There is enough history; and living people around to tell you stories about the marvels of stock market. While some traders would swear by it; some would be regretting ever having gone into it; some may be curious and wishing to tread the path; and rest may be indifferent to its existence.
My mail box is often more than half full from mails from people writing in to know the answer to the same old question, “how to make money trading stocks?” My reply must always sound somewhat disappointing because I always end up telling them that there is no sure shot way to do it, because if there was one, nobody on the exchange would be poor; and secondly nobody would be doing anything other than trading stocks. I’d like all new investors to clearly understand from the word GO that fixed mechanics and formulas are not meant to operate in stock markets. Don’t look for one size fits all items on this exchange.
A more appropriate question in my opinion would be “how to trade stocks”. More appropriate; simply because I have an answer to that question! Plus it reflects writer’s temperament and attitude towards learning the skill. Instead of asking how to make money trading stocks, you are focusing on making money; by asking the question “how to trade stocks” you are focusing on learning the skills. Here you are chasing the skill and once you master it money will follow you. So my first advice (yes, already!) is stop chasing money. Chase the skill instead. And I promise money will chase you.
So I have decided to write and dedicate one post for the new investors; those who are just starting out and who wish to learn basics of trading stocks. I am going to talk very primary stuff. And therefore there is no need to expect any intimidating, advanced, and complex stuff like financial statement analyses, capital gain tax; financial ratios, advanced trading strategies and so on.
So let’s begin with a basic explanation about what a Stock is. A stock represents a share in the company. Let us understand it with an example, say for a start-up of your company, and let us assume you need $50000 which you don’t have. So you divide this amount into 100 equal parts of 50 each and invite your family members and friends to contribute; alongside promising that number of shares they acquire will be proportion of their partnership in the business will be taken into consideration for the purpose of profit sharing.
The person who contributes $20000 holds four hundred ($50 per share divided to total amount $20000) shares; and likewise the person who contributes $10000 is said to hold two hundred shares in the company. Now suppose the company records a net profit of $20000 during its first year of operation, post all deductions. Now this $20000 will be divided into 1000 shares (which is total number of shares) and each share holder will be entitled to additional $2 per share; means profit got divided equally amongst all shareholders. Now some family member may wish to sell its share and there may be some people who may be wishing to buy them.
This is the starting point of trading; where someone is trying to sell his share in the business and somebody else is there looking to grab a share in that business. Prices at which the buying and selling would happen will be based on demand and supply of such shares. If more people are looking to buy a certain company’s share than there are buyers willing to sell them, it means demand is higher than supply and it will increase the price of such a share and in opposite condition price of share will fall.
Same procedure applies on larger scale with public limited companies where shares are offered in a much larger number to a much wider public and this happens via large trading platforms called exchanges. And people who help traders buy and sell shares of such companies on an ongoing basis are called brokers. While buying or selling stocks the trader must always keep his/her perspective on the stock and look at the company’s stability and what it represents before trading in its shares.
One major reason for stock prices to go down is that millions of people are buying and selling the same stock every minute and price changes in such a high octane auction environment is extremely likely. So every time price of shares of the company you bought (after giving a good thought) go down, you need not panic; because finally if your company is in good health and is showing good results, declaring dividends, etc; nothing can stop you from growing in the long run.
This is the reason why stocks are known to be highly fluctuating instruments. Since millions or more people are buying and selling the shares at the same time the price looses its balance and moves constantly. If sellers for a particular share are higher on a particular day than there are buyers then demand for that share on that day will be lower and this may lead to a drop in price and vice versa. I would like to re-emphasize and remind you that this price movement is hardly a reflection on the company’s performance.
Next let us understand what a stock Split is; a term we often hear people discussing in the trading circles. Stock split is said to have taken place in a company when it decides to split or divided its existing number of share into two, three whatever as per their board approved decision. Suppose if a company with 100000 shares of $30 each decides to split its share into two, it means for every share that the share holder holds he will get to hold two and the price of each share will become $15 instead of $30.
