Stock is an equity investment. If you buy stock in a corporation, you own a small part of that corporation and are described as a stockholder or shareholder.
You buy a stock because you expect it to increase in value. Or because you expect the corporation to pay you dividend income, or a portion of its profits.
In fact, many stocks provide both growth and income. When a corporation issues stock, the company receives the proceeds from that initial sale. After that, shares of the stock are traded, or bought and sold among investors, but the corporation gets no income from those trades.
The price of the stock moves up or down depending on supply and demand — or how many shareholders want to sell and how eager investors are to buy. Increased supply drives prices down. Increased demand drives prices up.
Most stock issued in the United States is common stock. Owning it entitles you to collect dividends if the company pays them, and you can sell shares at a profit if the price increases. But stock prices change all the time, so your shares could lose value, especially in the short term. Some common stocks are volatile, which means their prices may increase or decrease rapidly.
Despite the risk, investors have been willing to buy common stock because over time stocks in general — though not each individual stock — have provided stronger returns, or price increases plus dividends, than other securities.
Some companies issue preferred stock in addition to common stock. These equity investments, which also trade in the secondary market, are listed separately from the company’s common stock and trade at a different price. Preferred stock dividends are paid before common stock dividends, and preferred shareholders are more likely to recover some of their investment if the company fails. And, in some cases, preferred stock can be converted to common stock at a preset price.
The prices of preferred stock tend to change less than the prices of common stock over time, and the dividends typically aren’t increased if the company’s earnings increase. These characteristics help explain why preferred shares are sometimes described as hybrid investments—a combination of fixed income and equity.
CLASSES OF STOCK
Companies may issue different classes of stock, label them differently and list them separately on a stock market. Sometimes a class indicates ownership in a specific division or subsidiary of the company. Other times it indicates shares that sell at different market prices, have different dividend policies, provide greater voting rights, or impose sales restrictions on ownership.
In a reverse split a corporation exchanges more shares for fewer — say ten shares for five — and the price increases accordingly. Typically the motive is to boost the price so that it meets a stock market’s minimum listing requirement or makes the stock attractive to institutional investors, including mutual funds and pension funds, which may not buy very low priced stocks.
Buying and selling stock
The process of buying and selling stock has its own rules, its own language, and a special cast of characters. As an individual investor — sometimes called a retail investor — you buy and sell stocks for your portfolio through a brokerage firm where you have an account. The firm sends, or routes, your orders for execution, and reports back to you when the trade has been completed.
If you’re buying, the purchase price is debited from your account—or you transfer payment from your bank—and your new shares are credited. If you’re selling, the reverse occurs. The shares are debited and payment is credited. The transaction and the clearance and settlement process that transfers ownership are, almost always, handled electronically. The price you pay or receive depends on the size of your order and the activity in the market.
Regulation NMS — for National Market System — requires your firm to seek what’s called best execution by sending your order to the trading site with the best price or executing it at a higher price, known as price improvement. Institutional investors, including mutual funds, pension funds, hedge funds, insurance companies, and money managers, are more active in the stock market than individual investors.
They trade more often and in greater volume, typically a minimum of 10,000 shares in one transaction and often more. Together, these investors hold about 70% of all publicly traded US stocks, and a higher percentage in the biggest companies. You may have a stake in the investment decisions these institutions make indirectly in the case of stock mutual funds you own—or directly in the case of managed accounts, where you own shares an investment manager has chosen. Or you may benefit from the value that stocks add to institutional portfolios — for example, if you have a pension or life insurance policy or if you receive an academic scholarship from a university endowment.
The stock market players
The brokerage firm where you have an account is known as a broker-dealer (BD). BDs—with a few exceptions— must register with the SEC by completing Form BD, which is filed with the Central Registration Depository (CRD). You have access to the information the firm provides through FINRA or your state securities regulator.
A registered BD must be a member of a self-regulatory organization (SRO) and the Securities Investor Protection Corporation (SIPC). SIPC insures a firm’s customer accounts up to $500,000 in the event of bankruptcy or other firm failures, though not for investment losses. Brokers act as agents, buying and selling securities for the firm’s clients. Some brokers have only retail clients, some have only institutional, and some work with both. Stockbrokers — officially known as registered representatives — must register with FINRA and pass a qualifying examination, typically a Series 7.
Assistant representatives who take unsolicited buy and sell orders must also be licensed. Dealers act as principals rather than agents, buying and selling securities for the firm’s account rather than on a client’s behalf. Among other things, dealers may regularly buy and sell a particular security or securities, which is called making a market in the security. In contrast, registered traders, also called competitive traders, buy and sell securities for their own portfolios. Certain employees who handle a firm’s securities trading are also known as traders.
Stock market orders
- A market order instructs your broker to buy or sell at the current price, whatever that is at the time the order is executed. The risk, of course, is that you will pay more or receive less than you expect.
- A limit order means the trade should occur at a specific price, called the limit price, which is higher or lower than the current price. This lets you choose the point at which you believe the trade is appropriately priced. So, you won’t pay more or receive less than you wish. The risk is that in a fast market, where prices change quickly, your order may never be acted on.
- A stop order means the trade will take place when the stock hits the stop price. You typically use stop orders to limit potential losses or protect profits, in both cases when the current price seems likely to fall. The risk is that a stop order becomes a market order when the stop price is reached, and the actual sales price could be less than you hoped.
- A combined stop-limit order tells your broker to sell when the stock hits the stop price but not for less than the limit price. Contingent orders, such as one-cancels-all or one-triggers-all, are linked orders to be executed only under specific market conditions.
Institutional investors use many more order types. The New York Stock Exchange (NYSE) lists 30 for its traditional exchange and more than 50 on its electronic platform, NYSE Arca. Many order types are opaque, and some have been criticized as providing undue advantage to certain investors.
Wishing you a great week!
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