Ever hear a story of someone snapping up a rare antique at a garage sale and then reselling the item for a massive profit? The original trade may have seemed fair at the time, but without other buyers to drive up demand, the seller wouldn’t have any way to value the item. It’s one reason why the price can quickly climb when the new owner resells the item at auction.
Trading on the stock market works in much the same way: Two or more parties bid on the price of an asset to reach an agreed transaction. It’s an activity that plays out hundreds of millions of times a day, with stocks, bonds, commodities, currencies and other types of assets changing hands every minute. While trading is ultimately very simple, there are strategies and tactics buyers and sellers can use to ensure they’re getting a fair price. Here’s how trading works:
How does trading work?
To make any trade you need a seller and a buyer: One party to make an offer price and another to accept it. Prices tend to rise when buyers outnumber sellers and fall when there are a surplus of sellers trying to offload their investments. Bids and offers can be exchanged back and forth between two or more parties until both sides come to an agreement. On the markets, this back-and-forth negotiation happens almost instantaneously.
Types of trading
Markets work fast and some investors may try to find ways to use this to their advantage by trading quickly, while others employ more passive techniques to trade stocks. Here is just a look at two common trading approaches:
Buy and hold (position trading):
Just as a true sports fan might have a favoured team they believe in, a buy-and-hold investor could purchase and hold a stock for months, years or longer, regardless of short-term price volatility. A position trader may ignore fluctuations in the share price, unless they alter the expectation that the share price could ultimately rise.
This approach involves buying and selling stocks in a single day or, sometimes a few days, in order to capitalize on smaller fluctuations in an asset’s daily price. But there are risks. It can be extremely difficult to accurately time the market, and there’s no guarantee the value of a stock will rise. Notable types of day trading include:
- Scalp trading: Profiting from tiny price changes across a large volume of trades in a day — possibly in the hundreds.
- Swing trading: Capturing short-term profits over a few days or weeks, using technical analysis to determine when to enter and exit positions.
Which assets can we trade?
There are several types of assets you can purchase and invest in, each with unique market characteristics. And within each asset class, there may be even more choices available. Here are some commonly traded asset classes:
When you buy a stock, you are purchasing an ownership stake in a company, meaning you have a right to participate in the growth of a company and claim a share of its profits. Stocks can be highly volatile but the potential for reward could be higher than some other asset classes.
Mutual Funds and Exchange-Traded Funds (ETFs)
These types of investment products allow you to purchase a professionally managed basket of investments designed to achieve a specific asset mix or focus. Both Mutual Funds and ETFs can hold stocks, fixed income investments or commodities — or a mix of all three.
Bonds and GICs
Both bonds and guaranteed investment certificates are examples of fixed-income investments. These are essentially loans to a corporation or government in exchange for interest and your principal returned. While GICs and bonds differ in some key ways — including overall liquidity — both investments are considered low-risk when compared with equities.
These are typically raw materials and physical things we consume. Think of the food we eat, the oil and gas we put in our cars, or the minerals that power our phones and devices. Commodities also include precious metals such as gold and silver.
Options contracts give investors the right — but not the obligation — to buy or sell an investment at a previously agreed upon price, but only for a specified time period. There are two main types of options:
- Call option: This financial contract gives you the right to buy a stock, bond, commodity or other asset at a previously agreed upon price (the strike price) before or on a specified expiration date. Call options can be used to speculate on the price movement of the underlying asset, hedge an existing position or generate income through option premiums.
- Put options: This financial contract gives the holder the right, but not the obligation, to sell an investment at a pre-set price (the strike price), before or on an pre-set expiration date. Put options can be used to speculate on the price decline of an underlying asset, hedge an existing position or generate income through option premiums.
Trading: Pros and cons
Benefit: Trading is one way to grow your money
There is a seemingly endless number of assets to trade, and online platforms can make it easy to research and complete your transaction. Though timing the market is a near-impossible challenge, it can be possible to make money in a short period of time.
Disadvantage: Frequent trading can increase your risk exposure
While the level of risk can vary considerably depending on the type of asset you’re trading, you could easily lose some or all your money if a trade goes south.
- Trading requires a counter party. If you can’t find someone to buy at the price you are willing to sell an asset for (or sell you an asset for a price you are willing to pay) then your performance could be affected.
- The price of an asset can change quickly. This can happen for reasons that have nothing to do with the underlying asset. For instance, if the stock market falls, the value of high-quality companies may fall along with it.
- You may also have trading costs to consider. When you buy and sell an asset, transaction fees could cut into your profits or add to your losses.
