What are stocks?
Before you delve into the intricacies of the stock market, the first thing you should understand is what exactly a stock is. Stocks, which are also known as shares, are portions of companies that people can buy, and therefore own part of the company. But even though you may own a part of a company, only those who have invested a lot of money into the company have any real say in how the company is run.
There are two different types of shares: preferred shares and common shares. When you invest in common shares, there is a greater risk of losing part or even all of the investment that you have put into the company should the company stop functioning. Why is this? Because creditors, bond holders and preferred shared holders have a higher rank than the common shareholders, and because of this they will get the first chance to get some of the money they have put in if the company goes out of business.
By the same token, the investors who have preferred shares have a higher standing than the ones with common shares, but still have to get in line behind the creditors when it comes to how much of the company they own, or getting paid if the company goes out of business. In addition to having more of a say in the company decisions than those who have common shares, investors who have preferred shares can also look forward to higher dividends.
There are two ways to purchase stocks - investors can either use a brokerage, or buy their stocks through Direct Investment Plans or Dividend Reinvestment plans.
If you decide to purchase stocks through a brokerage, you can go one of two ways. If you are going to trust the experts to do the right thing, and leave it in their hands, then you should go with the services of a full service brokerage. But, if money is a consideration and you don't want to spend the money on a full service brokerage, you can go with a discount brokerage. Even though discount brokerages cost less than full service brokerages, they don't offer the same amount of assistance that the full service brokerages do.
If you decide to invest using a Direct Investment Plan or a Dividend Reinvestment Plan, check to make that the company that you are interested in investing in offers such plans because not all of the companies do.
History of the Stock Exchange
One of the biggest misconceptions is that the first stock exchange in America was the New York Stock Exchange. But those who think that this is true might be surprised to find out that the first stock exchange in America was actually in Philadelphia, PA, and it was founded in the year 1790. The very famous New York Stock Exchange was not founded until two years later, in 1792.
Another thing that you hear talk about with regards to the stock exchange is Wall Street. Sometimes people wonder how it got its name. That is actually a very interesting story. Back in 1653, a twelve foot stockade was built by the Dutch settlers to guard against British and Native American attacks. The sturdy wall stood for over 30 years, until 1685. At that time, the wall was torn down and a street was built in it's place - hence the name Wall Street.
The stock market has evolved greatly over the past few centuries. From its humble beginnings in Philadelphia, PA, to the New York Stock Exchange, which is known world wide, the stock market has grown in leaps and bounds. That's not to say that there haven't been problems. Most everyone has heard of the great stock market crash of 1929. There are now steps that the government has taken to prevent such a large crash from happening again, but that doesn't mean that the possibility still isn't there.
The stock market is a place where you can make a lot of money but you can also lose a lot of money as well. If you have decided that you want to try investing in the stock market, it's a good idea to do some research and get advice from people that you trust and who are already investing in the stock market. But be careful, because if you don't invest wisely you can lose a lot of money. Be wise with your investments and take the time to do your homework. This will help you to make the right decision when it comes to your investments.
Stocks vs. Bonds
So, in a simple example, if a company has a book value of $100,000 and they want to sell 100 shares, the shares might be considered worth $1000 each. In exchange for the share, a shareholder, also known as stock holder, would be entitled to a share of any net profits the company makes. Using our simple example, each share holder may get 1% of the net profit as a return on their investment. If the company makes no money, there would be no return on investment (ROI). In the event of a loss, the company might be worth only $90,000 and the shares might then sell for $900. This is an overly simplified view, but this is for illustration purposes only.
Using the same scenario, if that same company wanted to raise money, but not sell shares, they might sell bonds. Generally a bond is considered a loan to the company. (Bonds are also issued by municipalities, from local governments to federal governments.) This loan might be that the company will sell you a $1,000 bond for $800 and the bond would be worth $1,000 when it matures (in 8 to 10 years typically.) During the maturing, the company also agrees to pay a fixed amount every six months. The fixed amount usually is tied to the current interest rates, but does not have to be.
So what are the advantages and disadvantages of each of these? Unless a company goes bankrupt, you are guaranteed to have a return on investment with a bond. They are more stable, predictable and safer investments. They also aren’t usually giving you large returns. Another disadvantage is that they are not liquid, and you can pay a penalty for cashing them prior to their due date. Stocks, on the other hand, can give you greater returns, but carry a higher risk with no guarantees. They are more liquid, so if you need to get to your money more quickly, there are no consequences like penalties, just the standard fees involved for your transaction.