Companies decide to split shares with an objective of making it more affordable for people to trade it. On one hand where chances of its price increase improve; on the other it can also lead to drop in price that may take long to recover. Some people like to believe that splitting is a great move, but there is no truth in it because finally for the holder the value remains where it was. However there are some companies who as a policy do not split their shares and it’s a great reflection on their stability including the steady client base.
Then comes Market Capitalization. Not many people know what exactly market capitalization is and how can it be calculated. Once they understand it becomes easy for them to be able to use and apply it while building their own portfolio. In a layman’s language market capitalization is the total value of company in case someone wanted to buy it at its ongoing market rate.
It is an important concept because it helps people to arrive at and compare relative value and size of two or more companies. It helps a trader to decide which company to invest in. Suppose there are two companies with total 100000 and 50000 shares out in the market available at the current market price of $150 and $50 per share respectively. Market cap will help the trader to evaluate which company’s share hold a better challenge considering the future.
Flip side about market capitalization is that while calculating value of company, it does not take company’s debts into account. It simply considers total number of shares and, multiplies it by current market price to arrive at market capitalization; which is actually not the true price of the company.
Market capitalization is important because majority of traders who work based on portfolio build it based on Market Cap. It helps them balance it better; smaller companies growing at faster pace; balanced with a few shares from blue chip companies declaring big fat dividends year after year and a rock steady foundation, and so on.
Market capitalization can be divided into four groups. Micro Cap companies are those whose market capitalization is below three hundred million USD. Small Cap companies are those whose Market capitalization is between 300 million and 2 billion USD; Mid cap are companies with market cap between two and ten billion. Large Cap companies’ market capitalization lies between ten and fifty billion ND Mega Cap companies are those who are giants and their market capitalization is calculated at fifty billion or above.
We have covered basic introduction in this part. In our next and concluding part of A –Z Guide to Stock Trading, we will cover topics related to – dividends; things traders should know about stock prices; whether investing in blue chips is really such a good idea after all; how should you pick stocks for building your own portfolio; is investing in preferred stock any different from investing in stock; once you have finally decided about the companies whose stock you will buy, how should you ideally go about buying them; and finally learning to choose a broker with whom you will hopefully stick for the rest of your life.
Since next part of this article is mostly going to revolve around actual trading, let us get familiar with some of the most common and important terms used while trading.
1. Ask Price: This is the smallest price which the seller of the security is ready to accept while selling his holding.
2. Bid Price: Is the highest price at which the buyer is ready to buy a stock, commodity or any trading instrument.
3 Bear: Bearish is a trend and bear is the trader who drives this trend. A bear believes that the market in times to come will take a hit and prices will go down.
4. Blue Chip Company: a company with solid reputation, solid growth; solid history of returns including declaration of dividends; and finally flawless financial statements like balance sheet etc.
5. Book Value of a Company; is the total value of company arrived at after liabilities and debts being deducted from its total assets. Book value and market value are two very different things when it comes to evaluating a company and its stock. When market capitalization is compared to book value of company the latter stands nowhere before the former in value.
6. Broker: He is the person who helps the buyers and sellers of stock trade their preferred instrument on the exchange against a charge called either a fee or commission.
7. Bull – Bullish trader is opposite of bearish trader who believes that in times to come market will look up and prices will move upwards. This type of trader is the driver or bullish market trend.
8 Dividends: These are earnings or profits of the companies that are distributed amongst share holders every quarter or half yearly after discussion and due permission from its board of directors.
9.Dow Jones Industrial Average: This is a vey popular tool to judge the US stock market. DJIA comprises price-weighted list of the thirty high volume Blue Chip companies.
10. Market Capitalization: It is calculated by taking total number of available shares of a company and multiplying it by its market price to arrive at company’s market capitalization.
