Equities – a comprehensive guide to trading

Introduction to equity trading

Equity trading is a vital feature of financial markets which allows investors to take a stake in the ownership and growth of public companies. Technology advancements and the rise of online trading platforms have made equities trading increasingly accessible, drawing in millions of individual investors, and bolstering market efficiency and liquidity.

This guide provides an overview of the essentials of equity trading, the distinct types of equity trades and strategies, and the regulatory and technology aspects of equity trading.

Definition and overview of equity trading

Equity trading, also known as stock trading, involves the buying and selling of company shares on the stock market. By buying shares in a company, one becomes a partial owner and has the potential to benefit its future growth and profitability.

The first step takes place in what is called the primary market. A company that was initially a private entity (or, occasionally, state-owned) may choose to go public (or float) by issuing newly created shares in an initial public offering (IPO). Once the shares in an IPO book-building process have been allocated to buyers, a date is fixed for the shares to begin trading on the stock exchange, where the buying and selling of the securities take place continuously. This is the secondary market, which constitutes the bulk of stock market trading activity.

Money can be raised after IPOs through secondary offerings, which can be dilutive or non-dilutive.

Dilutive secondary offerings (also called follow-on or subsequent offerings) are new shares created by listed companies and placed for sale on the market. These processes dilute shareholders’ positions to raise proceeds for the corporation.

Non-dilutive secondary offerings are when significant shareholders place existing shares for sale. The proceeds do not go to the corporation, and the sale does not dilute other shareholders.

Already-listed companies can also raise money through rights issues, in which existing shareholders are given the option to buy new shares pro rata at a discount rather than purchasing them on the secondary market.

The benefits of effective equities markets include:

• Liquidity: Equity trading gives the market liquidity, benefitting both investors and businesses. Easy share buying and selling by investors ensures effective price discovery and lowers transaction costs.
• Capital raising: By selling ownership shares, primary equity markets enable businesses to raise money for expansion. Companies can facilitate the transfer of funds in exchange for company stakes by allowing potential shareholders to buy their stocks when they are issued.
• Investment options: Secondary equity markets offer a wide range of investment options. By spreading their investments across several businesses, industries, and regions, investors can diversify their holdings, which may improve profits while assisting in risk management.
• Market-based economy indicator: The performance of the stock market is a leading indicator of the state of the economy, reflecting investor confidence, economic expansion, and business health.

Overview of the equity trading process

Equity trading, a process that culminates in the purchase or selling of stocks, requires research, understanding market dynamics and making informed decisions. The institutions involved in this process can be divided into the buyside and sellside. Firms in the latter, such as brokers, are either direct members of stock exchanges or have access to non-member trading via other brokers. They provide (i.e., sell) their market access and trading expertise to their customers, funds, and investment firms as well as retail traders. These are known as the buyside, as they purchase market access and trading services.

Equity trading procedures:

1. Opening a brokerage account: To start trading, traders must open a reputable brokerage account and conduct thorough research on stocks they are interested in.
2. Research and analysis: They should understand their fundamentals, financial health, and market trends.
3. Placing trades: Once a stock is identified, traders can place either a market order or a limit order through their brokerage account.
4. Monitoring and managing positions: After executing trades, traders should actively monitor their positions, stay informed about market developments, and adjust their strategy as needed.
5. Risk management: Traders also employ risk management strategies such as setting stop-loss orders, diversifying portfolios, and managing position sizes.

