What Are Stocks & How Do They Work?

A stock represents ownership in a company. When you own a stock, you hold a share or a portion of that company's ownership. Publicly traded stocks are bought and sold on stock exchanges, allowing investors to become shareholders and potentially benefit from a company's profits and growth. 

Stock ownership comes with certain rights, such as the ability to vote on company decisions and receive dividends, the latter of which represent the portion of a company's profits that are distributed to shareholders. It should be noted that not all stocks pay dividends. 

The value of a stock can fluctuate based on various factors, including the company's financial performance, market conditions, and investor sentiment. Investors may buy and sell stocks with the goal of capital appreciation, or to generate income through dividends.

Stocks are categorized into different types, including common and preferred shares, and they play a crucial role in the broader financial markets, serving as a key instrument for companies to raise capital and for investors to participate in the growth and success of businesses.

Stocks can potentially generate positive returns for investors and traders through various means, as outlined below. 

Capital Appreciation: This occurs when the market price of a stock increases over time. If you purchase a stock at a lower price and sell it at a higher price, the difference represents your capital gain. Capital appreciation is one of the most common ways investors profit from stocks.

Dividend Income: Some companies distribute a portion of their profits to shareholders in the form of dividends. Dividends are typically paid out on a per-share basis, and at regular intervals (e.g. monthly, quarterly, annually). Investors who own dividend-paying stocks may therefore receive regular income in the form of dividend payments. The board of directors can lower or raise the dividend at any time, depending on the company’s growth/profitability outlook. 

Stock Splits: A stock split involves dividing existing shares into multiple new shares, typically with a lower nominal value per share. While a stock split doesn't inherently create value, it often leads to increased liquidity and can attract more investors, potentially driving up the stock's price in the long term.

Stock Buybacks: Companies may repurchase their own shares on the open market, reducing the number of outstanding shares. This can boost the stock price as earnings are distributed among fewer shares, potentially increasing the earnings per share (EPS) and making each remaining share more valuable.

Options Trading: Traders can use stock options to profit from price movements. Call options give the holder the right to buy a stock at a specified price, while put options give the holder the right to sell a stock at a specified price. Options traders can profit from price increases (with calls) or price decreases (with puts) without owning the actual stock. Learn more about options and how they work.

Short Selling: Market participants can profit from falling stock prices by engaging in short selling. This involves borrowing shares from a broker and selling them with the expectation of repurchasing them later at a lower price, and then returning those shares to the broker. The difference between the sale and repurchase prices represents a profit if the stock price declines. If the stock price rises, the investor/trader may book a loss. Learn how to short sell a stock.

Dividend Reinvestment Plans (DRIPs): Some investors choose to reinvest their dividends automatically by enrolling in DRIPs offered by certain companies. Instead of receiving cash dividends, these investors receive additional shares of stock, which can potentially lead to compounding returns over time.

Trading Strategies: Active traders may use various strategies, such as day trading, swing trading, or momentum trading, to profit from short-term price fluctuations in stocks. These strategies rely on technical analysis, chart patterns, and market trends to make quick buy and sell decisions.

Long-Term Investment: Many investors take a long-term approach, holding onto stocks for an extended period, sometimes decades, with the expectation that the company's value will grow over time. They may benefit from both capital appreciation and dividend income.

Initial Public Offerings (IPOs) and New Listings: Investors may participate in IPOs or invest in newly listed stocks, hoping that these stocks will increase in value as the company gains visibility. 

It's important to note that investing in stocks carries risks, including the possibility of losing money if the stock price declines. Additionally, individual stock performance can vary widely, so diversifying one’s investments across a range of stocks and asset classes is a common strategy to manage risk and optimize potential returns.

There are various forms and classifications of stock. Each type of stock or classification has its own unique features and characteristics, which ultimately cater to different investor preferences and objectives. The most common forms and classifications of stock are highlighted below. 

• Common Stock: Represents ownership in a company and typically comes with voting rights and the potential for capital appreciation.

• Preferred Stock: Offers fixed dividends and a higher claim on company assets in the event of liquidation but often has limited or no voting rights.

• American Depositary Receipts (ADRs): Represent ownership in foreign companies and are traded on U.S. exchanges. They simplify investing in foreign stocks for U.S. investors.

• Convertible Preferred Stock: Provides the option to convert preferred shares into a specified number of common shares, potentially benefiting from capital appreciation.

