Stocks - Owning Part of a Company Want to own part of a business without having to show up at its office every day? Or ever? Stock is the vehicle of choice for those who do. Dating back to the Dutch mutual stock corporations of the 16th century, the modern stock market exists as a way for entrepreneurs to finance businesses using money collected from investors. In return for ponying up the dough to finance the company, the investor becomes a part owner of the company. That ownership is represented by stock -- specialized financial "securities," or financial instruments -- that are "secured" by a claim on the assets and profits of a company.

Types of Stock
Common Stock Common stock is aptly named, as it is the most common form of stock an investor will encounter. It is an ideal investment vehicle for individuals because anyone can own it. There are absolutely no restrictions on who can purchase it. Young, old, savvy, reckless. Common stock is more than just a piece of paper; it represents a proportional share of ownership in a company, a stake in a real, living, breathing business. By owning stock you are a part owner of a business.

Shareholders "own" a part of the assets of the company and part of the stream of cash those assets generate. As the company acquires more assets and the stream of cash it generates gets larger, the value of the business increases. This increase in the value of the business is what drives up the value of the stock in that business.

Since Shareholders own a part of the business, they get one vote per share of stock to elect the board of directors. The board is a group of individuals who oversee major decisions made by the company. Far from being a perfunctory collection of do-nothings, the board wields a lot of power in corporate America. Boards decide how the money the company makes is spent. Decisions on whether a company will invest in itself, buy other companies, pay a dividend, or repurchase stock are all the purview of the board of directors. Top company management, who the board hires and fires, will give some advice, but in the end the board makes the final decision.

As with most things in life, the potential reward from owning stock in a growing business has some possible pitfalls. Shareholders also get a full share of the risk inherent in operating the business. If things go bad, their shares of stock may decrease in value, or even end up being worthless if the company goes bankrupt. You will learn about selecting stocks or businesses in the How Do I Analyze Companies? section.

Different Classes of Stock
Occasionally, companies find it necessary for various reasons to concentrate the voting power of a company into a specific class of stock where the majority is owned by a certain set of people. For instance, if a family business needs to raise money by selling equity, sometimes they will create a second class of stock that they control that has 10 votes per share of stock and sell a class of stock that only has one vote per share to others. Does this sound like a bad deal? Many investors believe it is and routinely avoid companies where there are multiple classes of voting stock. This kind of structure is most common in media companies and has been around only since 1987.

When there is more than one kind of stock, they are often designated as Class A or Class B shares. For instance, Berkshire Hathaway Class A shares trade as BRK.A, whereas Berkshire Class B shares trade as BRK.B. On the Nasdaq stock market, the class of stock becomes a fifth letter in the ticker symbol. For example, Bel Fuse trades under the tickers BELFA (the Class A shares) and BELFB (the Class B shares).

Other Types of Stock
You will learn about preferred stock and Real Estate Investment Trusts (REITs) in the section on Bonds.

How Stocks Trade
Probably one of the most confusing aspects of investing is understanding how stocks actually trade. Words such as "bid," "ask," "volume," and "spread" can be quite confusing.

Listed Exchange The New York Stock Exchange (NYSE) and the American Stock Exchange (AMEX, composed of the Boston, Philadelphia, Chicago, and San Francisco Exchanges and now merged with the Nasdaq stock market) are both "listed" exchanges, meaning that brokerage firms contribute individuals known as "specialists" who are responsible for all of the trading in a specific stock. Volume, or the number of shares that trade on a given day, is counted by the specialist and reported to the exchange along with information on the price and size of each trade.

NYSE trades still take place face-to-face in the trading pit where buyers and sellers physically converge on the specialist who matches buyers with sellers, but computers play a big part in the process these days. All trades are "auctions." There is no set price, although the last trade is often considered to be the "price" of a stock. In reality, the price is the highest amount any buyer is willing to pay at any given moment. When demand for a certain stock is high, the various buyers bid the price higher to induce sellers to sell. When demand for a stock is low, sellers must sell at lower prices to attract buyers and the price drops.

Over-the-Counter Market
The Nasdaq stock market, the Nasdaq SmallCap, and the OTC Bulletin Board are the three main over-the-counter markets. In an over-the-counter market, brokerages (also known as broker-dealers) act as "market makers" for various stocks. The brokerages interact over a centralized computer system managed by the Nasdaq.

Market makers may match up buyers and sellers directly, but mostly they maintain an inventory of shares to meet the demands of the market. So when you want to sell 100 shares of ABC stock, you do not have to wait for someone else to place an order to buy 100 shares of ABC; the market maker steps in, buys them from you immediately, then sells them when a buyer comes along. Market makers and specialists keep the markets "liquid" each in their own way. You are assured that, except in extraordinary circumstances, you can always buy or sell your shares if the market is open.

"Volume" numbers under the Nasdaq system are often inaccurate. Since most trades are in and out of the market makers accounts, what would be one trade on the NYSE (where buyers and sellers are matched directly) is usually two trades on the Nasdaq.

Bid, Ask, Spread
Handling all those orders is very valuable service, and market makers (and specialists) are appropriately rewarded. Suppose you want to sell ABC and the last trade was at $6.25. When your "market" order (an order to sell at the going price) goes out on the Nasdaq system, the companies that make a market in ABC will bid for the right to buy your shares. If they see a lot of orders for ABC, they might bid $6.50 for your shares, because they know that they can turn around and ask $6.60 to sell them. If they see a slackening of demand for ABC, they might only bid $6.00 and ask $6.10. On the NYSE, specialists won't match orders for the exact same price. They will match buy orders for slightly more than the seller is asking.

