An Introduction to the Stock Market

The stock market is where shares of public companies are traded, typically through what’s known as an exchange. Through the trading of shares, companies are able to raise capital while providing investors with the opportunity to own a portion of their company.

This partial ownership entitles investors to dividends (a share of the company’s profits), capital gains (rise in value/price of the shares) or profits (through selling the shares when their prices rise).

Broadly speaking, the stock market is divided into two markets: the primary market and the secondary market. The primary market is where IPOs (Initial Public Offerings) are made. In this market, institutional investors from investment banks buy the company’s shares. The secondary market is where subsequent trading takes place. Both individual and institutional investors can buy and sell shares at this market through exchanges like the London Stock Exchange.

Stock exchanges

Why do stock prices rise and fall?

The constant rising and falling of stock prices is called volatility – but what causes volatility?

Like products on any market, the price of stocks is based on the law of supply and demand. When there are more people willing to buy shares than there are people selling them (high demand and low supply) the price of the shares goes up. When the situation is reversed, share prices go down.

Supply and demand

What drives this demand and supply? Broadly, there are two main factors that drive the supply and demand of shares: current performance of the company and future growth prospects.

The current performance of a company is measured by the profit it’s able to make. For example, if a company makes profits, the value of its shares goes up. If it incurs losses, the price of its shares falls. Normally, companies announce their earnings four times a year. It is these quarterly earnings reports that form the basis of evaluating a company’s value.

The second most important determinant of the value of a company’s shares are its growth prospects. It is possible to have a company’s shares rise in price even when it doesn’t make a profit. A good example of this is Tesla Motors:

tesla-case-study

This phenomenon is quite rare, and only occurs when investors are ‘bullish’, which means they’re confident that over the long run the company will become highly profitable.

A more famous example of this is the dot com boom of the 1990s, where tech companies with no profits noticed their share prices rise continuously until the dot com bubble burst at the end of the decade. The reason is that many investors were convinced that these companies had a bright future and, therefore, were worth investing, even when they were not making profits.

What type of trader are you?

Apart from understanding why shares rise and fall, it is also important that you understand the people who actually cause the stock prices to rise and fall – the participants of the market.

Generally, there are two main types of stock market participants: traders and investors.

People often fail to differentiate between the two. However, these two important market participants are very different as both have widely different motives for their participation in the market. Stock traders give the market liquidity while stock investors provide the basis upon which the traders make their decisions.

Stock Investors
Stock investors buy shares with the intention of holding on them for long period of time. Often, this could be months or many years. Before buying shares, they carefully analyse the fundamentals of the company. This analysis includes looking at the financial statements of the company as well assessment of the company’s future growth prospects. Often, they prefer purchasing stock that is undervalued and has strong future growth prospects.

Stock Traders
Unlike stock investors, stock traders focus much of their attention on the market rather than the fundamentals of the company. With this method, they hope to make some profits by predicting short term movements of share prices. Often they buy and hold shares for a period ranging from a few seconds to weeks. In addition, unlike investors, most of stock market traders are professionals who trade either on full-time or part time basis.

There are many types of stock traders. Here are some of them.

Fundamental traders
These traders carefully study the financial statements of companies and the industries they operate in a bid to predict short term movements of the stock. Often, they go for undervalued stocks and sell them off when prices rise. Fundamental trading is not as effective in short term as it is in long term. That is why most fundamental traders combine it with other methods like break out trading to make it more effective.

Buy and Hold traders
These traders buy stocks and hold them for extended period of time, often lasting for years. The most attractive stocks to them are those that are either undervalued or those that are on downward spiral and are likely to rise in the near future once the downward trend ends.

Swing Traders
Swing traders carefully study the momentum of the market before buying shares. Part of this study includes careful analysis of a company’s financial statements and growth forecasts of the industry they operate in. Once they are convinced that certain shares are likely to keep on rising for a certain length of time, they buy the shares and sell them for a profit when they top or are about to top. Often, swing traders focus on a few industries they are well versed in. For example, a swing trader might just focus on finance and technology companies alone.

Day Traders
These traders buy and sell all their stocks within a day. They make sure they sell all their stocks before the end of trading to prevent them from incurring losses as a result of aftermarket gap downs (stocks falling in price the following day). Apart from stocks, they also trade in commodities (wheat, rice etc) and currencies. Often, they buy and hold stock for a very short time (from seconds to a few minutes). Day traders often spend a lot of time analyzing stock market prices. They, therefore, have to be full time traders.

The Inner Game of Stock Investing: Mastering Your Emotions

The stock market is a very volatile market. Stock prices often change fast. Given such kind of a market, it is not surprising that we have so many emotional investors who base their investment decisions not on sound assessment of financial information available but rather on the fluctuations of share prices. How do you know that you are an emotional investor? Here are some of the common characteristics of emotional investors.

