Investing Basics

3. Stocks

What Is a Stock?

Want to own part of a business without having to show up at its office every day? Or ever? Stock is the vehicle of choice for those who do. Dating back to the Dutch mutual stock corporations of the 16th century, the modern stock market exists as a way for entrepreneurs to finance businesses using money collected from investors. In return for ponying up the dough to finance the company, the investor gets shares of stock - specialized financial "securities," or financial instruments - that are "secured" by a claim on the assets and profits of a company. 

Types of Stock

Common Stock. Common stock is aptly named, as it is the most common form of stock an investor will encounter. It is an ideal investment vehicle for individuals because anyone can own it; there are absolutely no restrictions on who can purchase it. Young, old, savvy, reckless - heck, even professional mimes are allowed to own stock. [Editor's note: Complaints about this gratuitous and completely unnecessary shot at the fine profession of mime should be directed to the Association of Professional Mimes or, if you're really feeling ornery, the White House.] Common stock is more than just a piece of paper; it represents a proportional share of ownership in a company - a stake in a real, living, breathing business. 

By owning stock - the most amazing wealth-creation vehicle ever conceived (except, maybe, for just inheriting money from a relative you've never heard of) - you are a part owner of a business. Shareholders "own" a part of the assets of the company and part of the stream of cash those assets generate. As the company acquires more assets and the stream of cash it generates gets larger, the value of the business increases. This increase in the value of the business is what drives up the value of the stock in that business. 

Because they own a part of the business, shareholders get one vote per share of stock to elect the board of directors. The board is a group of individuals who oversee major decisions made by the company. Far from being a perfunctory collection of do-nothings, the board normally wields quite a bit of power in corporate America. Boards decide how the money the company makes is spent. Decisions on whether a company will invest in itself, buy other companies, pay a dividend, or repurchase stock are all the purview of the board of directors. Top company management - who the board hires and fires - will give some advice, but in the end the board makes the final decision. 

As with most things in life, the potential reward from owning stock in a growing business has some possible pitfalls. Shareholders also get a full share of the risk inherent in operating the business. If things go bad, their shares of stock may decrease in value - or even end up being worthless if the company goes bankrupt. You will learn about selecting stocks - or businesses - in Step 6. Analyzing Stocks. 

Different Classes of Stock. Occasionally, companies find it necessary for various reasons to concentrate the voting power of a company into a specific class of stock where the majority is owned by a certain set of people. For instance, if a family business needs to raise money by selling equity, sometimes they will create a second class of stock that they control that has ten votes per share of stock and sell a class of stock that only has one vote per share to others. Does this sound like a bad deal? Many investors believe it is and routinely avoid companies where there are multiple classes of voting stock. This kind of structure is most common in media companies and has been around only since 1987. 

When there is more than one kind of stock, they are often designated as Class A or Class B shares. On the Netcenter Company Lookup page, this is signified on the New York Stock Exchange and American Stock Exchange by a period and then a letter following the ticker symbol, a shorthand name for the company's shares that brokerages use to facilitate transactions. For instance, Berkshire Hathaway Class A shares trade as BRK.A, whereas Berkshire Class B shares trade as BRK.B. On the Nasdaq stock market, the class of stock becomes a fifth letter in the ticker symbol. For example, Tele-Communications, Inc. has TCOMA, the Class A shares, and TCOMB, the Class B shares. 

Other Types of Stock. You will learn about preferred stock and Real Estate Investment Trusts (REITs) in Step 5. Bonds. 

HOW STOCKS TRADE

Probably one of the most confusing aspects of investing is understanding how stocks actually trade. Words such as "bid," "ask," "volume," and "spread" can be quite confusing if you do not understand what they mean. Depending on which exchange a stock trades, there are two different systems. 

Listed Exchange. The New York Stock Exchange and the American Stock Exchange (composed of the Boston, Philadelphia, Chicago, and San Francisco Exchanges and now merged with the Nasdaq stock market) are both listed exchanges, meaning that brokerage firms contribute individuals known as "specialists" who are responsible for all of the trading in a specific stock. With the help of technology, the specialist quickly matches buyers with sellers. Sometimes referred to as "an auction market," the specialist can see who has blocks of stock to buy or sell at various prices and links them up. In return for this service, the specialist charges the buyer an extra fee of $6.25 or 12.5 cents per share, depending on the price of the stock. Volume, or the number of shares that trade on a given day, is counted by the specialist. 

