Turn on the TV news or open a newspaper, surf the internet or listen to the radio, and you will probably come across some information about the stock market: “The Dow Jonesclosed at record highs”; “The S&P 500 is trading down two-tenths of one percent”; “The stock market is reacting to news from Washington.” The stock market seems to be everywhere in our daily lives, but what exactly is the stock market? And, what are stocks that are bought and sold on this market? What does it mean for you, for your employer, or for your country’s economy when the stock market had “a good day”?
As the company continues to grow, however, there often comes a point where early investors become eager to sell their shares and monetize the profits of their early investments. At the same time, the company itself may need more investment than the small number of private investors can offer. At this point, the company considers an initial public offering, or IPO, transforming it from a private to a public company.
The answers to these questions are not always obvious once we begin to think about what stocks are. For example, you may have heard that owning stock means that you become an owner of that company. But what does that mean? As an "owner" can you rightfully walk into one of its offices and take home a chair or a desk? Can you hire and fire people? Of course, if you only own a small number of shares, you only “own” a small percentage of the company – but what if you own a majority of the shares, could you then take home a chair or fire workers?
In this tutorial, we will answer these questions and more, often going into some depth to explain core concepts. Once you’ve come to grasp these concepts and understand what makes the stock market tick, the hope is that you’ll become a smarter, more informed, and savvy investor. Even if you don’t have a brokerage account of your own and invest with your own money, you may very well be exposed to stocks via your 401(k) retirement account, pension plan, college savings plans, health savings plans, or insurance policies. Once a tool for the rich, the stock market has now turned into the vehicle of choice for growing wealth for many segments of the population. Advances in trading technology and low-cost stock brokerage services on the internet have opened up stock markets so that today nearly anybody can own stocks with the click of a mouse.
Before proceeding, however, it is important to distinguish between two common uses of the stock market: investing and speculation. Investing is when you hand over your money so that it is put to use for productive projects such as growth or expansion. Investing in a factory, in research and development, in a new business idea – these are all done with the expectation that in the future, the factory, the research, or the startup will be worth more than the original investment. That means you have a reason to believe the factory needs to be expanded, or that you understand broadly the type of research being done and what the payoff might be, or that you understand and believe in the business plan of the new venture. In other words, investing is a rational decision made with an eye to the future. When you invest, your money is intended to be put to work increasing value.
In this tutorial, we will answer these questions and more, often going into some depth to explain core concepts. Once you’ve come to grasp these concepts and understand what makes the stock market tick, the hope is that you’ll become a smarter, more informed, and savvy investor. Even if you don’t have a brokerage account of your own and invest with your own money, you may very well be exposed to stocks via your 401(k) retirement account, pension plan, college savings plans, health savings plans, or insurance policies. Once a tool for the rich, the stock market has now turned into the vehicle of choice for growing wealth for many segments of the population. Advances in trading technology and low-cost stock brokerage services on the internet have opened up stock markets so that today nearly anybody can own stocks with the click of a mouse.
Before proceeding, however, it is important to distinguish between two common uses of the stock market: investing and speculation. Investing is when you hand over your money so that it is put to use for productive projects such as growth or expansion. Investing in a factory, in research and development, in a new business idea – these are all done with the expectation that in the future, the factory, the research, or the startup will be worth more than the original investment. That means you have a reason to believe the factory needs to be expanded, or that you understand broadly the type of research being done and what the payoff might be, or that you understand and believe in the business plan of the new venture. In other words, investing is a rational decision made with an eye to the future. When you invest, your money is intended to be put to work increasing value.
Speculation, on the other hand, is akin to gambling. Speculators purchase something with the hope that they can soon sell it at a higher price, but without necessarily understanding – or even caring – about why the price should go up. Sometimes, speculators have a gut feeling, or are trading on rumor, but ultimately they do not concern themselves with the factory, the R&D, or the business plan. Speculation should not always be viewed as a bad thing, however; speculators add liquidity to markets, and many have done very well for themselves. At the same time, many smart investors have lost their fortunes in the stock market through speculation. The important distinction between investors and speculators is not a normative one, but rather that investors are generally more interested in the processes underlying prices; they are in it for the long haul, while speculators are more interested in the price itself, and with shorter time horizons for making money.
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2-what are stocks?
You have probably heard a popular definition of what a stock is: “A stock is a share in the ownership of a company. Stock represents a claim on the company's assets and earnings. As you acquire more stock, your ownership stake in the company becomes greater.” Unfortunately, this definition is incorrect in some key ways.