You buy and sell shares when they rise or fall by cents
As said earlier, the stock market is a very volatile one. Share prices keep on fluctuating on hourly basis. If you are the type of investor who constantly monitors share prices and quickly sells or buys shares when their price rises or drops even slightly, then you are an emotional investor.

Celebrating unrealized profits or mourning unrealized losses
If the share prices of a company rise from about £30 to £45, the £15 is the unrealized profits. If they fall from £45 to £30, the £15 is the unrealized losses. Getting ecstatic over unrealized profits or depressed over unrealized losses is a clear sign that you are an emotional investor.

Obsession with stock market news and frequent calling of brokers
Being overly concerned about the performance of your stocks, either through constant watching of stock market news or frequent calls to your broker is also a sign of emotional investment.

It is very hard for you to be a successful stock market investor if you are an emotional investor. Being too much focused on minimizing losses and maximizing gains can actually cause losses in the long run. That is why emotional stability and level headedness are important qualities you need to develop for successful stock market investment. Always invest with your head and not your heart.

Choosing the Right Stock Broker

The first step towards being a successful stock investor or trader is choosing the right broker. When making such a choice, there are certain important factors you need to consider.

Trading fees
Brokerage fees vary widely among different brokers. While it might seem natural to choose a broker who charges the least, such a choice is not advisable. Often, such brokers might surprise you with unexpected costs to pay and other hidden charges you might not be aware of. For this reason, it is advisable you choose a broker who charges reasonably but is transparent.

Fees

Regulation
Unregulated brokers often charge smaller fees but are risky to choose. This is because they can easily disappear with your money or fail to pay out your profits and there’s little you can do to get your money back.

All of the brokers that we recommend here on BrokerNotes are regulated. Our highest rated share dealing broker is Hargreaves Lansdown, who are regulated by the Financial Conduct Authority (the UK’s financial regulator).

Education
A good stock broker should be able to teach you the working of the stock market as much as possible so that you become a better investor. This education may be practical or theoretical, but it’s best to get both.

At a practical level, some brokers like ETX Capital have demo accounts where you can use fake ‘paper’ money to trade in stocks. In this way, you are able to learn the ins and outs of stock market investing and their platform without risking your hard earned money. On top of this practical learning should be theoretical learning through different learning materials like e-books.

Hargreaves Lansdown have some particularly good e-books, like this free one on how to pick shares.

Amount of Inactivity Fees Charged
There are some stock brokers who charge fees on clients who stay for certain period of time without trading. Such fee is called inactivity fee and is often around £10 for every three months stayed without trading. If you are a long term value trader, it is best you get a broker who doesn’t charge inactivity fee.

Inactivity fee

Customer Reviews
Often, customer reviews are the best indicators of a broker’s competence. If most of the reviews are positive it shows the broker is competent enough to invest on your behalf or give you great investment advice.

Type of Trader
Apart from stocks, you can also trade in bonds, commodities, derivatives and foreign exchange. Not all brokers are experts in all these forms of stock market trade. That is why it important that you get a broker who specializes in what you want to trade in.

How to pick your first stock

The stock market is a very volatile market. A company’s value is often a perception of investors. Yet investors are just normal human beings driven by emotions. The strongest of these emotions that affect the stock market are fear and confidence. Unfortunately, these emotions change frequently. An incident like a terrorist attack, political announcement, mergers and acquisitions, unveiling of a new company president among many other unforeseen factors can have great effect on the perceptions of investors about a company’s value. In this environment, it is very hard to correctly predict how a company’s stock will perform in future. However, developing a set of rules to guide you through stock investment will help you in picking stocks likely to give you rates of return higher than the average market returns as you continue to master the trade.

Invest in businesses you understand
If you are not familiar with how a company operates and makes money, it is advisable not to invest in its stock. Chances are high you will have difficulties understanding the company’s environment and how it affects its value. For example, many investors in the 1990s invested in any company that had a dot.com on its name without fully understanding their business model. The result was loss of trillions of dollars when the dot.com bubble burst. Successful investors like Warren Buffet have employed this strategy and reaped a lot of profits.

Companies with valuable brand names
Companies with a strong emerging brand or established brands like Nike and Coca Cola can be great to invest in over the long term as the value of their brand can help them through in hard times.

Past Performance
While past performance does not necessarily reflect future performance of a company, it is worthwhile to consider it before investing your hard earned money in their stocks. If a company has been having losses for the more than 5 previous years, what makes you think it will start being profitable in the near future? If a company is making losses, it means it is losing market to its competitors either through poor quality products or inability to change with evolving technology. Unless you have valid reasons why you think it might be profitable, avoid investing in the stocks of such a company.

Companies with large or medium market capitalization
Market capitalization is the product of shares on trade and their price. On average, companies with medium and large market capitalization have more returns and are unlikely to collapse easily compared to companies with small market capitalization.

