What are stocks and shares?
The stock market is one of the most recognisable and talked about areas of financial trading. Each day billions of dollars are exchanged by traders, buying and selling shares of individual companies on the stock market.
What exactly are shares (also often referred to as "stocks") and what exactly is the stock market?
Shares are a unit of ownership in a company
If you buy a share of a company, you have bought a unit of ownership of that company. This is why companies that allow people to buy their shares are referred to as public companies – they are owned, in part, by the public.
If you own just one share of a public company, you are a shareholder of that company. The more shares of a company you have, the higher the percentage of the company you own.
People buy and sell shares to make a profit
The main reason that anyone will buy a share of a company is to make money. They believe they will either get a return from dividend payments – part of the company's profit made to the shareholder by the company – or that the demand for the shares they buy will increase and they will be able to sell them at a later date for a profit.
If the demand for the shares of a company increases, then the price of those shares also increases.
There are multiple reasons why the demand for shares goes up, however, to illustrate this, let's use a simple example.
Due to the fact that buying shares can give the owner benefits, such as dividend payouts, there is a certain amount of demand for them.
If the company is very healthy and increases its profit, then the dividend payout is likely to go up. More people will want to buy those shares, which means that the price of those shares will also increase. This is just one scenario in which the demand for a company's shares will go up.
Does it make sense to buy and sell shares?
Buying and selling stocks and shares is riskier than holding cash in a savings account. Over the long term however, it tends to produce much better returns.
Compared with typical annual returns of 3% for a savings account, or 5% for a high-interest savings account, you could make profit of as much as 50% per year through trading shares in a single company - if you stock pick correctly. That said, you also face the risk of a similar sized loss.
Shares in general do however tend to outperform both cash and fixed-income products like bonds. Simply buying the
100 index of large UK-listed stocks could earn you 5% to 15% a year if held over the long term.
You could also achieve this by investing in a well diversified portfolio. Read the Intro to portfolio building to find out how.
Trading shares
Traders will try to determine whether the demand for those shares will increase in the future, so they can buy them at a low price and sell them for a higher price.
Through a mechanism call short selling – selling share without actually owning them – traders will also try and sell shares in the anticipation that they will decrease in value, in order to buy them back at a lower price.
The methods that people use to judge whether the shares of a company will go up or down in value are numerous.
For example, traders will look at the financial statements of a company, the products that the company is developing, possible growth prospects, the current business environment, as well as price charts – anything to determine whether the demand, and hence the price, will increase or decrease.
Shares are bought at the stock market through brokers
An individual cannot buy shares directly from someone or directly from a company (there are special circumstances where you can purchase shares directly, but we will focus on trading in the stock market for the purpose of this lesson).
People have to go to a stock market to buy and sell shares and access to the market is provided via a broker.
Short term trading vs long term trading
Traders will open long or short positions and can hold these positions for any time span they wish. Some traders prefer short term trading, holding trades for a few minutes and some prefer holding trades for longer periods.
Short term traders
Traders who are focused on short term horizons are likely to focus on technical analysis to take advantage of short term price movement. The long term prospects of a company are much less relevant because the trader is not looking to hold a trade for longer than a day, a few hours or even a few minutes.
This is not to say that the fundamentals of a company are completely ignored, because there are certain news announcements that can change the price of a share and short term traders can take advantage of this.
Longer term trading
Traders that hold positions for a longer term focus more on the fundamentals of a company to see if a price movement is likely to continue. A price movement will continue if the demand for those shares is sustained and so those looking to hold on to shares for a while will look at the longer term prospects of the company.
Technical analysis is not abandoned when trading on a longer time frame – a price chart can show good points to buy and sell. Predominantly, however, they rely on the fundamental analysis of a company to determine whether they are going to trade the shares of a particular company in the first place.
The next lesson will go more in-depth into the different ways you can trade shares.
Summary
In this lesson you have learned that:
- a share is a unit of ownership in a company. If you buy stock, you buy a small part of that company.
- traders buy stocks because they believe the value will go up and they can sell them for a profit at a later time. They can also short sell a share if they believe the price will go down.
- there are many different ways to determine whether a share will go up, such as financial statements, products in development, growth prospects and price charts.
- different traders will prefer holding open positions for different lengths of time.
- those that prefer short term horizons will generally pay more attention to technical analysis, but will still look to take advantage of the price changes caused by news releases.
- traders that prefer a longer time horizon will look more at the fundamentals of a company and less attention to shorter term charting patterns.
