Experienced stock traders will probably find today’s post a bit too basic, but I’ve been getting questions about how the stock market and stock trading work, so I though a Stocks 101 discussion might be in order.
The stock market is exactly that: a market. What markets do is bring buyers and sellers together. If you want to buy a dozen eggs for example, you don’t need to travel the countryside looking for someone selling them – you go to the supermarket. And the people that have eggs to sell also don’t have to search for buyers…in a very high-level and simplistic way, supermarkets bring buyers and sellers together, just as the stock market brings buyers and sellers of stock together.
If you’ve never bought stock before, and are thinking of making your first purchase, there are a few things you need to know about the mechanics of stock transactions, also known as “trades”. When you want to make a trade, either through a brokerage app or website (calling a broker to make a trade on the phone is still done, but rarely when it comes to small transactions), you place an “order”. There are four main types of orders you can place: a “market order”, “limit order”, “stop-loss order” and “stop-limit order”.
As entire chapters can be written about stock trades, I won’t go into too much detail about them today, but my second book (which I hope to have available by the end of October) will tell you how to use each of these strategies, or in some cases when not to use them.
Before talking about the different order types, just a few words about the mechanics of the market. Each stock, and indeed many financial instruments, has two prices: a “bid” and an “ask” price. Technically, the bid price is the highest price someone is currently willing to buy your stock from you if you’re selling it, and the ask is the lowest price someone is willing to sell stock to you if you’re are looking to buy it.
In practice, bid and ask prices are set by what are called “market makers”, or brokerage firms who hold an inventory of stock of certain companies, and maintain an orderly market ensuring there are always buyers and sellers for each stock who can transact at reasonable prices given current market sentiment. Of course it’s much more complicated than that, but that is essentially how the market works, and is enough knowledge to start trading stocks at a basic level if that’s what you’ve decided to do.
Now back to the types of orders. Let’s say you want to buy some stock, and maybe it’s the first purchase of stock you’ve ever made. If you are not particular about the price you buy it at, you might put in a market order. Placing a market order to buy a stock (or buying “at the market”) means you will pay the best price available when you place your order: typically the ask price. When you put in a market order to sell a stock, or sell at the market, you will typically receive the current bid price as of the time you place the order.
Let’s say instead that you are not willing to pay more than a certain price per share for the stock you are about to buy. I think it’s a great idea (an essential idea when you start to invest larger amounts of money) to have an idea of the fair value of a stock before you buy or sell it, and I will discuss this in MUCH, MUCH more detail in the next several weeks and in my upcoming books. So, if there is a limit to how much you are willing to pay for a stock, you put in a limit order (catchy how that works!).
So, let’s say a stock has a bid price of $51.00 and an ask price of $51.10, but you are not willing to pay more than $50 per share for the stock. You would then put in a limit order at a price of $50, your “limit” on how much you are willing to pay. You won’t actually buy the stock unless the ask price comes down to $50 or less. So when you place a limit order, you might not wind up buying the stock (or selling, depending on what you’re trying to do.). Your order will only be “filled”, or transacted, if the price the market maker is willing to sell the stock to you matches your limit price. If you’re selling a stock through a limit order, your will only actually sell the stock if the bid price rises to meet your limit price per share.
To avoid making this a monstrously long post, I will discuss the other two types of orders tomorrow, and why I don’t like them. I’ll wrap up the week with a few thoughts on stock pricing, and there will be a bonus post over the weekend on options for the truly brave!
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