The difference between the bid and ask price is the spread and it goes into the pockets of the market makers and specialists. The amount of spread will vary depending on the volume of shares traded. For a very heavily traded stocks, market makers will compete vigorously for the business and the spread will be quite small. For thinly traded stock, market makers may demand a very large spread because they may have to hold the stock for a long time before a buyer comes along, increasing the risk that they won't be able to sell it for as much as they paid.

Investors can set their own bid or ask prices, too, by placing orders to sell or buy only at a specific price. Market makers and specialists keep a close eye on these "open" orders, executing them when conditions are met, and using them to gauge demand for the stock.

Stock Derivatives: Options and Futures
Arguably the most volatile and risky investments possible, options and futures are "derivative" securities, meaning their value is "derived" from that of another security or commodity. Options and futures are both very volatile because they often carry an incredible amount of leverage. For instance, each option contract on an individual stock controls 100 shares of that stock for a fraction of the stock's current value. Since option traders have only invested a small percentage of the stock's price, any move in the price represents a big percentage change for their investment. Say they paid $5 per share for an option on a stock that sells for around $50 a share. If the price of the stock goes up $5, that's a 10% move in the price of the stock, but it's 100% of the option trader's investment. So a relatively small upward movement in the stock can be a huge upward movement for the option.

This potential for gain is offset by the fact that the entire purchase price of an option is at risk. If an investor holds an option and the underlying stock does not exceed the target price within the given time period, the option expires worthless and the entire purchase price is lost. (Most options end up worthless on their expiration date.) Traders also have to cover the price of the option. That five-dollar increase in the value of the stock wouldn't actually make the trader any money if the option expires at that point. It would just have covered the cost of the option. And if you think this is getting complicated, we've barely scratched the surface!

We do not consider options and futures to be worthwhile investments. Some people make a living trading derivatives -- they make their living trading against people like you. The chance of losing money with derivatives is much too high for options to be considered a useful part of any completely sound investment strategy.

Buying Stocks
Use a Brokerage
The most common way to buy stocks is to use a brokerage. You can either use one of the many way-too-expensive full-service (or full-price) brokers, or use a discount broker to execute your trades. You will learn more about the ins and outs of brokerages and how to pick one in our Why Do I Need a Broker? section. If you're really ready to get started, head straight to our discount brokerage area where you can compare brokers and open an account. When you use a brokerage, you can have a cash account or a margin account, meaning you can borrow money to buy stocks. (Note: IRAs and custodial accounts are not allowed to be margin accounts.)

Using margin gives you more "buying power" and can increase your returns and your risk. Do not get carried away by the term "buying power." A better name would be "borrowing power" because that is what you are doing, and you should not forget it, but brokers have a vested interest in encouraging their investors to use margin, so they like the sexy name. Brokers make a good part of their money from margin loans, plus buying on margin generates more commissions. Margin loans are a great racket. The broker collects the interest and has total control over the collateral for the loan, including the ability to step in and force you to sell stock if they think you are in danger of defaulting on their loan. Margin is a two-edged sword for investors, but it's a cash cow for brokers.

Dividend Reinvestment Plans (DRPs) and Direct Investment Plans (DIPs)
Known lovingly by many investors as Drips, these are plans sponsored by individual companies that allow shareholders to purchase stock directly from a company with only minimal costs or commissions. These plans are great for those who have small amounts of money but who are willing to invest it at regular intervals.

Shorting Stocks
If you buy a security with the expectation that the price will rise, you are "long" the stock. But you can profit from stocks that go down, too. This is an advanced investing technique called "short selling." When you short a stock, your broker arranges for you to borrow stock from a pool of shares maintained by brokers for that purpose. The shares are then sold and the proceeds from the sale are credited to your brokerage account.

At some point in the future, you must "close" the short by buying the same number of shares (adjusted for any splits that might have occurred) in the market and returning them to the short pool. If the price of the stock has gone down while you were holding it, you can use the money you received from the sale of the borrowed shares to buy the stock, and you will have cash left over. That's how you profit from a stock that goes down. Unfortunately, if the stock has gone up, you will have to add some money of your own when closing out a short position. That's how you lose money when a stock goes up.

Properly done, shorting can work as a hedge against a falling market. Improperly done, you can lose even more money on a short than you would lose if you invested in a company that went bankrupt. Imagine that you buy a company for $50 per share and it goes belly up. You have lost $50, but imagine shorting a stock for $50 that subsequently triples. When you close that short position, it will cost you $150 a share to buy back the shares you sold for $50. Many a short seller has been caught in this trap because brokers will not let you hold on to a short position unless you have money or other assets to cover the short at all times.

The basics of the shorting transaction are straightforward. Most online brokerages have a box to check for a short sale or a "buy to cover." Occasionally there will not be enough shares in the short pool and a short sale will not go through. There are also rules about shorting stocks that are dropping fast, so you cannot always assume a short sale will be as smooth as a straightforward purchase, but in most cases it is.

Summary
You are now conversant enough in stock market matters to impress those who are very easily impressed. You have learned that each share of stock represents a proportional share of a business and that the potential rewards are great but that stocks are also riskier than putting money in the bank. You are also aware of the different types of stock (and how each classification is reflected in the ticker symbol), how they are traded on the exchanges, and how to buy them. You even learned a little about options and shorting stocks. A word of caution at this point: Knowing the terms and general workings of the stock market is just the first step in your investing career.