What are Stocks?
Stock market – what is it?
The term ‘Stock market’ tends to used by lay people as a catchall to encompass the entire financial sector. In fact, it refers specifically to trading and investing in stocks and shares; as opposed to other markets such as forex to trade currencies, or futures to trade commodities such as oil and coffee. Historically, the latter two markets were only traded by professionals working for city institutions. In pre-internet days, most ‘retail’ traders and investors only had access to the stock market via a stockbroker. These days, anyone can invest or trade in just about any market and, as a consequence, most brokers have dropped the ‘stock’ prefix.
Stock exchange – what is it?
Historically, the function of a stock exchange was to provide a central meeting point where buyers and sellers could be matched. These days, this is achieved via electronic networks, so only people who are registered members of the exchange actually go there to trade. For a company to be listed on an exchange, it must fulfil specific criteria to do with capitalisation, turnover and profitability etc. Some companies either fail to meet the requirements, or elect not to be listed. In such cases, it’s still possible for two parties to trade shares in these companies ‘over the counter’ (OTC) or ‘off exchange’, although the transactions are often very large, say between an investment bank and its clients. Some companies can be listed on more than one exchange, e.g. General Electric, which is a constituent of both the New York Stock Exchange (NYSE) and the London Stock Exchange (LSE). For traders and investors, the value of a centralised exchange lies in its transparency, regulation and record keeping. For the companies that they trade and invest in, the value of the exchange lies in the access it provides to stock holders who, collectively, generate the capital they require to finance their business.
Equities, stocks and shares - are they all the same thing?
Yes and no! They are inter-related and interchangeable to some extent, but they do have different meanings.
Equity
This is an umbrella term meaning ownership interest and is not restricted to the stock market. For example, one can have ‘equity’ in real estate, which would be the difference between the current market value of a property and any money owed on it – usually in the form of a mortgage. In the context of trading and investment, equities – or the equity market – are synonymous with the stock market.
Stock
This is the total assets and earnings of a company, including all capital invested or paid into it, of which the ‘stockholder’ owns a percentage. Most companies offer investors ‘common’ stock, but a few also offer ‘preferred’ stock which entitles investors to dividends before they are issued to other shareholders. Some even offer ‘convertible preferred’ stock, providing the shareholder with the option of converting their preferred stock to common stock.
Share
Shares are merely a convenient way of dividing up a company’s ‘stock’ to enable individuals and organisations to have a speculative ownership interest – or ‘equity’ - in the company. Potential profit is received in 2 ways; either as a percentage of the company profits in the form of a dividend, or via capital appreciation in the value of the shares themselves. Share holders may receive other benefits such as the option to buy additional shares at preferential rates and to vote on key decisions at annual general meetings.
How to trade stocks
The traditional way to trade stocks is to buy and sell actual physical shares. These days, most traders do this via an account with an online broker, and the transactions are all electronic. Besides traditional share dealing, many online brokers offer alternative financial vehicles, providing traders with exposure to stock markets – without having to deal in actual shares. The two most notable ones are Spread Betting (SB) and Contracts For Difference (CFDs). To learn more about these, check out this FAQ:
What are the pros and cons of Spread Betting Vs CFDs? Other financial vehicles include options (see the Essentials of Options Sticky), warrants and single stock futures. Collectively, with the exception of Spread Betting, they are referred to as ‘derivatives’, as they are ‘derived’ from the stock. In other words, you’re not trading the actual shares themselves but, rather, another financial product based on – or derived from – the underlying stock. The reasons why some traders prefer these to traditional share dealing won’t be discussed here, other than to say that each of them has specific pros and cons. For example, in the U.K., buying actual shares incurs stamp duty. Derivative products are designed to get around this expense, but there is a downside; they can involve increased risk – especially for traders who don’t understand fully how they work. You must decide which financial vehicle is the most appropriate one for you, your circumstances and style of trading. Many T2W members start with a spread betting account, as they are quick and easy to open and don’t require large deposits. Most SB firms will enable you to trade shares in companies listed on the major exchanges and / or those listed on the major European and U.S. indices, such as the FTSE in the U.K., DAX in Germany and DOW in the U.S.
