Choosing a Broker and Opening an Account

Before you can trade stocks online, you have to select an online broker. Your online broker will execute your trades and store your money and stock in an account. The online trading industry has seen lots of mergers and acquisitions, but there are still many firms to choose from. Different firms also offer different levels of help, account types and other services. Here are some things you should keep in mind as you look for a broker.

E*Trade, Ameritrade and Charles Schwab are three of the many online brokerages.

• How much money you plan to invest. Most firms require investors to have a certain amount of money to open an account. This is different from a minimum account balance -- although most brokerages have those, too.

• How frequently you plan to make trades. Are you going to buy one stock and hold on to it? If so, you'll need to make sure the brokerage doesn't charge a fee for account inactivity. On the other hand, if you're going to make lots of trades, you'll want a lower fee per trade. Regardless of how much you plan to use your account, you should evaluate how much using the site will cost you.

• Your level of trading experience and how much guidance you need. Some of the least expensive brokerages don't offer much in the way of research or broker-assisted trades. Others, while still moderately priced, offer market analysis, articles on successful trading and help from licensed brokers.

• Any other services you may want. A few trading sites let you buy and sell stocks but not much else. Others are more like major banks, offering debit cards, mortgage loans and opportunities for other investments like bonds and futures.

Some sites, such as Keynote and Smartmoney, rate online brokerages based on success rates, customer service response time, trading tools and other factors. They can help you make a decision as you shop around for the best trading site for your needs, but keep in mind that there are no official standards for ranking or evaluating brokerages.

As with any site that requires your personal and financial information, you should make sure your online broker has good security measures, including automatic logouts and transmission encryption. You should also make sure your brokerage is reputable. The Investing Online Resource Center has a good list of links you can use to make sure your firm is legitimate.

Opening & Funding an Account

When you open an account with a United States online brokerage, you'll answer questions about your investment and financial history. These questions determine your suitability for the account you are requesting -- the brokerage cannot legally allow you access to investments that you cannot reasonably handle. You will also have to provide your address, telephone number, social security number and other personal information. This helps the brokerage track and report your investments according to tax regulations and the PATRIOT Act.

In addition to providing this information, you must make several choices when you create an account. With most brokerages, you can chose between individual and joint accounts, just like at a bank. You can also open custodial accounts for your children or retirement accounts, which are often tax-deferred. Unless you pay a penalty, you can usually retrieve earnings from a retirement account only when you retire.

Next, you must choose between a cash account and a margin account. You can think of a cash account as a straightforward checking account. If you want to buy something using your checking account, you have to have enough money in the account to pay for it. Using a cash account, you have to have enough money to pay for the stock you want.

A margin account, on the other hand, is more like a loan or a line of credit. In addition to the actual cash in the account, you can borrow money from the brokerage based on the equity of the stock you already own, using that stock as collateral. Then, you can buy additional stock. Your margin is the equity you build in your account.

According to the Federal Reserve Board, you must have at least 50 percent of the price of the stock you wish to purchase in your account. In other words, if you want to purchase $5,000 worth of stock, the value of the cash and stock in your account must be at least $2,500. You can borrow the other $2,500 from the brokerage.

Once you have made your purchase, you must keep enough equity in your account, also called your equity percentage, to cover at least 25 percent of the securities you have purchased. Here's how the brokerage determines this number:

• The market value of your stock minus the amount of the loan you took to buy the stock is your equity amount.

• Your equity amount divided by your total account value is your equity percentage.

If your equity percentage falls below the minimum, the broker has the right to issue an equity call. Typically, the brokerage will try to contact you, but the firm has the right to sell any and all of your assets to raise your equity percentage to the minimum. The brokerage is not obligated to contact you.

Margin accounts are definitely more complex than cash accounts, and buying on credit presents additional financial risks. If all of that sounds overwhelming, it's a good idea to stick with a cash account. If you'd like some more examples of how margin accounts work, check out the IORC's Investing Simulator Center.

Finally, you must decide how the brokerage will store your money between trades. Many brokerages offer interest-bearing accounts, so you continue to earn money even when you are not trading.

Once you have made all these choices, you must fund your account. You can make a deposit by check, make a wire transfer to the brokerage or transfer holdings from another brokerage.

Day Trading: Your Money at Risk

Day traders rapidly buy and sell stocks throughout the day in the hope that their stocks will continue climbing or falling in value for the seconds to minutes they own the stock, allowing them to lock in quick profits. Day traders usually buy on borrowed money, hoping that they will reap higher profits through leverage, but running the risk of higher losses too.

