Lesson 2: Stocks, Exchanges & Orders

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In this lesson, we’ll break down essential trading concepts such as market orders, stop-loss orders, and even touch upon some regulations like the U.S.-specific Pattern Day Trader rule. By the end of this guide, you’ll have a clearer understanding of these foundational topics, empowering you to take your first confident steps in the trading world.

What is a Stock?

So, what exactly is a stock? Think of it as a piece of a company that you can buy. When someone says they bought shares of a company, like “Beyond Meat” for instance, it means they own a portion of that company. The more shares you have, the larger the piece of the company you own.

Understanding Equity and Debt

Companies have two primary ways to raise money: equity and debt. We’re all familiar with debt, but what about equity? Equity involves selling a part of the company. As an investor, you’d look at whether the company is run efficiently, its future growth potential, and how you can exit or sell your share in the future.

The Role of Stock Markets

Stock markets provide a platform for buying and selling shares of companies. Unlike selling a personal business where you’d need to find a buyer, stock markets offer liquidity. This means you can quickly buy or sell shares. When a company decides to sell its shares to the public for the first time, it’s called an Initial Public Offering (IPO).

Trading Vocabulary

As you delve deeper into trading, you’ll come across various terms. For instance, “order entry software” refers to the platform you use to place trades. Jessica will be using Trade Ideas, which is one of many available platforms. Once you place an order, it goes to your broker, who then sends it to the stock exchange.

The Role of Stock Brokers

The British voice you might have heard in the video is from Interactive Brokers, which is Michael’s stock broker. They manage the funds. When you give them money, they handle all the transactions. You don’t have to physically exchange money every time you want to buy or sell a stock. They also ensure compliance with AML (Anti-Money Laundering) and KYC (Know Your Customer) regulations to ensure you’re not involved in illicit activities or money laundering.

Understanding Exchanges

Exchanges, like the New York Stock Exchange, provide a platform for trading. They host older, established companies like Macy’s and Walmart. When you place an order, it goes through a chain of command: from your trading software to your broker, then to the exchange, and back again. We’ll be focusing on trading in the equity markets, which involves trading shares of companies.

Trading vs. Owning a Company

When you trade, you’re essentially buying a piece of a company. This gives you certain rights, like voting rights. For instance, if you own a share of Apple, in theory, you could vote for the next CEO. However, in practice, your single vote would be insignificant compared to major stakeholders.

How Shares Work

A common question is how shares can be divided and subdivided. Think of a company as a pie. The pie can be split into two pieces or a trillion pieces. It’s all about the percentage owned. When you buy a stock in the market, you’re buying it from another trader, not directly from the company. Companies can issue more shares if they need to raise more money, but this dilutes the value for existing shareholders.

Understanding IPOs and Company Valuation

When a company decides to go public, they conduct an Initial Public Offering (IPO). This is where they determine how much of the company they want to offer to the public to raise funds. For instance, if a company believes it’s worth a billion dollars and wants to raise half of that, they might offer 50% of their shares to the public. This process also serves as an exit strategy for early investors, allowing them to sell their shares in the open market.

Dilution of Shares

If a company decides to issue more shares, it dilutes the value of existing shares. For example, if you owned 10% of a company and they doubled the number of shares, your ownership would drop to 5%. This can lead to dissatisfaction among shareholders, especially if they weren’t expecting the dilution. They might question why the company needs more money and why they didn’t opt for other financing methods.

The Role of Stock Exchanges

Stock exchanges provide a platform where the value of a company is continuously negotiated. Unlike a one-time valuation in a boardroom or on a show like “Dragon’s Den”, the market constantly determines a company’s worth. This continuous negotiation ensures that there’s always a clear understanding of a company’s value at any given time.

Understanding Bids and Asks

In the stock market, the bid is the price someone is willing to pay for a stock, and the ask is the price at which someone is willing to sell. Trades occur when a bid matches an ask. This system ensures that there’s always a clear understanding of a stock’s value and provides liquidity, making it easy for traders to buy or sell shares.

