Many of our readers already have a fair bit of knowledge on investing and trading in the US stock market. However, I thought I’d write this little primer on the basics for those of you who are only a few years behind us and are just starting out on on your journey exploring the fascinating world of financial markets. I know from experience the new vocabulary can be confusing and overwhelming. I hope if you are in this position you find this primer to be a helpful, easy-to-understand entry into investing and trading.
Time Frames & Taxes
In this primer, my frame of reference for investing and trading is exclusively through the lens of the US stock market. However, many of these rules and terms apply more broadly to other asset classes as well. All right, lets start with the most basic breakdown of the differentiation between investing and trading. According to the IRS all buying and selling of US equities can be broken down into two types: Long Term Capital Gains and Short Term Capital Gains.
Long Term Capital Gains
- Long Term is any stock or ETF that the investor holds for over a year. If after a year you choose to sell that stock you will be taxed a percentage on the profit you made. (In the event that you lost money you will be able to apply that loss to your gross taxable income and pay less taxes.)
- According to the IRS, Long Term Capital Gains are taxed at 0, 15, or 20 percent depending on your income level. For most of us, that rate will be in the 0 or 15 percent bracket. (If you are in the 20% bracket, why are you even reading this blog?)
Short Term Capital Gains
- Short Term is any stock you hold for less than a year. If you buy and sell the same stock or ETF within a year you will be taxed at a much higher percentage on the profits you make.
- Short Term Capital Gains Tax is tied to your Federal Income Tax Bracket. That means you will be paying anywhere from 10 to 37 percent on those gains. Most likely it’ll be somewhere in the mid-20’s.
In the broadest definition, Long Term positions are generally referred to as Investments, and Short Term positions are considered Trading. Is one better than the other? It all depends on what you are trying to accomplish. You need to be dedicated and confident in your strategy to make higher tax burden of Short Term Gains worth it to you over that of the Long Term Gains.
This is what most people are familiar with when they think about the buying and selling of stocks. This the domain of Warren Buffet. This is where the phrases “diversify your portfolio” and “buy and hold” live. The basics of investing are pretty straightforward. The investor will research the stocks, funds, bonds, and other investment vehicles they are interested in with an eye toward holding them long term. Generally, and investments are held for a minimum of one year. After a year, the investor will reevaluate their portfolio and see what holdings need to be re-balanced, added, or removed.
You will probably be most familiar with this type of stock interaction from your 401k, IRA, or ROTH IRA. The concepts of investing are simple and easy to understand. However, that does not mean being a successful investor doesn’t take a lot of work.
When it comes to trading, there are just about as many different styles and strategies as there are traders. However, we can break shorter term trading into some basic categories based on the time frames of these trades.
Intra-day Trading: (average trade = minutes, hours) This is any trade where the trader buys and sells the same stock within the same day. Within intra-day trading there are further breakdowns of styles and strategies.
Swing Trading: (average trade = overnight, days, weeks) The swing trader will use most of the same techniques as the intra-day trader just on a slightly longer time frame. This trader will look to “swing” a trade from a day, to a couple of days, up to a few weeks to capture a profitable move in the stock price.
Trend Following: (average trade = days, weeks, months) This trading style looks to find a upward or downward trend in a stock and jumps on for the ride. Trend following is as simple as seeing a stock that has been moving in the same direction for a time and getting into it hoping to capture part of that trend and make a profit. Like all trading, it is simple in theory and much more difficult in execution. Trend followers can hold a trade for a few hours up to several months, or sometimes even a year or longer.
Position Trading: (average trade = months, years) At times the position trader can be almost indistinguishable from an investor. This style of trader takes a much longer view of the market. They will be studying global economic factors. It make take the position trader several days or weeks to even make a trade because once they are in a trade they can hold it for several months to several years.
Within all of the trading styles mentioned above, traders will use various types of analysis to help them make their decisions. The styles of analysis can almost be viewed as further subdivisions of the trading styles. A trader can mix various styles of trading with different types of analysis to create their own unique strategy. The following are several of the most basic categories:
- Technical Analysis: Technical traders use charts to make their trades. They will find patterns and other indicators in the price action of the stock.
- Order Flow: This method is based around interpreting the volume of shares bought and sold to inform the trader’s own decisions about where the price of the stock is going.
- Fundamental Analysis: Less often used for intra-day trading, fundamental analysis is the study of the actual data of a company. The trader makes their decisions off of what they believe the company will do based on its own accounting and reports.
- News & Sentiment: This category is pretty self-explanatory. News effects the financial markets. The feelings of large groups of people, or the feelings of several people with large amounts of capital also have an effect. Yes, as crazy as it might sound on the surface, the emotions of the participants of the market (AKA “sentiment”) is a tradeable force.
- Chat With Traders: Probably the best resource for any and all the information you could want on Short Term Trading is this podcast. (I’ve written an in depth review of the podcast here.) I’ve learned more from listening to this podcast than from any other source. I took notes of things I didn’t understand and researched them more thoroughly in my free time. I can’t recommend this method enough. It took my learning to the next level much more quickly than I could have ever expected.
- Investopedia: Another great resource you probably are already aware of if you’ve done any research on this topic already. They have in-depth articles explaining every topic you could think of.
- Finviz.com: This is one my favorite websites for aggregating news and to find interesting stocks and ETF’s. The screener allows you to get very granular in your search parameters. The heatmap is a great way to see how various market sectors are performing at a glance. And the news page allows you to quickly scan headlines from all the major papers and blogs.
- Yahoo Finance: Maybe it’s just me, but it always struck me as funny that Yahoo would be a big player in the finance world. They are, and for good reason. Yahoo Finance was one of the original social finance platforms. This is another great place for headlines and stock screening as well.
If this sounds interesting to you and you have a few thousand dollars laying around that you want to try and invest or trade with, please, meet with a professional financial planner. They will have a lot of good, safe advice. After that if you still want to try self-directed investing and trading, research the various brokers that are out there. Almost all of them offer the 0 commission trades. There will be a few differences between them.
On the other hand, if you want to get your feet wet right away with a few hundred dollars, check out Robinhood. They’re a good option for investing or trading on a micro level. While not quite as fully featured as some of the bigger name brokers, they do have some great attributes to recommend them to us small-timers. One thing I’m very excited about is they are going to be introducing fractional shares soon! You’ll be able to continue adding to positions in small increments like DRIP program. Also, 0 commission trading on stocks and options, and no account minimums are a big plus.
If you are interested in Robinhood, or just want to see what it feels like to buy and sell a stock or two, follow my link at the end of this post. We will both get one free share of a random stock valued anywhere from $5 to $500.
I would love to hear any questions, comments, or feedback you have. Also, please share in the comments sections if you have favorite trading resource that I didn’t mention.