While day trading is neither illegal nor is it unethical, it can be highly risky. Most individual investors do not have the wealth, the time, or the temperament to make money and to sustain the devastating losses that day trading can bring.

Here are some of the facts that every investor should know about day trading:

• Be prepared to suffer severe financial losses

  Day traders typically suffer severe financial losses in their first months of trading, and many never graduate to profit-making status. Given these outcomes, it's clear: day traders should only risk money they can afford to lose. They should never use money they will need for daily living expenses, retirement, take out a second mortgage, or use their student loan money for day trading.

• Day traders do not "invest"

  Day traders sit in front of computer screens and look for a stock that is either moving up or down in value. They want to ride the momentum of the stock and get out of the stock before it changes course. They do not know for certain how the stock will move, they are hoping that it will move in one direction, either up or down in value. True day traders do not own any stocks overnight because of the extreme risk that prices will change radically from one day to the next, leading to large losses.

• Day trading is an extremely stressful and expensive full-time job

  Day traders must watch the market continuously during the day at their computer terminals. It's extremely difficult and demands great concentration to watch dozens of ticker quotes and price fluctuations to spot market trends. Day traders also have high expenses, paying their firms large amounts in commissions, for training, and for computers. Any day trader should know up front how much they need to make to cover expenses and break even.

• Day traders depend heavily on borrowing money or buying stocks on margin

  Borrowing money to trade in stocks is always a risky business. Day trading strategies demand using the leverage of borrowed money to make profits. This is why many day traders lose all their money and may end up in debt as well. Day traders should understand how margin works, how much time they'll have to meet a margin call, and the potential for getting in over their heads.

• Don't believe claims of easy profits

  Don't believe advertising claims that promise quick and sure profits from day trading. Before you start trading with a firm, make sure you know how many clients have lost money and how many have made profits. If the firm does not know, or will not tell you, think twice about the risks you take in the face of ignorance.

• Watch out for "hot tips" and "expert advice" from newsletters and websites catering to day traders

  Some websites have sought to profit from day traders by offering them hot tips and stock picks for a fee. Once again, don't believe any claims that trumpet the easy profits of day trading. Check out these sources thoroughly and ask them if they have been paid to make their recommendations.

• Remember that "educational" seminars, classes, and books about day trading may not be objective

  Find out whether a seminar speaker, an instructor teaching a class, or an author of a publication about day trading stands to profit if you start day trading.

Escaping Trades and Stock Frauds

Once you've opened and funded your account, you can buy and sell stocks. But before you do that, you want to get a real-time stock quote to confirm the current price of the stock. Your brokerage may provide real-time quotes as part of your service. Many free financial news sites offer delayed quotes, which are at least twenty minutes behind the market. If the market is moving quickly, a delayed quote can be substantially different from the real trading price.

Once you've gotten your quote and decided you want to make a trade, you can choose to place a market order or a limit order. A market order executes at the current market price of the stock. A limit order, however, executes at or better than a price you specify. If the price doesn't reach the limit you set, your trade will not go through.

Some brokerages offer additional options, often used to prevent high losses when a stock price is falling. These include:

• Stop order - A form of market order, this executes after the price falls through a point that you set. The order executes at market price, not at the stop point.

• Stop limit order - These are like stop orders, but they execute at a price you set rather than market price. In rapidly moving markets, the broker may not be able to execute your order at your set price, meaning that the stock you own may continue to fall in value.

• Trailing stop order - Like a stop order, a trailing stop executes when the price falls through a point you set. However, its selling price is moving instead of fixed. You set a parameter in points or as a percentage, and the sale executes when the price falls by that amount. If the price increases, though, the parameter moves upward with it. So, if a stock is trading at $20 per share, and you set a trailing stop order with a three-point parameter, your initial selling price would be $17 per share. But if the price then increases to $25 per share, your new selling price would be $22 per share.

You must also select whether your order stays active until the end of the day, until a specific date or until you cancel it. Some brokerages allow you to place "all or none" or "fill or kill" orders, which prevent a partial rather than complete exchange of the stocks you want to trade.

Contrary to many people's perceptions, making trades online is not instantaneous, even if you're placing a market order. It can take time to find a buyer or seller and to electronically process the trade. Also, even though you can access your account and place buy and sell orders twenty-four hours a day, your trades execute only when the markets are open. An exception is if your firm allows after-hours trading, which is riskier due to the reduced number of trades taking place.