To start with, stock holders do not own corporations; they own shares issued by corporations. But corporations are a special type of organization because the law treats them as legal persons. In other words, corporations file taxes, can borrow, can own property, can be sued, etc. The idea that a corporation is a “person” means that the corporation owns its own assets. A corporate office full of chairs and tables belong to the corporation, and not to the shareholders.
To start with, stock holders do not own corporations; they own shares issued by corporations. But corporations are a special type of organization because the law treats them as legal persons. In other words, corporations file taxes, can borrow, can own property, can be sued, etc. The idea that a corporation is a “person” means that the corporation owns its own assets. A corporate office full of chairs and tables belong to the corporation, and not to the shareholders.
This distinction is important because corporate property is legally separated from the property of shareholders, which limits the liability of both the corporation and the shareholder. If the corporation goes bankrupt, a judge may order all of its assets sold – but your personal assets are not at risk. The court cannot even force you to sell your shares, although the value of your shares will have fallen drastically. Likewise, if a major shareholder goes bankrupt, she cannot sell the company’s assets to pay off her creditors.
What shareholders own are shares issued by the corporation; and the corporation owns the assets. So if you own 33% of the shares of a company, it is incorrect to assert that you own one-third of that company; it is instead correct to state that you own 100% of one-third of the company’s shares. Shareholders cannot do as they please with a corporation or its assets. A shareholder can’t walk out with a chair because the corporation owns that chair, not the shareholder. This is known as the “separation of ownership and control.”
So what good are shares, then, if they aren’t actually the ownership rights we think they are? Owning stock gives you the right to vote in shareholder meetings, receive dividends (which are the company’s profits) if and when they are distributed, and it gives you the right to sell your shares to somebody else.
What shareholders own are shares issued by the corporation; and the corporation owns the assets. So if you own 33% of the shares of a company, it is incorrect to assert that you own one-third of that company; it is instead correct to state that you own 100% of one-third of the company’s shares. Shareholders cannot do as they please with a corporation or its assets. A shareholder can’t walk out with a chair because the corporation owns that chair, not the shareholder. This is known as the “separation of ownership and control.”
So what good are shares, then, if they aren’t actually the ownership rights we think they are? Owning stock gives you the right to vote in shareholder meetings, receive dividends (which are the company’s profits) if and when they are distributed, and it gives you the right to sell your shares to somebody else.
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If you own a majority of shares, your voting power increases so that you can indirectly control the direction of a company by appointing its board of directors. This becomes most apparent when one company buys another: the acquiring company doesn’t go around buying up the building, the chairs, the employees; it buys up all the shares. The board of directors is responsible for increasing the value of the corporation, and often does so by hiring professional managers, or officers, such as the Chief Executive Officer, or CEO.
For ordinary shareholders, not being able to manage the company isn't such a big deal. The importance of being a shareholder is that you are entitled to a portion of the company's profits, which, as we will see, is the foundation of a stock’s value. The more shares you own, the larger the portion of the profits you get. Many stocks, however, do not pay out dividends, and instead reinvest profits back into growing the company. These retained earnings, however, are still reflected in the value of a stock.
Stocks – sometimes referred to as equity or equities – are issued by companies to raise capital in order to grow the business or undertake new projects. There are important distinctions between whether somebody buys shares directly from the company when it issues them (in the primary market) or from another shareholder (on the secondary market). When the corporation issues shares, it does so in return for money.
Companies can instead raise money through borrowing, either directly as a loan from a bank, or by issuing debt, known as bonds. Bonds are fundamentally different from stocks in a number of ways. First, bondholders are creditors to the corporation, and are entitled to interest as well as repayment of principal. Creditors are given legal priority over other stakeholders in the event of a bankruptcy and will be made whole first if a company is forced to sell assets in order to repay them. Shareholders, on the other hand, are last in line and often receive nothing, or mere pennies on the dollar, in the event of bankruptcy. This implies that stocks are inherently riskier investments that bonds.
The same is true on the upside: bondholders are only entitled to receive the return given by the interest rate agreed upon by the bond, while shareholders can enjoy returns generated by increasing profits, theoretically to infinity. The greater risk attributed to stocks has generally been rewarded by the market. Stocks have historically returned around 8-10% annualized, while bonds return 5-7%.
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3-Different types of stocks?
When a company is first founded, the only shareholders are the co-founders and early investors. For example, if a startup has two founders and one investor, each may own one-third of the company’s shares. As the company grows and needs more capital to expand, it may issue more of its shares to other investors, so that the original founders may end up with a substantially lower percentage of shares than they started with. During this stage, the company and its shares are considered private. In most cases, private shares are not easily exchanged, and the number of shareholders is typically small.
