Trading Stocks – the ultimate guide

Stock trading can be a lucrative practise, but it can also be very high risk.

If you don’t take the time to understand stock trading thoroughly before you do it for real, you can risk losing money.

In this beginner’s guide, we’ll go through:

• The 1 crucial difference between trading and investing
• How you can benefit from trading stocks
• What the biggest risks of trading stocks are (and how to manage those risks)
• 3 methods for trading stocks (and which might suit you best)
• How to diversify across multiple stocks by making one trade
• How to calculate how much of your money you may consider for trading

And finally, we’ll also show you how to place your first few stock trades without risking any real money, so you can become a more confident, knowledgeable market mover before you get started properly.

So, let’s get started:

What are stocks and shares?

When a company wants to raise money to fund future projects and any other assets they believe they need, they can choose to give investors and traders the chance to ‘own’ a small part of the company in return for a capital payment.

These parts of a company are known as ‘shares’, and they are a legitimate form of ownership.

(Shareholders can vote on aspects of how the company is run. They may also be eligible to receive other benefits, such as dividend payments.)

The general term for a collection of shares is the ‘stock’. So, if you hear a trader talking about the ‘price of a stock’, they are usually referring to the price of each share.

What’s the difference between trading shares and investing in shares?

There are two main differences. The first difference is the time-frame:

• Investing is usually a long-term strategy, with the aim of achieving capital growth over years (and in many cases, decades)
• Trading is typically more short-term, with traders targeting faster profits in under a year (and in some cases, even as little as a few hours)

The other key difference is ownership:

• Investors will typically buy and own shares, so they can enjoy some of the investor benefits we mentioned earlier over the long-term
• Traders will often speculate on a share’s value without actually buying the shares, using derivatives such as CFDs or spread bets (we’ll cover both in more depth in a moment)

This isn’t a hard-and-fast rule, though. Some trades do buy shares outright. It depends on the trade, their financial goals and their own appetite for risk.

How traders make (or lose) money on stocks

Stock prices change continuously throughout the average trading day.

If you can work out which direction a stock price will move, you can profit from the change by speculating on whether that movement will be up or down.

• Long means you speculate the price will go up
• Short means you speculate the price will go down

Though trading gets more complex depending on how you trade, this is the basis for all stock trades.

A number of factors can impact stock movements, including:

• Performance of the company in question
• Wider economic factors
• Industry trends
• Major events (Covid-19 lockdown, for instance, triggered massive stock price losses

Why trade stocks at all?

It probably won’t surprise you to learn that most traders do so to try and make money. But their reasons for wanting extra money can vary quite a bit:

• To make extra spending money
• To add to their savings
• To put money aside for retirement

And there are some traders that do it as a full-time job. (Though this requires a lot of start-up capital and is not a realistic goal for beginners.)

You’ll probably have your own reasons for being interested in trading.

One thing you do need to be clear about is that learning to trade stocks is a lifelong discipline. Most elite traders consider themselves permanent students of the markets.

As Warren Buffet puts it:

“Risk comes from not knowing what you’re doing.”

The bigger your goals as a trader, the more time and effort you’ll have to spend studying the markets and working on the discipline of trading. (And it is a discipline.)

If you want to place a few trades a month with the aim of earning a bit of extra money, then you might be able to get away with just an hour or two’s study a week.

If you have more lofty goals, though, then be prepared to commit at least a couple of hours a day to your education.

What are the risks of trading stocks?

Risk 1. You can lose money

The main risk of trading stocks is, of course, that you can – and will - lose money on some trades.

NO trade is guaranteed to go up.

Even the very best traders suffer losses:

As legendary trader Paul Tudor Jones once put it:

“If I have positions going against me, I get out.”

This is a very important point:

If you’re not comfortable with the idea of losing money sometimes, do not trade.

This goes double for using leveraged instruments like CFDs or spread-betting.

Leverage allows you to place higher value trades with less initial capital upfront.

However, leverage means that you can lose more than your initial capital if the markets move against you.

This means that if you’re not comfortable with losses, then leveraged trading is even more unsuitable for you.

And it’s important that you decide now if trading is for you, because even if you are comfortable with losing trades…

Risk 2. Your emotional nature can work against you when you trade

“Successful trading is about managing your psychology, not predicting the markets.” - Mark Douglas.

Becoming a good trader isn’t just about understanding the market, it’s about understanding how to harness your own psychology.

See, all humans are emotional. (Well, mostly.) We all use our emotions to guide our decision making.

In a lot of situations, this is a good thing.

In the markets? Not so much.

In fact, a lot of people believe that human nature can be harmful to your chances of trading success.

There are actually specific, proven biases in human nature that can cause us to make bad trading decisions!