11. P/E Ratio: Suppose if stock of a company reporting for a 5 dollar profit per share is selling for $25 per share then in this case the P/E or price earning ratio will be 5. To arrive at P/E ration, market price of the share is divided by profit earned per share, which is $5 in this case.
12. NASDAQ is the most popular stock exchange in US based in New York. NASDAQ is where mostly technology shares are bought and sold. But otherwise exchange is a platform where not only shares but also options, bonds, future, currency, indexes, commodities, everything is traded.
In Part I of A-Z Stock Trading Guide for New Investors we covered basic lessons like, what a stock is, why stock prices are so volatile; how do traders make money trading them; things new traders need to keep in mind while examining stock prices; stock split; market capitalization and so forth. In this concluding lesson we are going to take a step further and cover other trading related aspects which will hopefully give you a clear view and idea about some more aspects of trading stocks online.
Let us start with dividends. These are part of profits that a company makes every year which it shares with its shareholders. It is not necessary that the company distributes the entire profit amongst its shareholders. It may decide to reinvest a part of it in business, hold some as reserve to meet contingencies and distribute some amongst shareholders. There are procedures to be followed by all companies prior to dividends being declared which may include meeting of board of directors, members and so on.
History proves that shareholders when they examine the over all output of the portfolio they hold, they come to a conclusion that they make more money by way of receiving dividend than they do from trading shares. Dividends are of many types, cash dividends; property dividends; special dividends that are paid once in lifetime; stock dividend etc. It is in the benefit of shareholder to understand various aspects related to dividend. The way they are calculated, the way they are declared; taxes; dividend re-investment plan and so on.
Next let us understand about blue chip companies and stocks. Blue chip stocks derive their name from the game of poker when the blue chip holds highest stake or value. Blue chip stocks are those that belong to a company which has shown consistent growth profits year after year. Owning blue chip companies’ stock is like owning a hen that lays golden eggs.
It would surprise our new investors and readers to know that though these stocks always ensure sure short return and people hardly lose money in such stocks, these stocks are seen as dull and unexciting; this can probably be attributed to lack of erratic moves in these stocks. I personally feel, speculators and short term traders would most agree and relate to this angle because when it comes to trading blue chip -`quick overnight profit’ is not what drives it.
What makes a company blue-chip? Well, the list is long and subjective. This is generally a large company that has shown consistent growth, earnings and diversification over the past years; a company whose balance sheet and other financial statements have shown favourable leanings and profits year after year; company that has almost always ended up paying dividend to its share holders; and the dividend has increased with each passing year; their credit ratings are good; debt burden is in control etc.
How to invest in blue chip stocks? Trader can invest in blue chip companies in several ways. They can go via a broker and pick up these stocks like they pick any other; they can get into direct stock purchase plan there is no need to employ a broker; then one can get into something called dividend reinvestment plan; another alternative is that a trader to get associated with blue chip companies is by way of investing in mutual bunds which exclusively deal in blue chip companies etc.
Next let us learn to identify opportunities where you can invest and start building your portfolio. The best way to go about building a sensible and long term portfolio is to go through the Standard and Poor listing and reference guide which contains details about small, mid and large cap index regarding everything from name of contact person and important position holders, to company’s address, phone number, returns, dividend declared; the S & P report also contains buy, hold, sell recommendation which you should not bother about. Instead, short list companies that look interesting to you in terms of growth in earnings; returns on equity and companies with moderate debt levels. Call the companies you finally shortlist for more information like access to their annual report online etc. When you examine facts from their report along with referring to their financial data you yourself will get enough ideas about investing in such companies.
Another way to build a stable portfolio is by referring to value line investment survey which you can subscribe to by paying $500 or visiting the nearby library and getting to see it for a much smaller fee. This report gives access to important data related to hundreds and thousands of companies without wasting any time.
Seek help of your friends or colleagues who invest and are more experienced than you. You can also hire wealth mangers or stock advisors if you feel more comfortable by having a professional on your side. However don’t feel intimated by his knowledge because finally it your money which is at stake. Have faith in your wealth manager and keep a tab on the market at the same time. Ask questions if you have.