The long & the short of it
Most T2W users are interested in equities to trade short term, i.e. anything from a few minutes to a few months. They tend not to have a particular loyalty or affinity to any one company, and are just as happy to profit from a fall in the company’s share price (by trading ‘short’) as they are to profit from a rise in its price (by trading ‘long’). Trading short is a confusing concept to many people as the idea of profiting from something that loses value is counter intuitive. However, the principle is fairly straightforward. When you buy a share in the expectation that its value will rise, you buy it from someone who takes the opposite view; i.e., either from an existing long holder who wants to sell because they think that price won’t rise any more - or from a short seller who thinks it’s about to fall. Short sellers don’t own the shares they sell; they borrow them from a third party – usually their broker. Here’s an illustration how it works. (The precise mechanics of this are somewhat different and beyond the scope of this Sticky. Also, please note this principle does not apply to all markets – e.g. futures.) Suppose you buy XYZ stock at USD $10.00 in the expectation of a price rise. You set a 5% stop loss at $9.50 and a 5% profit target at $10.50. You buy from a short seller who has the reverse objectives, i.e. they expect price to fall and set a stop loss at $10.50 and a profit target at $9.50.
Scenario A – price falls
For you, the trade is a loser and your stop loss is hit. The short seller sold to you at $10.00 and now buys the stock back from you at $9.50, netting them a gain of $0.50 per share traded. They sold at a higher price and bought back at a lower one, enabling them to profit from a fall in the value of the shares. The key point to remember is that at no time do they own any of the shares that they sell, they never bought them – they only borrowed them from their broker. Once the transaction is complete, the shares are returned to their broker who charges them a small fee for the loan service.
Scenario B – price rises
This time, your profit target is hit and you’re the one with a 5% profit, while the short seller takes a 5% loss. As with scenario A, when the transaction is complete, the shares borrowed by the short seller are returned to their broker.
Trading shares Vs investing in shares
Long term buy and hold investors (LTBH) tend to have a vested interest in a specific company and, as such, seek not only to profit from an increase in share price, but also from dividend payments. For them, the growth and success of the company is critical and, consequently, they will only take long positions. Indeed, some investors disapprove of traders, especially British traders who short British companies, i.e. short sell shares hoping to profit from a fall in their value. In their view, this is unpatriotic and serves to undermine not only the company concerned, but also the nation’s economy. During the economic meltdown in autumn 2008, both the U.K. and U.S. governments caved in to public pressure on this issue, when they placed a temporary ban on short selling stocks in the financial sector. Traders complained bitterly, arguing that it’s necessary to be able to trade both sides of the market (i.e. buy long and sell short) in order to maintain a liquid market, as well as a fair and balanced one. Supporters will say their points were vindicated when bank shares and other financial stocks continued to fall even after the ban on short selling was imposed. Their point was further underlined when the recovery of the sector – and the markets as a whole – took off soon after the ban was lifted.
Income or growth?
Traders and investors of equities have different objectives. Broadly speaking, LTBH investors will focus on buying shares in stocks that produce income in the form of a dividend, or ones that are set to grow, in the hope that the share price will rise substantially. Some will opt for a mix of the two, depending upon their attitude towards risk. A young company might have excellent growth potential (imagine buying into Microsoft or Google in the early days) – but the risks are greater. Conservative investors will go for very large and long established companies (sometimes referred to as ‘blue chips’) whose share price is unlikely to sky rocket but, equally, they are less likely to go bust than their smaller and younger siblings. The giants can’t offer investors much growth; instead, they offer stability and income in the form of a dividend. As a broad rule of thumb, in the U.K., income generating blue chips can be found in the FTSE 100, while younger growth companies can be found in the Alternative Investment Market (AIM).
Which is best for traders?
