How does stock trading work
Stocks for beginners: what are stocks and how does it work on the stock exchange?
What is a share?
A share is a stake in a listed company, more precisely in its share capital. Such companies are either a stock corporation (AG) or a partnership based on shares (KGaA). For them, selling stocks is a way to raise money for investments. In return, the shareholders are entitled to a share in the profit generated.
The companies pay out the profit in the form of a dividend at the end of the financial year. The amount of these stock dividends varies. It is decided by the annual general meeting of shareholders at which the company discloses its profits and losses.
But stocks are not only interesting as an investment because of the dividends. You can also generate returns with price gains. This is the case when stock prices rise and you can sell the securities at a higher price than you originally bought them. Since the stock exchange price fluctuates, shares always harbor the risk of loss as well as the opportunity for returns.
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Are stocks the right investment for me?
In principle, stocks offer significantly higher potential returns as a financial investment than saving with savings accounts or overnight money, because at the current low level of interest rates, inflation simply eats up the already low interest rates (September 2019). If, on the other hand, you invest money on the stock market for the long term and are not impressed by short-term price fluctuations, share trading offers you an interesting instrument for building up your wealth and for ETF retirement provision.
This is why stock trading is worthwhile!
Despite ups and downs and a few financial crises, the stock market has always been uphill in the past. The German share index (DAX) rose from 2,000 points in 1988 to over 11,000 points in 2016. This corresponds to an annual return of 19.3%. Those who only invested a fixed amount in DAX shares every month from 1990 to 2010 still achieved a return of around 6.8%, according to the Deutschem Aktieninstitut.
It is not possible to say with certainty whether stock exchange trading will develop just as well over the next 20 years. What is certain, however, is that your money on the savings account is currently not making any return at all.
What requirements should I meet if I want to invest in stocks?
Stock trading requires some prior knowledge, but in the end it is always a matter of luck. Therefore, before investing in stocks, you need to ask yourself a few questions about your personal and financial needs. You should definitely meet the following points if you dare to venture onto the trading floor:
- Patience: Stock market prices fluctuate. However, these fluctuations usually even out over a period of 10 years, for example. You should therefore have sufficiently good nerves not to sell shares prematurely, even if the share price falls, because if you liquidate your portfolio in a bull market (price low), you definitely make a loss.
- Sufficient financial cushion: If you invest in stocks, you may not need the money for at least 5, preferably 10 years and more. For the short term, you shouldn't invest in stocks. That means: Your deposit must remain untouched even in phases of unforeseen financial difficulties, such as illness or unemployment. You should therefore only go public when you have built up a nest egg of around three months' salary as security.
- Debt-free: A stock exchange rule is to pay off before investing. If you have outstanding loans, you should pay them off first. Because the loan interest is usually always higher than the return that you can earn with stocks. Never should you take out a loan to buy stocks!
- Initiative: Stock trading is not a book with seven seals. However, some familiarization with the subject is necessary. You need to be willing to take the initiative to acquire knowledge of how the stock market works and what strategies you can use to control the risk when buying stocks.
How does stock trading work on the stock exchange?
The place where stock trading takes place is the stock exchange. There are various stock exchanges at home and abroad. Every stock exchange functions as a marketplace on which many stockbrokers are constantly negotiating new prices not only for shares, but also for raw materials or certain rights.
The price of a share is the market price. It is negotiated according to the auction principle. All sales offers and purchase requests for shares, including price offers, are recorded in the order book. The price at which most would sell and buy a share forms the mean and, according to the so-called "highest execution principle", ultimately the price.
The stock market price depends on a number of very complex economic, political and psychological factors. Therefore, the price developments of stocks are very difficult to predict. In the stock market, however, numerous players try - sometimes with success, sometimes without.
The corona virus has brought the financial markets into a tailspin and unsettled many private investors. Are you wondering what the crisis means for your finances? Then we recommend our finances guide in times of crisis.
Stock ABC: These are the most important basic terms in stock trading!
To make it easier for you to find your way around the world of the stock market, which may still be strange to you, we have put together a small glossary of the most important basic terms on the trading floor.
You can download our ABC of stocks here.
How can I buy stocks?
