Trading The ultimate guide to trading shares - part 2 November 28, 2007 Adam Hamilton CPA, Zeal Research
Are you interested in trading in the stock markets? Do you have questions about getting started? You are certainly not alone. Almost weekly I hear from ordinary folks with basic questions about trading stocks. After addressing these on a consulting basis for years, I’ll outline some of the basics in this series.
Once your stock-trading account is open and funded, the actual mechanics of trading are very easy. To trade any stock, all you have to do is go to your broker’s website and log in to your account. Logging in will take you to a screen where you can actually execute trades. The screenshots in the exhibit below show TDAmeritrade’s interface (a US broker), but most of the online brokers’ interfaces are very similar and easy to use.
First you have to tell your broker whether you want to buy or sell a stock, which is done with the buttons on the left side of this interface. Then you have to enter the quantity of shares you want to trade as well as the stock’s symbol. In these examples I am using the stock of BHP Billiton traded on the NASDAQ, the world’s largest mining company. Both orders above, one buy and one sell example, use 10 shares of BHP.
Now in order to keep the stock markets running, we need market makers. These are specialized financial companies that buy and sell shares of particular stocks whenever sell and buy orders come in from traders. Even if no other traders want to trade at a particular moment, market makers will always buy and sell the stocks in which they make markets. Their service guarantees liquidity, that you can trade anytime you want. Market makers are compensated for this service through the bid-ask spreads.
Bid-ask spreads are different from commissions. When you trade a stock, you’ll probably have to pay your broker around $10 for the trade. The bid-ask spreads are an entirely different beast than these brokerage commissions. The bid price for a stock is the price at which the market maker is currently willing to buy, or is bidding for, shares. The ask price is where the market maker is currently willing to sell, or is asking for, shares. The bid price is always lower than the ask price so the market maker can earn a living on this spread.
Today these prices are determined instantly by computer. If traders are offering to sell 1000 shares of a particular company in a given second but other traders only want to buy 500, computers lower the bid and ask prices until supply meets demand. Maybe if the prices are lowered $0.05, for example, 750 shares will be offered for sale by some traders and simultaneously bid on by others. The slightly lower price reduces incentives to sell so supply drops and it increases incentives to buy so demand rises and they meet in the middle. This sell-side imbalance lowers real-time prices, while a buy-side imbalance raises them.
These relative supply-and-demand imbalances on a moment-by-moment basis are what drive stock prices. The bid and ask move higher or lower in lockstep, with the spread between remaining intact to compensate the market makers. So as a trader, when you want to buy a stock the higher “ask” price is what you will pay. It is what the market maker is asking (demanding) per share in order to do business with you.
And of course the lower “bid” price is what the market maker is willing to pay you for your own shares of a company. The market maker buys at his bid price and sells at his ask, earning the spread for this service. This means that you as a trader buy at the ask and sell at the bid, effectively paying the spread to the market maker. Many new traders get confused on bid and ask prices, but they make perfect sense if you remember they are from the market-maker’s perspective, not yours.
So to buy a stock, type in its symbol to get a price quote. Then look at the market-maker’s ask price. This is what you’ll have to pay. Then enter the stock symbol again if necessary in the actual buy interface (as opposed to the quotation one) and the number of shares you want to buy. Then you decide on “order type”, which is generally “market” or “limit”. This is a very important distinction that can save traders much angst.
The conventional type of order is a market order. This means you are willing to buy X number of shares of XYZ at whatever price the market maker happens to be asking when he receives your order. This sounds fine, and it is 99% of the time. But sometimes prices can move fast or even worse trading anomalies can happen that lead to bad fills on market orders. For example, what if you placed a market buy order when a stock traded at $70 but then it rocketed to $80 just before your order hit? You’d be stuck paying $80 a share when you thought you’d pay around $70. While very rare, there is still no need to accept this price risk.
It is far more prudent to use limit orders. A limit order is a conditional order to buy stock but only at or under a certain price. In the example above, BHP’s ask price is $70.50. So I put in a limit-buy order slightly over this at $70.65. This means, no matter what, I will not pay more than $70.65 for this stock. If it happens to run over this price before my order hits, then it simply won’t be executed and I can cancel it. And there is no charge for orders that aren’t executed. And since computers fill my order, if the ask is still $70.50 when it hits it will still fill at $70.50 despite my $70.65 limit. A limit buy order caps your buy price on the topside but you can still get a lower price if the ask is lower when your order is executed.
Limit orders work similarly on the sell side. If I want to sell 10 shares of BHP like in this example, the market maker is currently bidding $70.45 per share for my stock. But since I don’t want to get caught in some price anomaly and sell out at a way lower price than I intend, I can put in a limit sell order. In this case I went slightly under the bid, offering to sell my BHP at $70.30 or higher while the market maker is offering to pay $70.45. In practice I will still get $70.45 or whatever the current bid is when I execute my order, but I won’t get stuck selling my shares for $60 if some weird spike happens.
Now I don’t want to make you paranoid here, price anomalies are virtually nonexistent in major stocks and extremely rare in little stocks. Despite this, it is very prudent to protect yourself with limit orders. Limit orders allow you to specify the highest price at which you are willing to buy or the lowest at which you are willing to sell. So by setting limits on buys slightly above asks and limits on sells slightly below bids, you ensure that those are indeed the prices you will get. I always use limit orders for every single stock trade.
In the old days, limit orders could take longer to execute. This is no longer the case in our computerized markets. As long as your limit order is “marketable”, which means it is above the ask for a buy order or below the bid for a sell order, it will still execute instantly just like a market order. Although limit orders used to cost more than market orders in brokerage commissions, today they are usually all the same price. So use “marketable” limit orders to protect yourself whenever buying or selling stocks.
As you can see, actually buying and selling stocks is very easy mechanically. All you need to know is the symbol of the company you want to trade and the number of shares. You type this symbol into your trading account to get the current bid and ask prices from the market maker. Then you enter a buy or sell limit order with limit prices slightly outside the current ask or bid. Then hit the appropriate “finished” button to execute the trade, and within a second or two you will have bought or sold a real stock! Congratulations.
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