What is a Stock and How Does it Work?

What is a Stock and How Does it Work?

Stock is equity. When you buy a stock, you become a part-owner of the corporation. However, stock doesn’t always refer to shares or equity of one company. It may refer to a collective of shares in a fund, which may include equities in multiple companies. It is also possible to trade in an index or indices of stock markets or exchanges around the world.

What is a stock?

The simplest definition of a stock is a certain number of shares—Investopedia is another great resource for information. Let us consider a company called Earth Inc. This company goes public or is listed in the stock exchange. One of the basic requirements of a company going public or raising capital from the masses is issuing shares or stocks. The company decides how many shares it will issue. The owners and original investors or promoters of the company will hold onto many of these shares. The remaining shares will be available for the public to buy.

Let us consider Earth Inc. having a million shares, of which three hundred thousand are made available to be purchased by people and traded via stock markets or exchanges. This corporation can be listed in more than one exchange, but such dual listing is not very common. The three hundred thousand shares that are available for public buying and trading are available to you as an investor.

You can buy any number of shares, hold on to them, earn dividends, or sell them for a profit. Whether you buy one or fifty of these three hundred thousand shares, you are effectively acquiring a stock. You are now a part-owner of the company. Your ownership is the fraction resulting from the proportion of stock to the entire number of shares.

How does stock work?

A million shares of Earth Inc. are priced per share according to the company’s earnings and other factors.

If one share is priced at ten dollars, then a million shares are worth ten million dollars. The value of the company, also known as its market cap, is ten million dollars. In the realm of stock markets and trading, this is a very small company. But, we shall get into market caps and the varying sizes or values a while later.

There are two ways a stock works for an investor or trader. Since a stock makes you a part-owner, you are entitled to a part of the profit the company makes and you must also bear the loss, proportionate to your ownership.

When a company makes a profit, it may choose to issue a dividend per share. This is like a profit or reward for the shareholders. The company may also choose to use the profits to fund its growth and development, in which case there may not be any dividend. However, the price of each share will increase due to the profitability and subsequent growth of the company. An investor or trader can sell the stock for a profit since the price of each share has now increased from the value at which it was purchased.

Dividend vs. Trading for a Profit

Taking the example of Earth Inc. wherein every share is priced at ten dollars, let us consider the corporation deciding a dividend of one dollar per share after securing a profit. If you own fifty shares, then you will make fifty dollars. If you own a thousand shares, then you shall get a thousand dollars. The dividend of one dollar per share is paid for each of the one million shares that the company has issued.

Now, let us consider that there is no dividend announced by Earth Inc., despite making a profit. In such a scenario, the price of a share, which was ten dollars when you had purchased it, is likely to increase. The increase could be two dollars, so the current price would be twelve dollars. The increase could be further, say five dollars, if the market is optimistic about the growth and future of the corporation. In such a scenario, you can sell your stock at the current price of twelve or fifteen dollars per share, whichever is the case. If you own ten shares, then you make twenty to fifty dollars in profit.

Whether it is through dividends or by the virtue of trading for a profit, you can make money with stocks. You can buy a stock, hold on to it, get paid in dividends, and still sell the shares for a profit after that. You can buy a stock, wait for its price to increase, and sell it for a profit. There are many kinds of investment and trading strategies at play.

Investing and Trading in Stock

You may choose to buy a stock, hold on to it, earn dividends, and later sell the shares at a much higher value when the prices have undergone substantial appreciation. Earth Inc. shares priced at ten dollars per piece can be worth a hundred dollars each in a few years.

Facebook shares were worth $38 each when its initial public offering happened in 2012. Today, a share of the social network giant is priced at $226. You can buy a stock at a certain value, hold on to it for a few years if there is sufficient scope for growth, then make a windfall gain by selling those shares at a much greater price. Alternatively, you can trade in stocks.

Stock trading does not require you to hold onto shares for a very long time. Trading is more frequent. This is why share prices for all stocks fluctuate throughout the day. Many reasons influence these fluctuations. There is a plethora of market dynamics at play, from speculation to futures, shorts to influences of politics, industrial policies, labor reforms, local laws, and other factors.

If you are interested in trading—check out eTrade to get started— there you can buy a stock, wait for a sufficient increase to make a modest profit, and then sell those shares. You can keep doing this all day with as many shares as you want. Most individual stock market investors are traders. They do not buy stocks for ownership or to hold on and earn through dividends. Most people look for quick payoffs, and hence trading has become the norm. Institutionalized investors or those who are serious about portfolios tend to play the long term game. You may choose either of the two approaches or a combination of both.

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