The Stock Market Explained!

Let’s briefly describe The Stock Market for those who are new to the financial world.

What is The Stock Market?
It is by definition a market in which shares of companies stocks are bought and sold. Let me explain this. When companies start growing they need to find investors willing to invest on the company. They need to rise money to keep buying machines and products and to expand their businesses. At the same time many investors want to find companies where they can invest their funds, so they can receive passive income from the growth of those companies, which usually cause a growth on their portfolio of invested funds.

How is The Stock Market organized and why?
Companies discovered a long time ago that the most profitable, easy, fast and effective way to find the investors is through an organized system, in which there is liquidity, and through which all interested individuals could bring in funds to keep developing their businesses and enterprises. That originated The Stock Market, which have been evolving and improving for a long time. People can trade and invest on this market through Exchanges. For example the New York Stock Exchange, or the American Stocks and Options Exchange. Exchanges are regulated agencies, which facilitate the transactions between buyers and sellers and ensure the fairness of each transaction for everyone. Stockbrokers also facilitate transactions for their clients and earn a commission for doing so.

What is the difference between a trader and an investor?
On this market like in many others you can be and investor or you can be a trader/speculator. Investors are corporations or individuals that want to invest an amount of money, usually a large amount, and keep on the market for a while to profit from a long term trend. They want to grow their money, but they also want safe investments. They are not gamblers. They usually have large amounts of available funds so they can afford to leave their money on the market for months and some times even many years (2-5 years and more). Traders and speculators usually want fast profits. They may or may not have large amounts of available funds for trading and even if they do, they don’t want to risk them too much. This is because traders usually take considerably higher risks than investors do. Many of them not only trade shares of stock, but also derivatives. I explain that bellow. To get bigger profits they incur in biggest risk. Many of them are those that want to become rich in a few months. They want higher than average results. In fact they want the highest possible results. Many traders and speculators loose all their money on The Stock Market while others make fortunes. I think that knowledge, sound reasoning and common sense are three major factors affecting the outcome of any financial decision that you make.

What are stocks, stock symbols and stock shares?
The term stock usually refers to the name of the company or symbol. For example the stock symbol for Microsoft Corporation is MSFT. When you want to check quotes or check the graphics on your account you enter the stock symbol and get all the information. What are traded through exchanges are shares, shares of stock. A share is a piece of ownership. Think about this as a pizza where the pizza is the stock or the company and every slice is a share. There are companies with millions and millions of shares, (slices) while others have less shares. When you buy, sell invest or trade, you are commonly dealing with the companies shares. Usually if the companies increase in value, you make money. If the stock price rise you make money (If you have a long position, which means you bought the shares). Other factors could affect your profits also like news, rumors and market sentiment.

Do I need a stockbroker to become a trader or investor?
You can seek the advice of a license professional, a stockbroker, or you can trade by yourself using the Internet. There is an increasing number of individuals that are investing and trading from the comfort of their own house. To do it by yourself you will need to sign up with a brokerage firm like E*Trade or TD Warehouse or any other. There are many out there. You can choose which one fits your interests and your needs. Once you sign up and fund your account you can start trading for yourself. Although people often like to have a stockbroker make all the trading for them.

What is volatility?
I will define volatility in my own words. It is has to do with price fluctuations, how fast and often prices change. If the stock price decreases and increases fast and too much in a short period of time, it is said to be very volatile – the prices change too often, too fast and the difference is big, so the investment is risky. If the opposite happens and the prices almost don’t change at all, it is said to be a low volatile stock – if there are not sudden and unexpected price changes, then the investment is less risky. Traders usually prefer volatile stocks, because they seek to profit from sudden price changes in a short period of time. Investors prefer steady, slow but secure growth. They don’t like surprises very much.

What are derivatives?
Derivatives are financial instruments that derive their value from the underlying assets. There are a wide variety of derivatives and they are flexible instruments. Some derivatives for example may derive their value from other underlying derivatives. The main idea is that they do not convey ownership like stock shares, they just establish rights and obligations.

Derivatives are a little bit harder to understand than stock options. There are many different kinds of derivatives on the financial markets. Even experienced investors may know some of them, but not all of them. I will briefly mention the most commonly used, Options and Futures.

What is an option contract? What are stock options contracts?
If you buy an option you have the right but not the obligation to purchase something, whatever it is that is specified on the contract. In the case of stock options you have the right to purchase shares. Option contracts use specific terms. They also include a period of time in which you can exercise the option, which means you can buy the underlying asset. If you don’t exercise the option on the specified period of time, then your option expires worthless and you loose the premium, the money you paid for the option. Why are options so famous, so useful and so important? Option trading can make you earn much higher return on your investment or they just can make you loose everything fast. In other words you can leverage your investment. You can have explosive profits, but you must be willing to accept the high risks involved with option trading, you can loose it all fast. Remember that if you don’t sell the option contracts that you bough or if you don’t exercise them on the period of time specified on the contract, then you just loose your entire investment. Sometimes people start trading options without even knowing this! All of the above may sound a little confusing for new traders and investors. Stock options contracts may require you to study for a while before you can start to understand the entire process or how they work. I didn’t mention here definitions like the following. What is a call option? What is a put option? What is the option delta? What are the “Greeks”? What are options on futures? What are compound options? What are exotic options? And many, many more. Even when it sounds complicated for those that have no previous experience trading options, once you learn its inner workings and all the processes related to them, you can profit big time from these derivatives. Remember that in any business knowledge is the key to success.

What are Futures Contracts?
A futures contract is an agreement to buy or sell something, it could be a commodity or a stock for example, at a specified price on a particular date on the future. For example you make an agreement to buy 100,000 shares of Microsoft Corporation at $50 each two months from now. At the same time, someone somewhere is making the same agreement but instead of buying, that person is selling. These contracts are traded through exchanges which take neutral positions so they don’t loose. What’s the deal here? For example if today is January 1st, and you agree to purchase the stocks above by April 21st under those specified terms and conditions, and if the current stock prices is $45 per share check what happens. If the stock price rises in value from January 1st to April 21st let’s say to $75 per share, then you receive the contracts at $50 each share and immediately sell the contracts at $75 per share so your profit is huge. If the stock price goes down, you can sell the contracts before April 21st so you don’t loose that much. This is another kind of derivative that is very profitable for many traders. A very important fact is that you can also leverage your trades with this kind of derivative and get better results, but at the same time, you incur in higher risks.

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John Kaka
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