As the company continues to grow, however, there often comes a point where early investors become eager to sell their shares and monetize the profits of their early investments. At the same time, the company itself may need more investment than the small number of private investors can offer. At this point, the company considers an initial public offering, or IPO, transforming it from a private to a public company.
Aside from the private/public distinction, there are two types of stock that companies can issue: common stock and preferred shares
Common Stock:-
When people talk about stocks they are usually referring to common stock. In fact, the great majority of stock is issued is in this form. Common shares represent a claim on profits (dividends) and confer voting rights. Investors most often get one vote per share-owned to elect board members who oversee the major decisions made by management.
Over the long term, common stock, by means of capital growth, has tended to yield higher returns than corporate bonds. This higher return comes at a cost, however, since common stocks entail the most risk including the potential to lose the entire amount invested if a company goes out of business. If a company goes bankrupt and liquidates, the common shareholders will not receive money until the creditors, bondholders and preferred shareholders are paid.
Preferred Stock :-
Preferred stock functions similarly to bonds, and usually doesn't come with the voting rights (this may vary depending on the company, but in many cases preferred shareholders do not have any voting rights). With preferred shares, investors are usually guaranteed a fixed dividend in perpetuity. This is different from common stock which has variable dividends that are declared by the board of directors and never guaranteed. In fact, many companies do not pay out dividends to common stock at all
Another advantage is that in the event of liquidation, preferred shareholders are paid off before the common shareholder (but still after debt holders and other creditors). Preferred stock may also be “callable,” meaning that the company has the option to re-purchase the shares from preferred shareholders at any time for any reason (usually for a premium). An intuitive way to think of these kinds of shares is to see them as being somewhat in between bonds and common shares.
Common and preferred are the two main forms of stock; however, it's also possible for companies to customize different classes of stock to fit the needs of their investors. The most common reason for creating share classes is for the company to keep voting power concentrated with a certain group. Therefore, different classes of shares are given different voting rights. For example, one class of shares would be held by a select group who are given perhaps ten votes per share while a second class would be issued to the majority of investors who are given just one vote per share. When there is more than one class of stock, the classes are traditionally designated as Class A and Class B, etc.. For example, billionaire Warren Buffett’s company Berkshire Hathaway has two classes of stock, represented by placing the letter behind the ticker symbol in a form like this: "BRKa, BRKb" or "BRK.A, BRK.B".
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4-How stocks trade?
:- We saw in the last section that once a company completes an initial public offering (IPO), its shares become public and can be traded on a stock market. Stock markets are venues where buyers and sellers of shares meet and decide on a price to trade. Some exchanges are physical locations where transactions are carried out on a trading floor, but increasingly the stock exchanges are virtual, composed of networks of computers where trades are made and recorded electronically.
Stock markets are secondary markets, where existing owners of shares can transact with potential buyers. It is important to understand that the corporations listed on stock markets do not buy and sell their own shares on a regular basis (companies may engage in stock buybacks or issue new shares, but these are not day-to-day operations and often occur outside of the framework of an exchange). So when you buy a share of stock on the stock market, you are not buying it from the company, you are buying it from some other existing shareholder. Likewise, when you sell your shares, you do not sell them back to the company – rather you sell them to some other investor.
The first stock markets appeared in Europe in the 16th and 17th centuries, mainly in port cities or trading hubs such as Antwerp, Amsterdam, and London. These early stock exchanges, however, were more akin to bond exchanges as the small number of companies did not issue equity. In fact, most early corporations were considered semi-public organizations since they had to be chartered by their government in order to conduct business.
In the late 18th century, stock markets began appearing in America, notably the New York Stock Exchange (NYSE), which allowed for equity shares to trade (the honor of the first stock exchange in America goes to the Philadelphia Stock Exchange [PHLX], which still exists today). The NYSE was founded in 1792 with the signing of the Buttonwood Agreement by 24 New York City stockbrokers and merchants. Prior to this official incorporation, traders and brokers would meet unofficially under a buttonwood tree on Wall Street to buy and sell shares.
The advent of modern stock markets ushered in an age of regulation and professionalization that now ensures buyers and sellers of shares can trust that their transactions will go through at fair prices and within a reasonable period of time. Today, there are many stock exchanges in the U.S. and throughout the world, many of which are linked together electronically. This in turn means markets are more efficient and more liquid.
