Stock represents an equity investment. When you purchase stock in a corporation, you become a part-owner of that company, commonly referred to as a stockholder or shareholder. This ownership entitles you to a share of the company’s profits and, in some cases, voting rights on corporate decisions.
You invest in a stock with the expectation that its value will increase over time, or because you anticipate receiving dividend income, which is a portion of the corporation’s profits distributed to shareholders.
Many stocks offer both growth potential and dividend income. When a corporation initially issues stock, it benefits from the proceeds of that sale. However, once the stock is traded on the market, shares are bought and sold among investors, and the company does not receive any income from those subsequent trades.
Stock prices fluctuate based on supply and demand. When more shareholders want to sell than investors want to buy, the increased supply drives prices down. Conversely, when demand from buyers exceeds the number of shares available for sale, prices rise.
Common stock
Most stock issued in the U.S. is common stock, which gives shareholders the right to collect dividends if the company distributes them and the opportunity to sell shares for a profit if prices rise. However, stock prices fluctuate constantly, and shares can lose value, particularly in the short term. Some common stocks are highly volatile, experiencing rapid price swings.
Despite this risk, many investors are drawn to common stock because, historically, stocks as a whole — though not every individual stock — have delivered stronger returns, combining price growth and dividends, than other types of securities.
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Preferred stock
Some companies offer preferred stock in addition to common stock. Preferred stock, like common stock, trades on the secondary market but is listed and priced separately. One key difference is that preferred shareholders receive dividends before common stockholders, and in the event of the company’s failure, they have a higher claim on assets. Additionally, some preferred stocks come with the option to convert to common stock at a predetermined price, providing flexibility for shareholders.
THE RIGHT TO VOTE
As a stockholder, you have the right to participate in key decisions by voting on company policy proposals, shareholder proposals, and nominees to the board of directors. You can vote at the annual meeting, either in person or by proxy online, by phone, by mail, or by authorizing your broker or financial adviser to vote on your behalf.
Before the meeting, you’ll receive a proxy statement. This document provides essential information, including the company’s performance, compensation details of the top five executives, introductions of board nominees, and recommendations on how to vote on various proposals.
Preferred stock prices are generally less volatile than common stock prices, and dividends usually remain stable, even if the company’s earnings increase. This is why preferred shares are often considered hybrid investments, blending features of both fixed income (due to consistent dividends) and equity (because they represent ownership in a company).
Companies may also issue various classes of stock, which may be labeled and listed separately on stock exchanges. These classes could signify ownership in a particular division or subsidiary, or they might come with different market prices, dividend policies, voting rights, or restrictions on ownership and sales.
Stock splits
Consider a company’s stock trading at $100 per share. If the company announces a two-for-one stock split, each shareholder receives an additional share for every one they already own, while the price drops to $50 per share. For example, if you originally held 300 shares priced at $100 each, you would now have 600 shares valued at $50 each, but the total value remains unchanged at $30,000. A stock split is similar to exchanging a dollar bill for coins—the overall value is the same. However, the stock price may rise back toward the pre-split level, potentially increasing the value of your investment. Stock splits can take various forms, such as three-for-one, three-for-two, or even ten-for-one.
In a reverse stock split, a company consolidates shares, reducing the number of outstanding shares—such as exchanging ten shares for five—causing the price per share to rise accordingly. The typical goal of a reverse split is to increase the stock price to meet a stock exchange’s minimum listing requirements or to make the stock more appealing to institutional investors like mutual funds and pension funds, which often avoid very low-priced stocks.
BLUE CHIP
The term is borrowed from poker, where blue chips represent the highest value. In the stock market, blue chip stocks are those of the largest and most consistently profitable companies. While there isn’t an official list of blue chip stocks, the designation generally refers to well-established firms with a history of reliable performance. This list can change over time as companies’ fortunes and market conditions evolve.
Buying and selling stock
The process of buying and selling stocks involves specific rules, terminology, and a distinct group of participants. As an individual investor, often referred to as a retail investor, you conduct transactions through a brokerage firm where you maintain an account. The brokerage firm processes your orders, executes trades, and informs you once the transactions are complete.
When purchasing stocks, the cost is deducted from your account or transferred from your bank, and the new shares are added to your portfolio. Conversely, when selling, the shares are removed from your account, and the payment is credited. Most of these transactions, including the clearance and settlement processes that transfer ownership, are managed electronically. The price you pay or receive can vary based on the size of your order and market conditions.
