Stock Investing Guideline
Investors buy and sell stocks in a stock market, also known as a stock exchange. A stock exchange may be a physical location, such as the NYSE (New York Stock Exchange) where stocks are traded in a trading floor, or a virtual space such as the NASDAQ (National Association of Securities Dealers Automated Quotations). Before investing in the stock market, an investor should ideally have a basic understanding of the different types of financial securities, and some proven investment strategies.
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Why Stocks Are Issued
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Historically, stocks have been the most popular financial security. Stocks represent ownership claims on a company, and as such, a stockholder is entitled to profits earned by the company on a periodic basis. A company may sell stocks to raise funds for different activities, such as an expansion project. If the company decides that it needs more funds than it currently has, it may issue and sell stocks to investors through an IPO (initial public offering). From the investors' point of view, they get ownership claim in exchange for their funds, and are entitled to periodic distributions of company earnings, in the form of dividends.
Capital Gains
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Apart from dividends, another source of earnings from owning stock is capital gains—the most apparent reason investors trade stocks. When an investor buys shares of a company stock at a certain price, and then sells the shares to a second investor at a higher price, he is making a capital gains on his investment. For example, if investor Tim bought 100 shares of ABC Inc. at $500 and then sold the shares for $750, he would make a profit of $250 on the transaction. After selling the stocks, the company updates the information in its records which now shows the name of the second investor as being the owner of the 100 shares.
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Short Selling
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In short selling, an investor makes a profit when the price of a particular stock goes down. This happens when the investor anticipates that the price of a share will go down, and anticipating lower prices in the future, borrows shares from his broker and sells the shares at the current market price. When the price falls, he buys back the shares and makes a profit on the transaction. For example, suppose investor Ben believes prices of ABC will go down from today's price of $50 per share, to $30 per share in two weeks. Now suppose Ben borrows 1 share and sells it for $50. In two weeks time, if the price goes down to $30, he will buy back the share and return it to his lender. This transaction will earn him $20.
Long And Short Positions
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Both Tim and Ben followed the most basic principle of the stock market to make a profit—buy low, sell high. When a stockholder holds on to shares to sell them at a higher price, he has a long position on the stocks. In contrast, a short position is when the investor sells high first, and then buys low. In the examples above, Tim has a long position and Bob has a short position.
Risk Tolerance
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One of the most important lessons in stock trading is to invest according to risk tolerance. Some stocks are more volatile than others, meaning that their prices fluctuate over a wider range. These stocks are high-risk investments because investors stand to lose a lot of money if the stock prices depreciate significantly. Investors make risky investments because, according to financial theory, high risk has the potential for high return; if the stock prices of a risky investment went up, investors would make a lot of money. In contrast, low risk investments are associated with low returns. When an investor makes a low risk investment, he would either make or lose money, but very little compared to higher risk investments.
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References
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