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Stocks, Stock Market and Investing Basics By Regina Guinn
What is a Stock and a Stock Exchange? If you think you don’t know enough about stocks
and the stock market to trade your own account, then you are not alone.
In this article, I will provide you, the individual investor, with the basic
concepts of how the stocks and the stock market work and how types of
securities investments vary. It is meant to cover investing basics
including stock trading and online trading.
To raise money, companies may issue shares of
stock. Stock shares represent
ownership of a company. You have certain rights as a shareholder.
They include the right to dividends that a stock may issue. Dividends are
earnings that a company may distribute to its shareholders, usually based on
a dollar amount per share and are considered a bonus to owning stocks.
Stocks are “publicly” traded when they are traded on the stock
exchanges. Publicly traded companies are subject to a host of
regulatory and accounting rules, governed by the Securities and Exchange
Commission (SEC), FINRA (Financial Industry Regulatory Authority), and the
Sarbanes-Oxley Act.
What is the stock market? The stock
market is composed of many “exchanges” where brokers and institutions buy and
sell (“trade”) stocks. There are dozens of stock exchanges around the
world. In the US, the most widely known are the New York Stock Exchange
(NYSE) and the National Association of Securities Dealers Automated
Quotation (NASDAQ). The NYSE is an actual building located on New
York’s Wall Street where “floor” brokers buy and
sell stocks on behalf of their firms’ clients. These are the folks in
the green jackets that you see on CNBC. NASDAQ, on the other hand, is a
“virtual” exchange, meaning that there is no building, but rather trading is
done electronically. There
are other exchanges such as the American Stock Exchange (AMEX), the
Philadelphia Stock Exchange (PHLX) and many small regional stock
exchanges. These are not to be confused with commodities (e.g., oil,
gas, corn, soybeans) exchanges, such as the Chicago Mercantile
Exchanges. Internationally, the major exchanges include the London,
Frankfurt, Hong Kong, Tokyo, Shanghai, Brazil, Mexico City, Toronto and
Vancouver. Bonds
Bonds are
essentially IOU's. They can be issued by companies and governments
(federal, state and local). Bonds are another way that companies and
governments raise money, but when an investor buys a bond s/he is lending the
issuer the money in return for interest payment(s). Bonds issued by
companies are rated for creditworthiness by the major credit rating agencies
such as Moody's and Standard and Poors. Bonds and notes issued by the
US Treasury are considered higher quality and are issued for 30 years, 10
years, and 5 years. Bills are issued for maturities of 1 year or
less. Federal agencies also issue notes and bonds and vary by their
maturity. Federally issued securities are desired for their federal tax
exempt status. Municipal bonds are usually tax free at the federal,
state and local levels. Bondholders rank higher than stockholders
in the case of a corporate bankruptcy reorganization. Bonds are generally not investments that have long term growth
prospects. Investing in
bonds, as in stocks, has risk. If you sell a bond before its maturity
date, you may receive less or more than what you paid for it, depending on
the current interest rates.
Options can be traded in a manner similar to the underlying stocks which they represent. An option gives the holder the right to buy or sell a stock at a particular price. Many investors like options because they provide more leverage than buying the stock itself. Options can pose a high risk and they are generally not suitable for novice investors.
Each exchange has its second by second profit
or loss expressed as an “index.” The index is typically a price
weighted average of a pre-set number of stocks. When people talk about
the “market” being up or down, they’re typically referring to the Dow Jones
Industrial Average (DJIA, Dow), which includes 30 “Blue Chip” stocks and is
one of many averages or indices. Other major US indices are the NASDAQ,
S&P 500 and S&P 100 (Standard and Poors 500 and 100), and Russell 2000 (small cap companies). Overseas,
they include the FTSE (pronounced “Foot-see” for Financial Times (of London)
Stock Exchange), Hang Seng (Hong Kong), Nikkei 225 (Tokyo) and Shanghai
Composite.
Stock ticker symbols are one to four character
symbols that uniquely represent each stock (e.g, T, GE, MMM). Symbols
with 1 - 3 characters trade on the NYSE. Symbols with 4 or more symbols
trade on NASDAQ (e.g., MSFT, INTC). Benefits and Risks
The benefits to being a shareholder include ownership of a company, the right to vote for the board of directors and on proposals, the potential for price appreciation, and the potential for additional income from dividends. Generally, people buy stocks for the profit potential-- they believe the price will go up at some point at which they will sell, and then make a profit. In terms of trading, this is called “Bullish” and when buying a stock, investors take a “long” position.
The risks of owning stock include the possibility that the price of the stock will drop and you will sell the stock for less than you paid for it. If a company goes bankrupt, shareholders' claims are subordinate to lenders and bondholders. That means if you own shares in a company that goes bankrupt and its shares become worthless or nearly worthless, you will not likely recoup any of your losses. Shares may decline for a number of reasons, including market forces, financial mismanagement, and fraud. As a shareholder, you are subject to all of these risks.