How equity trades are executed:

1. Order placement: Investors decide to buy or sell a stock. Common order types include market orders that are executed immediately, and limit orders that are executed at specified prices (see details in next section).
2. Order transmission and routing: Orders are sent to brokerage firms electronically. Brokerage systems use variables like cost and time to determine the optimal execution path.
3. Order routing options: Direct Market Access (DMA) routes large trades directly to exchanges or Smart Order Routing (SOR) algorithms route orders to different venues for optimal execution.
4. Order matching and execution: Orders enter exchange order books. Matches occur based on price and time priority. While the execution of market orders is quick, limit orders may take more time.
5. Trade confirmation: In this stage brokers confirm trade execution with investors, agreeing on the details of shares, execution price, and fees.
6. Clearing and settlement: Clearinghouses ensure trade completion, with settlement taking one or two business days (T+1 or T+2).
7. Post-trade processing: Reconciliation, regulatory reporting, and precise record-keeping form this stage of the trade.

Key Takeaways

• Equity trading involves buying and selling company shares on the stock market and allows investors to participate in public companies’ ownership and growth
• Technology advancements and online platforms have made equities trading accessible to millions of individual investors
• Equities trading enhances market efficiency and liquidity, with the stock market also serving as an economic indicator
• Equity trading, a process that culminates in the purchase or selling of stocks, requires thorough research and following market developments both before and after placing an order
• The execution of trades generally follows a standard procedure, and includes order placement, order transmission, trade confirmation and clearing and settlement

Types of equity trades

Trade instructions

There are diverse ways traders can instruct the market to buy or sell stocks, or arrange for trades to be executed:

• Market order: an order to buy or sell a security immediately at the best available current price. Market orders are quickly executed, but there is no guarantee for the exact price at which the order will be filled. A market order deals with the execution of an order. The price of a security is secondary to the speed of completing the trade.
• Limit order: an order to buy or sell a security at a specific price or better. A buy limit order will only be executed at the limit price or lower, and a sell limit order will only be executed at the limit price or higher. Unlike market orders, limit orders mainly deal with the price, meaning that the transaction will not take place if the security’s value is resting outside of the parameters set in the limit order.
• Stop order: conditional instructions placed by investors to automatically execute a trade when a specific price level is reached and help manage risk, including:
  • Stop-loss orders: These trigger a market order when the stock price reaches a specified level (the “stop” price). They help limit losses or lock in profits.
  • Stop-limit orders: These trigger a limit order when the stock price reaches the specified level. They provide more control over execution price but may not always execute if conditions are not met.

Day trading, swing trading, and long-term investing

The different trading strategies refer to traders’ methods and approaches to engaging with the market based on time frames and techniques.

• Swing trading entails capitalizing on short-term or midterm swings in a stock price. Swing traders rely primarily on technical analysis to uncover opportunities and time their entry/exit, and often use charting tools to help discover and visualize these signals. Swing trades occur over a few days or a few weeks.

• Day trading seeks to scalp small profits multiple times a day and close out all positions at the end of the day. As the name suggests, it involves making dozens of trades in a single day, based on technical analysis and sophisticated charting systems.
• Long-term Investing is focused on assets that appreciate over several years. Long-term investments are assets planned to be held for more than three years. Investment instruments include cash, real estate, or stocks. Investors with long-time horizons assume a significant level of risk to increase returns.

Common equity trading strategies

There are other common equity trading strategies that can be applied to any of the broader trading strategies discussed above:

• Momentum trading is a short-term trading strategy where traders buy and sell financial assets based on recent price trends, aiming to capitalize on upward or downward trends until they fade. Traders work with market volatility by finding buying opportunities in short-term uptrends and selling when securities lose momentum, then returning cash to search for the next uptrend or buying opportunity.
• Value investing is a strategy where investors buy undervalued stocks or trade them for less than their intrinsic values. It is based on the theory that investors should buy businesses rather than stocks, ignoring market trends and noise. The practice involves buying stocks at a low price and realizing gains when they recover. It can be more casually described as buying stocks on sale. This approach focuses on the fundamentals of the company the stock represents.
• Growth investing is a stock-buying strategy targeting companies that are expected to grow at an above-average rate compared to their industry or the broader market. Growth investors tend to favor smaller, younger companies poised to expand and increase profitability potential in the future. Growth investing is focused on increasing an investor’s capital.

