What Is Equity Trading?

Introduction to equity trading 

Equity trading is a fundamental pillar of financial markets, enabling investors to acquire ownership stakes and participate in the growth of listed companies. Technological advancements and the proliferation of electronic trading platforms have democratized equities trading, attracting millions of individual investors and enhancing market efficiency and liquidity.

This blog provides a comprehensive overview of the fundamental aspects of equity trading, identifying the types of equity trading and the strategies used, as well as exploring the regulatory framework and technological infrastructure that support this vital market segment.

An Overview of the equity trading process 

Equity trading, the process of buying or selling stocks, requires extensive research, a thorough understanding of market dynamics, and the ability to make informed decisions. The institutions involved in this process can be broadly classified as buy-side and sell-side. Sell-side firms, such as brokers, are either direct members of stock exchanges or provide trading access to non-members through other brokers. They provide (i.e., sell) their market access and trading expertise to their clients, including funds, investment companies, and retail traders. These clients are known as the buy-side because they purchase market access and trading services.

Equity Trading Procedures:

Opening a Brokerage Account: To begin trading, individuals must create an account with a reputable brokerage firm and conduct in-depth research on the stocks they are interested in.

Research and Analysis: Traders should develop a solid understanding of the fundamentals, financial health, and prevailing market trends associated with their chosen stocks.

Placing Trades: Once a specific stock is identified for trading, individuals can enter either a market order, which aims to execute immediately at the best available price, or a limit order, which specifies the price at which the trade should be executed, through their brokerage account.

Monitoring and Managing Positions: After executing trades, traders must actively monitor their positions, keep abreast of market developments, and adapt their trading strategy as needed.

Risk Management: Prudent traders also employ various risk management strategies, such as placing stop-loss orders to limit potential losses, diversifying their portfolios across different assets, and carefully managing the size of their trading positions.

How Equity Trades Are Executed:

Placing Orders: Investors begin the process by choosing to buy or sell a specific stock. Common order types include market orders, designed for immediate execution, and limit orders, which are only executed at a specified price or better.

Order Transmission and Routing: Once placed, orders are electronically transmitted to brokerage firms. Brokerage systems rely on multiple factors, such as cost efficiency and execution speed, to determine the optimal order routing path.

Order Routing Options: There are several routing options, including Direct Market Access (DMA), which routes large-volume trades directly to exchanges, and Smart Order Routing (SOR) algorithms, which intelligently route orders to different trading venues to achieve the most favorable execution.

Order Matching and Execution: Orders are then entered into the exchange’s electronic order books. Buy and sell orders are matched based on price priority (best prices are matched first) and time priority (earlier orders at the same price are matched first). While market orders typically execute quickly, limit orders may take longer to execute, depending on market conditions and price levels.

Trade Confirmation: At this crucial stage, brokers formally confirm the trade execution with investors and agree on the specific details of the transaction, including the number of shares traded, the execution price per share, and any associated fees or commissions.

Clearing and Settlement: Clearinghouses play a vital role in ensuring a smooth trade completion. Settlement, the actual transfer of ownership of securities and their corresponding funds, typically occurs one or two business days after the trade date (referred to as T+1 or T+2).

Post-Trade Processing: The final stage involves reconciling trade details, reporting the transaction to regulatory authorities as needed, and maintaining accurate and valid records of trading activity.

What Is the Process of Equity Trading? 

Open a Demat account and a trading account: The first step is to create an Demat account and a trading account. These two accounts serve two different but essential purposes. The trading account is used to execute buy and sell orders, while the Demat trading account serves as an electronic repository for the stocks you own.

Consider Stock Prices: Stock prices are volatile and subject to multiple influencing factors. Before embarking on any investment activity, it’s essential to understand these factors to make informed decisions regarding when to enter and exit trades effectively.

Conduct comprehensive Stock Research: Fundamental analysis is a cornerstone of investing and trading, enabling you to assess a stock’s intrinsic value. When analyzing a company and its stocks, a range of factors should be considered, including its assets, net worth, liabilities, and historical financial performance.

Placing a Trading Order: After completing your company analysis, you must make an investment decision. Next, you must determine the type of trading order you will place: a buy order if you intend to purchase shares, or a sell order if you intend to sell your existing holdings.

After you place your order, the trading system will verify whether your specified order price matches the offers of other buyers or sellers in the market. If a match is found, the trade will be executed accordingly.

It’s important to realize that stock prices are subject to frequent fluctuations, which can negatively impact your trades. To mitigate these risks, you can use stop-loss orders. This type of order instructs the system to automatically exit your trade if the price reaches a pre-determined stop-loss price—the price at which you want to limit your potential losses.

Equities vs Stocks: What Is the Difference? 

In financial markets, the term “equities” is used as a formal and professional synonym for stocks and shares. While the terms “stocks” and “shares” are commonly used by individual investors in everyday dealings, the term “equities” is more commonly used among investment professionals and in academic discourse. Importantly, the use of the term “equities” helps distinguish ownership investments in companies from other asset classes such as bonds or real estate. This distinction is why phrases such as “equity markets” or “equity investments” are often used when referring to the broader category of investments based on ownership of company stock.

