How to Trade Stocks - Types of Accounts and Major Players

Accounts

The most common type of investment account is a cash brokerage account. Put in the cash, trade whatever you want. You can also buy on margin: borrow up to 50% of the value of the securities from the broker. (More on margin later.)

There are accounts that let you defer taxes (IRA, 401(k). etc.) or save for a specific purpose (college, HSA - Health Saving Account, etc.), often with tax advantages. What you can hold in that type of account - mutual funds, stocks, bonds, CDs - is determined by the account provider.

Many advisors offer managed accounts where the money manager you select buys and sells securities for your account based on your profile.

Major Market Players

Institutions

Mutual funds, insurance companies, banks, pension funds, endowments, trusts, broker-dealers, etc., control 75% of all trading.

Every institution has a trading desk where money managers take their buy/sell orders. These may be for hundreds of thousands of shares at a time. An order of this size can move the stock price. So the job of institutional traders is to get the best possible price without disrupting the market (lowest price for buys, highest price for sells). When millions are on the line, every trick in the book will be deployed. Often at your expense.

Institutions also trade their own capital. These traders are very good and aggressive. Good - because they trade just a handful of stocks day in and day out. Aggressive - because they are under pressure to produce and because they are taking risks with OPM (Other People's Money). They trade against you. If they lose, they lose their bonus or job. If you lose, you lose your capital.

Specialists

Stocks that trade on NYSE are assigned to specialists. Each specialist is responsible for maintaining an orderly market in a handful of stocks assigned to him. That means two things:

Matching buy and sell orders for customers at the best possible price; and

Buying and selling for their own account when there is a trade imbalance. (The specialist takes the other side of the trade if there are no buyers or sellers.)

The advantage a specialist has is that he can see all the orders in his book and act to profit from it.

Market Makers (MMs)

The Nasdaq is not really an exchange: it's an electronic market place. Various broker-dealers choose to make a market in specific stocks. These traders are called market makers. They also match clients' orders and trade for their own account.

There is also a growing number of more specialized and/or sophisticated participants:

Hedge Funds

Unlike mutual funds, hedge funds are largely unregulated because they cater to "sophisticated" investors - institutions and the rich. Like mutual funds, they invest in stocks, bonds, and other financial instruments, but unlike mutual funds, they are not restricted by a stated investment objective, and can go from domestic large cap stocks to emerging market debt to oil, long and short. In addition to the annual fee, hedge funds charge a percentage of profits they generate, which explains their aggressive trading and dangerously high leverage.

Private Equity

As the name suggests, these funds invest in privately held companies that they buy outright and then take public a few years later. Their impact on daily trading is limited to an occasional buyout of a publicly traded company and an occasional IPO.

Venture Capital

These guys invest in startups which they eventually seek to IPO or sell to another publicly traded company to cash in their profit. VCs profit the most in a hot IPO market when they push half-baked deals out the door, as happened during the 1999 Internet bubble.