Risk management in equity trading

Risk management is a key component of active trading, involving measuring potential losses against profit potential on new positions in financial markets. It helps traders avoid holding losing positions for too long and helps identify, analyze, and control risks to capital and earnings.

Key Takeaways

• There are different ways–market order, limit order, stop order–traders can instruct the market to buy or sell stocks, or arrange for trades to be executed
• The different trading strategies—swing trading, day trading, and long-term investing—refer to traders’ various methods and approaches to engaging with the market based on time frames and techniques
• The main strategies include momentum trading, value investing and growth investing. They differ in investment focus and philosophy
• Risk management is a crucial aspect of active trading, involving comparing potential losses against profit potential, preventing long-term losses, and controlling capital and earnings risk

Regulatory considerations and compliance in equity trading

To maintain market integrity and investor protection, traders must be aware of regulatory and­ compliance requirements, including:

• Market manipulation and insider trading: Preventing practices like front-running (a broker or investor joining a trade with foreknowledge of a large deal and impacting the asset price), spoofing (traders placing a bid with no intention of fulfilling it, instead cancelling the bid or offer before execution), and wash trading (a form of manipulation whereby an entity simultaneously sells and buys the same financial instruments). Implement robust surveillance systems and provide regular training to detect and avoid violations.
• Best execution: Ensuring trades are executed in the client’s best interest, considering factors like price, speed, and execution likelihood, and regularly assessing and improving policies for optimal execution.
• Order handling and allocation: Prioritizing client orders over proprietary trades, avoiding conflicts of interest. Monitoring practices to ensure fair treatment of clients.
• Disclosure and transparency: Maintaining clear disclosure of fees, expenses, and valuations. Adhering to reporting obligations, including transaction, position, and trade surveillance reporting.
• Pre-trade risk controls: Implementing and regularly assessing the effectiveness of pre-trade checks for credit, position, and market risk limits to prevent excessive risk-taking.
• Systemic risk management: Effectively managing positions to prevent liquidity shortages and systemic risks, ensuring market stability.
• Cybersecurity and data protection: Protecting sensitive data and trading systems from breaches. Complying with cybersecurity and data protection regulations like GDPR.
• Anti-money laundering (AML): Implementing comprehensive AML policies, conducting customer due diligence, and monitoring transactions for suspicious activities.
• Compliance training and education: Providing training on regulatory requirements, market abuse, conflicts of interest, and insider trading to foster a culture of compliance.
• Regulatory changes and cross-border compliance: Staying informed about regulatory changes, ensuring compliance across jurisdictions, and adapting policies and systems to meet new requirements. The UK’s departure from the European Union, for instance, requires market participants operating in both areas to be up to date with the respective regulatory frameworks as differences emerge. Staying compliant is an integral part of the costs of doing business internationally.
• Supervision and oversight: Establishing a robust governance framework, promoting ethical behavior, accountability, and transparency through regular monitoring, risk assessments, and independent audits.
• Conflicts of interest: Separating proprietary trading from other business activities to ensure traders act in clients’ best interests.

Key Takeaways

• Traders must prevent market manipulation, ensure best execution, and prioritize client orders over proprietary trades to maintain market integrity
• Comprehensive compliance includes implementing pre-trade risk controls, anti-money laundering policies, and protecting sensitive data
• Ongoing compliance training and education are essential for fostering a culture of compliance and ensuring adherence across jurisdictions
• Robust governance, supervision, and the separation of proprietary trading from other activities are crucial for ethical behavior and client-focused trading

Technology and tools for equity trading

Equity trading relies on a mix of traditional and modern technologies and tools.