Understanding Different Market Entry Points

The various acronyms you see, like “ID”, represent different ways to enter the market. While these might seem confusing, they are essentially different pathways to the same destination: the stock exchange. Each method has its own benefits, but for most traders, especially beginners, these distinctions won’t matter much. When you place an order, it’s routed through these pathways to the exchange.

Trading on Multiple Markets

A common misconception is that when you open your trading platform, you’re only trading on one market. In reality, while a stock like Macy’s might be traded on the New York Stock Exchange, there are multiple ways to access that exchange. These different pathways are based on your location and how you want your order to be filled.

The Importance of Bid-Ask Spread

The bid-ask spread is a crucial concept in trading. The bid represents the price someone is willing to pay for a stock, while the ask is the price someone is willing to sell it for. Trades occur when these two prices match. For instance, if you see a stock with the last traded price of $37.18, it doesn’t mean you can buy or sell at that exact price. The actual price you get depends on the current bid and ask.

Interpreting the Bid-Ask Spread

A tight spread, where the difference between the bid and ask is just a penny, indicates a highly traded stock. In contrast, a stock that isn’t traded often might have a wider spread, sometimes spanning several dollars. It’s essential to understand that the last traded price isn’t necessarily the price you’ll get when you place an order.

Order Types in Trading

Understanding the different types of orders is crucial for efficient trading. Here’s a breakdown of the primary order types:

Limit Order

A limit order allows you to specify the maximum price you’re willing to pay when buying or the minimum price you’re willing to accept when selling. For instance, if you place a limit order to buy a stock at $34.90, you won’t pay more than that amount. If the stock’s price drops, you might even get it for less. Conversely, if you set a limit order to sell at $34.97, the system will execute the sale at that price or higher.

Market Order

A market order is essentially a directive to buy or sell a stock immediately at the best available price. It doesn’t guarantee a specific price, but it ensures a quick execution. This type of order is like hitting the “I’m feeling lucky” button. While it might seem like gambling, with the right strategies and understanding of the market, you can tilt the odds in your favor. Unlike gambling, you can also decide to pull out at any moment if you feel the trade isn’t going your way.

The Flexibility of Trading

One of the significant advantages of trading over traditional gambling is the flexibility it offers. In trading, you can change your mind at any point. If you don’t like how a trade is progressing, you can exit early. This flexibility allows traders to manage their risks and adjust their strategies in real-time.

Stop-Loss Order

A stop-loss order is a tool that allows traders to set a specific price at which they want to buy or sell a stock. For instance, if you’re holding a stock and want to ensure you exit the position if the price drops to a certain level, you can set a stop-loss order at that price. This type of order can be used both for entering and exiting trades. For example, if a stock is trading within a tight range and you want to buy it once it breaks out of that range, you can set a stop-loss order at the breakout price. This ensures that you automatically enter the trade once the price reaches your specified level.

Market Order vs. Stop-Loss Order

While a market order allows you to buy or sell a stock immediately at the best available price, a stop-loss order only triggers once the stock reaches a specific price. The key difference is that with a market order, you’re prioritizing speed of execution over the price, while with a stop-loss order, you’re prioritizing a specific price over speed.

Pattern Day Trader Rule (U.S. Specific)

In the U.S., there’s a rule known as the “Pattern Day Trader” rule. This rule states that if you don’t have at least $25,000 in your trading account, you’re limited to making only three day trades per week. A day trade is defined as buying and selling the same stock on the same day. This rule is in place to ensure that trades have time to “settle” before being sold. Settlement refers to the process of transferring ownership of a stock from the seller to the buyer, which can take up to three days. This rule is designed to protect novice traders from overtrading, but it can be restrictive for those who wish to trade more frequently.

Ways Around the Pattern Day Trader Rule

For those who find the Pattern Day Trader rule restrictive, there are a couple of ways to navigate around it:

Offshore Trading: One option is to open trading accounts offshore. However, traders need to exercise caution when considering this route, ensuring they’re working with reputable platforms and understanding the associated risks.
Proprietary Trading Firms (Prop Firms): Another option is to join a proprietary trading firm. In this setup, traders interview with the firm, and if deemed competent, they’re given the firm’s money to trade. Profits are then split between the trader and the firm, often on a percentage basis. For instance, the firm might take 50% of the profits, leaving the trader with the other half.