Traders tend not to care whether a company is a growth company or a steady income giant. Their horizons are short term, sometimes intraday, so they tend not to expect huge price rises and certainly don’t care about dividends. Their focus is on volatility and liquidity. ‘Blue chips’ tend not to have a lot of volatility, but they enjoy fantastic liquidity. A day trader who can afford to buy 20,000 shares of Microsoft will make a cool $1,000 if its share price rises just $0.05 cents on the day. On the other hand, a growth stock like Apple might have huge volatility and move several dollars or more in one day. However, it may be less liquid, making it harder for the trader to buy large quantities of shares and then sell them at the price they want. However, if the stock rises by $2.00, the trader need only to have bought 500 shares to realise the same $1,000 profit as the trader of the blue chip giant. It must be stressed that these are generalisations – there are many exceptions to the rule!
The Pro’s & Con’s of Stocks
There is endless debate on T2W and, doubtless, on other forums too, about the relative merits of one market verses another. Many new members pose the question, ‘is one market easier to trade than another?’ The pros and cons of any market are subjective and are governed by what best complements your trading style and objectives. This subject is explored in greater detail in the FAQ
Which Should I trade - Stocks, Futures or Forex etc.? Outlined below are some of the key features of stocks and their associated upsides or downsides – depending upon your point of view.
1. QUALITY
There are literally thousands of stocks available to trade, listed on the world’s stock exchanges. Whatever you want – it’s out there – somewhere!
Upside: On any given day, somewhere, there are stocks waiting for you that are suited perfectly to your style and strategy. On very quiet days where nothing is going on in other markets, there will be stocks trending strongly. Alternatively, the main market indices can be near vertical all day long, but you’ll be able to find stocks that are bobbing about in a tight range – if that’s what you want.
Downside: Unless you trade the same stock – or the same basket of stocks – day in and day out, you’ll have the problem of finding the right stocks for your particular style and strategy. For day traders, this may involve adding stocks to their watch list that they’ve never heard of before – let alone traded. Stocks tend to be correlated to their sector and market index, so equities traders tend to require a lot of screen real estate and eyes in the back of their head to keep track of lots of different elements at the same time. This is an art in itself and the prime reason cited by traders who abandon equities in favour of a market with a relatively small number of tradable instruments such as Forex or Futures.
2. RANGE
In addition to the vast quantity of stocks to trade, there is also a huge range. As mentioned in the introduction, the value of shares available ranges from under GBP£0.10p - through to the world’s most expensive stock - costing around USD$120,000. The latter is the cost of a single class A share in Berkshire Hathaway, the company owned by Warren Buffett, who is often referred to as the world’s greatest investor and one time richest man.
Upside: Traders are only limited by their imagination in ways to filter suitable stocks to trade. There are limitless fundamental and technical parameters that will enable each trader to find the most appropriate stocks for their style and strategy.
Downside: Filtering suitable stocks can be time consuming if done by hand, and have cost implications if bespoke software is used.
3. SPREAD
The spread on stocks can vary a lot. Highly liquid stocks with low volatility will often have very tight spreads of only a point or two. (NB: the generic term ‘point’ is used to avoid referencing pence for U.K. stocks and cents for U.S. stocks etc.) Conversely, the spread can open up significantly on volatile stocks, especially high priced ones.
Upside: As a rule of thumb, the wider the spread - the more volatile the stock - which tends to result in very large price moves that aren’t always available in other instruments. Conversely, if you’re a scalper and require very tight spreads on highly liquid instruments with low volatility, then these are also available. Basically, there are stocks with spreads to suit all trading styles and strategies.
Downside: Novice stock traders tend to overlook the spread, especially on cheap stocks. For example, take ‘penny shares’, so called because the share price is under £0.10p. If the spread is 1p, i.e. 9p bid / 10p offer – then the spread is 10% of the value of the share. In other words, the price will have to move 10% in the required direction just to break even - and that’s without taking commissions and stamp duty into account (in the U.K.). Whereas, a stock trading at 99p bid / £1.00 offer, only has to move 1% to reach break even. Spreads require active management from one stock to the next and are something else for the stock trader to take into account
4. VOLATILITY
Understanding how volatility affects the price of a stock is critical to traders who trade different stocks everyday – particularly to day traders. Intra-day volatility can vary enormously, especially on U.S. stocks. This will determine where stops are placed and, in turn, the size of the position traded. Note that volatility and spread are closely linked; very volatile stocks tend to have wider spreads than less volatile ones.