There also exists a number of loosely regulated over-the-counter exchanges, sometimes known as bulletin boards, that go by the acronym OTCBB. OTCBB shares tend to be more risky since they list companies that fail to meet the more strict listing criteria of bigger exchanges. For example, larger exchanges may require that a company has been in operation for a certain amount of time before being listed, and that it meets certain conditions regarding company value and profitability. In most developed
countries, stock exchanges are self-regulatory organizations (SROs), non-governmental organizations that have the power to create and enforce industry regulations and standards. The priority for stock exchanges is to protect investors through the establishment of rules that promote ethics and equality. Examples of such SRO’s in the U.S. include individual stock exchanges, as well as the National Association of Securities Dealers (NASD) and the Financial Industry Regulatory Authority (FINRA).
The prices of shares on a stock market can be set in a number of ways, but most the most common way is through an auction process where buyers and sellers place bids and offers to buy or sell. A bid is the price at which somebody wishes to buy, and an offer (or ask) is the price at which somebody wishes to sell. When the bid and ask coincide, a trade is made.
Some stock markets rely on professional traders to maintain continuous bids and offers since a motivated buyer or seller may not find each other at any given moment. These are known as specialists or market makers. A two-sided market consists of the bid and the offer, and the spread is the difference in price between the bid and the offer. The more narrow the price spread and the larger size of the bids and offers (the amount of shares on each side), the greater the liquidity of the stock. Moreover, if there are many buyers and sellers at sequentially higher and lower prices, the market is said to have good depth. Stock markets of high quality generally tend to have small bid-ask spreads, high liquidity, and good depth. Likewise, individual stocks of high quality, large companies tend to have the same characteristics.
Some stock markets rely on professional traders to maintain continuous bids and offers since a motivated buyer or seller may not find each other at any given moment. These are known as specialists or market makers. A two-sided market consists of the bid and the offer, and the spread is the difference in price between the bid and the offer. The more narrow the price spread and the larger size of the bids and offers (the amount of shares on each side), the greater the liquidity of the stock. Moreover, if there are many buyers and sellers at sequentially higher and lower prices, the market is said to have good depth. Stock markets of high quality generally tend to have small bid-ask spreads, high liquidity, and good depth. Likewise, individual stocks of high quality, large companies tend to have the same characteristics.
In addition to individual stocks, many investors are concerned with stock indices (also called indexes). Indices represent aggregated prices of a number of different stocks, and the movement of an index is the net effect of the movements of each individual component. When people talk about the stock market, they often are actually referring to one of the major indices such as the Dow Jones Industrial Average (DJIA) or the S&P 500.
The DJIA is a price-weighted index of 30 large American corporations. Because of its weighting scheme and that it only consists of 30 stocks – when there are many thousand to choose from – it is not really a good indicator of how the stock market is doing. The S&P 500 is a market cap-weighted index of the 500 largest companies in the U.S., and is a much more valid indicator. Indices can be broad such as the Dow Jones or S&P 500, or they can be specific to a certain industry or market sector. Investors can trade indices indirectly via futures markets, or via exchange traded funds (ETFs), which trade like stocks on stock exchanges. (See also: Opinion: Dow 20,000 Is Stupid.)
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5-Trading stocks and order type :-
In this section, we discuss the practical matter of going about buying and selling shares of stock. Individuals typically buy and sell shares by using a licensed brokerage firm or broker who makes the actual trade. Historically, stockbrokers were hired only by wealthy individuals and families, but today a wide range of stock brokerages exist for all price ranges. So-called “full-service” brokers offer a suite of research, opinion, and expert advice and can offer a personal relationship between the broker and the client. For more budget conscious clients, discount brokerages exist that offer a much more bare-bones service offering, in some cases simply executing purchases and sales. Over the past two decades, electronic trading has grown significantly, with many online brokerages offering both research and opinion as well as trades at low prices, some asking as little as $5 or less per trade in commission. (See also: How To Choose Your First Stock Broker.)
Regardless of the type of brokerage used, the mechanics of buying or selling shares is fairly uniform. First, a stock quote is obtained. In the early days of stock exchanges, price information was transmitted via tickertape – a long ribbon of paper that printed basic data via telegraph wire. That is why today we still refer to stock quotes as the ticker.
A stock quote carries a lot of information including the current bid and offer (sometimes called the ask) prices as well as the last price that traded. The bid is the highest price that somebody in the market is willing to pay at a given time, while the offer is the lowest price that somebody is willing to sell. If you are interested in buying shares, you will make a bid, and if you want to sell an offer. When the price of a bid and offer coincide, a trade is effected.
In addition to this price information, data on trading volume (number of shares traded) is often included. Stock quotes obtained online are often real-time quotes that confer second-by-second details, and online quotes also often include charts and interactive tools. Stocks are quoted by their ticker symbol, represented by between one and four capital letters, which are often loosely representative of the company name. For example the ticker symbol for Microsoft Corp. is MSFT, Caterpillar Inc. is CAT, and Apple Inc. is AAPL.
