Stock Trading in 7 Steps: How It Works

Stock trading involves buying and selling shares in public companies — called stocks — to try to make money. You can earn a profit by buying stocks at a lower value than when you sell them.

What is stock trading?

Stock traders watch the short-term price changes of stocks closely, and then they try to buy low and sell high^[0]

Trading stocks can bring quick gains for those who time the market correctly, but most people, even professional investors fail to do that the majority of the time. A single company's fortunes can rise more quickly than the market, but they can just as easily fall.

“Trading isn’t for the faint of heart," says Nathaniel Moore, a certified financial planner at AGAPE Planning Partners in Fresno, California.

Most investors are best served by putting their portfolio in long-term, well-diversified investments like index or mutual funds. But if you have extra cash and you want to want to learn how to start trading, online brokerages have made it possible to trade stocks quickly from your computer or through mobile apps.

But before you dive in, you should make sure you know how the stock market works and the details of trading in it.

» Learn more: Stock Trading vs. Investing: What’s the Difference?

Types of stock trading

There are two types of stock trading: active trading and day trading.

Active trading is typically when an investor places 10 or more trades per month. They often use strategies that rely heavily on timing the market. They try to take advantage of short-term events (at the company or in the market) to turn a short-term profit.

Day trading means playing hot potato with stocks — buying and selling the same stock in a single trading day. Day traders care little about the inner workings of the businesses. They try to make a few bucks in the next few minutes, hours or days based on daily price swings.

» Read more: How to day trade

How to trade stocks in 6 Steps

If you're trying your hand at stock trading for the first time, the logistics of trading stocks comes down to six steps:

1. Open a brokerage account

Stock trading requires funding a brokerage account. That's a type of account designed to hold investments. If you don't already have an account, you can open one with an online broker in a few minutes. But don’t worry, opening an account doesn’t mean you’re investing your money yet. It just gives you the option to do so once you’re ready.

» See NerdWallet’s ranking of the best brokers for stock trading

2. Consider investing in funds

If you're new to investing, starting with a low-cost index fund could be a good option. Index funds allow you to invest in a bunch of stocks all at once, which reduces your risk. Imagine you invest in 500 companies through a fund versus a single company through a stock. If that one company goes out of business and you just own that one stock, you lose your whole investment. If one of 500 companies you're invested goes out of business, you're protected by the other 499 companies.

Most financial advisors recommend having the majority of your investment portfolio be in well-diversified funds, and then purchasing individual stocks with a small portion of your portfolio.

» Learn how to invest in index funds

3. Set a stock trading budget

Even if you're great at trading stocks, putting more than 10% of your portfolio in an individual stock can be risky.

"If all of your money’s in one stock, you could potentially lose 50% of it overnight," Moore says.

Other common do's and don’ts include:

• Invest only the amount of money you can afford to lose.

• Don’t use money that’s earmarked for near-term, must-pay expenses such as a down payment or tuition.

• Ratchet down that 10% if you don’t yet have a healthy emergency fund and 10% to 15% of your income funneled into a retirement account.

» View our picks for the best stock apps

4. Learn to use market orders and limit orders

Once you have your brokerage account and budget in place, you can use your online broker's website or app to place your stock trades. You'll be shown several options for order types. These dictate how your trade goes through. We go through these in detail in our guide for how to buy stocks. These are the two most common types:

• Market order: Buys or sells the stock ASAP at the best available price.

• Limit order: Buys or sells the stock only at or better than a specific price you set. For a buy order, the limit price will be the most you're willing to pay. The order will go through only if the stock's price falls to or below that amount.

5. Practice with a paper trading account

"Try investing in the market without putting money in the market yet to just see how it works," says Moore.

You can do that by investing your time, he says. Pick a stock and watch it for three to six months to see how it performs. You can also learn the market via the paper trading tools offered by many online stock brokers. Brokers that offer paper trading let customers test their trading skills and build up a track record before putting real dollars on the line.

» Learn more: Read our explainer on paper trading with stock simulators

6. Measure your returns against a fitting benchmark

This is good advice for all types of investors — not just active ones. The ultimate goal for picking stocks is to perform better than a benchmark index (a stock index is just a list of stocks, for example, the S&P 500 is a list of 500 of the biggest U.S. publicly-traded companies). So ideally, the one stock you pick should outperform the S&P 500 as a whole. It could also be the Nasdaq composite index (for those investing primarily in technology stocks). Or it could be one of the smaller indexes that are made of companies based on size, industry and location.

Measuring results is key. If a serious investor is unable to outperform the benchmark (something many pro investors struggle to do), then it makes sense to invest in a low-cost index fund or ETF — these are automatically invested so they closely align with one of the benchmark indexes.

» View our list: The best-performing stocks this year

7. Keep your perspective

Being a successful investor doesn’t require finding the next great breakout stock before everyone else. By the time you hear that a certain stock is poised for a pop, so have thousands of professional traders. The potential likely has already been priced into the stock. It may be too late to make a quick turnaround profit, but that doesn’t mean you’re too late to the party. Truly great investments continue to deliver value for years. That's a good argument for treating active investing as a hobby and not a get-rich-quick scheme.

How to manage stock trading risks

Wherever you fall on the investor-trader spectrum, taking things slowly, ignoring 'hot tips' and keeping good records can help you do it safely.

1. Lower risk by building positions slowly

There’s no need to cannonball into the deep end with any position. Taking your time to buy (via dollar-cost averaging or buying in thirds) helps reduce exposure to price swings. Moore says you can also look into high-dividend stocks, which pay out a portion of earnings to investors, and ETFs, which allow you to spread your risk out among multiple companies.

» Learn more: See our list of high-dividend stocks and how to invest

2. Ignore 'hot tips'

People posting in online stock-picking forums and paying for ads touting sure-thing stocks are not your friends. In many cases, they are part of a pump-and-dump racket. That's when shady people purchase buckets of shares in a little-known, thinly traded company and hype it up on the internet.

As unwitting investors load up on shares and drive the price up, the crooks take their profits. They dump their shares and send the stock careening back to earth. Don’t help them line their pockets.

» Learn more about the various types of stocks

3. Keep good records for the IRS

If you’re not using a tax-advantaged account — such as a 401(k), Roth or traditional IRA — taxes on gains and losses can get complicated.

The IRS applies different rules and tax rates and requires the filing of different forms for different types of traders. If you've sold stocks for profit, make sure to set aside some extra cash for a larger-than-normal tax bill. Another benefit of keeping good records is that loser investments can be used to offset other taxes through a neat strategy called tax-loss harvesting.

Where to trade stocks

To trade stocks you need a broker. But don’t just fall for any broker. Pick one with the terms and tools that best align with your investing style and experience. A priority for active traders will be low commissions and fast order execution for time-sensitive trades. See our picks for the best day trading platforms to learn more.

New traders should look for a broker who can teach them the tools of the trade. Some offer educational articles, online tutorials and in-person seminars. (See NerdWallet's roundups for the best brokers for beginners). Other features to consider with stock trading apps are the quality and availability of screening and stock analysis tools, on-the-go alerts, easy order entry and customer service.

No matter what, the time spent in learning the fundamentals of how to research stocks and experiencing the ups and downs of stock trading — even if there are more of the latter — is time well spent, as long as you’re enjoying the ride and not putting any money you can’t afford to lose on the line.