Other than some type of savings account or other interest-bearing instrument, the first venture into investing for most people is probably the stock market, either in individual company equities or in mutual funds of many different types. Many people have a stake in the stock market through their 401(k) or other retirement plans.

Buying a stock gives you a piece of the company, entitling you to collect dividends and gaining from any appreciation in the value of the stock. Companies sell these shares to raise money for all kinds of reasons, granting ownership rights rather than borrowing money and paying interest. Unlike many derivative instruments, stocks do not expire and can be held indefinitely. For that reason,

The supply of a company's shares is fixed. With a limited number of stocks, competitive buying and selling determines the price of the stock. Stock markets normally operate with a specialist system with market-makers responsible for making markets in specific stocks.

The Federal Reserve sets the margin amounts for stocks, requiring investors to have a minimum of 50 percent of the price of stock in their account as a down payment to own the stock. It is much more difficult to sell stocks than buy them as selling usually has to be done on an uptick, and you have to borrow shares from a brokerage firm’s inventory if you want to sell. If you borrow margin money to buy shares or borrow shares to sell, you pay the broker interest.

Trading Individual Stock Instruments

You have a number of alternatives to become involved in the stock market as either an investor or trader.

Individual Company Shares
You have thousands of choices, and your biggest challenge is to pick the right stock from the right sector from the right overall market environment at the right time. Much of the analysis for investing in individual stocks involves scanning through the vast array of stocks to find those that meet the criteria you select. Getting accurate data and reliable information about a company in a timely manner can make it difficult to get an edge.

Stock Options
Instead of buying shares in the company, you can use options to buy or sell the right to be long or short the company's shares at a specific price.

Single Stock Futures
Futures on major individual stocks began trading in November 2002 but still trade on a relatively small scale. Single stock futures do provide greater flexibility and tax advantages for those wanting to buy or sell selected major stocks.
 

Trading 'Market' Instruments

Many investors do not have time nor expertise to evaluate and select the "right" individual stocks so various instruments have been developed to capture the performance of a broader spectrum of stocks.

Mutual Funds
Mutual funds package stocks from a sector, from a region, the market as a whole or many other ways to provide a diversified fund based on a collection of individual stocks. Basing performance on a number of stocks reduces risk and can enhance profits compared to investing in a few individual stocks. Funds can be geared to provide aggressive growth, growth and income, long-term appreciation or a number of other investment goals, and their performance is often measured against some benchmark.

Mutual funds have become so popular and the number of funds so numerous that it is now as difficult to pick a “good” mutual fund as it is a stock. Although these funds offer diversity and professional management for investors, they have some limitations and may not be the best vehicles for active traders.    

Index Funds
Rather than select individual stocks for a fund, some funds just include all of the stocks in an index such as the S&P 500 Index or one of the sector indexes. Their performance should roughly coincide with the performance of the index.

Index Options
These derivatives are also based on an actual cash index such as the S&P 500 Index (SPX) and the S&P 100 Index (OEX), which cover a number of stocks. Overall market direction and time are important elements to consider.

Exchange-Traded Funds (ETFs), Index Shares, Index Tracking Stocks
These products act like an index but are traded like a stock and have become very popular since they were introduced by the American Stock Exchange in 1993. More than 300 ETFs are available today. The most popular leaders include:   

• DIA or "DIAMONDS" – based on the Dow Jones Industrial Average and priced at approximately 1/100 of the value of the DJIA.
   
• QQQ or "Qubes" – based on the Nasdaq-100 Index and the most successful index share contract. It is priced at approximately 1/20 of the value of the index.
   
• SPDRs – based on the S&P 500 Index.
   
• Select Sector SPDR Funds – based on nine specific industry sectors.
   
• WEBS – World Equity Benchmark shares on 17 different foreign countries based on Morgan Stanley Capital International (MSCI) Indexes.
   
• HOLDRS – depository receipts on selections of stocks in various areas.

ETF instruments offer traders a number of advantages:

• Invest in a portfolio of stocks represented by an index with a single transaction in one stock-like instrument.
• Provide diversification of a stock index – one trade buys or sells "the market."
• Trade short-term or long-term – no time factor, no expiration like futures or options, no penalty fee for getting out before the 6-12 month minimum time period that some mutual funds require.
• Trade continuously throughout the trading day, unlike mutual funds, which can be purchased or redeemed only at the end of the day.
• Marginable just like stocks.
• Short selling allowed on a downtick any time during the trading session, unlike many common stocks.
• Limit orders can be used to sell or buy at a specific price without having to wait for whatever the close is on a given day.
• Dividends accrue to stocks in the index.
• Move into and out of positions quickly as a proxy for stocks.
• Lower cost than buying multiple stocks in an index.

Stock Index Futures and Options on Stock Index Futures
Trading in stock index futures goes back to 1982 and has evolved into one of the most successful electronically traded markets with contracts based on the S&P 500 Index, Dow Jones Industrial Average and Nasdaq-100 Index.

As the stock market soared in the late 1990s, the size of the S&P 500 Index was reduced several times to be more compatible with individual trader accounts. Originally priced at $500 times the index, the full-sized contract was cut in half to $250 times the index. The most popular index futures contract now is the S&P 500 e-mini, which has a multiplier of $50 times the index and is traded electronically almost around the clock. The e-mini Nasdaq-100 Index, with a multiplier of $20 times the index, has also become popular for short-term trading.

1. What Is a Good Trading Instrument?
2. Trading Equities
3. Trading Futures
4. The Role of an Exchange
5. The Role of the Brokerage Firm
6. The Role of the Regulator
7. How to Pick a Broker
8. How to Place Orders

Main Trading Resources Section