What is share trading?

Share trading is the buying and selling of company stock with the aim of making a profit. It allows you to obtain legal ownership in a specific company. Once you have shares in a company you own part of the underlying asset. This means you can receive company dividends and are able to vote in company meetings.

CMC Markets

There are few things in the world as widely known and little understood as share markets. Market reports fills the pages of our newspapers and websites every day and evening news bulletins have always carried a report on the movement of major indices like the S&P 500, and yet for many it remains a foreign, and seemingly impenetrable, world. That’s a shame, because share trading is actually more accessible and easier to follow than almost any other investment activity.

When you buy or sell shares, the trader enters into a contract to exchange the legal ownership of the shares for money. This exchange is called ‘settlement’ and usually occurs two business days after the trade takes place. You can purchase shares through a broker, using individually-held electronic funds or leverage your share trading using a margin loan from a margin loan provider.

A CMC Markets stockbroking account enables you to easily and efficiently access the direct share market. It includes competitive online brokerage, order processing in less than a second, and unlimited free conditional orders for all clients. Our stockbroking platforms also gives you access to in-built fundamental research and risk analysis tools.     

What are shares?

Shares are units of ownership in individual companies. Owning shares entitles the holder to a proportion of the companies’ profits. When you share trade, profits come from increases in the value of company shares and the payment of dividends to shareholders, and these are based on company performance.

Investors have seen the stock market offer better long-term returns than many other investments. With low minimum investments, you don’t need significant capital to get started and there are thousands of companies across a wide range of market sectors for you to choose from.

What is the stock market and how does it work?

A stock market is a regulated environment where investors can connect to buy and sell shares. Although its common to hear people talk about “the stock market” as though it’s a single entity, there are actually multiple stock exchanges around the world. These were initially set up to service a particular area or country though technological changes mean it’s now common for companies to have their headquarters in one country and be listed in another. These exchanges are subject to the laws of the countries they are located in and are overseen by local regulators, such as the Securities and Exchange Commission in the US. That goes for the companies that list on these exchanges as well.

Companies list their stock on an exchange by selling shares directly to investors via a process called an initial public offering (IPO). Once the company has listed, investors and traders can buy and sell those shares from each other, via a broker.

You will likely have seen a stock exchange portrayed in movies as an action-packed room full of people shouting at each other over deals, but these days most trading actually occurs online. This means traders are no longer limited to the operating hours of a particular exchange and can trade on different exchanges around the world. For example, somebody living in Australia may trade on the London Stock Exchange after they finish work in the evening.

What affects stock prices?

Share prices fluctuate constantly in the short term according to investor demand, which is driven by factors like news events, market fundamentals, the macro economy and market sentiment. For instance, if a supermarket chain announces that its sales have been growing at a faster than expected rate, its shares may rise as investors price in the likelihood of higher earnings growth. Alternatively, a negative piece of economic data – such as jobs figures or GDP – may spark fears of a recession or tougher trading conditions and lead to a market-wide sell-off.

Over the longer term, however, a company’s share price is driven primarily by its fundamentals: how fast its sales are growing, how resilient are its earnings, what are its competitive advantages. Investors and traders can try to answer these questions by reading analyst reports or by looking through the company’s own financial statements.

Whether you are looking for short-term or long-term opportunities, however, it’s important to remember that the market is always forward looking. It’s what’s in a company’s future, not its past that matters. A business that has just posted record earnings but warned its sales are likely to fall in the year ahead would likely watch its stock price fall. Visit our guide to understand more about how market cycles can impact investors.

Growth anticipation 

The primary driver of a company's valuation is its ability to grow earnings and eventually dividends. There are a number of ways that a company can increase its earnings over time:

Growing the business
Companies can increase sales by entering new markets, entering into partnerships and joint ventures, winning new contracts or customers, developing and launching new or improved products, improving marketing and sales offerings and more.

Raising prices
​During positive economic times, some companies gain the ability to charge higher prices for their products as demand increases. This is particularly significant for resource producers during bull markets for commodities.

Cost controls
A company can also improve its profitability by reducing expenses, although those that do run the risk of cutting corners. To measure this, investors often look at expenses such as administrative, sales and marketing, interest and depreciation as a percentage of sales to determine how efficiently management is running the business. Looking at operating earnings as a percent of sales (margin) can also give an indication of the profitability of the company.

Risk of disappointment

It's important for investors to recognise that while companies can enjoy great success, there are also numerous risks that could cause them to lose money or see business decline dramatically. Fear of negative outcomes can limit the upside potential for shares, or even cause declines.

Operating risks
​There are many possible problems that a company may face as a part of normal business, including  machinery breaking down, the entry of new competitors, price wars, input cost increases, adverse economic conditions, lost contracts or customers and more.

Political risk 
​This varies by country but relates to the potential that a new government could gain power and implement adverse economic policies such as tax increases, new regulations, asset nationalisations, and other initiatives.

Currency risk 
​Companies operating in multiple countries run the risk that increases and decreases in currencies relative to each other could impact the company's revenues or cost structure and may increase or reduce the earnings power of foreign operations in terms of the home currency.

Legal risk 
​This relates to the possibility that the company could be sued. This particularly appears in sectors where there can be disputes over patents and intellectual property which could lead to significant damage awards or injunctions against doing business.