If you want to buy stocks, you don't have to go public yourself. Instead, you need a share custody account. This is a kind of checking account in which you keep your securities instead of money. From this portfolio you can both buy and sell shares.
You can set up a deposit at your branch bank. The far cheaper alternative is now an online deposit with a direct bank or a special online stock broker. Not only are the custody account management fees usually cheaper or even free there. The so-called transaction fees, which are incurred every time shares are bought and sold, are also significantly cheaper.
Tip: Compare the price-performance index of the individual depot providers before you decide on a depot. You can find cheap depots in our depot comparison.
What types of stocks are there?
There are different types of stocks in stock trading. Not every listed company offers every share. It is good to know the differences before making a purchase. The different types of stocks can be divided into four groups: There are
- Shares with and without voting rights,
- Shares with informal transferability and those that have to be transferred to the new owner upon sale,
- Shares with and without so-called par value as well
- young and old stocks.
Voting and Non-Voting Shares: What are Ordinary Shares and Preferred Shares?
In addition to the right to a dividend, ordinary shares give the owner a vote at the annual general meeting of shareholders. The fewer shareholders the company has or the more common shares you have, the more the individual vote weighs. You can then co-decide within a certain framework on the further company goals or also in the discharge of the board of directors.
Preference shares, on the other hand, are shares without voting rights. In return for not having a say, the company offers you slightly higher dividends. In addition, in the event of a company liquidation, your claims would be served preferentially over those of holders of common stock.
Shares with and without a “price”: What is the difference between par value shares and no-par shares?
Par value shares indicate the portion of the share capital that you hold in the company with a concrete monetary value. The minimum face value is € 1. While the share price fluctuates, the face value always stays the same. In the earlier paper stocks, this value was printed on the corresponding security. This type of stock is on the decline, however.
No-par shares do not quantify a monetary value, but rather represent the percentage of the share capital per share. They are all of the same value. The more shares you have, the higher your share in the company. No-par shares are also called quota shares. They are often identified by the abbreviation “o. N. ", which stands for" without nominal value ".
For private investors, the distinction between unit value shares and par value shares is almost irrelevant. In any case, there are hardly any par value shares in circulation.
Anonymous and personalized shares: what are registered shares and bearer shares?
Registered shares are shares that are issued to their owner. The owner will be entered by name in the company's share register. This allows the company to communicate with you directly. You will then find out about the date of the annual general meeting by post, for example. When a registered share is sold, it is transferred to the new owner. In the past by hand, today banks do the rewriting digitally without any hassle.
Bearer shares, on the other hand, are “nameless” securities. You change hands without changing personal details. The owner is simply whoever owns the share. The company does not know who holds its shares and you can only find out the date of the above-mentioned annual general meeting from public announcements, for example from the daily newspaper.
Good to know: The restricted registered shares, derived from the Latin for vinculum, represent a special case. Anyone can buy such a share, but then the company decides whether it wants to give you all voting and dividend rights. Mainly distributed in the United States, such stocks are designed to prevent hostile takeovers. In Germany, Allianz, Münchner Rück and Deutsche Lufthansa issue registered shares with restricted transferability.
Newly issued and existing shares: What do “young” and “old” shares mean?
If a company that is already on the stock exchange needs more capital, it can carry out a capital increase. In addition to the old shares, new shares are also issued. These so-called “young” shares can only be bought by existing shareholders. Because the profit shrinks when it is distributed in this way on more shoulders, many stock corporations grant their existing shareholders a so-called subscription right. You can then buy new shares at a preferential price in order to participate in the company in the same proportion as before.
Which stock suits me?
The different types of stocks offer different options. Which one is right for you depends on your needs. We have put together some statements below that could help you make your choice.
Which statement can you agree with?
- Having a say is important to me! With one common share you can steer the fortunes of the company. Only large investors have a real influence. In addition, common stocks are often significantly more expensive with a lower dividend at the same time. However, if the company is sold, the value of the ordinary shares rises sharply because the new management is then primarily interested in voting rights.
- I am concerned with the return on investment! Preference shares do not grant voting rights, but you receive a slightly higher dividend and the purchase price is lower. Most private investors choose this type of stock.
