Subject: Trading - Basics

Last-Revised: 1 Jan 2004
Contributed-By: Chris Lott (contact me)

This article offers a very basic introduction to stock trading. It goes through the steps of buying and selling shares, and explains the fundamental issues of how an investor can make or lose money by buying and selling shares of stock. This article will simplify and generalize quite a bit; the goal is to get across the basic idea without cluttering the issue with too many details. In some places I've included links to other articles in the FAQ that explain the details, but feel free to skip those links the first time you read over this.

You may know already that a share of stock is essentially a portion of a company. The stock holders are the owners of a company. In theory, the owners (stock holders) make money when the company makes money, and lose money when the company loses money. Once there was age of internet stocks where companies lost lots of money but the shareholders still made lots of money (and then lost money themselves), but let's just say that the main trick is to buy only stocks that go up.

Next we will walk through a stock purchase and sale to illustrate how you, an investor in stocks, can make money--or lose money--by buying and selling stocks.

1. One fine day you decide to buy shares of some stock, let's pick on AT&T. Maybe you think that company will soon return to being the all-powerful, highly profitable "Ma Bell" that it once was. Or you just think their ads are cool. So now what?

2. Although there are many ways to buy shares of stock, you decide to take the old-fashioned route of using an old-fashioned stock broker who has an office in your town and (imagine!) takes your phone calls. You open an account with your friendly broker and deposit some good old-fashioned cash. Let's say you deposit $1,000.

3. You ask your broker about the current market price quoted for AT&T shares. Your broker is a good broker, and like any good broker he knows that AT&T's ticker symbol is the single letter 'T'. He punches T into his quote request system and asks for the current market price (supplied from the New York Stock Exchange, where T is primarily traded), and out pops a price of 20.25 (stocks were once quoted as fractions like 1/4 but are now done with decimals). Looks like your $1,000 will buy almost 50 shares, but because this is your very first stock trade, you decide to buy just 10 shares.

4. You ask your broker to buy 10 shares for you at the current market price. In the lingo of your broker, you give a market order for 10 shares of T. Your broker is a nice guy and only charges a commission on a single stock trade of $30 (not too bad for someone who takes your phone calls). Your broker enters the order, and his computer then figures the price you will ultimately pay for those 10 shares, which is 10 (the number of shares) times 20.25 (the current price for the shares on the open market) for a total of 202.50, plus 30 (the broker's commission, don't forget he has to eat too), for a grand total of $232.50.

5. Then magic happens: your broker instantly finds someone willing to sell you 10 shares at the current market price of 20.25 and buys them for you from that someone. Your broker takes money from your account and sends it off to that someone who sold you the shares. Your broker also takes his $30 commission from your account. In the end, your hard-earned money is gone, and your account has 10 shares of AT&T. A (very small) fraction of the company, as represented by those 10 shares, is now in your hands!

   Now it's time for a few details, which you can safely skip if you choose. The person who sold you the shares was a specialist ("spec") on the NYSE; for more information, look into the NYSE's auction trading system. Roughly, a specialist is a type of middleman and a member (like your broker) of the financial services industry. After you give the order, the shares do not appear instantly; they appear in your account three business days after you gave the order (called "T+3"). In other words, trades settle in three business days.

   Please pardon a fair amount of oversimplification here, but the trade and settlement procedures involved with making sure those 10 shares come to your account can happen in many, many different ways. You're paying that commission so things are easy for you, and indeed they are: for a relatively modest fee, your broker got you the shares.

   It may be important to point out here that AT&T, that big company from Bedminster, New Jersey, did not participate in this stock trade. Sure, their shares changed hands, but that's all. Shares of publicly traded companies that are bought on the open market never come from the company. Further, the money that you pay for shares bought on the open market does not go to the company. Sure, the company sold shares to the public at one point (an event called a public offering), but your trade was done on the open market.

   After the trade settles, then what? Your broker keeps some of the $30 commission personally, and some goes to the company he works for. The shares are in your brokerage account. This is called holding shares "in street name." If you really want to hold the stock certificates, your broker will be happy to arrange this, but he will probably charge you about another $30. Since you feel you've paid your broker enough already (and you're right), you decide to leave the shares in your account ("in street name").

6. The next day, AT&T shares close at a price of 21, which is a rise of $0.75. Great, you think, I just made $7.50. And in some sense you're right. The value of your holdings has increased by that amount. This is a paper gain or unrealized gain; i.e., on paper, you're $7.50 wealthier. That money is not in your pocket, though, and you do not need to tell the IRS. The IRS only cares about actual (realized) gains, and you don't have any, not yet.

7. The following day, AT&T shares close at a price of 22. which is another rise over the price you paid and a rise over the previous day. Fantastic, you think, boy can I pick them, today I made another $10! At this point, you have a paper gain of 10 times 1.75 which is 17.50. Not too bad for two days.

8. That evening you decide that maybe AT&T really isn't such a great wireless phone company after all and it's time to sell. You make a call the next morning, and although your broker is a bit surprised to hear from you again so soon, he's obliging (after all, it's your money). Again your broker asks for a quote of the current market price for 'T.' The current market price for AT&T on the NYSE is 22.50 (wow, another rise). Your broker accepts your order to sell T at the market. Again his computer figures the money you will receive from the sale: 10 (the number of shares) times 22.50 (the current market price) for a total of 225, less his commission of 30, for a grand total of 195.

9. Magic happens again: instantly your broker finds someone willing to buy the 10 shares of AT&T from you at the current price, and sells your shares to that someone. That someone sends you $225. Your broker deducts his commission of $30 from the proceeds of the sale, so eventually the shares of AT&T disappear from your account and a credit of $195 appears. Note again that the company did not participate in this trade, although shares (and fractional ownership of the company represented by those 10 shares) changed hands.

   As explained above, that someone was a person at the NYSE called a specialist ("spec"), a member of the financial services industry. The trade will be settled in exactly 3 business days (upon settlement, the shares are gone and you have the cash). Again I apologize for the oversimplification here.

10. So you calculate the result. Gee, you think, the stock went up every day.. and I paid $232.50.. but I only received $195.. and pretty quickly you come to the inescapable conclusion that you lost $37.50, even though you had a paper gain every day. This is the problem with commissions: they reduce your returns. You paid over 15% of your capital in commissions, so although the share price rose about that much in just a couple of days, you lost money because the commissions exceeded the gains.

11. Eventually you do your taxes. You have a short-term capital loss of $37.50 from this pair of trades. Depending on your tax situation, you may be able to deduct your loss from your gross income.

Now you should understand the basic mechanics of buying and selling shares of stock, and you see the importance of commissions.

Just for comparison, let's run the numbers if you had bought 50 shares instead of just 10 (maybe you found another few dollars). The purchase price of (50 * 20.25) + 30 is 1042.50. The sales price of (50 * 22.50) - 30 is 1095. The difference is $52.50 in your favor. What this says is that commissions can really hurt the small investor, and is a good reason for really small investors to consider investing via no-load mutual funds or direct investment plans (DRIPs).