• Market data feeds: Access to real-time and historical market data is essential for informed trading. Data is the lifeblood for markets, but it comes at a cost, both in terms of paying for the data itself, and in time and resources required to work with providers, understand what data you need, how you are allowed to use it, and having the analytics in place to interpret it. Third-party providers can add value by handling data licensing, and by normalizing data feeds, such as standardizing formats from different providers to make it easier to work with and integrate into internal systems.
• Trading platforms: Online brokerage platforms are essential for executing trades as they provide investors with access to a wide range of equities and various trading tools.
• Algorithmic trading: Algorithms analyze market data and execute trades automatically. They can optimize execution speed and efficiency, allowing firms to achieve their execution goals while controlling their operational overheads. While algos are essential for high-frequency trading, they are increasingly used across all types of trading strategy.
• Technical analysis software: These tools offer chart analysis, pattern recognition, and automated alerts to help traders make informed decisions based on technical indicators.
• Risk management software: These solutions help traders monitor and mitigate risks by calculating position sizes, setting stop-loss orders, and managing overall exposure.
• News aggregators: These tools provide real-time news updates on companies and markets, helping traders stay ahead of market-moving events.
• Order management systems (OMS): OMS streamline the order execution process, from order creation to execution and settlement, ensuring compliance and efficiency.
• Portfolio management software: Portfolio management tools help traders and fund managers track and analyze the performance of their portfolios, manage assets, and generate reports.
• Mobile trading apps: With the rise of mobile technology, apps like Robinhood, E*TRADE, and TD Ameritrade Mobile are critical to attracting retail traders, who can execute trades, monitor markets, and manage portfolios on the go.

Specialized tools are available in all these areas, but firms often seek integrated trading platforms that offer functionality in multiple areas to control their operational costs and simplify their workflows.

While equity trading is defined by the blend of traditional and modern technology, human judgment, intuition, and market knowledge remain invaluable even in the age of automation

Key Takeaway

• Online brokerage platforms are essential for executing trades and providing investors access to various equities and trading tools
• Algorithmic trading and AI models optimize execution speed, efficiency, and trading strategies through data analysis and automation
• Technical analysis software, risk management tools, and news aggregators aid traders in making informed decisions and mitigating risks
• Market data feeds, order management systems, and portfolio management software streamline order execution, ensure compliance, and track portfolio performance

Future trends in equity trading

The future of equity trading is expected to be shaped by rapid technological advancements, which promise greater efficiency, speed, and data-driven insights. All this while global markets grow and become more interconnected, and institutional and retail investors demand new financial instruments and assets, from swaps and active ETFs to crypto derivatives.

However, these benefits come with challenges, including the integration of old and new systems, cybersecurity threats, and increased market volatility.

As these trends unfold, equity trading participants must stay informed and be agile to navigate the complexities of the future market landscape.

The financial services industry is experiencing significant advancements in automation, algorithmic trading, artificial intelligence, machine learning, blockchain, and cryptocurrencies. Automated trading strategies allow for faster decision-making and reduced human error, while AI-powered tools analyze vast amounts of data, identify patterns, and make predictions. Machine learning algorithms may aid in risk management, portfolio optimization, and trade execution, with applications in loan underwriting, risk forecasting, and personalized customer service.

Mobile trading apps, cloud-based platforms, and the enable traders to access markets from anywhere, enabling informed decision-making.

Additionally, evolving regulatory frameworks will be crucial to ensuring the ethical and secure use of modern technologies, maintaining market stability, and protecting investor interests. Legislators are taking action to better police systemic risk in the financial system by requiring financial firms and their technology vendors to strengthen operational resilience from a cybersecurity perspective. Legislation, such as DORA in the EU, is symbolic of this push.

Staying informed about these trends and embracing new technologies can give traders a competitive edge in the evolving trading landscape.

Conclusion

As the global trading landscape continues to evolve and present new challenges, equities trading is more complex than ever. Traders, to make informed decisions, need to understand market dynamics, be familiar with the right traditional and modern technology tools, and be able to adapt to a changing regulatory environment. With the rapid advancement of automation, equity trading continues to be a dynamic field, where staying informed and being flexible are essential for traders to grow their business.