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 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.  


Reading the Market



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 and News



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 FinanceCNN Money, and Wall Street Journal Market News.



Types of Orders



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.  









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.      



Mutual Funds 



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 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:




Stock Charts

Big Charts

American Association of Individual Investors




1 - 

2 - 

3 - FINRA Margin Information


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.











Regina Guinn CoolTrade Article

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