Online Stock Fraud
With erratic prices, corporate scandals and "market corrections," you may think you already have enough to worry about when it comes to trading stocks. But there is one more important worry to add to the pile -- investment fraud.

Long before the days of online trading, a few unscrupulous brokers defrauded investors or absconded with their money. Fraudulent firms known as boiler rooms have also employed brokers to make unsolicited phone calls to investors, selling bogus or overvalued stock. People must evaluate their broker's ethics and judgment, and part of the broker's job is to protect investors from fraudulent stocks.

With online trading, though, people must research stocks on their own, deciding what to buy and sell without the help of a broker or an investment planner. Fraudsters have taken advantage of this, leading to several notable methods of defrauding investors. These include:

• Pump-and-dump schemes - People spread the word about a "sure thing" stock via online message boards, online stock newsletters, email and other methods. The resulting interest in the stock drives up the price. The organizers of the scheme sell their stocks for a huge profit, and then stop promoting it. The price plummets, and investors lose money.

• Fraudulent IPOs - Some investors like IPOs because they provide a chance to "get in on the ground floor" and to make a substantial profit. Some scammers, though, spread the word about an upcoming IPO for companies that never intend to go public or that don't exist. Then, they abscond with investor' money.

• Fraudulent OTC stocks - Con artists promote stock in companies that do not exist or start a pump-and-dump scheme for an OTC stock. After investors buy stock in non-existent companies, scammers simply take the money and run.

• Fraudulent company information - Publicly traded companies have to release information about financial performance. Overstating or misrepresenting a company's goals and achievements can drive up the stock price.

Fortunately, you can protect yourself from most of this by doing your own research. In addition to researching your brokerage, you should research any company you plan to invest in, including reading annual reports and financial statements. You should also check the SEC's Electronic Data Gathering, Analysis & Retrieval (EDGAR) system, especially if you are going to participate in an IPO. EDGAR includes IPO information and periodic reports from companies in the United States and other countries. Filing information with EDGAR is required by law.

Also, it's always a good idea to remember that if a stock deal seems too good to be true, it probably is.

How Online Trading Works

Legend has it that Joseph Kennedy sold all the stock he owned the day before "Black Thursday," the start of the catastrophic 1929 stock market crash. Many investors suffered enormous losses in the crash, which became one of the hallmarks of the Great Depression.

What made Kennedy sell? According to the story, he got a stock tip from a shoeshine boy. In the 1920s, the stock market was the realm of the rich and powerful. Kennedy thought that if a shoeshine boy could own stock, something must have gone terribly wrong.

Now, plenty of "common" people own stock. Online trading has given anyone who has a computer, enough money to open an account and a reasonably good financial history the ability to invest in the market. You don't have to have a personal broker or a disposable fortune to do it, and most analysts agree that average people trading stock is no longer a sign of impending doom.

The market has become more accessible, but that doesn't mean you should take online trading lightly. In this article, we'll look at the different types of online trading accounts, as well as how to choose an online brokerage, make trades and protect yourself from fraud.

Review of Stocks & Markets
Before we look at the world of online trading, let's take a quick look at the basics of the stock market. If you've already read How Stocks and the Stock Market Work, you can go on to the next section.

A share of stock is basically a tiny piece of a corporation. Shareholders -- people who buy stock -- are investing in the future of a company for as long as they own their shares. The price of a share varies according to economic conditions, the performance of the company and investors' attitudes. The first time a company offers its stock for public sale is called an initial public offering (IPO), also known as "going public."

When a business makes a profit, it can share that money with its stockholders by issuing a dividend. A business can also save its profit or re-invest it by making improvements to the business or hiring new people. Stocks that issue frequent dividends are income stocks. Stocks in companies that re-invest their profits are growth stocks.

Brokers buy and sell stocks through an exchange, charging a commission to do so. A broker is simply a person who is licensed to trade stocks through the exchange. A broker can be on the trading floor or can make trades by phone or electronically.

An exchange is like a warehouse in which people buy and sell stocks. A person or computer must match each buy order to a sell order, and vice versa. Some exchanges work like auctions on an actual trading floor, and others match buyers to sellers electronically. Some examples of major stock exchanges are:

• The New York Stock Exchange, which trades stocks auction-style on a trading floor
• The NASDAQ, an electronic stock exchange
• The Tokyo Stock Exchange, a Japanese stock exchange

Worldwide Stock Exchanges has a list of major exchanges. Over-the-counter (OTC) stocks are not listed on a major exchange, and you can look up information on them at the OTC Bulletin Board or PinkSheets.