Next we shall discuss what preferred stock are and how can you invest in them. Preferred stocks are stocks that find a place between bonds and our regular stocks. Preferred stocks come with some amount of guarantee where getting dividends are concerned. The years in which dividends are announced by the companies’ preferred stock holders get a priority over common stock holders.
Even in the situation of bankruptcy or company being wound up for any reason these preferred stock holders will have first right over the assets of the company when it comes to money being paid to them against the shares they are holding. Though these make for a comparatively safe investment however, the preferred stock holders can’t expect large capital gains. Preferred stock holders may or may not have voting rights in the company whose preferred shares they are holding depending on policies of individual companies.
The dividend paid on preferred stock may differ depending on terms that they were issued on. Some times preferred stocks also come with a clause which gives the holders of these stocks, the flexibility to convert them into ordinary shares. Then there is something called participating preferred stock which receive dividends and above it receive a special dividend. The permutations and combinations in which these shares may be issued or held are countless.
As far as reaction and moves of preferred stock vis-à-vis movements of ordinary shares are concerned, let’s understand it with an example. Suppose a computer or electronics goods manufacturing company discovers an innovation which is likely to bring a revolutionary change in the industry; in such a scenario ordinary stocks of such companies will see a sudden surge; however the news for preferred stock holders makes no difference as these stocks stand at a disadvantage at such times and lose out on such breaking news.
But if the new discovery it is finally found was blown out of proportion and as a result of this share prices will tumble down overnight; the advantage with preferred share holders is that as long as fundamentally if company is still in good economic health, these share will not be affected adversely even in such a situation.
Now the big question is, how much sense does it make to buy preferred stock? Well for individual investors preferred stocks don’t make much sense but for corporate firms it makes for a great investment options. Fed tax laws exempts preferred stocks dividends to the extent of 70%. As it brings tax relief for them Preferred stocks make for good option.
Individual investors do not get this relief and are required to pay tax on entire dividend received. What a trader should ideally do in invest in corporate bonds. This option will help you get a better after-tax yield; and if the trader belongs to the higher tax bracket he should opt for municipal bonds.
This brings us to the last step which is to start investing in stocks. There are four ways of investing. The first one is 401K plan, which is a retirement benefit plan. There are many plus points for people who opt for this plan like, Tax advantage, Employer match program, Investment customization and flexibility, Portability, Loan and hardship withdrawals. 401B plan is for traders who are not looking for profit.
The next way to invest is via Traditional Individual Retirement Account; trader can invest with the help of a broker; and lastly through dividend reinvestment plan. With the help of any of the above mediums trader can invest in the following ways. Trader can buy common ordinary shares, he/she can buy preferred stock; municipal bonds; the highly liquid money markets; and lastly index funds, mutual funds, and real estate investment trust.
Before investing a trader should do an in-depth research; he should examine financial statements like balance sheet, cash flow statement, and income statements etc of the company he is wishing to invest in. Besides financial statements the trader should also check their documents like the 10K, Proxy statement; annual report etc. Trader should also look into the company affairs and management.
The concluding lesson is dedicated to choosing a suitable broker for yourself. Your relationship with your brokerage firm whether you are planning to hire a stock broker; commodities broker; or future broker, bond broker, or a brokerage firm that undertakes all kinds of instruments trading, is going to last forever so it is utmost crucial that they are chosen with the required caution.
Before you sign on the dotted line with your broker it is advised that you read their terms and conditions carefully and discuss as much and for as long as you are not convinced. Have a look at their margin money requirement, their rules regarding credit terms, discounts, fee, commission; whether they are into manual trading or automated or both are applied in tandem; types of trading they undertake on behalf on their members; their help desk; forums and other facilities that they provide and so on.
For more information about stock trading please feel free to contact us.