Welcome back to “Back to Basics – Part 2”.

Welcome back to “Back to Basics – Part 2”. If you missed the first part, you can find it on the channel. In this series, we’re introducing my fiancée, Jessica, to the world of investing in the stock market. We aim to teach her the basics, and then she will document her journey on her own YouTube channel, showcasing her path to either riches or ruin.

What is a Stock?

A stock represents a piece of a company that you can buy. For instance, when I mention that I bought shares of “Beyond Meat”, it means I own a portion of that company. The number of shares you own determines the size of the portion of the company you have.

Understanding Equity and Debt

When companies need money, they have two primary ways to obtain it: equity and debt. We’ve all seen shows like “Shark Tank” or “Dragons Den” in Canada. Entrepreneurs pitch their ideas, seeking investments. When they ask for an investment in exchange for a percentage of their company, they are offering equity. In simple terms, equity is selling a part of the company. As an investor, you’d evaluate if the company is well-run, its future growth potential, and how you can exit or sell your stake later.

The Role of Stock Markets

The stock market provides liquidity. It’s a platform where people constantly look to buy or sell stocks. This continuous exchange ensures that if you want to buy or sell a stock, like Apple, you can do so almost instantly. This is the advantage of public exchanges over private deals. With public exchanges, there’s always a buyer and a seller, ensuring fluid transactions.

Initial Public Offerings (IPOs)

When a company decides to go public, it conducts an IPO. This process allows the company to sell its shares to the general public for the first time, providing them with an influx of capital.

Trading Platforms and Order Entry

For your trading journey, you’ll be using “Trade Ideas” as your order entry platform. There are various platforms available, but I personally believe Trade Ideas is among the best. When you place an order, it goes through your trading software, in this case, Trade Ideas, and then to the stock market.

Brokerage and Exchange Dynamics

My stock broker is Interactive Brokers. They manage the funds. When I give them money, they handle all the transactions. I don’t have to physically pay money every time I want to buy a stock or receive it back. They handle that. There are regulations in place, like AML (Anti-Money Laundering) and KYC (Know Your Customer), to ensure that I’m not involved in illicit activities. If you’ve seen shows like “Ozark”, you’d know about money laundering. These checks are in place to ensure that their platform isn’t used for such activities.

The Role of Exchanges

The exchange is where the matching of buy and sell orders happens. For instance, the New York Stock Exchange houses many established companies like Macy’s and Walmart. Every time you place a trade, it goes through a sequence: from your trading software, to your broker, to the exchange, and then back.

Trading Platforms

For our trading journey, we’ll use “Trade Ideas” as the order entry platform. There are many platforms out there, but I believe Trade Ideas is among the best. When you place an order, it goes through your trading software (in this case, Trade Ideas) and then to the stock market.

Understanding Stock Ownership

When you hear someone say they bought shares of a company, like “Beyond Meat”, it means they own a portion of that company. The number of shares you own determines the size of the ownership stake you have in that company.

Equity and Debt

Companies have two primary ways to raise money: equity and debt. Equity involves selling a portion of the company. For instance, when entrepreneurs on shows like “Shark Tank” or “Dragons Den” in Canada seek investments in exchange for a percentage of their company, they’re offering equity.

How Shares Work

When a company is fully owned, it can decide to split its ownership into shares. The number of shares doesn’t change the total value of the company; it just divides the ownership. For instance, if a company is worth $1 million, it can be divided into 1 million shares, each worth $1. When a company goes public, it doesn’t sell all its shares. Some shares are retained by the founders or early investors. For example, if Facebook goes public with 2 million shares, it doesn’t mean that’s all the shares Facebook has. Some shares are held back and are not available for public trading.

Share Dilution

Sometimes, companies issue more shares to raise more money. This dilutes the ownership of existing shareholders. If you owned 10% of a company and the company issued more shares, your ownership percentage would decrease.