When you buy and sell stocks online, you're using an online broker that largely takes the place of a human broker. You still use real money, but instead of talking to someone about investments, you decide which stocks to buy and sell, and you request your trades yourself. Some online brokerages offer advice from live brokers and broker-assisted trades as part of their service.

If you need a broker to help you with your trades, you'll need to choose a firm that offers that service. We'll look at other qualities to look for in an online brokerage.

Why Invest

Maybe you don't have $2000 burning a hole in your bank account, but perhaps you can afford to invest your lunch money. Brown-bag your lunch and sock away just $4 a day, 250 days a year. It's not a lot, but if you're in your early 20s, you've got the investor's best ally on your side -- time. If you invest $1,000 once a year in an investment that averages an 11% annual return -- the annual stock market return since 1926 -- it'll grow to more than $1 million after 46 years, which is right around the time you'll be ready to retire.

Of course, as you get older and more financially stable, you should be able to put away more to invest. Upping the ante to just $166 a month (lunch money plus about what you pay for basic cable TV and a movie channel), would put you at the million-dollar mark in just 39 years.

Simply put, you want to invest in order to create wealth. It's relatively painless, and the rewards are plentiful. By investing in the stock market, you'll have a lot more money for things like retirement, education, recreation -- or you could pass on your riches to the next generation so that you become your family's Most Cherished Ancestor. Whether you're starting from scratch or have a few thousand dollars saved, Investing Basics will help get you going on the road to financial (and Foolish!) well-being.

The power of compounding

The table below shows you how a single investment of $100 will grow at various rates of return. Five percent is what you might get from a certificate of deposit (CD) or with a government bond, 10% is a little less than the historical average stock market return, and 15% is what you might get if you decide to learn how to pick your own stocks and take advantage of some of our lessons in advanced investing techniques.

Growing At

Year	5%	10%	15%	20%
1	$100	$100	$100	$100
5	$128	$161	$201	$249
10	$163	$259	$405	$619
15	$208	$418	$814	$1541
25	$339	$1083	$3292	$9540

Why is the difference between a few percentage points of return so massive after long periods of time? You are witnessing the miracle of compounding. When your investment gains (returns) begin to earn money, too, and those returns start to earn... small amounts of money can mushroom very quickly. Extend the time period or raise the rate of return, and your results increase exponentially. For instance, if you start young, say at 15 years of age, note how quickly a single $100 investment grows, especially in the later years.

Growing At

Age	5%	10%	15%	20%
15	$100	$100	$100	$100
20	$128	$161	$201	$249
25	$163	$259	$405	$619
30	$208	$418	$814	$1541
40	$339	$1083	$3292	$9540
50	$552	$2810	$13,318	$59,067
60	$899	$7298	$53,877	$365,726
65	$1147	$11,739	$108,366	$910,044

Looking at it another way, let's compare two teenagers and their lifetime savings habits. Bianca baby-sits a lot and spends most of her spare time reading. She saves $1000 a year starting when she's 15 and invests it in the stock market for 10 years earning 12% per year on average. After 10 years, she comes out of her shell, stops adding money to her nest egg, and spends every penny she earns club hopping and on trips to Cancun. But she keeps her nest egg in the market.

Compare her account to that of her friend Patrice, who squandered her early paychecks on youthful indiscretions. At age 40 Patrice gets a wake-up call when her parents retire on nothing but Social Security. She starts vigorously socking away $10,000 every year for the next 25 years. Guess who has more at age 65? That's right, Bianca. (You figured it was a setup, didn't you?) Her 10 years of saving $1000 per year (just $10,000 total -- the same amount Patrice put away in just one year) netted her $1.6 million by age 65. Patrice, on the other hand, scrimped for 25 years to invest a quarter million dollars out of her own pocket and ended up with just under a million. Neither will be going to the poorhouse, but you see our point: Bianca's baby-sitting money grew for 50 years, twice as long as Patrice's, and Bianca barely missed it.

(It's almost not fair to mention this, but Bianca's money was in a Roth IRA. Patrice could only put 20% of her money in the Roth ($2000 per year). So Bianca's $1.6 million is tax-free, but Patrice will be paying capital gains taxes on most of her money.)

We will revisit the subject of compounding in Step 2, but for now suffice it to say that the power of compounding is the single most important reason for you to start investing right now. Every day you are invested is a day that your money is working for you, helping to ensure a financially secure and stable future.