Traders who think the market will go down are
“Bearish.” These traders may “short” a stock to profit in a declining
market. Here are the basics of shorting: First, the trader must
borrow shares through his brokerage
firm. If the shares are available, he borrows them, then sells
them. If the price drops, he’ll place an order to buy them back at a
lower price, profiting the difference. The risk here is that if the
price goes up, he’ll eventually have to buy them back at a higher price.
Realized and Unrealized Profits (Gains) and Losses
An “unrealized” loss is when the value of your
stock drops, but you still own it. You only “realize” a loss when you
sell it for less than what you paid for it, meaning you lost real money, not
just its value on paper. For this reason, you will receive cautions
about panicking when the market is down and placing a sell order. You
only really lose money when you sell a stock that’s down. On the opposite side, you “realize” a gain when
you sell a stock for a profit. Just because your stock is up, doesn’t
mean it’ll stay up. You’ll need to decide if you want to “take a profit,”
meaning sell while it’s up to realize an actual gain.
Taxes also have an impact on your profit and
loss. In an Individual Retirement Account (IRA) or other retirement
account, such as a 401(k), you generally won’t pay
taxes on the gains in your account, but neither will you be allowed to deduct
any losses. In a taxable brokerage account, you’ll be
liable for short or long term gains, depending on how long you have owned the
stocks. You may be allowed to deduct some of your losses. There
is a yearly limit on this and you may be able to “carry over” losses to
future years. Consult
your tax advisor for specific information regarding tax treatment of stock
sales. How Do You Buy
Stocks?
Most individual investors purchase stocks through stock brokers. There are two types of "markets" for stocks: the primary market and the secondary market. The information below will help you learn stock trading.
The primary offering is when the stock is being
offered for the first time, by an underwriting group. It's also known
as an Initial Public Offering (IPO) and is usually offered by a single or
small group of investment banks. There are a limited number of shares
and not everyone who places an "indication of interest" will
receive the allotment they requested. The price isn't guaranteed, and
if it's a "hot" IPO, the price may be driven up
substantially. A large percentage of those who bought during the IPO
will try to "flip" it, or sell it right away for a large
profit. The secondary market is the exchanges, where the shares
are traded after the IPO.
Stock brokers come in many shapes and sizes
nowadays. Other terms for stock brokers include registered representatives,
financial consultants, and investment advisers. There are the
traditional "full commission" firms, such as Morgan Stanley, where
you work with just one broker.
They are known for their research and financial planning capabilities.
He or she should provide recommendations on what to buy and sell. These
brokers receive a percentage of the commission on what you buy or sell or a
percentage of the assets they manage for you. There are also
independent financial advisers who are not affiliated with large regional or
national firms.
With online brokers, you can place your order
directly online. The cost is usually much less, in the neighborhood of
$7 - $12 per typical stock trade of 100 shares. They usually offer
money market funds for uninvested cash. They may or may not have
research available; sometimes there is an extra charge for third party
research reports on stocks.
There are also discount online brokers,
typically with commissions of $1 - $5 per 100 share lot. They are
usually no frills, meaning that they may not offer a money market fund.
Their websites may not be as user friendly and phone calls may have a longer
wait time.
You can check on your broker or brokerage firm
by going to the FINRA BrokerCheck Website. For detailed information, read the How To Choose
A Broker article.
The stock market has a tendency to lead the
economy by 3 to 6 months. Remember, investors are trying to buy low and
sell high. In order to buy low, they need some kind of news that will
indicate that the stock will rise. Therefore, investors tend to follow
the news in the markets and economy overall and in particular, for the stocks
they own. This is especially important for beginner
investing.
On a daily basis, the stock market can be
sensitive to news. Some of the news releases that can sway the market
are interest rate announcements from the Federal Reserve ("The
Fed"), earnings on stocks on the Dow, and future guidance on
earnings. Steep increases or decreases in oil prices, jobless claims, and the unemployment rate will also generally move
the market. If there is no significant news for the day or it hasn't
been released yet, then the previous
sessions in overseas markets will tend to trend into the US market. If
Asian markets were down overnight and there is no significant news to affect
the US markets, then the US markets will likely open down also.
Consumer sentiment, consumer confidence,
pending home sales, new home sales, existing home sales, S&P Case-Shiller
Home Price Index, housing starts, ISM Manufacturing Index, and retail sales
may also move the market1.
There are many great sources of news related to
the market that will help you learn online stock trading including Yahoo Finance, CNN Money, and Wall Street Journal Market
News.
Market Order - The order is
to buy or sell at the earliest possible opportunity at the best available
price.