Market Makers: who are they and how do they influence stock prices?

Market makers play an important role in the stock market by ensuring that at any given time you can buy or sell any stock you want.

Market makers tend to be brokerage companies or banks like Barclays, Goldman Sachs, or Citibank. So, how do market makers make a profit from this?

They make a profit by using something called a spread. Just like when you buy foreign exchange currency for travel money, a spread is the difference in price between how much it costs to buy and sell a stock.

The spread

It’s important to be mindful of the spread, because market makers always see you coming. For example, if a company is hyped in the news, market makers will often increase the spread to increase their profits. The size of the spread also depends on how regularly people buy and sell that share.

For a large company like Vodafone, the spread is likely to be a few pence. For a company that’s less frequently traded, like Games Workshop, it could be several pounds.

Even though the spread is typically a few pence per share, market makers trade in millions of share and in the process make remarkable profits. These profits are the rewards for risks they take because they can also make huge losses if they buy stocks at certain prices and then the prices keep on falling for prolonged period of time.

How to understand whether a company is worth investing in

Whether you are directly investing in stocks or using mutual funds, you need to carefully analyse the company’s financial statements for investment value.

Such statements include statements on the income of the company, cash flow statements and balance sheets. A company with solid earnings, positive cash flow and strong balance sheet is likely to give you good return on your investment. Yet fear of financial jargon and a lot of effort needed to research and analyse financial statements and other relevant data of companies puts off many investors.

Fortunately, there are many investment tools you can use to quickly obtain and analyse financial statements of companies. One of the best tools for analysing a company’s share price and financial data is ADVFN.

Here’s an example of ADVFN page for Tesco.

Tesco ADVFN

There are many different rules and criteria for working out whether a company is a good investment or not. As a general rule of thumb, you want to figure out whether the company is undervalued – or worth less than it will be in the future.

One such criterion is the Graham/Schloss criteria. This criterion, first formulated by Ben Graham and modified by Walter Schloss, is based on the fact that the best stocks to invest in are those that are undervalued.

As explained earlier, the value of a company is a perception of investors. Sometimes these perceptions are correct but more often they are wrong. There are many companies whose share prices do not reflect their real value. If they are undervalued, it is likely that their stock prices will start rising with time to reflect their true value. How do you identify an undervalued stock? A Graham/Schloss criterion helps you do that. In this criterion:

  • The P/E ratio should be 9 or less
  • The ratio of current assets to current liabilities should be 1.5:1
  • The company should be one that pays dividends
  • Debt to net current assets ratio should be less than 1.1:1
  • Share price to tangible book value ratio should be less than 1.2:1

With this criterion, sign up for ADVFN. Choose UK screener so that you only apply the criterion to UK listed companies.

Choose the Graham/Schloss criteria and then add constrainers. These constrainers include specifying the percentage of ratio of financial values like share price be less than 120% of tangible book value. Save the information after putting in the constrainers. Once this is done, you will get a list of all publicly listed companies that meet the Graham/Schloss criteria.

By using this tool, you are able to get companies that have undervalued stock very fast without necessarily being an expert in stock trading.

Buying your first shares

The first step in buying shares is depositing money into your brokerage account. As a beginner, it is advisable not to deposit a lot of money in this account. Only put what you can afford to lose.

With the money in the account, you can buy the stock of your choice either online or by placing a call to your broker. Often, market makers issue ask (buy) price and bid (sell price) for a wide variety of stocks in specific quantities. However, you don’t need to always buy and sell shares at the price set by market makers. You can control the prices at which you are willing to buy and sell shares by placing different types of orders meant to reduce the risk of incurring losses while trading or investing in stocks.

Buy Limit Order
By placing a buy limit order, you set the maximum price you are willing to pay for the stock you desire. If you place such a limit, you are unlikely to get the specified price immediately. For example, if your preferred shares are selling at £4.50 and your buy limit is £4, you won’t be able to buy the shares until the share price comes down to £4.

Buy Market Order
With this order, you automatically buy stock at the prevailing market prices and not the price at the time of execution. For example, if at the time you place the order the sale price of your preferred stock is £6 and then it moves up to £6.2, you buy the shares at the new market price. In this way, you are guaranteed to immediately either sell or buy shares.

Buy stop Order
This order instructs the broker to buy certain stock only when the share price rises past a given amount. For example, you can specify that they buy shares of company x when the share price rises to £8.

Sell Stop Order
This order instructs the broker to immediately sell your shares when the share prices fall past a specified price.

It is important to note that the brokerages fee is not dependent on the quantities of shares you purchase but on the number of transactions. An investor buying 10,000 shares and another one buying 200 shares will be charged the same amount. Often, the amount is £8-£12 for every transaction.