Market Orders and Limit Orders:-
Next, the type of trade has to be determined. A market order is simply an order that instructs the broker (or online trading platform) to buy or sell shares at the best available price. If you wanted to buy 100 shares of AAPL at market, and the quote shows: Bid: $139.80 (100), Offer: $140.00 (50), Last: $139.95 (250). This tells us that the last trade was 250 shares at $139.50 and it indicates 50 shares are offered at $140.00. Suppose another 200 are offered at $140.05. Your market order would buy the 50 shares at $140.00 and then purchase 50 more at the next best price at $140.05.
A market order does not guarantee the price you will get, but it does guarantee that you will get the number of shares that you want, in this case 100. When an order is completed, it is said to be filled. A market order is most often used in cases where the buyer or seller is most concerned with filling the size of the order and not concerned with the price. A limit order specifies the price at which you want to trade. For example, you may specify that you want to buy AAPL for $140.00 but no more, in which case you would buy the 50 shares offered at $140.00 and then wait for some other seller to come down to your price. Until that happens, the new quote would be Bid: $140.00 (50), Offer: $140.05 (200), Last: $140.00 (50)
A limit order can also be designated all-or-none (AON), meaning that you won’t agree to buy your shares unless you can get all 100 that you want. If the original limit order in this example were AON, you would not buy the 50 that are offered until another 50 came along. Limit orders are used by those who are primarily concerned with the price they want to receive, but they are not guaranteed that the size of their order will be filled. Price versus getting filled on the size of your order are the primary trade-offs between market and limit orders.
Stop Orders:-
Stop orders are contingent on a certain price level being attained to activate the trade. With a stop order, your trade will be executed only when the security you want to buy or sell reaches a particular price (the stop price). Once the stock has reached this price, a stop order essentially becomes a market order and is filled. For instance, if you own stock ABC, which currently trades at $20, and you place a stop order to sell it at $15, your order will only be filled once stock ABC drops below $15. Also known as a stop-loss order, this allows you to limit your losses.
This type of order can also be used to guarantee profits. For example, assume that you bought stock XYZ at $10 per share and now the stock is trading at $20 per share. Placing a stop order at $15 will guarantee profits of approximately $5 per share, depending on how quickly the market order can be filled. Stop orders are particularly advantageous to investors who are unable to monitor their stocks for a period of time, and brokerages may even set these stop orders for no charge.
One disadvantage of the stop order is that the order is not guaranteed to be filled at the preferred price the investor states. Once the stop order has been triggered, it turns into a market order, which is filled at the best possible price. This price may be lower than the price specified by the stop order. Moreover, investors must be conscientious about where they set a stop order. It may be unfavorable if it is activated by a short-term fluctuation in the stock's price. For example, if stock ABC is relatively volatile and fluctuates by 15% on a weekly basis, a stop-loss set at 10% below the current price may result in the order being triggered at an inopportune or premature time
Other Kinds of Orders:-
Orders may also be tagged with instructions regarding how long an order is good for. An immediate-or-cancel (IOC) order is cancelled if the order isn’t executed right away. This is typically used in conjunction with a limit order. When an IOC order is combined with an AON order, it is designated fill-or-kill (FOK). A day order is a limit or stop order that is cancelled at the end of the trading day, and will not be active the next morning. A good-til-canceled (GTC) order is active until the instruction is given to cancel it, and may remain active for many days at a time or longer.
Margin Trading and Short Selling:-
In addition to the mechanics described above, many brokerages offer margin trading, allowing their customers to borrow money to buy shares in excess of the amount of cash in their account. Margin also allows for short selling, which is where a market participant borrows shares they do not own in order to sell them with the hope of buying them back in the future at a lower price. A short seller is betting that the price of a stock will go down, rather than up.
Let’s recap some of the main points we’ve learned in this tutorial:
- • >Stocks are claims to a company’s profit stream and are granted voting rights in installing its board of directors or in approving large corporate actions such as being acquired. Shareholders are not owners of a corporation’s assets and do not involve themselves with corporate management.
- Stock is equity, bonds are debt. Bondholders are guaranteed a return on their investment and have a higher claim in recovery from a bankruptcy than shareholders. This is generally why stocks are considered riskier investments and require a higher expected rate of return.
- You can lose all of your investment with stocks. The flip-side of this is you can make a lot of money if you invest in the right company.
- The two main types of stock are common and preferred. It is also possible for a company to create different classes of stock.
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