Upside: Stock traders can usually find volatile stocks on quiet range bound days while traders of other instruments – e.g. futures – are staring at their screens, tearing their hair out with frustration because the market is flat as a pancake.
Downside: Correctly gauging volatility, placing stops accordingly and trading appropriate size can be a delicate balancing act and the difference between making a profit or a loss. It is quite common for inexperienced stock traders to end the day / week net positive in terms of points made, but for their account to show a negative balance. Often as not, the reason for this is because they’ve failed to factor volatility into the equation and had positions that are too big on losing trades and too small on winning ones. Check out this article by Trader333:
Position Sizing as an Approach to Risk Management - which offers a neat solution to this very problem.
5. LIQUIDITY
Liquidity is of vital importance to most traders. This governs the price(s) you enter and exit trades. Poor liquidity is liable to result in slippage – i.e. being filled at a price far less favourable than the price you want. Limit orders are a great tool to combat this problem but, the risk here is that your order won’t get filled at all – or only partially filled. As a rule of thumb, the shorter the timeframe being traded, the more important liquidity is. Scalpers trading fairly large size (i.e. lots of shares) for small moves of a few points - need to know they can get in and out of their trades at the exact prices they require. This is less of an issue for swing traders holding smaller positions with wider stops over a time frame of a few days or more. For more information on different order types, check out this FAQ:
What's the difference between Stop Loss and Limit orders?
Upside: As with volatility and spread – you can choose the best stocks to trade from the huge selection available. There are more than enough to suit every conceivable trading style and strategy.
Downside: Some stocks are like wolves in sheep’s clothing, they can lure you in, only for you to discover that you’ve been filled at a lousy price and the same thing is likely to happen when you exit, because the stock is very ‘thin’ and ‘illiquid’. This tends not to be as big an issue for Forex and Futures traders, as these are the most liquid markets in the world and one of the main reasons why they are so popular.
6. RISK
You’re probably thinking that trading of all kinds carries risk – and you’re right! However, risk varies from one market to the next (e.g. equities or forex), from one tradable instrument to the next (e.g. Google or EUR/USD) and from one financial vehicle to the next (e.g. options or CFDs). You must understand the specific risks associated with each one and do what you can to minimise them.
Upside: You can spread your risk across many equities in different sectors. That said, a rising tide floats all boats – and vice versa. This artificially inflates the price of weak companies and depresses the price of strong ones; providing lots of opportunities for the astute trader or investor. (Note: the flip side of this is also true, see ‘Downside’, below.)The upside potential of any individual company is virtually limitless. The wealth of investors like Warren Buffett comes from seeing the value of shares rise 1000% or more. Day traders can experience moves of 10%, 20% or more in an individual stock, whereas, traders of index futures or forex rarely - if ever - experience moves this big.
Downside: Companies can – and do - go bust and their share price can literally go to zero. This can’t happen with index futures or Forex, which is why the leverage in those markets is so fantastic. In other words, with a small account funded to the tune of say a few hundred dollars, you can trade tens of thousands of dollars worth of currencies. Whatever you trade, beware of ‘Black Swan’ events (e.g. 9/11) which can – and do – happen and impact all markets. Futures and Forex markets tend to recover more quickly from such events than individual stocks. For example, think of BP following the deepwater Horizon oil spill in the Gulf of Mexico. The share price of most companies tends to be at the mercy of the sector they are in and the market as a whole. In other words, the price of fundamentally very strong companies can fall if their sector is weak or the market as a whole is in a bear trend. Also, having no upside limit to the price is great if you’re long and the price is rising. On the other hand, many stock traders have blown up their accounts by being short a stock that’s rocketing skywards. The bottom line with risk is to understand it, plan for it and be ready for it when the worst happens. Be in no doubt that, just as night follows day, sooner or later the worst will happen!
Summary
This essential Sticky is intended as an introduction to the stock market, It‘s not intended to be a definitive guide! Before trading the stock market (or any other market come to that), learn as much as you can about it. There’s loads more information available right here on T2W. Check out the links in the next post and read the threads in this forum as well as the journals by equity traders in the
Trading Journals forum.