Over-the-Counter Market. The Nasdaq stock market, the Nasdaq SmallCap, and the OTC Bulletin Board are the three main over-the-counter markets. In an over-the-counter market, brokerages (also known as broker-dealers) act as market makers for various stocks. The brokerages interact over a centralized computer system managed by the Nasdaq, providing liquidity for the market to function. One firm represents the seller and offers an ask price (also called the offer), or the price the seller is asking to sell the security. Another firm represents the buyer and gives a bid, or a price at which the buyer will buy the security. 

For example, a particular stock might be trading at a bid of $6 and an ask price of $6.50. If an investor wanted to sell shares, he would get the bid price of $6 per share; if he wanted to buy shares, he would pay the ask price of $6.50 per share. The difference is called the spread, which is paid by the buyer. This difference is split between the two firms involved in the transaction. Volume on over-the-counter markets is often double-counted, as both the buying firm and the selling firm report their activity. 

Stock Derivatives - Options and Futures

Arguably the most volatile and risky investments possible, options and futures are "derivative" securities, meaning their value is "derived" from that of another security or commodity. Options and futures are both very volatile because they often carry an incredible amount of leverage. For instance, each options contract on an individual stock controls 100 shares of that stock for a fraction of the stock's current value. This can make for huge upward moves, but this is offset by the risk of losing 100% of the money put into the option. (Most purchasers of options lose money.) If an investor owns an option and the underlying stock is not within the given price range within the given time period, the option expires worthless. The Motley Fool does not consider "investing" in options to be a very sound strategy - the chances of the options expiring worthless are much too high for options to be considered a useful part of any completely nutritious investment strategy. 

Buying Stocks

Use a Brokerage. The most common way to buy stocks is to use a brokerage. You can either use one of the many way-too-expensive full-service (or full-price) brokers or a discount broker to execute your trades. You will learn more about the ins and outs of brokerages and how to pick one in Step 7. Picking a Broker. When you use a brokerage, you can have a cash account or a margin account ("Danger, Will Robinson. Danger!"), meaning you can borrow money to buy stocks. For more details on margin, check out this Margin Foolnote. 

Dividend Reinvestment Plans (DRPs) and Direct Investment Plans (DIPs). Known lovingly by many investors as Drips, these are plans sponsored by individual companies that allow shareholders to purchase stock directly from a company with only minimal costs or commissions. These plans are great for those who have small amounts of money but who are willing to invest it at regular intervals. You will learn more about DRPs and DIPs in the Motley Fool's comprehensive Drip Area, which is more exciting than it sounds! 

Shorting Stocks

If you buy a security with the expectation that the price will rise, you are "long" the stock. If you sell a stock you borrow from someone else hoping that the share price will go down, you are "short" the stock. And if you are neither short nor long the stock but are looking at it a lot, you are "medium" the stock. (Kidding.) When you short a stock, you hope to repurchase it later at a lower price and then return the shares to the owner and keep the difference. Although shorting is not the place for new kids on the investment block to start, more experienced investors may want to consider adding shorting strategies to their investment toolbox. Shorting not only offers you a way to make money if a stock goes down but also acts as a hedge against falling markets. 

The basics of the shorting transaction are straightforward. You first contact your brokerage in order to determine whether it can borrow shares of the stock you want to short. When you receive the borrowed shares, you immediately sell them and keep the cash, promising to return the shares at some future time. The plan is to eventually repurchase the shares at a lower price and return them, keeping the difference yourself. But, sellers beware, if the stock's price rises, you might have to buy back the shares at the higher price and thus lose money. The biggest danger of shorting stocks is that stocks that are shorted can keep rising and rising, potentially costing a short-seller more than all the money put at risk. The most money that can be lost "long" on a stock is all the money used for the purchase. For more information on shorting, check out this Shorting Foolnote. 

Summary and Next Steps

We hope that wasn't the most painful thing you've had to read this week. You're now conversant enough in stock market matters to impress those who are very easily impressed. You've learned that each share of stock represents a proportional share of a business and that the potential rewards are great but that stocks are also riskier than putting money in the bank. You're also aware of the different types of stock (and how each classification is reflected in the ticker symbol), how they are traded on the exchanges, and how to buy them. You even learned a little about options and shorting stocks. 

