What are Stocks, and How Do They Work?

Stocks are financial instruments that represent fractional ownership of a company. Equities is another name for stocks. Units of stock are called shares. Being the owner of a company’s stock may have various benefits, including the following:

• Capital gains. If you purchase the stock of a company and its price rises, you can profit from the increase in the value of the shares. 
• Dividends. Some stocks pay dividends, which can come in the form of more stock or cash. In the US, companies usually pay dividends quarterly.
• Voting rights. Owning a company’s shares may grant you the right to vote at annual shareholder meetings.

There are two major kinds of stock: common stock and preferred stock. 

Common stock owners can vote on corporate policies and elect the board of directors. Common stockholders may also receive dividends. Common stockholders receive their money after preferred stockholders when a company goes bankrupt. Most investors in stocks are buying common stock. 

Preferred stock owners usually don’t have voting rights, but they receive dividend payments before common stockholders and may receive payments at a higher dividend yield. They also have a priority claim on assets in the event of the company going bankrupt. 

There are several types of preferred stock. 

• Callable shares are preferred shares that the issuing company has the right to buy back at a pre-set price in the future. 
• Convertible shares are preferred shares that have the option to be exchanged for common shares after a defined date. 
• Cumulative shares are preferred stock requiring that the company pay any unpaid dividends to preferred shareholders before common shareholders. 
• Participatory preference shares have a fixed dividend rate and pay additional dividends if the issuing company achieves predetermined financial goals.

It is also helpful to understand these other common categories for stocks: 

• Growth stocks are stocks of companies whose revenues and earnings are expected to increase faster than average. Growth stocks often have high price-to-earnings (P/E) ratios and usually don’t pay dividends.
• Income stocks are stocks of companies that pay regular, reliable, and relatively high dividends. They are also usually less volatile than growth stocks.
• Value stocks are stocks of companies with a price that seems low relative to the company’s financial performance. This may be reflected in a low P/E ratio. 
• Blue-chip stocks are stocks of long-established, stable, and well-known companies. Apple (AAPL) and Coca-Cola (KO) are examples of blue-chip companies.
• Large-cap stocks are stocks of companies with a market capitalization of more than $10 billion. Large-cap stocks are often viewed as relatively safe and stable due to the sheer size of the companies they represent. 
• Mid-cap stocks are stocks of companies with a market capitalization of between $2 billion and $10 billion. Mid-cap stocks are viewed as having a combination of stability and growth potential.
• Small-cap stocks are stocks of companies with a market capitalization of between about $300 million to $2 billion. Small-cap stocks have high growth potential but can be volatile and risky.
• Penny stocks are stocks of companies that trade for less than $5 per share. These stocks represent high potential risk and reward for investors. Penny stocks have a low market capitalization, are illiquid, and trade outside of major stock market exchanges.

Stock market sectors describe the different types of stock investments. There are 11 major stock market sectors.

• The Energy Sector includes companies involved in the production and supply of energy. ExxonMobil (XOM) and Chevron Corporation (CVX) are examples of companies in the energy sector.
• The Materials Sector covers companies that produce the raw and man-made materials used by other industries. Dow (DOW) and DuPont (DD) are examples of companies in the materials sector.
• The Industrials Sector includes companies that produce equipment used in manufacturing and construction. General Electric (GE) and Caterpillar (CAT) are examples of industrial sector companies.
• The Utilities Sector contains companies that provide basic amenities such as water and electricity. Duke Energy (DUK) and American Electric Power (AEP) are examples of companies in the utilities sector.
• The Healthcare Sector is composed of companies providing medical goods and services. UnitedHealth Group (UNH) and Cigna (CI) are examples of leading companies in the healthcare sector.
• The Financials Sector is made up of companies providing financial services such as banking, investments, and insurance. Bank of America (BAC) and Visa (V) are examples of companies in the financials sector.  
• The Consumer Discretionary Sector covers companies offering non-essential products. Starbucks (SBUX) and Walt Disney (DIS) are examples of companies in the consumer discretionary sector.
• The Consumer Staples Sector contains companies making products that are considered essential for everyday life. Procter & Gamble (PG) and Target (TGT) are examples of companies in the consumer staples sector.
• The Information Technology Sector represents companies that make software, hardware, and semiconductor equipment. Microsoft (MSFT) and Alphabet (GOOGL) are examples of companies in the information technology sector.
• The Communication Services Sector includes companies that provide communications services through a fixed-line, wireless, and the internet. AT&T (T) and Comcast (CMCSA) are examples of communication services sector stocks.
• The Real Estate Sector is made up of companies that develop and manage real estate. American Tower (AMT) and Crown Castle (CCI) are examples of companies in the real estate sector.

IPO stands for initial public offering and describes the process (also called floating or going public) of a company issuing stock for the first time. Money raised from an IPO is used to help a company cover operating expenses, pay off debt, and grow its business. IPOs allow early investors in the company to profit from their investments. Companies also benefit from a high level of publicity during their IPOs. When a company decides to go public, investment banks such as Goldman Sachs or Morgan Stanley provide underwriting services for new stock issues. After an IPO, a company’s shares are traded on a stock exchange, for example, the New York Stock Exchange or Nasdaq, making them available for purchase by the general public. 

Stock prices rise or fall in value based on supply and demand. When there are more buyers, stock prices are driven higher, and when there are more sellers prices are pushed lower. The bid/offer price represents the best price available to buy or sell a stock. 

When placing a stock trade through an online brokerage account, your order is sent over the internet to your broker. On receiving the order, the broker decides how to route it to be executed. It may be sent to an exchange, a market maker, or an electronic communications network (ECN). In the US, there is a legal mandate called Best Execution that obligates a broker to take care to execute a customer’s order in a way that gets the best result for the customer.

There are many types of trading in the stock market. Traders focused on technical analysis look at a stock’s price movement and trading volume to inform their decisions. These traders may look for candlestick chart patterns such as ‘Head and Shoulders’ or moving average crossovers as signals to enter a trade.

Meanwhile, traders using fundamental analysis draw from sources such as the company’s balance sheet and income statement in their strategy. These traders may also look to economic data such as the employment report or GDP to make trading decisions.

Beyond analysis, traders often specialize in trading in a specific timeframe. Day traders buy and sell stocks within a day in the hopes of capturing profits from short-term price moves. Swing traders hold stock positions for days, weeks, or months and long-term investors hold their positions for over a year. 

Investors typically buy and sell stocks through a brokerage firm, such as Ameritrade or Fidelity. These brokers provide them with access to major stock exchanges. Amid intense competition within the industry, online brokers have made it very easy to get started. Most US brokers have low or $0 minimums for the initial deposit to open an account. Commission-free trading has also become the standard among leading US online stock brokers. Fractional share trading now makes it possible to invest in companies with high price stocks, even if you have a low account balance.

Alternatively, it is possible to bypass using a broker when investing in stocks. Many companies allow the purchase of their stock directly via a direct stock purchase plan (DSPP). Buying stocks through a DSPP has the advantage of saving broker fees, which in the past have been substantial. However, with broker fees now slashed to a minimum, the appeal of DSPPs is diminished.