How Does Buying Stocks Work?

By: Steven Melendez | Reviewed by: Ashley Donohoe, MBA | Updated August 07, 2019

Buying stocks can be a good way to invest your money, whether you're saving for retirement or a more immediate goal. You can buy stock through a stockbroker or, in some cases, through the company that issued the stock. Indirectly investing in the stock market is also possible by putting money into a fund that pools money to invest in the market. Keep in mind that you can lose money in the stock market, and make sure you understand the risks involved in stock trading.

Understanding How Stocks Work

A share of stock represents an ownership interest in a company. Stock that's available for anyone to buy is known as publicly traded, and it can be bought and sold through companies called stock brokerages.

Investors often buy stock in the hopes that it will rise in value so that they can sell it later at a profit. This is the meaning behind the old adage buy low and sell high, but selling stock for a profit isn't the only way to make money in the stock market. You can also see income from dividends, which are payouts from companies to investors. Dividends are proportional to how many shares of the company's stock the investor owns; those represent a way for the company to share its profits with its investors.

Buying stock can be quite lucrative if you pick the right stocks at the right time, such as buying into a startup that's on the verge of becoming a household name. It's important to remember, though, that you can also lose money in the stock market if you buy a stock and its price dwindles. If a company goes bankrupt and doesn't have money to return to investors, you might even lose your entire investment. Don't invest more than you can afford to lose in the stock market, and keep in mind that even the best investors don't see the returns they're hoping for on every stock pick.

Working With a Stockbroker

If you're going to buy and sell stock, you'll usually work with a stock brokerage firm. Many now have online presences where you can buy and sell stock with the click of a mouse or the tap of a smart phone screen. Their online portals often feature other tools as well to let you access analyst reports discussing company performance, see historic performance of various stocks and transfer money between your bank account and your brokerage account. You'll usually want to transfer money from your bank to your brokerage account to buy stock, unless you already have deposited money in your brokerage account or have some on deposit from selling other investments.

Stock is generally listed with a company name and a ticker symbol, which is often a shortened version of the company name. Make sure when you buy and sell stock that you're looking at the correct company, since multiple organizations can have similar names.

Broker Fees and Prices

Brokerages often charge fees, known as trading commissions, for helping you to buy and sell stock. Different brokerages charge different commissions for different types of trades, and some don't charge commissions at all. They may also charge you for trading specialized investments, such as stock options, or for access to specialized tools, like research databases or guidance from financial experts.

Shop around for a brokerage that offers the services you want at a price you like. Not every deal is right for everyone. One investor may prefer to pay a minimal commission for basic stock trades, while another investor might prefer to pay a premium for a slicker interface, expert advice or tools for researching stocks.

Buying Direct From the Company

In some cases, you can buy stock directly from the company that issued it without going through a brokerage firm. Some companies offer plans where anyone can write in or visit a website to purchase a certain amount of stock, potentially automatically reinvesting dividends in additional shares of the stock as they're paid out. If you're considering such an option, read the fine print to determine whether it's a better or worse deal than buying through a traditional brokerage.

Some companies also provide special opportunities for their employees to own company stock, and this may be done a few different ways. Employee stock options give workers the right to buy company stock at a particular price after a certain amount of time, while stock grants give employees shares in the company as part of their compensation. In many cases, options or grants must vest, or mature for a certain amount of time, before they're available for employees to exercise or sell. Check with your employer to understand if any stock options or grants are available to you.

Other companies offer what are called employee stock ownership plans. They generally set up accounts where employees accumulate shares in company stock as they continue to work for the business. Details can vary, but typically when they leave the company, they get paid for all of their fully vested stock.

Understanding Penny Stocks

Stocks with values below a certain threshold, usually $5 per share, are considered penny stocks. Some investors have found themselves doing well by investing in penny stocks that escalate in value, sometimes delivering great returns. Many penny stocks, though, belong to either struggling startups that may never gain traction in the market or once-larger companies that have fallen on hard times. That means it's also easy to quickly lose an investment in penny stocks.

A number of penny stocks are also what are known as over-the-counter stocks. That means they're traded through networks of brokers rather than through the major exchanges like the New York Stock Exchange and the Nasdaq Stock Market. In practice, that can mean it's harder to find up-to-the-minute price quote information for them and harder to immediately buy or sell them, since there are fewer people looking to trade penny stocks at any particular time and less infrastructure to facilitate speedy trades.

Penny Stock Risks and Scams

A risk with penny stocks is a type of scam known as a pump-and-dump scheme. In such a scam, a crooked investor will buy shares in a penny stock and then publish materials encouraging other investors to buy the stock without disclosing that he already owns it. When they do so, the original investor will sell his shares and stop promoting the stock. At that point, the price will decline, often to its original level, leaving the newer investors at a loss.

To avoid these scams, try to only take stock market advice from sources you trust, and make your own decisions about what seems like a good investment. Use information from analyst reports, publications in reputable media and documents filed by companies with regulators like the Securities and Exchange Commission. Avoid taking stock tips from dubious sources, such as anonymous internet postings or newsletters of unclear origin. Approach advice about other investments, such as cryptocurrencies or precious metals, with the same skepticism.

Investing in Mutual Funds

You don't have to directly own shares in individual companies to benefit from fluctuations in the stock market or receive dividends. You can invest in funds that invest in the stock market rather than doing so directly. When you're considering funds, make sure to understand the fees that they charge, the types of investments they make, past performance and reputation.

Traditionally, many investors put money into actively managed mutual funds, which hire market experts to decide which stocks to buy and which to sell. Financial publications often follow which funds and fund managers have good track records and publish information about how they make their investment decisions.

Investing in Index Funds

More recently, many investors have begun putting money into index funds, which buy bundles of stock according to particular published rules. For example, many track stock market indexes such as the Standard & Poor's 500 index, the Dow Jones Industrial Average or the Nasdaq index. These funds can be cheaper than actively managed funds, since they don't require human experts, and they can be lucrative for investors when the market goes up as a whole. Other index funds track certain sectors of the economy, such as oil-and-gas firms or real estate companies.

Investing in Exchange-Traded Funds

Many modern funds are exchange-traded funds, meaning shares in the funds can be bought through a brokerage in a way very similar to buying individual stock. Using a ticker symbol, you can buy and sell shares through most brokerages. Make sure you understand the fees involved in doing so.

Trading Stocks and Paying Taxes

When you buy and sell stock, you're typically liable for any profit you make at the time you sell the stock. If you've held on to the stock for a year or more, you can pay tax at the federal long-term capital gains rate, which is 0, 15 or 20 percent depending on your overall income. The majority of taxpayers pay 15 percent. If you've only held on to the stock for less than a year, you must pay at your ordinary income rate, which is usually higher.

You can deduct any costs involved in buying and selling the stock, such as trading commissions, from your net gain. If you sell a stock at a loss or hold on to it until it becomes worthless, you can declare a capital loss. Capital losses can be deducted from capital gains. If capital losses exceed capital gains, up to $3,000 can be deducted in ordinary income per year. Rolling unused capital losses into future tax years might help offset future gains and income, but you can't roll them backward.

If you own a stock and it pays dividends, you generally must pay tax on the dividend the year you receive it. Some dividends, known as qualified dividends, are taxed at the long-term capital gains rate.

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About the Author

Steven Melendez is an independent journalist with a background in technology and business. He has written for a variety of business publications including Fast Company, the Wall Street Journal, Innovation Leader and Ad Age. He was awarded the Knight Foundation scholarship to Northwestern University's Medill School of Journalism.

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