Regulation NMS (National Market System) mandates that your brokerage firm strive for “best execution,” meaning they must send your order to the trading venue offering the best price or execute it at a better price, known as price improvement. Institutional investors, such as mutual funds, pension funds, hedge funds, insurance companies, and money managers, generally participate more actively in the stock market compared to individual investors.
CUSIP IDENTIFIERS
In the United States, every security is assigned a unique nine-character CUSIP identifier, which encodes both the issuer’s name and the specific issue. This system ensures clear communication of orders between broker-dealers, accurate and efficient handling of trades, and timely payment of dividends and interest to the correct owner. Unless there is a significant structural change to the issuer, the CUSIP for a security remains consistent throughout its time in the market.
Institutional investors trade more frequently and in larger volumes, typically executing transactions of at least 10,000 shares, and often even more. They collectively own about 70% of all publicly traded stocks in the U.S., with a higher concentration in the largest companies. As an individual investor, you might be affected by their decisions indirectly if you invest in stock mutual funds, which these institutions manage. Alternatively, if you have a managed account, your investments are directly influenced by the choices of an investment manager. Additionally, you might benefit from the impact of institutional investments on broader portfolios, such as through pension plans, life insurance policies, or university endowments that fund scholarships.
The stock market players
The brokerage firm where you maintain an account is known as a broker-dealer (BD). Most BDs, with a few exceptions, must register with the SEC by submitting Form BD to the Central Registration Depository (CRD). You can access information about the firm through FINRA or your state securities regulator.
A registered BD must be a member of both a self-regulatory organization (SRO) and the Securities Investor Protection Corporation (SIPC). SIPC provides insurance for customer accounts up to $500,000 in cases of bankruptcy or firm failures, although it does not cover investment losses. Brokers act as agents, buying and selling securities on behalf of clients. Some brokers cater exclusively to retail clients, others to institutional clients, and some serve both types of clients. Stockbrokers, officially known as registered representatives, must register with FINRA and pass a qualifying examination, typically the Series 7.
Assistant representatives who handle unsolicited buy and sell orders must also be licensed. Dealers, in contrast to brokers, act as principals, buying and selling securities for their own accounts rather than on behalf of clients. Dealers may regularly trade specific securities, a practice known as making a market. Registered traders, or competitive traders, buy and sell securities for their own portfolios. Certain employees involved in a firm’s securities trading operations are also referred to as traders.
Stock market orders
When trading stocks through a broker, you use various order types to manage how and when your trades are executed. Here are the four main order types:
- Market Order: This instructs your broker to buy or sell at the current market price. The main advantage is the immediate execution of your trade, but the downside is that you might end up paying more or receiving less than you anticipated if the price changes before your order is filled.
- Limit Order: This specifies a particular price, known as the limit price, at which you want to buy or sell. Your order will only be executed if the stock reaches this price, ensuring you don’t pay more or receive less than you desire. However, in a rapidly changing market, there’s a risk that the stock may never reach your limit price, leaving your order unfilled.
- Stop Order: This triggers a trade once the stock reaches a predetermined stop price. It’s commonly used to limit potential losses or lock in profits when the price is moving unfavorably. The risk is that once the stop price is hit, the order becomes a market order, and the actual execution price may be worse than expected.
- Stop-Limit Order: This combines elements of both stop and limit orders. It triggers a trade when the stock hits the stop price but ensures it’s only executed at or above a specified limit price. This type of order helps you avoid selling at too low a price but also risks the order not being filled if the stock price falls below your limit price.
Additionally, contingent orders like one-cancels-all (OCA) or one-triggers-all (OTA) are linked orders that only execute under certain market conditions, allowing for more complex trading strategies.
WHERE THE COMMISSION GOES
When you pay a commission to buy and sell stocks, it is typically split between your broker and the brokerage firm according to a prearranged contract. The brokerage firm sets the commission rates and any additional fees, but if you trade frequently and in large volumes, your broker might be able to negotiate a lower rate for you. Generally, there is more flexibility for negotiating commissions when the rates are higher.
INSTITUTIONAL ORDERS
Institutional investors utilize a wide variety of order types, significantly more than individual investors. The New York Stock Exchange (NYSE) offers 30 order types for its traditional exchange and over 50 on its electronic platform, NYSE Arca. Some of these order types are complex and not fully transparent, and there has been criticism that they may give certain investors an unfair advantage.
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