Welcome to Chasing Alpha, your comprehensive destination for everything finance. The stock market is the most sophisticated casino in the world. Everyday, billions of dollars move in and out of the market. Some trades are winners, some are losers and others lack any logic whatsoever. But while the stock market is incredibly complex, it can be simplified by starting with a solid foundation. To gain a basic understanding of the stock market, one must understand the key ideas of the market. What causes the stock market to go up and down? What positions can one take in the market? When should one exercise these positions? What are the risks associated with each of these positions? 

The stock market is a simple supply and demand equation. When a company is doing well, people want to buy the stock, which increases demand and decreases supply — the stock goes up. When a company is doing poorly, people want to sell the stock, which decreases demand and increases supply — the stock goes down. When there are more buyers than sellers, prices go up. When there are more sellers than buyers, prices go down.

Buying 

When someone buys a stock, they are exchanging money for equity in a company. A company will use the money generated from listing themselves on a stock exchange to grow their business, which will improve their company, which will then incentivize more people to invest. It is best to buy stocks when they are down so they are acquired at a cheaper price, and therefore have more room for the stock to go up. A good way to find stocks to invest in is to look at familiar companies. Investing in a trusted product or service is an effective way to invest because one’s consumer opinions are likely mirrored by a larger group of people, and therefore mean the company is worth investing in. Another key to buying stocks is to buy ones that are undervalued. An undervalued stock is worth significantly less than its rivals and/or does not get a lot of attention. Finally, investing in companies that have great advancements coming in the future is generally a good strategy.

Selling 

Selling is exchanging one’s equity in a company for cash. It is generally a good idea to sell if a stock is overvalued. One way to figure out if a stock is overvalued is by looking at its competitors. Are they similarly priced, or is there an outlier? Compared to its competitors, if a stock is disproportionately climbing up in price, then it is likely overpriced and it might be a good idea to sell it. As an investor, it is not wise to stay in overpriced stocks because eventually more investors will realize that said stock is overpriced, sell it and trigger a mass sell off.  Overpriced stocks are like a bubble: Eventually, they will burst. It is important to note selling stocks for a profit triggers capital gains taxes, which tax the profits made from selling a stock. The percentage of one’s gains taxed is based on how long the stock was held. Shorter-term investments (a year or less) are taxed at a higher rate than long-term investments (anything over a year). But investors shouldn’t make trades exclusively based on tax decisions. Short or long term capital gains tax is better than being in the negative. It can be said it’s a privilege to be in a position where an investor could pay capital gains, because that means they are making money. 

Shorting 

Shorting is when an investor sells stocks they don’t own. When an investor shorts a stock, they are betting it will go down. A short position is the term for when a stock is being shorted by an investor. If someone starts shorting a stock, they have a short position open on that stock. A short position increases in value if the stock being shorted decreases in value; a short position decreases in value when the stock being shorted increases in value. In order to close a short position, an investor buys the number of shares to get back to a total number of shares of zero or more. Essentially, an investor makes money shorting if the stock they are shorting goes down in price. It is recommended beginners stay away from this feature until they have a better understanding of the value of stocks along with how markets move. 

Options Trading

Options contracts give the buyer the right, but not the obligation, to buy or sell a predetermined number of shares at a set price. The original purpose of stock options was to provide stock insurance. Many investors view trading like driving a car. They never make a move without insurance. For example, if an investor buys a stock at $100, they can buy a put option on that same stock at $100. If the stock were to go down to $90, the investor would have the right to exercise their put option and sell the stock at $100 instead of the current price of $90. Investors also use options to make predictions on stock prices in order to profit. If an investor thinks a $100 stock will increase to $115, rather than buying the stock at $100, they can buy a call option that expires in 30 days at $110. This means at any point within 30 days, the investor can buy the stock at $110. If the investor is right and the stock goes to $115, they can exercise their option and buy the stock for $110. Buying said stock at $110 rather than $115 is financially beneficial because the investor is buying at a discount compared to the current market price. Options are far from free and are an easy way to lose a lot of money if an investor doesn’t know what they’re doing. Most custodial accounts, or accounts primarily geared at those under 18, won’t let minors trade options. One must have at least one year of experience in the stock market, though ideally more, before even looking at options. 

Market Tips

 Buying and holding has been proven time and time again to be the best strategy for maximizing profits. In every finance class, a student will hear the phrase, “Time in the market over timing the market.” This translates to the fact that actively trading stocks is a losing game. Another downside to actively managed portfolios is that they have much higher fees and taxes which reduces profits. Less than 10 percent of actively managed hedge funds — companies trading stocks on behalf of clients — can beat the market over a 10-year period. If the large majority of professional investors can’t beat the market, it is illogical for an average investor to think they can. 

Diversification is another key to success in the stock market. An investor who puts all their eggs in one basket is setting themselves up for failure. Investing in an index fund such as the S&P 500 is a great way to diversify one’s portfolio. The S&P 500 is composed of the top 500 American stocks. If America is doing well, so is the S&P. Here is a breakdown of how the S&P is divided up. 

To conclude, if someone wants to build generational wealth, it is crucial they start investing as soon as possible. History has shown the stock market always goes back up regardless of economic conditions. Investing today will pay major dividends both literally and figuratively in the future. Play around with a compound interest calculator to see how investing can build extreme wealth.