WHAT ARE STOCKS AND HOW DO THEY WORK?
WHAT ARE STOCKS?
Stocks are units of ownership of a public company. By buying shares of a stock, an investor becomes a shareholder, with specific privileges such as eligibility for voting rights and receiving dividends (if the shares have voting rights and if the company pays them).
While ‘shares’ and ‘equities’ are closely related to, and are often used interchangeably with, ‘stocks’, there are some nuances:
- Shares: individual units of a specific company’s ownership that investors can buy in varying numbers – e.g., you can buy 5 or 1,000 shares of Company XYZ
- Equities: if you own shares of stock, you own equity in the company which is where the term ‘equities’ comes from -- e.g., if you own 1000 Company XYZ shares, and the company has 100,000 shares in total, you have a 1% equity stake in the company
- Stocks: portions of ownership in one company, or more, making up of any number of shares – you can own company stock worth 2 shares, or 100 shares for example
HOW DO STOCKS WORK?
Companies looking to expand rapidly will look towards the public market to help them raise capital. Companies work through many processes to issue shares and raise capital, such as selling shares through the primary market through the initial public offering (IPO) process.
When a company's shares start trading on a listed exchange, like the New York Stock Exchange (NYSE), they are in a secondary marketplace since each share transacted on an exchange was previously owned by another investor.
Investors can realize a return on investment (ROI) by selling the shares at a higher price than the original purchase price (excluding any additional fees). Additionally, investors can generate income by receiving dividends if the company pays one to shareholders. However, investors that close or sell their shares at a price lower than their original purchase will incur a loss.
A stock's price generally plays a vital role in the company's financial health, which is why investors may use the stock's performance when formulating an investment decision. The same applies to stock trading by speculating on the direction of a company's share price.
WHY DO COMPANIES GO PUBLIC?
Companies generally go public to raise money for various endeavors such as funding new projects, expansion, and paying off debt.
Companies can weigh their options for going public, including an initial public offering (IPO), a special purpose acquisition company (SPAC) merger, or a direct listing. The most common method is the IPO route. A key difference setting it apart from SPAC mergers and direct listings is that the IPO process is expensive since it guarantees that a certain number of shares will sell at the initial price in the primary market.
STOCKS AND INITIAL PUBLIC OFFERINGS (IPOs)
An initial public offering, or IPO for short, is the most popular way for companies to enter the stock market.
Some of the key characteristics of an IPO are:
- New shares of the previously and privately held company list on a chosen stock exchange
- One or more underwriters facilitate the process, including stock issuance
- Underwriters determine the IPO price using relevant valuation models
- Existing shareholders such as company founders, employees and early investors cannot sell shares during the lock-up period, which typically lasts between 90 and 180 days after the company lists publicly
BUYING VS SELLING IN STOCK TRADING
Stock trading refers to a shorter-term timeframe when compared to stock investing, which implies a longer-term timeframe.
Regardless of the ownership timeframe, a stock trader profits when the market moves in favor of the trader's assumption. However, if it goes the opposite, the trader incurs a loss. For this reason, stock trading and investing are binary.
In trading, buying and selling represent a directional assumption. If a trader thinks Company XYZ's share price will rise, they'll buy (or go long) the stock. On the other hand, if they think it'll drop, they'll sell (or short) the stock. This is where trading and terminology can get a little tricky.
When you short a stock1, your broker will locate shares for you to sell in the open market. After the order is filled, you want the stock price to go down to yield a profit. It is the exact opposite of owning shares of stock (where you want the stock price to go up).
By being short the shares, if the price of the stock goes up, your position will be marked as a loss. Furthermore, because stocks can theoretically go to “infinity,” the risk to the upside is “unlimited.” If the share price climbs higher, you assume the risk in the number of shares by the amount of increase from the price you shorted the stock.
To summarize:
- Buying shares to open is a bullish strategy, and you’ll sell the shares to close your position
- Selling shares to open is a bearish strategy, and you’ll buy the shares to close your position
PREFERRED STOCK VS COMMON STOCK
While owning preferred stock and common stock both make an investor a company shareholder that can receive dividends (if the company pays them), there are differences relating to some rights that are connected to each.
| PREFERRED STOCKHOLDERS | COMMON STOCKHOLDERS |
|---|---|
Normally receive higher dividend payouts and get paid before common stockholders | Often receive lower dividends (if it’s available, as the payout isn’t guaranteed) |
Get preference over common stockholders in cases of liquidation | Have lesser claim to assets in cases of bankruptcy |
Either not eligible for voting rights, or have limited voting rights | Eligible to vote as a shareholder |
CLASSES OF STOCK
Classes of stock are categorizations of shares that generally link to voting rights – they’re also usually in place to ensure that a large degree of control is held by companies’ founders and/or executives.
While a Class A stock may represent one vote per share, a Class B stock may only be held by a founder or executive of the company and be worth ten votes per share. Class C stockholders may not be eligible for any voting rights.