Order Types in Trading

Understanding the types of orders you can place is crucial in trading. Let’s delve deeper into the various order types:

Limit Order: This is the most common type of order. When you place a limit order, you’re specifying the maximum price you’re willing to buy at or the minimum price you’re willing to sell at. For instance, if you place a buy limit order at $34.90, you’re saying you want to buy at that price or lower. Conversely, if you place a sell limit order at $34.97, you’re indicating you want to sell at that price or higher. Limit orders give you control over the price at which your order will execute.

Market Order: This is essentially the “just do it” order. When you place a market order, you’re asking the broker to execute your buy or sell order immediately at the best available price. While market orders ensure that your order will get filled, there’s no guarantee on the price, especially in fast-moving markets. It’s like pushing the “all-in” button in poker, but with the ability to take your chips off the table at any moment.

Stop Order: Not mentioned in this chunk, but a stop order (or stop-loss order) is designed to limit an investor’s loss on a position. It becomes a market order once a certain price (the “stop price”) is reached.

Stop-Limit Order: This combines the features of a stop order and a limit order. Once the stop price is reached, the stop-limit order becomes a limit order to buy or sell at the limit price or better.

Stop-Loss Order: This is a protective measure. For instance, if you’re long on a stock and want to exit if the price drops to $34.89, you can set a stop-loss order at that price. This ensures that if the stock price hits that level, your position will automatically be sold, limiting your potential loss. This is especially useful if you’re not able to monitor your trades constantly, like if you’re at work or on vacation.

Using Stop-Loss for Entry: Interestingly, stop-loss orders can also be used for entry. Let’s say you’re observing a stock that’s consolidating within a tight range. You believe that if it breaks above a certain price, it could surge higher. You can set a stop-loss order to buy the stock if it reaches that breakout price. This way, you don’t have to constantly watch the stock; the order will automatically execute if the condition is met.

Settlement and Pattern Day Trader Rule: This is more relevant for U.S. traders. In the U.S., there’s a rule that if you don’t have at least $25,000 in your trading account, you’re limited to three day trades per week. This is due to the “settlement” process. When you buy a stock, it takes up to three days for the transaction to “settle”, meaning for all the paperwork to be processed and for you to officially own the stock. This rule might seem restrictive, but it’s designed to protect novice traders from overtrading and potentially losing a lot of money quickly.

Impact of the Rule: This rule can be quite limiting, especially for traders who don’t have $25,000 to start with. It means that if you buy a stock, you have to wait for three days before you can sell it. You’re allowed three such “quick trades” per week. While this rule might have made sense in the past when trades were processed manually, it’s a bit outdated in today’s electronic trading world. However, it’s essential to be aware of these regulations if you’re trading in the U.S.

Ways Around the Pattern Day Trader Rule

For those feeling restricted by the Pattern Day Trader rule, there are a couple of ways to navigate around it:

Offshore Trading: You can open up accounts offshore. However, be very cautious when considering this option. The regulations and protections might not be the same as those in your home country.
Proprietary Trading Firms (Prop Firms): Prop firms are companies where traders trade the firm’s money rather than their own. You can interview with a prop firm, and if they believe you have the necessary skills and knowledge, they might offer you a position. In this setup, you’ll be trading the firm’s capital, and there’s usually a profit split. For instance, the firm might give you 50% of whatever profits you make. This is another way to bypass the Pattern Day Trader rule since you’re not trading with your own capital.

The Real Game of Trading

The essence of trading isn’t just about making quick profits. It’s about understanding the market, developing strategies, and continuously learning. Following the journey of successful traders can provide insights and inspiration. For instance, observing someone’s journey of opening an offshore trading account can offer a real-world perspective on the challenges and benefits of such a decision.

Conclusion

Trading is a dynamic and ever-evolving field. Whether you’re navigating around regulations like the Pattern Day Trader rule or exploring new strategies, continuous learning is key. Engaging with the trading community, following experienced traders, and staying updated with market trends can enhance your trading journey. Remember, it’s not just about the profits; it’s about the journey, the learning, and the growth.

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