Trading vs. investing: Short-term gains or strong returns over time
Are you a trader or an investor? It can be important to understand the difference. A trader is someone who aims to generate income from a short-term gain over a short time horizon (eg. days or weeks). Trading can be less about the type of asset you’re buying or any long-term fundamentals and more about “price action” of an underlying asset and whether it can be resold for a profit. The duration for investing, by comparison, can vary widely and will depend on your financial goals, risk tolerance, investment strategy and individual circumstances. Investing goals can be measured as short-term (eg. a month to two years), medium-term (eg. two to five years) or long-term (eg. anything longer than five years). Investors who are choosing stocks may care more about a company’s fundamentals, such as profits and earnings. When you’re investing, you might buy shares of a company because it fits with your investment plan over the long-term and you think it can generate strong returns over time.
Key considerations as you begin trading
Learning the basics
Here are some terms you could encounter when you start trading:
- Volatility: Stock prices can naturally rise and fall over the course of a day or a month as different potential buyers and sellers haggle over the price of an asset. This is called volatility. The more dramatic the swings, the higher the level of volatility — and potential risk for losses (as well as gains).
- Trading on margin: This is the process of borrowing money to make a trade. In order to be eligible for margin trading, specific conditions have to be met, such as maintaining a certain level of cash and stocks in your brokerage account. While margin trading has potential to help grow your money faster, it also increases your risk. Not only do investors have to pay the loan back, but they also pay interest on borrowed funds.
- Going long: This expression describes investors who have purchased an asset and believe it will rise over time. With a long position, your capital is tied up in the asset, meaning you may have to sell your investment if you want to access your money.
- Going short: This refers to investors who are betting that a company’s shares will fall. For example, an investor might borrow shares from a brokerage firm through a margin account and immediately sell them with the intention to buy the same stock back later at a lower price. As a strategy, this can be effective but risky: If the shares don’t fall as expected, but instead continue to rise, it could expose you to unlimited losses requiring you to buy the shares at a much higher price in order to close out the transaction in your margin account.
Keep your risk tolerance in mind
As an investor, understanding your risk tolerance can be essential to managing your portfolio, especially when considering short-term cash needs, short-term and long-term returns, and the volatility of assets. Knowing your risk tolerance can help you address immediate financial requirements while also making informed decisions in the pursuit of higher short- and long-term returns. For example, an effective diversification strategy, guided by your risk tolerance, could help accommodate varying levels of asset volatility, which may ultimately help optimize your portfolio for your financial objectives.
Success in trading could depend on your level of discipline, patience and knowledge. Developing a trading strategy and having a game plan with each trade could prove helpful. A plan could involve identifying in advance your entry and exit targets, and knowing when to get out of a bad trade.
What are common trading strategies?
There are generally two types of basic trading strategies: active and passive.
- Active trading: You’re trading on a monthly, weekly or even daily basis.
- Passive Trading: You buy and hold investments for the long term — even for a lifetime.
How to start trading in Canada
When you’re reading to start trading for yourself, you’ll need to open an online brokerage account, such as a TD Direct Investing or Easy Trade account. With the rise of easy-to-use investing website and apps, anyone can trade actively or passively from their mobile device or home computer. You’ll find plenty of tools to help you find and evaluate potential investments.
FAQ: What is trading
How do traders make money?
Traders make money by speculating on the rise and fall of the prices of financial instruments, such as stocks, bonds and commodities.
How much can a beginner trader make?
While there is no limit to how much you can make as a self-directed trader, another way to look at it is how much you can afford to risk. Trading can be time consuming so it can be important to adopt a strategy you’ll be able to sustain over time.
How do I learn to trade?
Many online brokerages offer access to learning tools. You can trade on your own by opening an online trading account and learning as you go with small amounts to gain confidence. You might also consider: following the stock market, finding a friend or mentor to learn with, or taking advantage of online webinars and education tools offered by a brokerage such as TD Direct Investing.
How do I start investing with little money?
Online brokerages such as TD Easy Trade have no minimums to invest and, in TD’s case, offer 50 free trades annually.
Which is better, trading or investing?
It depends. How you choose to trade or invest can vary widely and will depend on your financial goals, risk tolerance, investment strategy and individual circumstances. All investors make trades. The question is how frequently you are making trades. Long-term investors with a diversified portfolio could make relatively few trades, simply adding contributions to an existing position. Active traders can also perform well making trades daily. If you do consider this approach be prepared to spend time researching potential investments and consider that you may face higher transaction costs.
What is a brokerage account?
Unlike a bank account, a brokerage account is an investment account that allows you to buy and sell a variety of investments, such as stocks, bonds, mutual funds and ETFs.