Part I: A few things you should know
Chapter 1: What is share trading?
To really understand what share trading is, we should look at what the stock market is and how it came about. I am a second generation share trader and before I was even a teenager my father sat me down and explained to me what a stock market is. Here is the story as it was told to me as a child . . .
A long time ago, before the stock market ever existed, there was a man we will call Mr A. One day Mr A had an idea ā a great idea. An idea about how to build a better ship . . .
But it was an idea about a big ship and Mr A did not have enough money to build his ship. So Mr A got depressed . . .
In fact there were lots of men and women with lots of great ideas about lots of things, but none of their ideas ever became a reality, until one day Mr A had an idea about money. His money idea was to break up his ship venture and find other people to share in it.
So Mr A formed a company and went to Mr B, who was a good salesman, and got him to sell āsharesā in his new shipbuilding company. Mr A paid Mr B well, so Mr B worked very hard and managed to sell all of the shares. This made Mr A very happy.
In fact, Mr B made so much money selling Mr Aās idea that he brokered deals between the other people who had ideas and members of the public who wanted to invest. And when Mr Aās company began to make money, he divided the profits among the shareholders. He sent money to the shareholders every year that he made a profit.
One of his investors, Mr C, had an idea and wanted to sell his holdings in Mr Aās company to pursue his own clever idea. But it was very hard for Mr C to sell his shares because Mr A did not want to buy them back and there was no marketplace for shares. So Mr C started one and called it a stock market.
And that is the ABC of how the stock market began!
Of course, this is a very simple explanation of how stock markets came into existence and why we have them, but it is conceptually accurate. Stock markets serve the very serious functions of raising venture capital and facilitating the transferring of interests in companies from one investor to another. Here are some additional key points worth noting:
ā¢ Mr A and people like him are entrepreneurs.
ā¢ Mr B brokers deals between entrepreneurs and investors and is called a stockbroker.
ā¢ Furthermore, thanks to Mr C and the creation of the stock market, Mr B also brokers deals between investors, transferring company interests from one party to another.
ā¢ When stockbrokers place shares with investors it is called the primary market.
ā¢ When shares are bought and sold in the stock market it is called the secondary market.
ā¢ Company profits are split and distributed regularly to shareholders as dividends.
ā¢ Stock markets also regulate publicly listed companies to protect investorsā interests.
That pretty much explains what a stock market is, so now we can move to the really big question: what is share trading?
Share trading ā a simple explanation
How to define share trading is a very common point of confusion for many stock market participants, including newcomers and even the more experienced, so Iām going to examine how to define share trading from several directions to provide you with as much clarity as possible. Letās start with a very simple explanation (with pictures, of course).
The fortunes of a company inevitably change over time, so the price of the shares that represent a companyās value increase and decrease in sympathy with these changes (see figure 1.1).
Figure 1.1: share prices rise and fall over time
Itās therefore possible to make money from buying and selling shares, providing you sell the share for a higher price than you paid for it. So while you own the share, the shareās price must increase (see figure 1.2, overleaf ).
In investment circles this is given the fancy name of ācapital growthā. It all sounds simple enough, but so often people confuse ātradingā with āinvestingā, so now Iāll clarify the difference between these two distinctly different ways of dealing in shares.
Figure 1.2: rising share price
Share trading and share investing
āTradeā means ābuying and selling for profitā. If I say I am a share trader, I am stating that I buy and sell shares for a profit, which seems simple enough, but there are deeper implications to this statement. For instance, if I am buying shares with the intention to sell them at a future date for a profit, I would have to be expecting them to rise in value.
Hereās the confusing bit ā āinvestā means āto use money to make a profitā, which includes any money-making endeavour that requires money. So a share trader qualifies as a type of investor because they are applying money to the stock market to generate a profit. Contrary to popular belief, a person who deals in shares is not defined as a ātraderā by the number of trades they perform each year. This definition was created by a certain government department and, while it may serve their purposes well, it is very misleading for the rest of us.
If you purchase a share with the intention to sell it at any time in the future for a profit, then you are a share trader. The value of the share must obviously go up while it is in your possession, but you could sell it after one week, one year, 10 years or even longer. An example of a very long-term trade is art that is purchased and owned by several generations in one family before being sold. The same family may own the art for 100 years or even longer, but by definition it is still trading.
Warren Buffett is an investor
World-renowned investor Warren Buffett defines an investor as being an āasset managerā. Warren Buffettās company, Berkshire Hathaway, is an asset management company that buys interests in companies that are undervalued, improves their operation over time, then derives a return from them via the companyās increased profits.
Warren Buffettās favourite holding time is forever because he buys into companies to derive an ongoing interest in their operation, not to sell their stock at some point in the future for capital growth. Thus, Warren definitely is not a share or stock trader (shares are called stocks in the US).
In other words, he is primarily interested in ongoing profits and he views any capital growth largely as a bonus. Warren is therefore focused on a companyās profits as a proportion of a companyās value, which is a function of its share price. Unlike a share trader who will sell shares that start to fall in value, Warren will buy more shares if a company becomes undervalued (in his opinion) due to a falling share price. So a share trader wants to buy a rising share price and an investor (or asset manager) like Warren wants to buy a high income/profit yield, which occurs when the share price falls ā perfectly opposed objectives!
Here is an example to help clarify Warrenās perspective.
Letās assume that a company pays an annual dividend of $1.00 and the share price is $10.00. The dividend yield or income yield, therefore, is
$1.00/$10.00 = 10 per cent per annum.
Now letās assume the share price drops to $8.00 but the dividend remains at $1.00 per annum ā a not unlikely occurrence given that a companyās profitability is not necessarily linked to its share price. The dividend yield would, therefore, increase to
$1.00/$8.00 = 12.5 per cent per annum.
So if youāre an investor like Warren Buffett and looking to buy a highly profitable or high yielding stock, the direction of the share price is largely irrelevant because, like Warren, you have no intention of selling the share at a later date. In fact, if the share price was to halve during a stock mark...
