Stock Market Basics
Stock Market
Companies sell stock (pieces of ownership) to raise money and provide funding for the expansion and growth of the business. The business founders give up part of their ownership in exchange for this needed cash. The expectation is that even though the owners have surrendered a portion of the company to the public, their remaining share of stock will become increasingly valuable as the business grows.
Corporations are not allowed to sell shares of stock on the open market without the approval of the Securities and Exchange Commission (SEC).
Despite their popularity, however, most people don't fully understand stocks. Much is learned from conversations around the water cooler with others who also don't know what they're talking about. Stocks can (and do) create massive amounts of wealth, but they aren't without risks. The only solution to this is education. The key to protecting yourself in the stock market is to understand where you are putting your money.
Stock Exchanges
A stock exchange or securities exchange is a corporation or mutual organization which provides "trading" facilities for stock brokers and traders, to trade stocks and other securities. Stock exchanges also provide facilities for the issue and redemption of securities as well as other financial instruments and capital events including the payment of income and dividends.The securities traded on a stock exchange include: shares issued by companies, unit trusts and other pooled investment products and bonds. To be able to trade a security on a certain stock exchange, it has to be listed there. Usually there is a central location at least for recordkeeping, but trade is less and less linked to such a physical place, as modern markets are electronic networks, which gives them advantages of speed and cost of transactions. Trade on an exchange is by members only. The initial offering of stocks and bonds to investors is by definition done in the primary market and subsequent trading is done in the secondary market. A stock exchange is often the most important component of a stock market.
Supply and demand in stock markets is driven by various factors which, as in all free markets, affect the price of stocks. There is usually no compulsion to issue stock via the stock exchange itself, nor must stock be subsequently traded on the exchange. Such trading is said to be off exchange or over-the-counter. This is the usual way that bonds are traded. Increasingly, stock exchanges are part of a global market for securities.
Stocks
Corporations issue official-looking sheets of paper that represent ownership of the company. These are called stock certificates, and each certificate represents a set number of shares. The total number of shares will vary from one company to another, as each makes its own choice about how many pieces of ownership to divide the corporation into. One corporation may have only 2,500 shares, while another may issue over a billion shares such as IBM and Ford Motor Company.There are two different types of stock a corporation can issue: common and preferred stock. In addition, to give incentives to an investor to purchase ownership in a company, warrants are used.
Common Stock
Common stock is a form of corporation equity ownership represented in the securities. It is a stock whose dividends are based on market fluctuations. It is dangerous in comparison to preferred shares and some other investment options, in that in the event of bankruptcy, common stock investors receive their funds after preferred stock holders, bondholders, creditors, etc. On the other hand, common shares on average perform better than preferred shares or bonds over time.
Holders of common stock are able to influence the corporation through votes on establishing corporate objectives and policy, stock splits, and electing the company's board of directors. Some holders of common stock also receive preemptive rights, which enable them to retain their proportional ownership in a company should it issue another stock offering.
Additional benefits from common stock include earning dividends and capital appreciation.
Preferred Stock
Preferred stock, also called preferred shares or preference shares, is typically a 'higher ranking' stock than voting shares, and its terms are negotiated between the corporation and the investor.Preferred stock usually carries no voting rights, but may carry superior priority over common stock in the payment of dividends and upon liquidation. Preferred stock may carry a dividend that is paid out prior to any dividends being paid to common stock holders. Preferred stock may have a convertibility feature into common stock. Preferred stockholders will be paid out in assets before common stockholders and after debt holders in bankruptcy. Terms of the preferred stock are stated in a "Certificate of Designation".
Stock Warrants
In finance, a warrant is a security that entitles the holder to buy stock of the company that issued it at a specified price, which is usually higher than the stock price at time of issue.Warrants are frequently attached to bonds or preferred stock as a sweetener, allowing the issuer to pay lower interest rates or dividends. They can be used to enhance the yield of the bond, and make them more attractive to potential buyers. Warrants can also be used in private equity deals. For instance, it was a common practice during the height of the dot-com bubble for a landlord of sought-after commercial real-estate to demand warrants from high-tech startups as part of the lease agreement. Frequently, warrants are detachable, and can be sold independently of the bond or stocks.