Limit Order - An order to
buy or sell at the specified price. Limit orders can be Day only or
Good Till Cancelled orders. Day Order - Good through the end of today's session. Good Till Cancelled (GTC) Order -
The order is good until cancelled (by whoever placed it) or 60 calendar days,
whichever comes first.
Pro - You can decide at what price you're willing to trade. Con - You're showing your "hand" (as in poker), so the
market makers can see your order and may decide to trade just outside of your
price if they want.
Stop Orders - These are done to try to
limit losses, so this type of order is sometimes informally called a
"stop loss" order. There are two types of Stops.
Stop
Limit Order - Trade the stock at this
specific price. If it's a fast market and you are looking to sell the
stock, it may trade below this price, in which case the order will not be
filled.
Stop
Order - Trade this stock at any
price if it goes below (if selling) this price.
Spread
The spread is the difference between the bid and the ask
prices. For heavily traded stocks, the spread is usually $.01.
Prices for stocks are now quoted and traded in dollars and cents. The
size of the order is usually in round lots of multiples of 100. An odd
lot would be 50 shares, for example. Some brokers
charge a higher commission for odd lots.
Bid - The current price to sell shares.
Offer/Ask
- The current price to buy shares.
This is essential "investing for
dummies" information. The more educated you are, the better chance
you have of making a profit. Margin is the ability to borrow against
the value of the stocks and/or cash in your account. The Federal
Reserve2 determines if a security is marginable (can be used for
collateral). You will be able to borrow a maximum of 50% of the
purchase price of a stock. Each brokerage firm can set more restrictive
policies. Most firms require $2000 or more to open a
margin account.
Pro - You can
leverage your purchase. As the price of the stocks you already own goes
up, you have more margin "buying power" available. If you buy
a stock on margin and the price goes up and you sell it for a profit, you
have only used a portion of your funds available. This leaves your
other funds available for additional investments.
Con - Once you have bought or sold stocks on margin and you have a margin balance, it's essentially money owed to the brokerage firm. If the value of your account goes down, either because the stocks' value has decreased or because you may have withdrawn cash, you will have less buying power available. If the value of the account falls below the minimum set by the broker or the Federal Reserve, you will be required to bring your account value up to the minimum by depositing additional cash and/or marginable securities.
If you can't
bring your account up to the minimum, your brokerage firm can liquidate your
positions (sell if your position is long or buy back if your position is
short). It is not required to notify you in advance, although most
firms will try to contact you. If your firm doesn't contact you, you
won't get to choose which securities to sell. Your position can be
liquidated at a loss and because of the leverage, you may lose more than you
deposit into the account. For most options accounts (except for buying covered calls), you will need a margin account. Short sales also require a margin account.
Fundamental and Technical Analysis
Analysts and investors generally use fundamental (aka
qualitative) or technical (quantitative) analysis to determine if a stock is
a good candidate to buy or sell short.
Fundamental analysis involves looking at the
financials of the company and its position within its sector and
industry. This includes reviewing all financial statements, especially
earnings, price to earnings (P/E) ratio, income, cash flow, sales, dividend
yield, debt and assets.
Technical analysis is the study of the price,
volume and momentum of a stock to predict future price movement. Most
traders use charts to identify trends (the trend is your friend), support and
resistance to make decisions. The indicators most frequently used
include price (opening, closing, high, low) simple moving average (SMA) (3,
5, 18, 50 and/or 200 day), exponential moving average (EMA), moving average
convergence-divergence (MACD), relative strength index (RSI), and volume.
A mutual fund is like a basket of different
investment types, including stocks, bonds, and cash. Essentially,
investors pool their money together into a common fund, run by a manager or
team of managers. The managers continually buy and sell securities with
the intent of making a profit and therefore charge a management fee for their
services. The theory is that if the fund has several different
investments, it will be somewhat diversified (at least among, say, many different
stocks), and therefore, less prone to loss. Mutual funds produce a
prospectus, which states how the fund will be run, the fees the investment
objective and the fund style. Investment objective examples include
capital preservation (ideally to lose no principal), growth, income, or
growth and income. Investment categories are large capitalization
(large companies), small cap, international, and global (excludes US).
Styles include growth and value (usually looking for stable dividend and
slight growth over time). Mutual funds can specialize in certain
sectors or industries such as healthcare, technology or real estate.
Diversification Diversification
can be across multiple stocks, different industries, different sectors and
different asset classes (e.g. stocks, bonds, cash) and different economies
(e.g., US, Japan, China). Other good Investing 101 sources include:
American Association of Individual Investors
Sources:
1 - http://www.bloomberg.com/markets/economic-calendar 2 - http://commodity.com/energy/oil/
Disclaimer – This article is not meant to
provide investment or tax advice. Significant risk is involved in
investing in securities. Copyright
2009. All rights reserved. No portion of this article can be
reproduced without specific written permission from the author. |
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