When you hear the words "stock market," it sounds like a frightening mess that is impossible to make sense of. Bears, bulls, short, call options, IPO–what do all of these things mean? What is the point of the stock market? What is a stock anyway? Who is buying and who is selling? All of this may seem confusing, but in truth, the stock market is based on two fundamental principles: buy it low, sell it high, or sell it high, and buy it low. With that in mind, let’s dive in!
What is Stock?
Succinctly, a common stock is a share of a company (which is why stocks are also called shares). For example, if a company had one million shares, and you bought one share, you would own one millionth of a company. Another type of stock is preferred stock, which is less volatile (i.e. less likely to vary a lot in price) than common stock and has higher priority than common stock when paying dividends. Even though preferred stocks do not include voting rights, it still signifies ownership of a part of the company. So what does this ownership mean?
- Voting rights (only common stock): you get to decide on company matters. This is why shares are actually very important in companies; the more shares you have, the more decision-making power you have. This is why it is recommended for one person in a private company (typically the CEO) to hold at least 51% of the shares, so that decision-making can be faster and more streamlined.
- Dividends: There are two kinds of stocks, and each pays a different dividend (i.e. a part of the company profit). Common stock is not guaranteed a dividend–every quarter, the company can choose if they want to pay a dividend or not. Preferred stock, however, must pay a dividend every month or quarter.
However, dividends are often not a reliable way to make money fast, especially with common stock. The most common use of stock is to buy it at a low price, say $10, then sell it at $30. While this kind of price increase is highly unlikely (Apple stock only increased about 130% over the course of the past year), assuming it were to happen, you would turn a profit of $20. The hard part is predicting whether the stock will rise or fall.
A company first sells stock during its IPO, which is the first time the company allows the public to acquire shares. This is known as the primary market. There are multiple motives behind this:
- To raise money. Billions of dollars can be raised at IPOs.
- To allow public ownership. Going forward, the company must satisfy popular demand, and there is no easier way to do that than allowing the public to get a say in company matters.
Buy or Sell?
So when should you buy, and when should you sell? If you believe a stock’s price will go up, you should buy the stock as soon as possible. For example, if you believe the stock price will increase from $10 to $20, you probably want to buy it when it still costs $10, rather than wait for it to increase to $15, to maximize profit. You should sell when you think the price will go down. For example, say you bought this stock at $10, and it has now reached $20 but is predicted to drop down to $15. In order to maximize profit, you should try to sell it at the highest price ($20) rather than a lower price ($15). Of course, it is hard to predict price increase and decrease. Here’s a simple guide on how to get a relatively good idea on what the price of the stock will look like in the future:
- How is this company doing? If it’s suffering a lawsuit, for example, less people will be likely to give this company money or buy its products and earnings will be reduced, thus driving down the stock price.
- Are they going to have any new sources of revenue in the near future? I remember Intel stock dropped because they had delayed the release of their new computer chip. Many people sold their stocks on that day, driving down the price by a lot (about 17%).
- What is its potential for growth? Is it already a mature company that won’t grow rapidly anymore? Or is it likely to develop in the future?
- Do a SWOT analysis: strengths, weaknesses, opportunities, threats.
- Look at current stock trends (i.e. stock price over past year, global economy performance, industry performance, national economy performance).
Another thing to keep in mind (this part is fully my opinion): the more money you invest, the shorter you should keep it in the stock market. Why? Imagine you invest $200 in the stock market. Over the course of half a year, the stock grows by 5%, and at the end of the year, it increases by 10%. If you had sold your stock in the middle of the year, you would have earned $10. But if you wanted to make $10 when only investing $100, you would have to wait until the end of the year. So what’s the downside of investing more? Well, if the price dipped by 10% instead at the end of the year, if you had invested $200, you would be losing $10. On the contrary, if you have invested $100, you would only be losing $5. Hence, keeping a lot of money in the stock market at once can be dangerous, and it is usually a better idea to sell stock at first gain, in my opinion.
Advanced: Call Options, Margin Accounts
Earlier, I said a way to make money in the stock market was to buy low and sell high. But what about selling high, then buying low? At first, this seems absurd: how can you sell stock without buying it first? It turns out, this can be accomplished with something called a margin account.
In a nutshell, a broker (a professionally trained stock expert) lends you some stock to sell, on one condition–you must put some money in a margin account so that if the stock price rises instead of going down, they can use that money to buy their stock back. For example, if you borrowed 5 shares worth $50 each and put $60 in your margin account for each, if the stock price rises to $60, they will take the money you put in the margin account and buy the stock back.
There is also a mechanism called a call option, which entitles you to buy a stock at a certain price for a certain duration, as long as you pay a certain price per share. For example, a call option might allow you to buy a stock for $50 in the next 6 months, for $5.40 per share. You might want to purchase a call option if you believe the stock price will go up within the next few months. For example, if the current stock price is $45, you might buy the above call option if you believe the price will go up to $60 in the next 6 months.
The stock market is not as scary as most people think. Not only is it a great stream of income, it is also highly essential to keeping the economy alive. Otherwise, companies will never get the investors they need and will peak lower than public companies. Although the stock market can be risky, many have grown rich by investing in the stock market.