Buying Stocks
You can buy shares of stock, bonds or mutual funds direct from a broker, or you can open an account with an online brokerage, paying by Paypal or credit card. You usually have to make a minimum initial deposit, and fill out forms with the brokerage to cover things like beneficiaries in case you die with your investments intact.You can still buy shares of stock like Grandpa and Grandma did, having actual stock certificates issued to you, and keeping them in a safe deposit box or maybe in the freezer for safekeeping. In this case, the stock is listed in your name, and the drawbacks are that you have to keep track of the papers yourself, and if you want to sell, you have to mail or take the papers to the correct place, which takes more time than it needs to. Most people leave the stocks listed under the brokerage, "held in street name". You can access your funds for trading with a phone call, and your stocks will be insured by the federal government in case your brokerage goes bankrupt or in case of fraud.
Buying shares of stock can be inexpensive—the going rate online is $7 a trade. Some stocks can be bought from the individual company, but you may prefer to invest in a mutual fund where there's no minimum purchase required after whatever it takes to initially open your account. You can and should learn to get the best price you can for a stock by limiting broker's fees, by not believing everything you read on the Internet and by using our valuation techniques to purchase the right companies. Don't believe a company's current image, which is controlled by publicists; believe what it has accomplished in the past. Don't believe the photo on the prospectus that shows happy, well-fed people laughing because the company's products have made them so happy. Believe the stocks section in the newspaper that shows the day's rise or fall in price; believe the history of a stock, which is based on facts.
Everyone hopes to buy a cheap stock which will then take off and make buckets of money, and sometimes that happens, but more often you buy a mid-priced stock which rises moderately year after year, eventually earning you a tidy sum. If you can't come to terms with the idea that your stock will rise and fall daily but that you need to keep it for years to really earn the profits, you may be more comfortable placing your money in bonds.
Bonds
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest (the coupon) and/or to repay the principal at a later date, termed maturity. It is a formal contract to repay borrowed money with interest at fixed intervals.A bond comes to maturity in a certain, predetermined period of time, and at that time, it's worth a predetermined amount of money. Bonds usually don't pay as much as the stock market earns because they are very low risk: you get what you pay for. For some people, watching stocks move up and down is a crazy-making experience; their stomachs go to pieces with worry. For these people, a nice, sturdy bond is a better investment.
Thus a bond is like a loan: the issuer is the borrower, the bond holder is the lender, and the coupon is the interest. Bonds provide the borrower with external funds to finance long-term investments, or, in the case of government bonds, to finance current expenditure.
Bonds and stocks are both securities, but the major difference between the two is that stock-holders are the owners of the company (i.e., they have an equity stake), whereas bond holders are lenders to the issuers. Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely. An exception is a consol bond, which is a perpetuity (i.e., bond with no maturity).
Bonds are issued by public authorities, credit institutions, companies and supranational institutions in the primary markets. The most common process of issuing bonds is through underwriting. In underwriting, one or more securities firms or banks, forming a syndicate, buy an entire issue of bonds from an issuer and re-sell them to investors. The security firm takes the risk of being unable to sell on the issue to end investors. However government bonds are instead typically auctioned.
Options
In finance an option is a contract between a buyer and a seller that gives the buyer the right — but not the obligation — to buy or to sell a particular asset (the underlying asset) at a later time at an agreed price. In return for granting the option, the seller collects a payment (the premium) from the buyer. A call option gives the buyer the right to buy the underlying asset; a put option gives the buyer of the option the right to sell the underlying asset. If the buyer chooses to exercise this right, the seller is obliged to sell or buy the asset at the agreed price. The buyer may choose not to exercise the right and let it expire. The underlying asset can be a piece of property, or shares of stock or some other security, such as, among others, a futures contract.For example, buying a call option provides the right to buy a specified quantity of a security at a set agreed amount, known as the 'strike price' at some time on or before expiration, while buying a put option provides the right to sell. Upon the option holder's choice to exercise the option, the party who sold, or wrote, the option must fulfill the terms of the contract.
The theoretical value of an option can be evaluated according to several models. These models, which are developed by quantitative analysts, attempt to predict how the value of the option will change in response to changing conditions. Hence, the risks associated with granting, owning, or trading options may be quantified and managed with a greater degree of precision, perhaps, than with some other investments.
Exchange-traded options form an important class of options which have standardized contract features and trade on public exchanges, facilitating trading among independent parties. Over-the-counter options are traded between private parties, often well-capitalized institutions that have negotiated separate trading and clearing arrangements with each other. Another important class of options, particularly in the U.S., are employee stock options, which are awarded by a company to their employees as a form of incentive compensation.
Other types of options exist in many financial contracts, for example real estate options are often used to assemble large parcels of land, and prepayment options are usually included in mortgage loans. However, many of the valuation and risk management principles apply across all financial options.