Building a Foundation in Equities Trading
If you are completely new to equities trading, you likely have a more ‘romantic’ impression of the stock market. You may hold typical mental imagery from Wall Street billionaires on one side of the spectrum to the ‘Great Depression’ and ruined investors raining out of office windows. Certainly fortunes can been made on the equities market, and the suicide rate did increase from 1925 to 1932, however, these extremes are more the fuel of legends. Let’s look at more realistic perspective.
What Are Stocks?
Stocks or equities are simply financial instruments. A financial instrument is physical or virtual document that represents some kind of monetary value wrapped up in a legal agreement. They originated, as most documents of this nature, out of a need for money. In this case, the needy entity is that of some business requiring funding to grow in some manner. Rather than taking on debt which has to be repaid, the company sells shares of their company to the public. They give up a certain amount of control in exchange for large venture capital. This is the basic principle behind stocks, shares or equities (these terms are synonymous).
Equity and Debt Securities
Expanding on the concept of shares, we enter the realm of financial securities which is simply a financial instrument that is fungible. This means that it can be purchased or traded. Securities can fall under the category of either equity or debt securities. Stocks are equity securities since they represent ownership or value in the entity they represent. They can be either private or publicly accessible but both can create profit in the form of interest, dividends and growth. Stocks offer around a 10% return on investment and have high liquidity so they’re an attractive investment. The downside is of course the risk, but you can mitigate this with informed decision making and diversification. Debt securities on the other hand, are based on a debt relationship. Examples of debt securities are bonds, T-Bills and CD investments.
Common and Preferred Shares
Public stocks can be broken down further into common and preferred shares. Preferred stocks are an upper echelon stock which often pays fixed dividends and takes priority over common stocks in dividend or liquidation payouts. Preferred stock typically has more restrictions. Some preferred stocks, for example, may not have voting rights and may be callable (company can buy them back at any time). Common stocks, on the other hand, are usually the largest class and always have voting rights of 1 vote per share. The largest responsibility a stock holder has as a voting shareholder is electing the board of directors. This is the body of people that make all the major decisions and control the daily operations of the company.
An option, by definition, is a contract that gives the buyer a right to sell or purchase an underlying asset by a specific period of time. It is not an obligatory action. Generally, the way and option operates is, the right is purchased for a defined amount of money and expires at the end of the period of time. When the option expires, the investor can either act upon the agreed option terms, or decline and lose the initial investment. Because stock options deal with an underlying investment, they are often called derivatives due their value being derived from this investment. One of the desirable traits of options are that you can make money when the market goes up or down. This makes stock options a viable investment for both speculation and hedging. Hedging, if you’re not sure what that is, is lessening the exposure of your investments to a downturn. By using put options for example, you would make some of your money back in the case that that particular stock lost money.
Calls and Puts
The two types of options are ‘calls’ and ‘puts’.
- Call Option: A call option gives the holder the right to buy an asset at a certain price within a defined period of time. The holder would be hoping the value would be much higher than the agreed price at the time of expiration.
- Put Option: On the flip side, a put option gives the holder selling rights. In this case they would hope the price falls so that they will be receiving a greater selling price than the current worth of the asset at expiration.
The sellers of the call or put options are considered to be the ‘writers’ of the option and the buyers of the option are called the ‘holders’ as referred to above. The holders are not obligated to buy or sell by expiration but the writers are required to buy or sell as per the option contract.
More Option Terminology
- Strike Price: This is the set price of the underlying stocks. This would be the price a holder would sell for on a successful put option and the price of purchase for a successful call option.
- Listed Option: This option is sold on a regulated exchange at a 100 share fixed price. The expiration date is also fixed.
- Intrinsic Value: This refers to the amount above or below the strike price for successful call or put options. For example, if a call option had a strike price of $40 and the current market value was $55, the intrinsic value would be $15. An option is considered ‘in-the-money’ when the profitable option criteria is met.
- Premium: The term for total cost of option. Parameters like stock and strike price, time remaining until expiration and volatility are used to determine this value.
Each market you’re considering is governed by the geographical area it resides in and will therefore have its own wrinkles. Canada, for instance, has this responsibility divided on a Provincial level, where in the U.S., it is governed by the Securities and Exchange Commission (SEC). It’s a good idea to familiarize yourself with the laws of the market you may be interested in.