Online Trading Guide
As passively traded index funds grow in popularity, online trading is become ever more prevalent and important within the industry. Vanguard, an online brokerage that pioneered low cost index funds, has over $3 trillion in assets under management alone. As technology improves, trading becomes more efficient and cheaper, and more people have access to cost-effective, quality investments than ever before thanks to the prevalence of online trading.
Online trading is a broad term that encompasses trading several different securities across multiple types of accounts. The most basic account for trading is a brokerage account. Online brokerages will hold your money in an account until you decide to buy a security at which point they will use their trading software to match your buy order with another person’s sell order and execute the buy order for you. Conversely when you sell a security, the broker will execute the trade and put the money back into a holding account. A brokerage account is the bare bones basic account for trading. Below is a list of trading accounts with special privileges.
401K/403B – These accounts are offered by for profit and non-profit companies respectively. These accounts are employer sponsored retirement accounts. Employees designate a certain amount from their paychecks which go into the retirement account using pre-tax income. Many companies will match a percentage of an employee’s contributions into their account. The benefit of these types of accounts is that by using pre-tax dollars and having funds matched means investors can put more money into the investments they make, which will help compound returns. The companies then usually hire a service to manage their employees’ accounts. Typically employees are given some investing options, but it is up to the employees to really watch their investments to make sure they perform well and holdings do not become overly concentrated in a single asset. Due to the fact that these are retirement accounts, you will encounter a tax penalty if you withdraw funds before the age of 59.5 in addition to being taxed on the income from the account withdrawals. Withdrawals are taxed as regular income after the age of 59.5.
Traditional IRA – This type of online trading account has many similar attributes to a 401K/403B but is not employer sponsored. With an IRA account you can contribute a maximum of $5,500 annually if you are under 50, $6,500 if you are over 50, but you cannot contribute when you are 70.5 or older. Contributions are tax deductible in the year that they are made. At the age of 70.5 the IRS mandates you make a minimal withdrawal from your account every year which is taxable.
Roth IRA – This type of IRA differs from a traditional IRA in that contributions are not tax deductible in the year contributions are made, but can be withdrawn from an account tax free after the age of 59 1/2. With a Roth IRA account you can contribute $5,500 if you are under 50, $6,500 if you are over 50. There are limits for contribution amounts if a single person holding an account makes over $117,000, capping out at $133,000, while for a married account holder experiences limits that start at $184,000 and cap out at $194,000.
Asset Classes Available
Stocks – The stock market is a fascinating marketplace. Most stocks traded on exchanges represent buying and selling of ownership stakes in public companies, which is traditionally what is thought of when talking about the stock market. However, exchanges host stocks that represent far more than just ownership of a single company. Securities traded on stock market exchanges can be ownership in a fund that represents ownership in other asset classes such as bond funds, baskets of stocks, commodities, or a variety of other securities. Investors can access all of these securities with their online trading brokerage.
Bonds – While buying stocks is giving money for an ownership stake in a company, which can ebb and flow with the company’s performance, buying fixed-income (bonds) assets is the equivalent of issuing a loan to a company or government. Bonds are described as fixed-income because traditionally bonds are set up so that the initial purchaser of a bond buys that bond for a certain amount of money, and receives period interest payments typically quarter, annually or semi-annually (depending on the bond covenants) for the full amount of years the bond term is for. At the end of the bond term, the bond owner will receive the initial payment back in addition to the interest payment. While the structure is meant for a bond owner to retain ownership, bonds are openly traded on exchanges with supply and demand conditions driving prices just like in the stock market.
Mutual Funds – Once thought of as a safe buy and hold option, this is an actively managed diversified financial product that could mitigate volatility. Shareholders of a mutual fund invest their money in a mutual fund manager whose job was to diversify the entire portfolio of holdings in different asset classes such as stocks, bonds, and money market accounts in an effort to meet specific investing objectives outlined by the fund. There has been a recent outflow of funds from mutual funds, especially since many charge expensive management fees ranging between 1-2% while failing to outperform less expensive passively managed funds such as index funds.
Exchange Traded Funds (ETFs) – These are low cost funds designed to represent a basket of stocks. These stock baskets could be comprised of an industry group, sector, special interests like sustainability, or even entire indexes. These funds are low cost because they are essentially depend on computer software that rebalances holdings every day so that they roughly mimic the cumulative weighted performance of the securities they represent. Owing to their low cost and diversity, funds have been flowing into ETFs in the trillions of dollars in recent years.
Options – These are amongst the most complicated products online brokerages offer. Options are derivative products, meaning that they trade based on the performance of other assets such as commodities, stocks, indices, futures, and even bonds. Options are bought as contracts, which can be traded in active exchanges. They can be expensive, but can yield higher returns than investing in other asset classes. Options can be used as aggressively or conservatively as an investor wants, as long as the investor fully understands the options they are trading.
Online trading does carry risks similar to all types of investments, but can provide the tools for wealth creation as well as wealth preservation and income. Investing is a critical factor for long-term financial health. It is extremely important that people understand online trading and match with the right company to meet their investing needs and goals.
Learn about the different types of online trading accounts and how they meet your investing objectives. Read this guide and understand what determines the right online trade broker for you.