Stock Swapping

Mar 15, 2000 |Todd Temple

"It seems like everyone's getting rich off the stock market these days. Everyone, that is, but you." If this sounds familiar, read on. Temple's primer on investing may be just what you need to get started.

These days it seems everyone is getting into the stock market. What was once a financial country club for the rich is now an investment playground for the rest of us. Some of the newcomers to the stock world have made more money playing the market than the experts have managed to earn in a lifetime of investing. And not long ago an office-worker friend of mine became a millionaire when her employer’s stock turned her options into gold.

Then there’s you. Well, not all of you, but some of you, I bet. Maybe you’ve stayed away from the market because, if truth be told, you don’t get it. And now that everyone else seems to get it – and can’t stop talking about it – it would be awfully embarrassing to reveal your ignorance. Not a problem. This month I’m going to give you a quick and oh-so-simple course in the ways of the stock market. So even if you don’t have money to invest, you’ll be able to hold your own in a conversation on the topic.

If You’re a Stockholder, You’re a Company Owner

Buying a share of stock in a company is the same as buying a portion of the company itself. In the financial world, stock is called an equity investment: A stockholder, or shareholder, has equity in the company. (The other popular way to invest in a company is through a bond, which is a debt investment – you’re really just renting, or lending, your money to the company.)

Most companies start out as private ventures – the founder or founders own the entire company – that is, all the stock. If those owners need to come up with more money to grow the company, they’ve got two options: They can borrow someone else’s money (with a loan or bond), or they can give up some of their ownership by selling stock to investors.

A company can sell, or issue, its stock in two ways: privately or publicly. Many startups issue stock privately just to get the company off the ground. These early, bold investors typically get sweet deals because they’re taking a greater risk with a startup than with a company that’s proven itself. The number of private shareholders is limited by law, so the company will typically seek out just a few investors willing to put up a lot of money. These people are often called venture capitalists – they provide the capital for a new business venture.

Share Swapping

You hear a lot more about publicly issued stock. Especially lately, when it seems like every other week someone becomes a billionaire the day his Internet company’s stock goes on the market. When a company first makes its stock available to the general public, it’s known as an initial public offering, or IPO. This means that the stock is traded in a public market and is available to anyone, not just big-time investors. The original owners get the proceeds from this initial sale. After that, the stock is traded between the rest of us investors; the company makes no direct profit from these subsequent transactions, or trades.

The trades themselves take place on a stock exchange, which is like a flea market or swap meet, where buyers and sellers haggle with each other to make the best deals. The most popular markets are the New York Stock Exchange (NYSE) and NASDAQ (National Association of Securities Dealers Automated Quotations). There are many other exchanges around the world; some work like the NYSE, where traders haggle it out in a big, noisy room. Others are like NASDAQ, with transactions taking place entirely electronically.

With billions of dollars changing hands during market hours, exchanges don’t let just anyone do business there. Instead, they limit the actual trading to brokers who are members of the exchange and are authorized to do the buying and selling on behalf of their clients – folks like you and me. So to buy or sell stock, you must hire a broker to do the deal for you. The broker takes care of the paperwork (which is now mostly data-work), and charges you a commission for the service.

Once upon a time, brokerage firms charged hefty commissions with high minimums that could easily eat up any profit made in a small transaction. This kept a lot of small investors out of the market. Then along came discount brokerages that charged lower commissions to those who didn’t need personalized service. And recently, the Internet has spawned online brokerages that charge very low commissions, thus opening the market to even the smallest investors.

Like items being sold at a public market, shares sold in the stock market are priced according to what people are willing to pay. You may offer to buy shares of a certain stock at one price, but if someone else offers a higher price, the seller will take the better deal. So a stock’s price often fluctuates throughout the day, depending on how badly people want to buy or sell it.

Since stock prices aren’t fixed, when you tell a broker to buy or sell shares, you must give a price. You can do this by setting a range. For example, you can place a buy order that says, in effect, "Buy 100 shares of XYZ stock, but don’t pay more than $20 per share." If the broker can find someone willing to sell the stock at that price, your order will be filled. If not, your order will come back unfilled: Raise your bid or go without. The same is true with a sell order. You tell the broker the price you want for your stock, and if someone’s willing to pay that price, your order will go through.

Making Money in Stocks

The most commonly understood means of profiting from the stock market is to buy shares at a low price and sell them at a higher price. That’s called long selling. But it’s also possible to make money on a stock whose price goes the other way. It’s called short selling: If you think a stock’s price is going to fall, you can borrow shares from a broker, sell them at the current, high price and keep the money. If things go according to your plan, the stock’s price will drop. Then you can buy enough shares at the lower price to pay back to the broker the shares you borrowed. Your profit: the difference between the price you sold the stock and the price you bought it at, less commissions and interest on the borrowed shares. But if the stock’s price rises instead of falls, you’ll have to pay even more for the stock you buy to pay back the broker. In other words, you lose.

There’s another way to make money from stocks that doesn’t involve selling at all. When a company is young and growing, it reinvests all its profits. But as a company matures, it may decide that it doesn’t need to keep pouring all its profits into growth. So it distributes some of the windfall to its shareholders by paying a dividend. Each stockholder gets a share of the distributed profits that’s equal to his or her stake in the company. Stocks that pay dividends are popular with older folks who depend on these payments for income. They’re less popular with younger people who earn regular paychecks and are trying to get the most out of their investment dollars in a shorter time.

As you can guess, there’s a whole lot more to stocks than I’ve covered here. But these are the basics — just enough to get you started without boring you with the gory details. But before making an investment, you’ll want to learn more: Despite all the recent hype about the riches awaiting you in the stock market, it’s still easier to lose than to gain money there. And go slow. Learn all you can about a company before investing, and make a small investment to test the waters. It’s no fun to lose your precious savings on your first adventure.

Copyright © 2000 Todd Temple. All rights reserved.

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