These include:

• Recency bias. We tend to think that the most recent information we get is the most valuable. So, we might see a stock lose value for 5 days, and then sell it. Even if it’s been steadily going up for the last six months, and we have a lot of evidence that the company is well-run.
• Loss aversion. Humans value not losing a lot more than we value winning. It’s not uncommon for traders to uncover very strong evidence that a stock could be about to shoot up in price, and still not act on the opportunity because their fear of loss is too strong.
• Anchoring bias. We tend to overvalue the first piece of information we receive about a topic. Imagine you hear from a fellow trader that they’ve made a 100% trade on a stock that’s still growing in value, and that there’s still a chance of making 30% on the same stock. Mad as it sounds, there will be some traders that don’t take this chance because compared to the 200% return, 30% suddenly doesn’t seem that impressive.

These are just 3 of the behavioural biases that can affect traders. And there are plenty more.

As Warren Buffet puts it:

“If you cannot control your emotions, you can’t control your money.”

The psychology of trading is, unsurprisingly, a huge topic. Far too big to cover properly here. (We recommend you read this resource from Investopedia.)

But suffice to say, becoming a successful trader requires not only a mastery of the markets, but of our own emotions. Which is tougher? We’ll let you figure it out!

What are the best ways to trade stocks? 3 key methods

There are 3 main methods for trading stocks, and they all have their own unique risks and potential rewards.

1. Direct investment.

As we mentioned earlier, some traders still take the traditional route and buy shares outright.

By doing this, you can enjoy legitimate share holder benefits such as dividends and potential voting powers in the company.

If you’re a private trader, you won’t typically use leverage when you buy shares directly.

This can be a good thing in terms of risk, because as long as you’re placing a ‘long’ trade on the stock price, your losses are limited to the whole of your capital.

Essentially, the furthest a stock price can fall is to zero. So, if you place a trade worth £5,000, then even if the stock does fall all the way to zero, you can’t lose more than that £5,000.

We’re not minimalizing that as a loss, of course. But it’s important to understand this concept, because when you place a short trade, your losses are technically unlimited.

See, when you short, you’re hoping the price will go down, and you lose money if it goes up. There’s no technical limit as to how much a stock can increase by, so there’s no limit to your losses.

(It’s also worth noting that shorting a stock without using derivatives can be complex. You can read our guide on short-selling here for a more in-depth explanation, but suffice to say that if you plan to make shorting a regular part of your trading strategy, then direct investment may not be ideal for you.)

2. Spread-betting

Spread-bets are popular with many traders because they’re relatively simple to execute.

When you spread-bet, you speculate on the share price as you would as an investor, but you don’t actually own the stock.

Spread-betting is what’s known as a ‘derivative’. This means that while the price derives from the same share price that the regular investor would trade, you don’t own the underlying asset.

You simply ‘speculate’ whether the share price will go up or down in ‘points’, choosing how much money you want to wager per point.

How much you speculate per point is down to how much leverage you want to use. If you choose to go with a higher amount per point, then your profits will be magnified.

Had you traded this example at £5 per point, for example, then the same 60 point gain would have give you £300 profit.

The important thing to remember, though, is that leverage also magnifies losses. Had you bet £5 per point and the share price had fallen by 60 points, you would have lost £300.

The more leverage you use, the bigger risk you’re taking if the markets move against you. Many traders refuse to use leverage altogether for this reason.

Whether you choose to use it or not will be entirely down to your own trading goals, financial resources and your tolerance to risk.

3. CFDs

CFDs are similar to spread-bets, in that they are also derivatives. So, once again, trading CFDs mean that you do not own the underlying asset.

And, as with spread betting, going long or short on a stock using CFDs is essentially the same process, meaning that if you plan to make shorting a key part of your strategy, CFDs could potentially suit you.

The main difference between CFDs and spread-betting is how position sizes are measured.

Spread-betting, as we know, is measured purely in terms of points gain or lost.

CFDs, on the other hand, are measured in what’s known as ‘lots’. (Or ‘contracts’.)

‘Lots’ are a unit of measurement unique to the asset you’re trading. In the case of stocks, the ‘lot’ is the price of a share.

If you trade stock on Easyjet and the share price is £491.50, then that is the size of a ‘lot’.

When you trade a CFD, you decide on the value of your trade in ‘lots’.

So, if you want to place a trade worth around £5,000, then you would open 10 ‘CFD contracts’ for a trade size of £4,915.

If the price of a ‘lot’ then falls to £450, your total trade would fall to a value of £4,500, and your loss would be £415

Leverage in CFDs.

CFD leverage is slightly different to spread-betting.

When you use leverage in CFDs, it’s done as a fraction of your total position size.

So, if you wanted to place a trade on Berkshire Hathaway stock worth £50,000, and you used leverage of 1:20, you would only need £2,500 in capital to place the trade. (£50,000/20 = £2,500.)

If you chose 1:40 leverage, the initial capital required would halve to £1,250.

‘Long’ or ‘short’?

There are two key ways to enter a CFD trade.

