How Does Online Stock Trading Work?

Today, it’s easier than ever to start trading stocks online. Seriously, you could buy or sell stocks from the comfort of your home with a laptop, a cup of coffee and your favorite pajamas.

Everyone and their second cousin (twice removed) is trying to get in on the action and find the next Amazon or Tesla stock. But how does all of this online stock trading stuff work? And is it really the best way to invest your hard-earned cash? Let’s take a closer look.

How Online Stock Trading Works

Remember: When you’re stock trading, you are basically buying and selling stocks with the goal of making a profit on those trades. And in recent years, brokerage firms have made it possible to make these trades online. Here are a few steps you’ll need to take to get started.

Step 1: Choose a Brokerage Firm

Sounds obvious? Maybe, but you have to start somewhere! If you’re going to buy and sell stocks online, the first step is to choose an online stock broker. What does a broker do? They help you make your trades and give you a place to keep your money and your stocks.

There are many different stock brokers out there, and they are not created equal. Some brokers require a certain amount of money to open an account or a minimum balance to keep on investing. If you just plan to buy one or two stocks and then just let them sit there, some brokers charge fees for inactivity (that’s lame, we know). One brokerage firm might provide research, helpful tools and other neat resources for beginners while another is geared toward more advanced traders.

That’s why it’s really important you do your research on brokerage firms and count all the costs of doing business with a specific broker!  

Step 2: Open a Brokerage Account

Once you’ve settled on a brokerage firm, it’s time to open a brokerage account to trade stocks with. But before you do, you’ll need to provide some information and answer some questions.

What kind of questions, you ask? Most of those questions will be about your investment and financial history. How you answer those questions will determine whether or not you’re eligible for an account. You see, the brokerage firm can’t legally allow you to open an account for investments you can’t handle.

You’ll also be asked for some basic information—things like your address, telephone number and Social Security number—to help the brokerage firm track your investments and report them for tax and legal purposes.

Step 3: Pick the Type of Brokerage Account You Want

What kind of brokerage account should you get? It depends on what your goals are for the account and who will be in control of the money and investments inside the account. Here are some of the main types of brokerage accounts to choose from.

Individual or Joint Taxable Brokerage Accounts

Individual taxable brokerage accounts are simply your standard, run-of-the-mill accounts with one owner—which is you. That means you call all the shots! When you die, all the assets will pass on to your estate.

If you’re married and want to open an account together with your spouse, that’s where a joint taxable brokerage account comes into play. These accounts can have two (or more) owners, and each owner has the right to invest or manage the account’s funds as they please. And when one owner dies, the other owner has rights to the entire account (that’s what “rights of survivorship” means).

But these accounts have a lot in common! Here are some things you should know about individual and joint taxable brokerage accounts:

• You can invest in a wide range of investments, from mutual funds and single stocks to bonds and ETFs.
   
• Unlike traditional and Roth retirement accounts, there are no tax advantages here—you have to report your earnings each tax year to the IRS.
   
• There are no age limits or required distributions, so you have the freedom to deposit and withdraw from these accounts whenever you want to.

Cash or Margin Accounts

Market chaos, inflation, your future—work with a pro to navigate this stuff.

Okay, this next part is important, so listen closely. Whichever account you open has to be either a cash account or a margin account. Cash accounts are basically just like a checking account—if you have enough money in the account to buy an investment, you can buy it. If you don’t, you can’t buy it. Simple enough! 

Margin accounts are a different beast altogether. With this kind of account, you can borrow money to buy stocks. Did you hear that? You could go into debt to invest. That’s just stupid with a capital “S.” Never borrow money to invest! If you’re going to open a brokerage account, make sure it’s a cash account and not a margin account.    

Step 4: Start Trading Stocks

Now’s the moment you’ve all been waiting for—you’re ready to start buying and selling stocks! Once you’re ready to make a trade, you generally have two choices: You can either make a market order or a limit order.

When you want to buy or sell a stock with a market order, that means the trade will be executed right away at the stock’s current market price. With a limit order, you’re placing an order to buy or sell a stock once it reaches a certain price or better.

So let’s say there’s a stock you want to buy. Its market price right now is $5 per share. If you want to buy the stock right away, you would place a market order for that stock at $5 per share. But if you’re only willing to pay $4 per share, you could place a limit order to buy a certain number of shares if the price hits $4 or lower (but if the stock never goes down to $4 per share, the order never goes through).

And remember, when you place an order for a trade, it’s your brokerage firm that is making those trades on your behalf—and those services usually come with commissions and fees that pile up quickly. That’s why stock traders have to make sure their winnings are enough to outweigh these costs . . . which is easier said than done.

Stock Trading and Taxes

We talked about this a little bit earlier, but it’s worth mentioning again in case you missed it: There are no tax advantages when you invest inside a taxable brokerage account.

