information on them at the OTC Bulletin Board or PinkSheets.

When you buy and sell stocks online, you're using an online broker that largely takes the place of a human broker. You still use real money, but instead of talking to someone about investments, you decide which stocks to buy and sell, and you request your trades yourself. Some online brokerages offer advice from live brokers and broker-assisted trades as part of their service.

If you need a broker to help you with your trades, you'll need to choose a firm that offers that service. We'll look at other qualities to look for in an online brokerage next.

Choosing a Broker

E*Trade, Ameritrade and Charles Schwab are three of the many online brokerages.
E*Trade, Ameritrade and Charles Schwab are three of the many online brokerages.
Logos are registered trademarks of their respective companies. All rights reserved.

Before you can trade stocks online, you have to select an online broker. Your online broker will execute your trades and store your money and stock in an account. The online trading industry has seen lots of mergers and acquisitions, but there are still many firms to choose from. Different firms also offer different levels of help, account types and other services. Here are some things you should keep in mind as you look for a broker.

  • How much money you plan to invest. Most firms require investors to have a certain amount of money to open an account. This is different from a minimum account balance -- although most brokerages have those, too.
  • How frequently you plan to make trades. Are you going to buy one stock and hold on to it? If so, you'll need to make sure the brokerage doesn't charge a fee for account inactivity. On the other hand, if you're going to make lots of trades, you'll want a lower fee per trade. Regardless of how much you plan to use your account, you should evaluate how much using the site will cost you.
  • Your level of trading experience and how much guidance you need. Some of the least expensive brokerages don't offer much in the way of research or broker-assisted trades. Others, while still moderately priced, offer market analysis, articles on successful trading and help from licensed brokers.
  • Any other services you may want. A few trading sites let you buy and sell stocks but not much else. Others are more like major banks, offering debit cards, mortgage loans and opportunities for other investments like bonds and futures.

Some sites, such as Keynote and Smartmoney, rate online brokerages based on success rates, customer service response time, trading tools and other factors. They can help you make a decision as you shop around for the best trading site for your needs, but keep in mind that there are no official standards for ranking or evaluating brokerages.

As with any site that requires your personal and financial information, you should make sure your online broker has good security measures, including automatic logouts and transmission encryption. You should also make sure your brokerage is reputable. The Investing Online Resource Center has a good list of links you can use to make sure your firm is legitimate.

Opening & Funding an Account

With a cash account, you buy stocks with the money in your account. With a margin account, you can buy on credit.
With a cash account, you buy stocks with the money in your account. With a margin account, you can buy on credit.
Photo courtesy Pixel Perfect Digital

When you open an account with a United States online brokerage, you'll answer questions about your investment and financial history. These questions determine your suitability for the account you are requesting -- the brokerage cannot legally allow you access to investments that you cannot reasonably handle. You will also have to provide your address, telephone number, social security number and other personal information. This helps the brokerage track and report your investments according to tax regulations and the PATRIOT Act.

In addition to providing this information, you must make several choices when you create an account. With most brokerages, you can chose between individual and joint accounts, just like at a bank. You can also open custodial accounts for your children or retirement accounts, which are often tax-deferred. Unless you pay a penalty, you can usually retrieve earnings from a retirement account only when you retire.

Next, you must choose between a cash account and a margin account. You can think of a cash account as a straightforward checking account. If you want to buy something using your checking account, you have to have enough money in the account to pay for it. Using a cash account, you have to have enough money to pay for the stock you want.

A margin account, on the other hand, is more like a loan or a line of credit. In addition to the actual cash in the account, you can borrow money from the brokerage based on the equity of the stock you already own, using that stock as collateral. Then, you can buy additional stock. Your margin is the equity you build in your account.

According to the Federal Reserve Board, you must have at least 50 percent of the price of the stock you wish to purchase in your account. In other words, if you want to purchase $5,000 worth of stock, the value of the cash and stock in your account must be at least $2,500. You can borrow the other $2,500 from the brokerage.

Once you have made your purchase, you must keep enough equity in your account, also called your equity percentage, to cover at least 25 percent of the securities you have purchased. Here's how the brokerage determines this number:

  • The market value of your stock minus the amount of the loan you took to buy the stock is your equity amount.
  • Your equity amount divided by your total account value is your equity percentage.

If your equity percentage falls below the minimum, the broker has the right to issue an equity call. Typically, the brokerage will try to contact you, but the firm has the right to sell any and all of your assets to raise your equity percentage to the minimum. The brokerage is not obligated to contact you.

Margin accounts are definitely more complex than cash accounts, and buying on credit presents additional financial risks. If all of that sounds overwhelming, it's a good idea to stick with a cash account. If you'd like some more examples of how margin accounts work, check out the IORC's Investing Simulator Center.

Finally, you must decide how the brokerage will store your money between trades. Many brokerages offer interest-bearing accounts, so you continue to earn money even when you are not trading.

Once you have made all these choices, you must fund your account. You can make a deposit by check, make a wire transfer to the brokerage or transfer holdings from another brokerage.

When your account is open, you're ready to trade. We'll look at the trading process next.