• If you go ‘long’ (you believe the stock price will go up) then you want to be the buyer.
• If you go ‘short’ (you believe the stock price will go down) then you want to be the seller.

This makes sense when you think about it:

• If you buy a stock that’s worth $550 and then it grows to be worth $650, you can sell it back and pocket $100 in profit.
• If you choose to ‘sell’ a stock to someone which is worth $500 and it falls to be worth $400, you can then buy the stock back and make $100.

In the case of CFDs, you don’t actually own the stock, but the principle is the same.

How does leverage increase risk in CFDs?

When you trade stocks using CFDs, your profits and losses are calculated based on the total position size, not your initial capital.

So, if your £50,000 position size gives you a 20% profit, your profit would be £10,000. Even if you used leverage of 1:40 and your initial capital outlay was only £1,250.

But this would also be the case if you lost 20%. Despite only using £1,250 capital, your losses would still be £10,000.

As you can see, leveraged trades offer substantial potential risk and reward for traders. Again, whether you choose to use leverage will be entirely down to your own personal risk profile.

ETFs and blends – how to diversify your risk across multiple stocks with less trades

All traders need to take risk into account, and diversification is a part of managing risk.

In trading terms, diversification really boils down to not putting all your capital into a small number of trades.

By doing so, if one or two trades perform badly – and as we’ve discussed, some will – you won’t lose so much of your capital that you’re unable to continue trading.

As you can probably imagine, diversification is a very in-depth topic that market traders spend years studying. (You can read a comprehensive guide to diversification at the Motley Fool here.)

In recent years, though, more and more traders have begun to use two instruments to help give themselves some diversification within a single trade:

ETFs

ETFs are ‘Exchange Traded Funds’.

ETFs basically comprise of a number of different stocks, usually based across a particular market (such as the FTSE 100 or the S&P500) or a particular theme (such as technology or renewable energy stocks).

Essentially, they allow you to diversify your capital across a number of individual stocks by placing a single trade.

So, let’s say that you as a trader want to trade in renewable energy stocks, but because the sector can be volatile, you don’t want to put your capital in a single renewable energy stock.

Instead, you trade an ETF containing the top 10 stocks in the industry. With a single trade, your capital is spready across the best companies so that if one company fails, you won’t lose everything.

The same goes for an ETF based on an index.

So, for instance, let’s say you believe that the UK is set to improve as a whole due to a change in interest rates.

You could place a single trade on an ETF that tracks the FTSE 250. So, if the UK’s economy does improve, the index as a whole will go up, even if one or two companies actually start to suffer as a result of the change.

As you can see, for more risk averse traders, ETFs can be a useful tool.

(It’s worth bearing in mind that while ETFs can offer diversification within an index or a sector, if the whole index or sector falls, the ETF can decline in price. If the whole tech sector suffers a crash as it did in 2001, an ETF contain tech stocks will likely also drop in price. )

Blends

Blends are a relatively new trading instrument, and work in a similar manner to ETFs. They’re usually based around a particular theme.

So, for instance, you be optimistic about the UK retail sector, but not want to trade individual stocks.

A ‘blend’ will comprise of a certain percentage of UK retail stocks, allowing you to trade the different companies within a single move.

So, you might have a blend that is 20% Primark, 20% Marks & Spencer, and so on.

(The details on which stocks are included in the blend - and the percentages - will usually be decided by your trading broker, and the information should be displayed on your trading account.)

As with ETFs, if the sector or ‘theme’ of the blend falls, then you can still lose money.

For more thorough diversification, traders may hold blends or ETFs in several sectors at once. For example, government bonds often perform well when stocks fall. So, a trader may choose to have a position in an ETF that covers both.

How much to consider when trading?

All trading carries risk. It’s entirely possible to lose all your money on a trade.

How much you choose to risk on a trade is, in the end, your decision. It’s down to your individual risk profile.

One generally accepted rule for risk management is to never risk more than 1% of your total trading account on a single trade.

So, if you have $10,000 in capital to trade with, you should never be placing more than $100 in a single trade.

When we say total trading account, it’s important to be clear: we do not mean ‘total savings’.

If you want to trade, you should set aside a part of your total savings as ‘risk capital’. That is, money that you can afford to lose.

You should never trade with money you cannot afford to lose.

How much of your total net worth should you allocate as ‘risk capital’?

Well, the British Financial Conduct Authority recommends that you never put more than 10% of your total net assets in high-risk investments

How can you practice trading CFD on stocks without risking money?

When you open an account with markets.com, you also get immediate access to a full ‘demo’ account complete with fake funds.

This means you can place both CFD and spread-bet trades as many times as you like without risking any real capital.

You can get comfortable calculating things like margin and leverage, and you can get used to tracking positions in real-time, just as you would when placing proper trades.

Then, when you’re comfortable, you can start to trade for real in the exact same environment you’ve practised in.

Interested? Click the link below to start signing up for a markets.com account.