WHY BUY AND INVEST IN STOCKS?
Trading and investing in any product is often driven by short-term and long-term financial goals, and each product comes with its own set of benefits and risks. Discover a few of the potential benefits and risks of stock trading and investing below.
POTENTIAL BENEFITS OF TRADING OR INVESTING IN STOCKS
- Generate additional income
- Save for retirement or other savings goals (down payments, education, etc)
- Counteract effects of high inflation
- Easy to buy or sell the stock if the underlying is actively traded
- The ability to hedge other positions with long or short stock investments
- Capture investment yields in the form of dividends received (if the company pays them)
- Eligibility to vote on certain company matters (if long)
RISKS OF TRADING OR INVESTING IN STOCKS
- Potential losses if the underlying’s price breaches the breakeven price
- Illiquid stocks make buying and selling more difficult
- Buying and selling stock can be capital intensive
- Traders and investors need to be able to withstand potential market volatility
HOW TO TRADE OR INVEST IN STOCKS
Understanding how to trade or invest in stocks is essential in working towards achieving your investment goals. When trading stocks, you're focusing on short-term exposure through speculation. On the contrary, investing in stocks gives you long-term exposure by buying the stock outright and holding it until you’re ready to sell it.
HOW TO BUY AND INVEST IN STOCKS
- Learn about stocks and how to buy and invest in them
- Create a tastytrade account or log in
- Define your investment goals, long-term timeframe, and risk tolerance
- Choose a stock to buy and open your position
- Monitor your position and sell your investment
HOW TO TRADE STOCKS
- Learn about stocks and how to trade them
- Create a tastytrade account or log in
- Create a trading plan, timeframe, and a risk management strategy
- Choose a stock and open your position
- Monitor and close your position
| STOCKS | BONDS |
|---|---|
Stocks are units of ownership that make investors company shareholders with certain rights, such as eligibility for voting rights and receiving dividends if the company offers them | Bonds are units of debt – investors receive regular interest payments and full repayment of the initial capital at the maturity date in exchange for loaning the money |
More potential for profit as a company’s share price can technically rise in perpetuity, but the full investment value is at risk | Profit potential is lower as bonds are generally less volatile. Bond holders are also paid before stockholders in the case of an entity liquidation |
Lower bond yields are likely to incentivize investors to seek portfolio gains in the stock market, and vice versa | Higher bond yields offer investors an alternative way to realize portfolio gains compared to the stock market |
Generally traded on a listed exchange | Generally traded over-the-counter (OTC) |
STOCKS VS OPTIONS: WHAT ARE THE DIFFERENCES?
Both stock and options trading can give traders exposure to single-name stocks. The goal might be the same, but there are differences in the trading vehicles:
| STOCKS | OPTIONS |
|---|---|
Financial instrument that can be traded outright, or through derivatives such as options | Financial derivative contract that enables traders to buy or sell underlying assets like stocks and ETFs at a specific strike price and expiration |
Static directional exposure in shares of stock | Dynamic exposure – movement in aspects such as time left to expiration, the strike price position in relation to the stock price, and implied volatility levels all impact option prices |
A long stock trader incurs a loss if the stock price drops | In some instances, traders can profit even if their directional assumption is incorrect in the case of short options trades |
Stocks do not expire and closing a position isn’t tied to an expiration | Closing a position or converting the position to stock is tied to the expiration date of the contract |
Limited Strategy selection (can only be long or short) | Greater flexibility with strategies to create bullish, bearish, or neutral positions |
FAQs
A stock is a financial security that represents units of ownership of a company that’s listed on a listed exchange such as the NYSE. Investors can buy shares of stock to hold equity in the company long term, or they can trade stocks in a short-term manner to speculate on the near-term movement of the stock price.
People buy stocks for several reasons. Some of these include:
- Possible capital appreciation
- Receiving dividends (if the company pays them)
- Voting on certain company matters (if eligible)
You can start buying stocks by following the below steps:
- Learn about stocks and how to buy and invest in them
- Create a tastytrade account or log in
- Define your investment goals and risk tolerance
- Choose a stock to invest in and open your position
- Monitor your position and sell your investment
There are two main types of stocks – common stock and preferred stock. These differ based on the rights that stockholders of each have.
Discover the differences between common stock and preferred stock
Stocks and bonds usually have an inverse relationship. Investors often cash out of stocks, in favor of bonds when bond yields rise, and vice versa.
Stock and options trading can both give traders exposure to single-name stocks, but there are several differences between the two trading vehicles. For example, your directional assumption must be correct to make a profit when trading stocks outright; however, this isn’t necessarily the case with options trading with so many other variables impacting the price of an options contract.
All investments involve risk of loss. Please carefully consider the risks associated with your investments and if such trading is suitable for you before deciding to trade certain products or strategies. You are solely responsible for making your investment and trading decisions and for evaluating the risks associated with your investments.