How Does Online Trading Work?
- For decades, personal investors placed orders to buy and sell stock through personal brokers. At many brokerages, the size of a customer's account often determined the level of personal service. In the late 1980s, a handful of innovative brokerages allowed their clients to trade stocks using dial-up services, like Prodigy or Compuserve. As the Internet blossomed in the 1990s, online trading services realized that they could eliminate the overhead of branch offices by expanding offerings direct to consumers.
Today, millions of households use online trading accounts to conveniently invest in the stock market. Users can log on to their accounts through secure web connections. Once online, users can review their current positions, investigate potential purchases, and execute trading orders. Many online trading websites link customer accounts to their traditional checking or savings accounts held at storefront banks. A growing number of online brokerages offer direct deposit and employee savings programs to make investing even easier.
Most brokerages actually set up new online trading customers with two accounts. The online trading investment account represents a customer's holdings in various stocks, bonds, funds, and other investment vehicles. Meanwhile, a "cash account" holds the deposits transferred in by new customers. It also serves as the holding account for the proceeds from stock sales and dividends. New customers fund their cash accounts by writing a check or transferring funds directly to the online trading provider. - Customers use funds from their cash accounts to buy new shares. Buying stocks on most online trading websites is often as easy as selecting a stock and entering the desired number of shares. Typically, more expensive online trading services execute orders within seconds, locking in a price advantage on rising share values. Less expensive online trading services may fulfill orders over the course of the business day, sometimes costing customers more for hot stocks.
Some online trading services allow customers to buy "on margin." This service works like a credit account, using a customer's other stock and cash holdings as collateral. The ease of placing margin buys using online trading services spawned a surge in day trading activity, since customers could easily buy and sell winning stocks without touching their savings or portfolios.
However, a losing trade can eat into a customer's other holdings. Should a customer's overall portfolio drop below a minimum level, a brokerage can issue a "margin call." During a margin call, an online trading service can automatically sell off a customer's other holdings to cover losses. Therefore, stock market experts advise new online trading customers to avoid buying stocks on margin until they have gained sufficient experience with their cash-backed positions. - Selling shares converts stock into cash, which is swept back to a customer's cash account within a few business days. Some online trading services allow customers to "dollar cost average" their buy and sell orders. This strategy splits a large buy or sell request into a series of smaller requests over days or weeks. Customers can use this technique to amortize the effects of wild market swings. Because online trading services charge a service fee for every trade, experts suggest minimizing the number of trades to get the maximum value from a portfolio.
Once funds have settled back to a customer's cash account, customers can purchase more stock or disburse their money. Some brokerages encourage customers to consolidate their personal finance activity by offering checking and ATM card services to cash accounts. Used responsibly, online trading accounts allow investors tremendous flexibility with their personal finance decisions.