Factors Affecting the Cost of Equities 

Market Risk: Overall market risk, determined based on the expected return of the market, directly impacts equity prices. As the expected return of the market rises, the cost of stock for individual companies tends to rise as well.

Company’s Beta Profile: A company’s beta, which measures the volatility of its stock relative to the overall market, significantly impacts the cost of equity. A higher beta indicates that the stock is considered a riskier investment, perhaps due to a riskier business strategy or lower financial stability. Therefore, investors will demand a higher rate of return to compensate for this increased risk.

Dividend Policy: A company’s dividend policy may affect the cost of equity. Investors may accept a lower required return on their stock investment if the company is committed to paying large dividends or has a clear dividend policy. Similarly, a consistent dividend growth rate may lead investors to expect a lower cost of equity.

Interest Rates: Interest rates play a crucial role in determining the overall cost of capital, including the cost of equity. The cost of capital is typically higher when interest rates are increasing and lower when they are declining. This is because interest rates represent the opportunity cost of capital and affect the returns investors can earn from alternative investments.

Market Liquidity: The market liquidity of a company’s shares also affects the cost of equity. Investors may seek a lower return on their investments in companies with highly liquid shares. This is because high liquidity often means the ease of buying and selling shares without significant price impact, which is generally viewed as reducing investment risk.

Company Size: A company’s size affects its cost of equity. Smaller companies are often considered riskier compared to larger, more established companies. As a result, they often face higher equity costs to attract investors who demand greater compensation for the higher risks associated with investing in small companies.

Types of Equity Trades  

Traders use various methods to instruct the market to execute buy or sell orders for stocks. These instructions specify how and when the trade will be executed:

Market order: An order to buy or sell a security immediately at the best current market price. Market orders prioritize rapid execution, but the exact price at which the order will be executed is not guaranteed. The primary focus of a market order is on completing the trade, while price is a secondary consideration to the speed of execution.

Limit Order: A limit order is an order to buy or sell a security at a specified price or better. In a limit buy order, the order will only be executed at or below the specified price. In contrast, a limit sell order will be executed at or above the specified price. Unlike market orders, limit orders focus primarily on price. The transaction will not be completed if the security’s value falls below the price parameters defined in the limit order.

Stop Orders: These are conditional instructions placed by investors to automatically execute a trade when a predetermined price level is reached. Stop orders are primarily used for risk management and include the following types:

Stop-Loss Orders: These instructions activate a market order when the stock price reaches a specified level, known as the “stop price.” Their purpose is to limit potential losses or lock in current profits. Once the stop price is reached, the order is treated as a market order and executed at the best available price.

Stop-Limit Orders: These instructions activate a limit order when the stock price reaches a specified level (the “stop price”). Once the stop price is reached, the limit order is activated at the specified price (or better). This allows for greater control over the execution price than a stop-loss order. However, there is a possibility that the order will not be executed if the market price moves away from the specified limit price before the order can be filled.

Day Trading, Swing Trading, and Long-Term Investing 

Different trading strategies represent the various methods and approaches traders use to interact with the market, which are categorized according to specific time frames and techniques.

Swing Trading: This strategy relies on taking advantage of short- and medium-term fluctuations, or “swings,” in a stock’s price. Swing traders rely primarily on technical analysis to identify potential opportunities and accurately time their entry and exit from the market. They often use charting tools to detect and visualize these signals. Swing trading trades typically span a period ranging from a few days to several weeks.

Day Trading: This approach focuses on making small profits by executing numerous trades within a single trading day, with all positions closed before the end of the day. As the name suggests, day trading involves executing dozens of trades, often relying on meticulous technical analysis and sophisticated charting systems.

Long-term investing: This strategy focuses on acquiring assets with the expectation that their value will appreciate over several years. Long-term investments are generally defined as assets intended to be held for more than three years. Common investment instruments include cash, real estate, and stocks. Investors with a long-term investment horizon typically tolerate a significant level of risk in pursuit of potentially higher returns over time.

Common Equity Trading Strategies 

In addition to the broader trading strategies we discussed earlier, several other popular equity trading strategies can be applied:

Momentum Trading: A short-term strategy in which traders buy and sell financial assets based on prevailing price trends. The goal is to capitalize on upward or downward momentum until the trend shows signs of weakening. Traders actively react to market volatility by identifying buying opportunities during short-term uptrends and selling when securities lose their upward momentum. They then return to their cash positions in search of the next emerging uptrend or buying opportunity.

Value Investing: This strategy involves investors purchasing stocks that are considered undervalued or trading at prices lower than their intrinsic value. This strategy is based on the principle that investors should focus on buying companies rather than simply trading stocks, ignoring short-term market trends and price fluctuations. This practice involves purchasing stocks at low prices, with the expectation of making gains when the market price recovers to reflect their intrinsic value. This approach can be informally described as buying stocks when they are on sale, and focuses primarily on the financial health and prospects of the company the stock represents.

