Saturday, April 16, 2011

The Basics of Stocks - Part II: Investing In Stocks

There are many ways to make an investment and receive a profit in the world. Some common investments include: trading goods or services for money, purchasing a plot of land to let its value appreciate, and investing in bonds and stocks. But how exactly can stocks be used to produce a profit, and more importantly, what are the steps to go about trading stocks if you are a beginner?

Let's refresh ourselves on what a stock is once more. Quite simply, a share of stock is a partial stake of ownership in the company that you are purchasing stock from. This partial ownership of the company can be used for voting for changes in the company, as well as for making a profit from the company's value. So where can you, the investor, find the stock and how can you purchase it?

The New York Stock Exchange (NYSE) pictured above, is a major stock exchange. However, you don't need to physically be at the exchange in order to trade stocks. Online brokerages allow for trading right from your living room!
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First, let's find out where you can find stocks to trade. Stocks are traded on a stock exchange, such as the NASDAQ and NYSE. A stock is traded only on one exchange. For instance, Citigroup (C) is traded on the NYSE--this means that the stock is not traded on the NASDAQ. It can only be found at the NYSE for trading. However, you don't have to physically go to the exchange in order to trade stocks. Since most stocks are traded through an online brokerage firm, you don't even need to leave your living room in order to trade stocks. What is the online brokerage firm? In layman's terms, the brokerage firm acts as the "middleman" between you and the exchange--just as a broker acts as a middleman for any transaction between a buyer and a seller. In return for the brokerage's service, you pay a commission for the transaction (this is called a commission fee and is usually around ~$10 USD for a single stock transaction for most online brokerages). Some popular online brokerage firms are: E*TRADE, Scottrade, and TD Ameritrade to name a few.

Now that we know where to trade stocks, let's take a look at the stock's properties. A stock has many properties--and I mean many properties--that are studied and constantly interpreted to make analysis tools in order to predict the stock's behavior. However, since we are only covering the basics of stocks, we will ignore these more intricate attributes and cover them later.

A stock--any stock--has three basic properties.

A stock symbol (also known as a ticker), is a unique identifier for the company associated with the stock.
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Firstly, a stock has a symbol (also called a ticker), which is used to represent the company in the exchange. A stock symbol is usually between one and four characters, but can be longer for certain cases. Some commonly traded stock symbols include: Google (GOOG), Citigroup (C), Amazon (AMZN), Apple (AAPL), International Business Machines (IBM). As you can see, the stock symbol is useful in condensing the name of the company.

Secondly, all stocks have a price. This price is determined by many things, but to put it simply, it is the investors (buyers and sellers) that determine the price of the stock by simply investing. The price of a stock can range from pennies a share (commonly called penny stocks) to hundreds--even thousands--of dollars for a share. The price of the stock is what follows after the stock symbol in nearly all brokerage firms and financial websites. The price that is shown on a ticker however, is usually ten minutes delayed from the actual price of the stock. However, real-time stock prices can be streamed at most brokerage firms. It is safe to say that the price of a stock is the single most important attribute of the stock.

The price of a stock is the most important attribute of a stock. It is important to note that the price of a stock can change over time, and in some cases, very rapidly. The price can be a double-edged sword for investors due to the potential for profit and loss.
Image Source: Google Finance

And finally, all stocks change in their price daily. Even though many may not consider this a property of stocks, I believe it is the single most important property of a stock. Why does the price of a stock change? As I mentioned earlier, the price of a stock is determined by the investors themselves. As the stock is bought and sold amidst investors, the stock price fluctuates accordingly. For example, if there are 100 investors for a single stock (assuming they all own the same amount of shares), and in a single day 60/100 of these traders decide to sell the stock while 40/100 traders decide to buy the stock, the stock price will fall as a net effect of more traders selling the stock than buying it. Not to delve too precisely into this, we just need to understand that the price of the stock is constantly changing due to this reason.

Now that we have understood the basic properties of a stock, how can we make a profit by investing in a stock? There are several ways to do this. The most common stock transactions are Buy, Sell, Short Sell, and Cover Short. For simplicity, I will only cover the Buy/Sell transaction in this post. Suppose that the stock you are looking to make a profit on is a hypothetical technology company. Furthermore, this technology company just released a new device that you believe will be very profitable and popular--a successful product. You predict that this company's value will increase as a consequence of this successful product. For this reason, you decide to buy the stock of this company today in anticipation for the price of the stock to rise in the future. Let's say you purchased 20 shares of stock at $50 a share for a total of $1000 in stock.

Investors can profit from many different trading strategies. In a "going long" strategy, investors can profit from an increase in stock price linked to the success of the underlying company.
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Fast forward six months down the road--and just as you predicted, the value of this company skyrocketed due to their product launch. And consequently, the price of the stock also rose in value to $85 a share. Remember those 20 shares of stock you purchased months ago? Right now, they are worth $1700 in total (20 x $85 a share = $1700). Realizing that you purchased the stock for $50 a share for a total of $1000 (20 x $50 a share = $1000), you decide to sell your 20 shares of stock for a profit of $700, since you initially purchased the stock for $1000 and now sold it for $1700.

This type of trading strategy is called "going long" since you are predicting that the price of the stock will rise due to the company's success. It is the most popular trading strategy--however it has its drawbacks. Suppose that instead of the product launch going successfully, the product flops and the company's value decreases. Consequently, the price of the stock dips to $35 a share. In fear of the stock price decreasing further, you decide to sell the stock to prevent further losses. Since the stock is now worth $700 (20 x $35 = $700), you made a net loss of $300 ($1000 - $700 = $300).

As a note, there are ways to prevent this type of loss by having a different stock transaction and/or a different trading strategy as well as a hedge against this transaction.

In summary, a stock is traded on a stock exchange and can be purchased via a brokerage firm. This brokerage firm will take a commission fee for the transaction, and you will own the stock. The three basic properties of the stock are its symbol, its price, and its change in price. And finally, a profit can be made by investing in the stock. There are many investment strategies--for a strategy in which you expect the value of the company to appreciate, you are "going long" on the stock. In such a trading strategy, if the price of the stock increases, you can profit by selling the stock and taking the difference between your initial purchase and your proceeds from the sell.


More posts to come on this subject!

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