A word of caution at this point: Knowing the terms and general workings of the stock market is just the first step in your investing career. We think that only fools (note the lowercase "f") would jump in and start shorting stocks or considering options at this point. Later on in Investing Basics we'll get back to individual stocks as we explore investing approaches in Step 6. But now onto Step 4. Mutual Funds - many of which are invested in the stocks we have discussed here. 

Margin Foolnote

Cash vs. Margin. If you invest in stocks just with the money you have in your brokerage account, you are using a cash account. If you borrow money from the brokerage to invest in stocks, you are using a margin account. If you borrow money in a margin account to buy stocks, keep in mind that this is not at all "free" money. Your collateral for borrowing the money is the marginable securities in your account, which means they are forfeit if you cannot otherwise repay the margin loan. You also have to pay a fixed amount of interest on the borrowed money on a monthly basis, which can reduce your overall returns. Because IRAs and other retirement accounts are cash accounts, you cannot use margin in them. 

Why Use Margin? Many investors use margin to "juice" up their returns, but fail to appreciate that it can also "squeeze" down their returns. Just as you can make more money than you otherwise would have by using margin, using margin inherently puts you in the Double Jeopardy round - where your running tally can either move up or move down much more quickly than without margin. The worst-case scenario is when a stock price drops so much that it causes a "margin call," which means you either add more money to the account or you automatically get sold out of the position at a loss. 

What Stocks Are Marginable? The Federal Reserve Board currently regulates which stocks are marginable. As a general rule, stocks selling below $5 are never marginable and recent initial public offerings are rarely marginable, although it does happen on occasion. Beyond this, individual brokerages also can decide not to margin certain securities for various reasons. Because of this, your brokerage is always the best source of information for finding out whether or not a security is marginable. 

Initial and Maintenance Margin Requirements. The amount you can borrow on margin is limited by both the Federal Reserve Board and the individual brokerage you use. There are two requirements - how much margin you can initially use and then how much margin you can have after you make the initial transaction. Although each brokerage is different, as a general rule 50% of the purchase price of any security can be margin. After you take the position, there is a maintenance margin account requirement that is normally much lower, often around 25%. Check with your brokerage to find out your initial and maintenance margin requirements. 

Calculating Buying Power. After you find out the margin requirements at your brokerage, you can calculate your buying power. This is how much total stock you can buy given your current cash and marginable securities, including margin. For instance, if you have $3000 in cash or marginable securities and the initial margin requirement is 50%, you have $6000 in initial buying power ($3000 equity/($3000 equity + $3000 margin) = $3000/$6000 = 50%). Be very careful when calculating how much buying power you have in your account, as nonmarginable securities do not contribute at all to your buying power. 

Margin Call. Should you fall below the margin requirements, you may be subject to a margin call. If so, you have three days to send in more cash or securities to cover the deficiency or you will be forced to sell out of your positions. How can you calculate how close you are to the requirement? If you took the $6000 position described above using $3000 in margin and your maintenance margin requirement was 25%, the position could fall as low as a total value of $4000 before you risked a margin call. ($1000 equity/($1000 equity + $3000 margin) = $1000/$4000 = 25%). 

Using Margin. Just as the Fool eschews credit-card debt, we do not believe that the average investor should or needs to be using margin. Although very aggressive, experienced investors could probably margin their accounts up to 20% without incurring a margin call, the fact that your losses are exacerbated should give even the most fearless investor pause. However, because most brokerages will let you short stocks only if you have a margin account - even if you have the cash to cover the short in your account - you may, nonetheless, end up signing that margin agreement and sending it off to the brokerage. Once this is done, however, don't be in any rush to give that margin a test spin: The Fool doesn't let new Fools use margin. 

Shorting Foolnote

What Is Shorting? An investor who sells stock short borrows shares from a brokerage house and then sells them to another buyer. Proceeds from the sale go into the short-seller's account. He must eventually buy those shares back (called covering) at some point and return them to the lender. The short-seller expects that the stock price will go down, so when he buys back the stock to cover, he will pay less for the shares and keep the difference. 

Thus, if you sell short 1000 shares of Gardner's Gondolas at $20 a share, your account gets credited with $20,000. If the boats start sinking - since David Gardner, founder and CEO of the company, knows more about singing gondolier show tunes than about keeping gondolas afloat - and the stock follows suit, tumbling to new lows, then you will start thinking about "covering" your short there for a very nice profit. Here's the record of transactions if the stock falls to $8: 

Borrowed and sold short 1000 shares at $20:	+$20,000
Bought back and returned 1000 shares at $8:	-$8000
Profit	+$12,000

But what happens if as the stock is falling, Tom Gardner, boatsman extraordinaire, takes over the company at his brother's behest, and the holes and leaks are covered? As the stock begins to take off, from $14 to $19 to $26 to $37, you finally decide that you'd better swallow hard and close out the transaction. You do so, buying back shares at $37 each. 