• Cumulative Preferred Stock: Guarantees that any missed dividend payments will accumulate and must be paid to shareholders in the future before common shareholders receive dividends.

• Non-Cumulative Preferred Stock: Does not accumulate missed dividend payments. If a dividend is missed, it is not owed to shareholders in the future.

• Participating Preferred Stock: Allows preferred shareholders to receive additional dividends beyond their fixed rate if the company's profits exceed a certain threshold.

• Non-Participating Preferred Stock: Caps the dividends paid to preferred shareholders at a fixed rate, regardless of the company's profits.

• Class A, Class B, and Class C Stock: Companies may issue different classes of common stock with varying voting rights, often used to maintain control within founding families or management.

• Restricted Stock: Typically issued to company insiders or employees, subject to certain restrictions or vesting periods before they can be sold or transferred.

• Treasury Stock: Shares of a company's own stock that have been repurchased and are held by the company itself. They do not have voting rights or receive dividends.

• Rights and Warrants: Rights are options given to existing shareholders to purchase additional shares at a specific price, often during a specified period. Warrants are similar but may be traded separately from the stock.

• Tracking Stocks: Created by companies to separate and track the financial performance of a specific business unit or division within the company.

• Master Limited Partnerships (MLPs): Represent ownership in a business entity structured as a partnership. Public MLP units are traded on stock exchanges and offer tax advantages but come with complex tax reporting requirements.

• Fractional Shares: Some brokerage platforms allow investors to purchase a fraction of a whole share, making it more accessible to investors with limited capital.

Market participants face a variety of considerations when investing in (or trading) stocks. Some of these considerations are highlighted below.

Establish Your Financial Goals and Risk Tolerance

• Determine your investment objectives, such as saving for retirement, buying a home, or building wealth

• Assess your risk tolerance to understand how much risk you are willing to take with your investments

Create a Budget and Potentially Set Aside Savings

• Ensure you have a budget in place to cover your daily expenses

• Consider establishing a savings account with several months' worth of living expenses (or more) in a liquid, easily accessible account

Choose an Investment Account

• Open a brokerage account on tastytrade to buy and sell stocks commission-free

• Consider whether you want a taxable brokerage account, or tax-advantaged accounts such as an Individual Retirement Account (IRA) or a 401(k) - if eligible

Conduct Market Research

• Conduct thorough research on the stocks you're interested in. Consider factors like the company's financial health, industry trends, competitive position, and growth prospects

• Read company reports, financial statements, news articles, and analyst reports

Determine Your Investment Approach/Strategy

• Decide whether you want to be an active trader, a long-term investor, or a combination of both

• Establish a clear investment strategy, such as value investing, growth investing, or dividend investing

• Learn more about technical analysis and fundamental analysis, and evaluate whether either of these disciplines (or a hybrid of both) might help guide your investment/trading approach

Execute Orders in the Market

• Log into your brokerage account and place buy orders for the stocks you want to invest in

• Specify the number of shares you wish to buy and the price at which you are willing to buy them

• Manage and/or close those positions according to your investment approach. 

Monitor Your Portfolio of Investments

• Keep an eye on your portfolio's performance and stay informed about market news and developments

• Review your investments regularly and consider rebalancing your portfolio if it deviates from your target allocation, or if it doesn’t match your risk profile and/or investment approach

Consider Building a Diversified Portfolio

• Consider diversifying your investments across various asset classes, including stocks, bonds, real estate, and cash

• Diversification can help spread risk and reduce the impact of poor performance in any single investment

Practice Disciplined Risk Management

• Set stop-loss orders to limit potential losses on individual stocks

• Utilize appropriate position sizing to ensure that capital is distributed in a balanced manner across your portfolio

Stay Informed and Educate Yourself

• Continuously educate yourself about investing

• Consider seeking advice from financial professionals 

Be Patient and Stay Disciplined

• Investing is usually a long-term endeavor. Avoid making impulsive decisions based on short-term market fluctuations

• Manage risk appropriately, and resist emotional reactions to market volatility

Remember that investing in stocks carries risk, and it's possible to lose money. It's crucial to do your research, have a clear plan, and be prepared for both ups and downs in the stock market. Additionally, consider consulting with a financial professional to help you make well-informed investment decisions based on your individual financial situation and goals.

Learn how to trade and invest in stocks.

Stocks and bonds represent different asset classes, which means they have different characteristics and risk profiles. They are also two of the most prominent asset classes in the investing universe. 