- I want to feel connected to the company as a shareholder! Companies communicate directly with the owners of registered shares. This creates an emotionally stronger relationship and may be right for you if you feel connected to the company.
Stock trading: how do I rate a stock correctly?
The value of a share is the share price. Predicting price developments is the specialty of stock market experts, but even they regularly fail, as has been shown time and again. What is actually traded on the stock exchange are expectations of future developments.
You can read expectations, for example, from the company's annual reports, from their profit development and future investment projects. However, on a larger scale, you should also keep up to date with the trends in the relevant industry. However, the overall economic situation and political developments also have the same influence. It takes time to get a gut feeling.
There are also some valuation factors for securities that experts use to assess whether a share is worth buying. These analytical instruments are called indicators. We present the most important ones below:
- Dividend yield: The ratio between the share price and the last dividend paid is the dividend yield. The higher it is, the better. The formula is: (dividend: share price) x 100 = dividend yield in percent.
- Price-earnings ratio (P / E): Also known as the Price Earning Ratio (PER), this figure shows the profitability of a company compared to other companies in the same industry. To do this, the current market value is divided by the net profit of the share. The lower the P / E ratio is compared to others, the better, because the cheaper the share is.
- Price-Cash-Flow-Ratio (KCV): The cash flow describes the liquidity of a company, i.e. its immediately available capital. Again, the lower the KCV compared to others in the same industry, the better, as the share is then inexpensive.
- Price-to-sales ratio (KUV): This key figure sets the current price of a share in relation to the company's sales per share. The result shows the multiple of sales with which a share is currently traded.
- Price-to-book value ratio (P / B): The KBV evaluates the stock market value of the stock corporation itself. The current share price is divided by the book value per share. The book value is the sum of all intangible assets, tangible assets and fixed assets. The KBV should be at least 1 and says something about the future viability of the company.
What is the difference between stocks, equity funds, and ETFs?
Anyone who deals with stock trading will come across stock funds and ETFs again and again. What is meant are different types of investment that we would like to introduce to you in more detail.
Equity funds are bundles of stocks. You have the advantage that you spread the risk widely by not betting on one horse, but by bundling several stocks from different companies and from different industries. The broad diversification within the equity portfolio reduces the risk of total failure. Because if a share price fails, the loss of other shares can be mitigated.
These types of equity funds exist
There are two different types of funds on the market:
- active equity funds and
- passive index funds, which are also called "exchange traded funds", or ETFs for short.
With active equity funds, you buy into the fund of a professional fund manager, who will then try for you to end the day with a better price than the stock market itself. For example, the DAX itself could end up with a gain of 1%. Your actively managed fund on the other hand with 2%. Whether this succeeds depends on the skill of the fund manager, who is constantly selling worthless stocks from the fund and buying promising stocks. In practice, however, this does not always work.
With an ETF, on the other hand, a fund company replicates a stock market index for you, for example the DAX. The 30 strongest listed German companies will then be found in your portfolio. Your return develops parallel to the DAX without any further buying or selling activity. All you need to do is wait - hence the name of passive index funds.
ETFs are a long-term investment. Price fluctuations on the stock exchange, so the promise, will absorb them over a long period of time. Therefore, ETFs are often suitable for private investors who want to invest in stocks as a retirement provision or for long-term asset accumulation. When buying ETFs, you should start with an investment horizon of at least 5 to 30 years.
Shares, equity funds and ETFs, the differences at a glance
|management||Opportunity for returns||risk||costs|
|Trading individual stocks||active||high||very high||depending on order activity|
|Equity funds||active||high||high||approx. 1.5% p.a.|
|Index Fund (ETF)||passive||medium||low||up to 0.5% p.a. deposit costs|
The table shows that the choice of the right equity investment should primarily be related to personal risk tolerance and expertise.
To some extent, trading stocks is always a game of chance. With the right investment strategy, you can protect yourself from losing your savings. Depending on your own risk tolerance, you could, for example, invest 25% or 50% of your assets in an equity ETF and the rest in a bond fund that focuses on interest instead of price gains. In any case, keep money that you might need in the short term in a call money account. This so-called "slipper portfolio" recommends Stiftung Warentest for long-term asset accumulation and for old-age provision.
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