Here's the record of transaction: 

Borrowed and sold short 1000 shares at $20:	+$20,000
Bought back and returned 1000 shares at $37:	-$37,000
Loss	-$17,000

Ouch. So you see, in the second scenario, you lost $17,000 ... which you'll have to come up with. There's the danger of shorting - you have to be able to buy back the shares you initially borrowed and sold. Whether the price is higher or lower, you're going to need to buy back the shares at some point. 

Covering and Called Away. When you buy back the shares you have borrowed and return them, this is called covering your short. Although most of the time you can hold a short indefinitely, there are two situations in which you can be forced to cover. The first is when you get a margin call because you have hit your margin maintenance level (described in the Margin Foolnote. Unless you put more money in the account within three days, you will be forced to cover. 

The second circumstance is when you have your short "called away." You can actually be forced to cover if the shareholders you have borrowed from sell their positions. As they cannot sell what they do not have, your brokerage either has to come up with new shares for you to borrow or you have to cover. This is rare, but it occurs occasionally when a lot of one particular stock is sold short. 

You Can Lose More Than You Have. The most important thing to recognize when shorting is that you can lose more money than you initially invested in the short. Your downside is limited only by the fact that you will eventually get a margin call when your account reaches its margin maintenance level. The best you can hope for in a short sale is for a company to go out of business and stop trading, which means you never have to cover and you score a 100% gain. 

Short Interest. Many investors often want to know how much of a particular stock is sold short before they will short it themselves. Two ways to assess this are short interest and days to cover. Short interest is the total number of shares that have been sold short. Many investors will take this number and compare it to the total number of shares outstanding, or the "float" (shares available for trading by the public), in order to get a sense of the%age of stock that has been sold short. Many times, when a high%age of the float has been sold short, it becomes difficult to initiate new short positions. If too much of the stock is held short, it can lead to a short squeeze (see below). 

Days to Cover. Days to cover, also known as the short interest ratio, takes the number of shares sold short and divides this by the average daily volume in the stock to show how many days' average volume it would take to cover all of the shorts. For instance, if there are 1,000,000 shares sold short and the average daily volume is 10,000 shares, there are 100 days to cover (1,000,000/10,000 = 100 days). The reason many people pay attention to this is the belief that if a company has been shorted by a lot of people, it is actually a positive indicator because all those shorts have to buy back shares at some point. Academic studies have failed to support this notion, however, consistently showing that highly shorted stocks tend to underperform the indexes by a large margin. 

Short Squeezes. When a number of short sellers all try to cover their short positions at the same time, it can drive the stock price up very quickly. This is called a short squeeze, as the upward movement of the price actually induces more short-sellers to cover, pushing the stock price even higher. Although most of the time news will start a short squeeze, occasionally traders who see a company with a high number of days to cover will start buying the stock to set off a short squeeze. For this reason, we advise that you avoid shorting stocks that already have a fairly hefty amount of existing short sales. 

Dividends and Stock Splits. If a stock pays a dividend while you are selling it short, you actually have to pay the dividend. Because you borrowed the shares and sold them, the company does not have to pay a dividend to you as you do not own any shares. However, the person you borrowed the shares from expects a dividend and you have to ante up. If a stock splits 2-for-1 while you are selling it short, you owe twice the amount of shares back (although presumably at half the price). 

Why Short? Since you are betting that the stock price will go down when you short a stock, many people believe that shorting is un-American. However, you shouldn't totally rule out selling short - for long periods of time, like the 1930s and the mid-1970s, almost the only way an investor could have made money in the stock market was by short selling. The long and the short of it is that those who oppose shorting don't recognize that every transaction requires a buyer and a seller. Because it provides a ready supply of sellers, short selling helps maintain a liquid and rational market. 

Terms and tips mentioned in this article with detailed analysis:
• DRPs and DIPs
• Picking the Right Discount Broker
• Demonstration of Shorting A "Buzzard Bait" Stock
• Frequently Asked Questions About Direct Investing

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