Stocks are often associated with growth and the potential for higher returns but come with greater volatility. Bonds, on the other hand, are associated with income generation and capital preservation, making them less volatile but potentially offering lower returns.

Investors often use a combination of stocks and bonds in their portfolios to achieve diversification and align their investments with their financial goals and risk tolerance. The mix of asset classes in a portfolio is a key element of an investor's overall investment strategy.

More details on the differences between stocks and bonds are highlighted below.

Ownership vs. Debt

• Stocks: When you buy stocks, you are purchasing ownership shares in a company, making you a shareholder. As a shareholder, you have a claim on the company's assets and earnings, and you may have voting rights in certain matters.

• Bonds: Bonds represent debt securities. When you buy bonds, you are essentially lending money to an entity, such as a corporation or government, in exchange for periodic interest payments (coupon payments) and the return of the principal (the bond's face value) at maturity. Bondholders are creditors, not owners.

Risk and Return

• Stocks: Stocks are generally considered higher-risk investments compared to bonds. Stock prices can be highly volatile and are influenced by factors like company performance, market sentiment, and economic conditions. However, stocks also offer the potential for higher returns over the long term.

• Bonds: Bonds are generally considered lower-risk investments compared to stocks. Bonds provide fixed interest payments, which are contractually obligated, and the return of principal at maturity. While bond prices can fluctuate based on interest rate changes and credit risk, they are typically less volatile than stock prices.

Income Generation

• Stocks: Stocks can provide income through dividends, but dividend payments are not guaranteed, and companies can choose to reduce or eliminate dividends if they face financial challenges.

• Bonds: Bonds offer regular interest income, usually paid quarterly or semi-annually. Bondholders receive these interest payments regardless of the issuer's financial performance, making bonds a source of predictable income.

Maturity

• Stocks: Stocks do not have a maturity date. You can hold them indefinitely as long as the company remains publicly traded.

• Bonds: Bonds have a specified maturity date when the principal is repaid to the bondholder. Maturities can vary from a few months to several decades, depending on the bond.

Ownership Rights

• Stocks: Stockholders have certain ownership rights, such as voting on corporate matters like board elections and major business decisions.

• Bonds: Bondholders do not typically have ownership rights in the issuer's decision-making processes. They are primarily concerned with receiving interest payments and the return of principal.

Priority in Bankruptcy

• Stocks: In the event of a company's bankruptcy, stockholders are among the last to receive any remaining assets after creditors and bondholders have been paid.

• Bonds: Bondholders have a higher priority in bankruptcy proceedings and are more likely to receive repayment of their principal and interest before stockholders.

Liquidity

• Stocks: Stocks are highly liquid and can be bought and sold on stock exchanges during trading hours. However, stocks with lower market capitalizations are typically associated with lower volume. 

• Bonds: Bond liquidity can vary based on factors like the bond's maturity, issuer, and prevailing market conditions. Some bonds may be less liquid than stocks. 

Private stocks and publicly traded stocks differ primarily in terms of who can buy and sell them, how they are traded, and the level of regulatory and financial disclosure they are subject to.

Ownership and Accessibility

• Private Stocks: These are shares of ownership in a privately held company. Private companies are typically owned by a smaller group of investors, founders, or private equity firms. Ownership in private companies is often limited to a select group of individuals or institutions, and these shares are not available for purchase on public stock exchanges.

• Publicly Traded Stocks: These are shares of ownership in publicly traded companies, which are listed on stock exchanges like the New York Stock Exchange (NYSE) or the Nasdaq. Publicly traded stocks are accessible to a wide range of investors and can be bought and sold by the general public.

In the context of financial markets, a stock represents ownership in a company. When you own a stock, you hold a share or a portion of that company's ownership. Publicly traded stocks are bought and sold on stock exchanges, allowing investors to become shareholders and potentially benefit from a company's profits and growth. 

Stock ownership comes with certain rights, such as the ability to vote on company decisions and receive dividends, the latter of which represent the portion of a company's profits that are distributed to shareholders. It should be noted that not all stocks pay dividends. 

The value of a stock can fluctuate based on various factors, including the company's financial performance, market conditions, and investor sentiment. Investors may buy and sell stocks with the goal of capital appreciation, or to generate income through dividends.

Stocks are categorized into different types, including common and preferred shares, and they play a crucial role in the broader financial markets, serving as a key instrument for companies to raise capital and for investors to participate in the growth and success of businesses.