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. 

A CMC Invest account enables you to easily and efficiently access the direct share market to build your own portfolio of investments. Access companies listed in Australia on the ASX and overseas in 15 countries - all from one platform. 

What are shares?

Shares are units of ownership in individual companies. Owning shares entitles the holder to a proportion of the companies’ profits, through the form of dividends. When you trade shares, you could make money through ongoing dividend payments, or through an increase in teh share price when you come to sell your position.

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 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 impacts 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, negative 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: earnings, sale growth and industry competition. Investors try to predict price movements by reading analyst reports or by looking through the company’s own financial statements. 

Whether you're looking for short or long-term opportunities, it’s important to remember 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.

Calculating a company's financial strength

In difficult times, companies with high debt levels can find themselves unable to meet their obligations to have enough financing for their day-to-day obligations. Here are some important ratios to understand to determine a ompany's financial strength: 

• 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

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. Learn more about price to earning ratios in our introductory article.

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 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 dictate 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.

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.

The 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.