Insolvency risk 
​In difficult times, companies with high debt levels can find themselves unable to meet their obligations to have enough financing to meet their day to day obligations. To determine the financial strength of a company, there are a number of ratios that an investor can analyse. These include:

  • Debt to equity = total debt/total equity  (This measures how leveraged the company is.)
  • ​Times interest earned = operating income/interest payments (This measures the ability of the company to at least service the interest portion of its debt.)
  • ​Current ratio = current assets/current liabilities (This measures the ability of the company to meet near-term obligations with current resources.)

How does the market value growth? (P/E & PEG ratios)

Another useful question for investors to ask is how the market is valuing the shares of a company relative to its peers. The reason for this is that more expensive shares tend to carry higher expectations and higher risk of disappointment, while companies with low valuations and expectations carry the potential for upside surprises.

The most common measure of valuation is the price-to-earnings (P/E) ratio, which can be calculated as:

​P/E ratio = market capitalisation / net income

​or

​P/E ratio = share price / earnings per share

​This tells an investor what additional premium is likely to be applied to justify the company's current earnings.

​The earnings/price ratio would tell you how many years it would take for the company to make its current share price at the current rate of earnings, the payback period in a sense. Therefore, a higher P/E ratio, indicates higher expectations for earnings growth. 

​​​With valuation tied to growth, another key measure for investors to consider is the price/earnings-to-growth (PEG) ratio, calculated as:

PEG ratio = current P/E ratio / current rate of earnings growth

​​So a company with a 30% growth rate and a 30x P/E would have a PEG of 1.0, which is widely considered to be the benchmark level. ​A PEG greater than 1.0 means that the market is pricing in even faster growth for the company, which raises the prospect of disappointment, while a PEG of less than 1.0 suggests that there may be room for valuation to increase.

​The only problem with using P/E ratios to compare valuations is that the market tends to put a premium on certain sectors, making peer group comparisons easier than comparisons across a wider range of stocks.

Trading vs investing

For a trader, the focus is always on the short term as they look to profit from fluctuations in stock prices. Every trader has a different strategy but many will hold a stock for less than a day, trying to ride the intra-day movements in its price and selling up before the end of the session. 
 
Traders have the option to go both short and long with a stock, meaning they can buy a share to try to profit from a rise in its price (long) or sell it to profit from a fall (short).
 
Investors typically have a longer-term focus and many will choose to hold shares for years or even decades, hoping to profit from a rise in prices over time and perhaps to collect a regular income stream from dividends along the way.

Dividends 

Dividends can also have a significant impact on market sentiment. While earnings can be dependent on accounting estimates, dividends represent a payment of actual cash to shareholders. Dividends have become an important component of shareholders' income and return expectations.

​​Because some shareholders rely on dividends for income, companies that cut their dividends tend to see their shares punished severely by the marketplace, and those that eliminate them entirely tend to lose institutional shareholders who are restricted by policies that dicatate they can only own dividend-paying shares. Because of this, companies tend to only raise dividends to levels that they feel confident they can maintain over the longer term.

​​This suggests that changes to dividends can give a strong indication of management's expectations of future results. A dividend increase is indicative of confidence, while a dividend cut generally indicates that a company has encountered major difficulties.

  • The dividend yield is calculated as: dividend per share / price per share
  • The higher the yield, the higher the current return on your capital from dividends.

Sometimes, a high dividend yield can indicate undervaluation, but sometimes it may indicate concerns that the dividend rate may be cut.

​​To measure the riskiness of the current dividend level, investors can look at the ​dividend coverage ratio:

Dividend coverage ratio​ = earnings per share / dividends per share


​​This measures the company's ability to earn its current dividend. The higher the level, the stronger the potential for dividends to remain at their current level or increase, while a level below 1 suggests the potential for a cut.

Another thing for share traders to consider is that once a dividend is declared, there is a cut-off date by which you must own the shares to receive the dividend. On the first day of trading where a buyer would not get the dividend, known as the ex-dividend date, the price tends to get marked down at the open by the amount of the dividend.​

Bottom line

As with any form of investment, it’s important to be aware of the financial risks involved with share trading. Every participant will have losing trades, probably many of them over time. That is an inevitable reality, so it’s vital to have a strategy to minimise losses – perhaps through the use of stop-losses or by limiting the amount of money you commit to individual trades.

Disclaimer
Investing in CMC Markets derivative products carries significant risks and is not suitable for all investors. You could lose more than your deposits. You do not own, or have any interest in, the underlying assets. We recommend that you seek independent advice and ensure you fully understand the risks involved before trading. Spreads may widen dependent on liquidity and market volatility. The information on this website is prepared without considering your objectives, financial situation or needs. Consequently, you should consider the information in light of your objectives, financial situation and needs. CMC Markets Asia Pacific Pty Ltd ABN 11 100 058 213, AFSL No. 238054 (the derivative product issuer), CMC Markets Stockbroking Limited, Participant of the ASX Group (Australian Securities Exchange) and SSX (Sydney Stock Exchange) and Chi-X (Chi-X Australia), ABN 69 081 002 851, AFSL No. 246381 (the stockbroking services provider) provides the financial products and/or services. It's important for you to consider the relevant Product Disclosure Statement ('PDS') and any other relevant CMC Markets Documents before you decide whether or not to acquire any of the financial products. Our Financial Services Guide contains details of our fees and charges. All of these documents are available at on this website or you can call us on 1300 303 888.
 
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