With a tax-advantaged retirement account, like your 401(k) or Roth IRA, you might enjoy tax-deferred growth or tax-free growth and withdrawals in retirement depending on the type of account you have.

But that’s not the case with a taxable brokerage account. Nope! Instead, you will pay capital gains taxes on the money you make buying or selling stocks in the same year those profits were made.

If you’ve held on to those stocks for more than a year, you’ll pay the long-term capital gains rate (which is 0%, 15% or 20% depending on your income). But if you buy and sell a stock that you’ve had for less than a year, then you’ll get pegged at the short-term capital gains rate (which is the same as your ordinary income tax rate).

And even if you don’t sell your stocks at all, you still will probably owe taxes if the company you own stock in pays you dividends (which are regular payments of a company’s profits to shareholders as a “thank you” for owning their stock).

The Risks of Stock Trading

Before you sign up for a brokerage account and start trading stocks left and right, you need to ask yourself: Is stock trading really the best way to invest your money?

Our answer is simple: No. Many have tried trading single stocks as a way to fast-track their way to building wealth, and many have failed spectacularly. And according to the National Study of Millionaires, not a single millionaire in the study said investing in single stocks was a big factor in their financial success.

Building wealth is a marathon, not a sprint—and while stock trading might give you a few wins here and there in the short term, it’s not a winning strategy over the long haul. Here are a few reasons why.

1. There’s not enough diversification.

Diversification is just a fancy word for having your money spread out between different investments, which lowers your risk while still allowing your money to grow. It’s that age-old idea of not putting all your eggs in one basket!

When you’re trading single stocks, it’s difficult to do that because you’re just buying and selling stocks of single companies. You might think, Well, I’ll just buy hundreds of different stocks. But there’s a lot more to it than that. You’ve got to get the right balance of stocks from different sectors and markets so you can succeed in the long term. And that ain’t easy to do on your own.

2. It’s extremely time-consuming and difficult.

Stock trading takes up time . . . a lot of time. You have to do your research on the companies you are investing in and study complicated charts and keep up with the latest investing news . . . it’s basically a full-time job. And even then, it’s really difficult to separate the winners from the losers!

Studies have shown that the vast majority of folks who go into day trading end up losing money over time. In fact, less than 1% of day traders are actually profitable.^1,2 Does that sound like a winning strategy to you?

3. Your emotions could run wild.

One day you might be feeling the rush of watching a stock you invested in shooting up “to the moon.” A week later, you might be pulling your hair out while that same stock’s value crashes back down to earth. One reason why most stock traders are unsuccessful is that they base their decisions on their emotions—and that’s pretty much always a terrible idea.  

This is the life of a stock trader, and it’s why 3 out of 4 day traders end up calling it quits less than two years after they start.³ Why would you ever want to join that race? The emotional and psychological toll of stock trading just isn’t worth it. There’s a better way.

How to Invest for the Future

Investing for the future—and saving for retirement—doesn’t have to be complicated. In fact, it shouldn’t be complicated! Here are a few guidelines that can help get you on the path to building wealth for the long haul.

1. Save 15% of your income toward retirement.

Once you’ve paid off all your debt (except your home mortgage) and have a fully funded emergency fund in place, you’re ready to start investing! And once you’re ready, we recommend setting aside 15% of your gross income toward retirement.

Why 15%? First, that number still leaves you with some wiggle room in your budget to save for other important financial goals—like saving for your kids’ college funds and paying off your home early. And second, we have found that if you consistently save 15% of your income month after month, year after year, chances are you will put yourself on the path to becoming an everyday millionaire!

2. Put your investments in tax-advantaged retirement accounts.

Retirement accounts like your 401(k) at work and a Roth IRA can give you tax advantages that brokerage accounts can’t. Tax-free growth? No taxes on withdrawals in retirement? Sign us up! That’s why those tax-advantaged retirement accounts should be the first place you go to invest for the future!

3. Invest in good growth stock mutual funds.

Mutual funds are a type of investment where investors pool their money together to buy a certain kind of investment. So growth stock mutual funds are filled with stocks from dozens of different companies, which spreads out your investments across many different stocks and lowers your risk!

We recommend going a step further and dividing your investments evenly across four different types of mutual funds: growth, growth and income, aggressive growth, and international.

4. Work with a financial advisor.

Does this all feel like a lot to sort through? The good news is you don’t have to figure it all out on your own. Through the SmartVestor program, you can find a financial advisor who can help you pick mutual funds and guide you throughout your financial journey.

There’s a reason why most of the millionaires we talked to for the National Study of Millionaires said that they worked with a financial advisor to help them reach their net worth.

Find your SmartVestor Pro today!

This article provides general guidelines about investing topics. Your situation may be unique. To discuss a plan for your situation, connect with a SmartVestor Pro. Ramsey Solutions is a paid, non-client promoter of participating Pros.