A Stock Trade: How it Works
By Gabe Velazquez & Bill Addiss | Updated: April 11, 2019
What Happens When You Buy a Stock?
The process for buying and selling stocks is much different today than it was prior to advent of the internet and advancement of technology. These innovations have made trading faster and much more accessible to the general public. In addition, these changes have lowered the costs of trading so that trades can be made with lower commissions and from a variety of platforms thanks to electronic trading and specialty brokers, in essence leveling the playing field for the average trader and investor.
Buying Stock on the Exchange : The Secondary Market
This is the way most retail investors buy stocks. The goal of an exchange is, quite simply, to provide a forum for the buyers and sellers to meet to buy/sell their shares. Given that these stocks were already issued and not an IPO (covered later), these exchanges are referred to as the Secondary Market. Most of us are probably familiar with the NYSE (New York Stock Exchange) or NASDAQ Exchange (National Association of Securities Dealers Automated Quote) on which stocks are traded, but there actually a much wider number of exchanges in the US, including but not limited to:
These exchanges do not do business with the investor directly. Therefore, it is necessary to open an account with a traditional stock broker to be able to buy and sell stocks on these exchanges. There is a huge variety of services which brokers also offer their clients. Accordingly, there are a variety of fees they may charge.
Deep Discount brokerage firms, (like Robin Hood), actually charge no commission to their clients to trade stocks. However, the services and support they provide is limited. A discount firm, such as TD Securities or Ameritrade, offers a wider variety of services and, accordingly, charge a commission. A full service firm, such as Merrill Lynch, offers a huge variety of support and services, but charges a higher commission to buy and sell stocks. Prior to choosing a brokerage firm to use, a trader must decide what services they need as well as the fees they are willing to incur for those services.
The basic process for how to buy a stock is for a buyer to initiate a transaction through their broker with the objective being to limit loss and maximize returns. To do this electronically through a trading platform:
- The buyer would input an order to purchase a stock by using one of three types of orders: a limit order, which is at a specific price; a market order, which is placed where the closest seller (ask price) is offering stock for sale; or a buy stop which indicates to the broker to buy shares at market when the stock trades to a certain price (the stop price).
- When any of these order criteria -which are decided upon by the individual trader - are met, the order is filled and the stock is now in the possession of the buyer.
- The account is then adjusted to reflect the transaction. Money goes out of the buyer’s account and the new stock goes in.
- In a cash account (an account that doesn’t use margin), there is a transition period (generally two business days) before the transaction 'settles’.
- After the settlement is completed, the stock is then available to trade in the new owner’s account.
What Happens When You Sell a Stock?
When a trader wants to sell a stock, the seller would again initiate a transaction through their broker, but this time the objective is to limit costs on the purchase of a stock. The order types are the same as for buying a stock, described above.
Once the order is placed, the account is then adjusted to reflect the transaction. Money goes into the seller’s account and the stock is transferred to the buyer. There is still a transition period if a cash account was used. Presently, there are still those old school investors that feel more comfortable placing a stock trade by calling their broker and giving them instructions on how and when to buy or sell a stock. The active trader, however, will go on the broker’s website or trading platform and enter this information directly.
Other Ways to Buy and Sell Stocks
New Issue: The IPO (Initial Public Offering)
An Initial Public Offering is when the stock of a company is made available for sale to the public market for the first time. Prior to conducting the IPO, the company was funding itself thru other means, such as borrowing from Venture Capitalists, banks or other funding sources. In offering their stock to the public marketplace, the company can now raise capital by selling its shares to the general public. It is for this reason that the IPO market is also referred to as The Primary Market. That said, most IPOs are not actually available to the general public or retail investor but are marketed almost exclusively sold to the institutional investor. When an IPO is offered to the retail investor, due to the high risk involved in trading IPOs, it is recommended they not trade them.
Buying Stocks Directly from the Company
This method of buying a stock is not as well-known as buying stock on an exchange thru a broker, but for the long term investor it certainly warrants attention. It is referred to as DPP (Direct Purchase Programs). As of this year, hundreds of companies in the U.S. now offer this opportunity. As the name implies, this is the opportunity to buy stock directly from the company, through their agent. There are MANY benefits to buying a stock this way. They include:
- No (or low) commission - Because there is no broker, the retail investor can purchase stocks in these companies without paying any commission or fee or, in some cases, only an initial fee to set up the program with no recurring fees.
- Low Minimum Investments - Many of these programs give the investor the opportunity to invest in the stock in denominations as small as $25.
- Partial Shares - When buying stock on an exchange you have to buy it in full shares. These programs offer the opportunity to buy partial shares. For example, if a company is currently trading at $67/share, that means that investors buying stock in the marketplace would have to buy it in $67 increments. However, the company could offer a direct purchase plan where, once the program is established with a minimum initial investment, investors can make purchases in dollar denominations as small as $25. This means the investor is actually buying .37% of a share. This allows the investor to get a specific dollar amount of the stock, not necessarily a specific amount of share.
- Dividend Reinvestment - Another benefit is that for those companies which pay their investors a cash dividend, these programs offer you the opportunity to reinvest those dividends back into more stock rather than receiving the traditional cash payment. This essentially results in your investment compounding that interest.
The specifics of these programs can be different firm to firm. They may have different minimums to start the program, or subsequent purchase minimums. They may require a small transaction or administrative fee, so it is necessary to investigate the specifics of the stock you may be interested in. Given the benefits listed above, these programs are growing in popularity. It certainly requires the investor to do a bit more homework. If you are interested in investing in a company, and the company offers the opportunity, simply check the Investor Relations area of the company’s website for the specifics of their program. There are also services such as Computershare Direct Stock which will consolidate the information and provide the specifics on the variety of DPPs available.
NO matter how you choose to participate in the markets, learning how the stock market works is the first step. At Online Trading Academy, we teach our patented trading strategy to active traders on a professional traders workstation with advanced charting and order placement to facilitate their learning. Although the speed and accuracy of placing trades has been vastly increased due to technology, what hasn’t changed in stock trading is the underlying dependence on the immutable law of supply and demand to move prices. Simply, when there are more willing buyers than willing sellers in a particular stock, price will go up. If you are one of those willing buyers, you will have to enter a bid and wait for a seller to match your order. The reverse is true when you’re trying to sell a downward trending stock.