Growth Investing: A stock purchase strategy that targets companies expected to grow at a rate that exceeds the average growth rate of their respective industry or the broader market. Growth investors typically prefer smaller, younger companies with strong potential for future expansion and profitability. The primary focus of growth investing is to increase the investor’s capital through the appreciation of these high-growth stocks.

Risk Management in Equity Trading 

Risk management is an essential aspect of active trading and involves evaluating potential losses versus the profit opportunities of new positions in the financial markets. It helps prevent traders from holding unprofitable positions for extended periods and facilitates the identification, analysis, and control of risks related to capital and profits.

Advantages of Equity Trading 

Investing in equities is likely to generate higher returns compared to other investment avenues, especially when maintaining a long-term rather than short-term investment horizon.

Equities offer the potential for higher returns even during periods of inflation, thus acting as an effective hedge against the erosion of purchasing power.

Equities can provide a source of fixed income through dividends, which are a predetermined amount of money that a company distributes to its shareholders from its profits.

Investors have various direct and indirect ways to participate in the equity markets, including Initial Public Offerings (IPOs), shares, and mutual funds.

Future Trends in Equity Trading

Equity trading is undergoing a radical transformation, driven by rapid technological advancements that promise improved efficiency, speed, and data-driven insights. This evolution comes amid expanding and increasingly interconnected global markets, along with growing demand from institutional and individual investors for new financial instruments and assets, from swaps and active ETFs to cryptocurrency derivatives.

However, these developments are accompanied by significant challenges, including the seamless integration of legacy and new systems, the increased risk of cybersecurity breaches, and increased market volatility.

As these trends materialize, equity trading participants must stay well informed and demonstrate the flexibility necessary to effectively navigate the complexities of the future market environment. 

The financial services industry is currently witnessing significant advances in automation, algorithmic trading, artificial intelligence (AI), machine learning, blockchain technology, and cryptocurrencies. Automated trading strategies facilitate faster decision-making and reduce human error, while AI-powered tools have the ability to analyze vast data sets, recognize patterns, and generate predictions. Machine learning algorithms offer the potential to improve risk management protocols, optimize portfolio allocation, and enhance trade execution, with broader applications extending to loan underwriting, risk forecasting, and personalized customer service.

The proliferation of mobile trading applications and cloud platforms enables traders to access markets from anywhere, enabling them to make more informed and timely decisions.

Furthermore, the evolution of regulatory frameworks will be crucial in ensuring the ethical and safe use of modern technologies, maintaining the stability of financial markets, and protecting investor interests. Legislators are taking effective measures to strengthen oversight of systemic risks within the financial system by requiring financial institutions and their technology providers to enhance their operational resilience from a cybersecurity perspective. Legislation such as the European Union’s Digital Operational Resilience Act (DORA) embodies this increased focus.

Keeping up with these emerging trends and proactively adopting new technologies can give traders a significant competitive advantage in the ever-evolving trading landscape.

Which Type of Equity Trading is Considered Safe? 

Although equity trading inherently involves risk, there are strategies you can follow to reduce it. Here are some ways to help you reduce risk when trading stocks:

Use Stop-Loss Orders: As mentioned earlier, implementing a stop-loss order is an easy way to enhance trading security. This type of order automatically closes your trade once the price reaches a predetermined level. By setting this level, you can effectively control potential losses. If the price exceeds the specified level (either above for a sell stop or below for a buy stop), the order will be triggered to close your position.

Analyzing the stock’s historical performance: Another way to reduce potential risk is to focus on strong-performing stocks. Historical performance is an important indicator that warrants analysis when making investment decisions. Take this example: If ABC stock’s price has seen significant increases over time, this indicates strong demand and positive growth prospects. Conversely, a consistent decline in price over time indicates that the stock’s performance may not be as good.

Is Equity Trading Different from Trading on Equity? 

At this point, the concept of equity trading has become a general one. To reiterate, equity trading involves the buying and selling of stocks in financial markets.

In contrast, equity trading is a financial strategy followed by companies, involving borrowing funds through various means, such as debts, debentures, preferred shares, or loans, to purchase assets expected to generate increased revenue for the company.

This clearly demonstrates that, despite the similarity of the terms, equity trading and trading on equity represent two entirely different concepts within the realm of finance.

In conclusion, the ongoing evolution of technology and regulatory frameworks is reshaping the equity trading landscape, promising increased efficiency and accessibility, but also posing new challenges. Keeping abreast of these trends and adopting a disciplined approach to risk management is critical to success in this ever-evolving arena. Whether you’re a day trader capitalizing on short-term price movements or a long-term investor focused on sustainable growth, a solid foundation of equity trading principles is essential for navigating the complexities and harnessing the potential of the financial markets.

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