In other words, a bond is like the tortoise and a stock like a hare. Remember though, sometimes it is rabbit season, and your hare may be scalped.
Normal advice given to investors is to have more money in the higher risk stocks while you are younger and to gradually shift to the more conservative bonds as you get closer to retirement.
Stock Splits - Boon or Bust?
Another method used is known as shorting a stock AKA short selling. It is not a common practice especially for newer investors, but it is good to understand the concept. The first thing to understand is that you are not the official ‘owner’ of the stock that you are shorting, but you have the right to that stock at some future date at a pre-determined price.
The belief for someone shorting is that a particular stock will decrease in price. That is, in other words, that the price per share will be lower than it is today. I know this sounds confusing, but hopefully by the end of this article, you will have a handle on it. You are telling your broker that you are willing to buy the stock for a set price in the future. You then ‘borrow’ the shares and they are sold. Your responsibility to pay for them lies in the future.
This is more clearly explained by giving an example with some numbers thrown in. Check this out and then return to the first couple paragraphs, and you should have a pretty firm grasp.
You are short selling 100 shares of ABC Mills. Today’s price for ABC is $50. You research has indicated that the price will drop to $40 per share. Fast forward one year. ABC has dropped in price, but only to $45 per share. Because the initial price for the transaction was $5,000 and your shorted price for those shares is $4,500 you have made $500. You had contracted to buy those shares in advance, at whatever price they demanded. In this case, your short strategy worked out and you made some money. (Remember that brokerage fees still apply to this type of trade, so the $500 doesn’t take into account commissions, and certainly is pre-tax, as well – just a point to always keep in mind.) In the event that you shorted the same stock, under the same situation, and the price went up, you would end up paying the difference. So if the price actually rose to $55 in the same time frame, you would owe $500 to the owner of record.
A different way of making money when a stock price falls is called a put. This method is similar to a short, but a put gives the buyer the option to sell the stock for a fee. The buyer is not obligated to sell the stock, but does have the right to do it. Using the example above, if I would buy the PUT on those 100 shares, I would pay an agreed upon amount to the owner of the shares for the right to sell them at a later date. For this example, say I paid the owner $2 per share for the put option 1 year out. The price moved from $50 to $45 in the one year period. I could then choose to sell the stock at the $45 price and make $500 (minus the put cost of $200.) If the price went up, instead of down, I could decline my option, and I would lose the $200.
Short-Selling and Put options of stocks are definitely more advanced techniques and is not recommended for the beginning investor. If this interests you, you will want to get more education than this introduction has provided. I would not recommend shorting unless you are experienced in the market and have very strong reasons to believe a stock price is going to drop. A good book for further reading on this subject is “The Art of Short Selling” by Kathryn Staley.
Day Trading
For those who don’t know, day trading involves buying and selling stocks during an extremely short time frame, usually not holding them for more than a day, hence the name. To be successful you need to be able to read signs of impending moves in the market, jump in before the majority of people know what is moving and to jump out as the move begins to subside. It is similar to trying to ride a wave, you want to jump on just as the water is beginning to swell and jump off before the wave crashes. It takes nerves of steel and a sure hand to really make it as a day trader.
Most successful day traders have a section of the market that they become intimately familiar with. They probably don’t know the broad range of things going on, but in their area, they are bona fide experts. The ‘secret’ is working with stocks that have regular high volumes of trade (minimum 300,000 shares traded daily) so that lots of shares are trading hands on a regular basis. Situations like that mean that there can be large fluctuations in the price per share, and that is where the money can be made.
The formulas that are followed are usually very technically oriented and traders don’t have much interest in the long term value of any given stock. There is no interest in dividends or the health of the company, just what is going on right now and in the very near future. If a rumor is floating of a merge or a new technology that is usually enough to start a wave of interest in a company, and that will have day traders salivating.
In general day traders are dealing with a lot of currency. They are not small time operators, but usually have large amounts of money and are trading big blocks of stocks. Some of them deal with ‘penny stocks’ (stocks priced under $5 per share) but some also deal with higher priced stocks.
In any case, day traders understand (and wanna-be day traders need to understand) that the money used has to be money they can afford to lose. Occasionally, even for the most experienced day trader, deals can go south and pretty much the entire bankroll will be lost. This is where some people can get in trouble if they allow emotions to get too involved.
Another factor in day trading is having the discipline to know when to walk away. Kenny Rogers said, “you gotta know when to hold ‘em and know when to fold ‘em” and this applies to poker and to day trading. Discipline means having your strategy and not straying from it. Having a “feeling” and straying from your plan has cost many a man his livelihood.
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