Making Trades

Once you've opened and funded your account, you can buy and sell stocks. But before you do that, you want to get a real-time stock quote to confirm the current price of the stock. Your brokerage may provide real-time quotes as part of your service. Many free financial news sites offer delayed quotes, which are at least twenty minutes behind the market. If the market is moving quickly, a delayed quote can be substantially different from the real trading price.

This content is not compatible on this device.

Once you've gotten your quote and decided you want to make a trade, you can choose to place a market order or a limit order. A market order executes at the current market price of the stock. A limit order, however, executes at or better than a price you specify. If the price doesn't reach the limit you set, your trade will not go through.

This content is not compatible on this device.

Some brokerages offer additional options, often used to prevent high losses when a stock price is falling. These include:

  • Stop order - A form of market order, this executes after the price falls through a point that you set. The order executes at market price, not at the stop point.
  • Stop limit order - These are like stop orders, but they execute at a price you set rather than market price. In rapidly moving markets, the broker may not be able to execute your order at your set price, meaning that the stock you own may continue to fall in value.
  • Trailing stop order - Like a stop order, a trailing stop executes when the price falls through a point you set. However, its selling price is moving instead of fixed. You set a parameter in points or as a percentage, and the sale executes when the price falls by that amount. If the price increases, though, the parameter moves upward with it. So, if a stock is trading at $20 per share, and you set a trailing stop order with a three-point parameter, your initial selling price would be $17 per share. But if the price then increases to $25 per share, your new selling price would be $22 per share.

This content is not compatible on this device.

You must also select whether your order stays active until the end of the day, until a specific date or until you cancel it. Some brokerages allow you to place "all or none" or "fill or kill" orders, which prevent a partial rather than complete exchange of the stocks you want to trade.

Contrary to many people's perceptions, making trades online is not instantaneous, even if you're placing a market order. It can take time to find a buyer or seller and to electronically process the trade. Also, even though you can access your account and place buy and sell orders twenty-four hours a day, your trades execute only when the markets are open. An exception is if your firm allows after-hours trading, which is riskier due to the reduced number of trades taking place.

Online Stock Fraud

With erratic prices, corporate scandals and "market corrections," you may think you already have enough to worry about when it comes to trading stocks. But there is one more important worry to add to the pile -- investment fraud.

Long before the days of online trading, a few unscrupulous brokers defrauded investors or absconded with their money. Fraudulent firms known as boiler rooms have also employed brokers to make unsolicited phone calls to investors, selling bogus or overvalued stock. People must evaluate their broker's ethics and judgment, and part of the broker's job is to protect investors from fraudulent stocks.

With online trading, though, people must research stocks on their own, deciding what to buy and sell without the help of a broker or an investment planner. Fraudsters have taken advantage of this, leading to several notable methods of defrauding investors. These include:

  • Pump-and-dump schemes - People spread the word about a "sure thing" stock via online message boards, online stock newsletters, email and other methods. The resulting interest in the stock drives up the price. The organizers of the scheme sell their stocks for a huge profit, and then stop promoting it. The price plummets, and investors lose money.
  • Fraudulent IPOs - Some investors like IPOs because they provide a chance to "get in on the ground floor" and to make a substantial profit. Some scammers, though, spread the word about an upcoming IPO for companies that never intend to go public or that don't exist. Then, they abscond with investor' money.
  • Fraudulent OTC stocks - Con artists promote stock in companies that do not exist or start a pump-and-dump scheme for an OTC stock. After investors buy stock in non-existent companies, scammers simply take the money and run.
  • Fraudulent company information - Publicly traded companies have to release information about financial performance. Overstating or misrepresenting a company's goals and achievements can drive up the stock price.

 

Fortunately, you can protect yourself from most of this by doing your own research. In addition to researching your brokerage, you should research any company you plan to invest in, including reading annual reports and financial statements. You should also check the SEC's Electronic Data Gathering, Analysis & Retrieval (EDGAR) system, especially if you are going to participate in an IPO. EDGAR includes IPO information and periodic reports from companies in the United States and other countries. Filing information with EDGAR is required by law.

Also, it's always a good idea to remember that if a stock deal seems too good to be true, it probably is.

Check out the links on the next page for lots more information on electronic trading, stocks and the stock market.

 

Related HowStuffWorks Articles

More Great Links

Sources

  • Ameritrade Education Center http://www.ameritrade.com/index1.html
  • InvestorGuide.com: Introduction to Investing Basics.http://www.investorguide.com/igup1-introduction-to-investing-basics.htm
  • InvestorGuide.com: Investment Choices http://www.investorguide.com/igup1-investment-choices.htm
  • Laise, Eleanor and William Maudlin. "Hook the Right Broker." SmartMoney.com, August 1, 2005. http://www.smartmoney.com/brokers/index.cfm?story=2005-intro
  • NASAA: Get the Facts About Online Investing http://moneycentral.msn.com/content/Investing/Startinvesting/P98893.asp
  • NSAD: Prohibited Conduct http://www.nasd.com/web/idcplg?IdcService=SS_GET_PAGE&ssDocName=NASDW_005876
  • Internet Fraud: How to Avoid Internet Investment Scams. SEC.http://www.sec.gov/investor/pubs/cyberfraud.htm
  • Weston, Liz Pullman. "How to Choose the Right Brokerage for You." MSN Money. http://moneycentral.msn.com/content/Investing/Startinvesting/P98893.asp