Of all of the trading/investment choices, financial instruments related to stocks are the most popular and widespread. Millions of Americans have a stake in the performance of the stock market directly or indirectly through individual accounts, 401(k) plans, individual retirement accounts, pension programs or some other means.
Startup or expanding companies can borrow the capital they need by issuing bonds, or they can sell pieces of the company to shareholders, sometimes in initial public offerings (IPOs) that attract a lot of publicity or with additional share offerings. How actively investors participate in this capital formation process is a vital factor in a country’s economic growth.
Opinions about stocks can be traded a number of ways. Here is just a brief overview.
Individual stocks
There are thousands of stocks from which to choose and almost as many investment/trading strategies, from hot “tips” on the internet to detailed recommendations from analysts who follow the stock closely.
For many, the lure of the stock market is the pick-and-stick method – trying to pick a little-known company that becomes a big winner and sticking with it. Their goal is to see the value of a stock appreciate. Others focus on established stocks – the “blue chips” – that pay regular and rising dividends, passing along a share of company profits to shareholders, or have a history of buying back shares to increase the value of remaining shares.
Those who use a fundamental approach to analyze stocks have many statistics to consider. The most popular is probably the price/earnings (P/E) ratio – the price per share divided by the past year’s earnings per share. Some favor a projection of forward earnings instead. A company’s P/E can then be compared with other company P/E ratios or industry averages to gauge whether the current stock price is cheap (P/E below 10, say) or expensive (P/E above 20).
Traders can focus on a number of other measures – sales, book value based on company assets, debt levels, company insider buying or selling . . . in short, this may be the type of relevant information that may be difficult for the individual trader to get in a timely manner and to interpret what it means when competing with professional analysts and traders. Often, how a stock performs depends on overall market and sector conditions.
In addition to buying and selling shares themselves, traders can use options on stocks to set up more complex strategies. Options are available on most widely traded stocks and can be used to get into a stock at a lower price or to earn incremental income on stocks being held in a portfolio. Or options can provide more leverage on a directional play or protection against an adverse move in the price of a stock.
Baskets of stocks
Instead of trying to pick the “right” individual stock, traders can buy a bundle of stocks in various forms to diversify their holdings and decrease their risk.
Mutual funds offer hundreds of combinations of stocks in many categories – aggressive growth, growth and income, emerging markets, specific sectors, countries or regions . . . In fact, it may take as much research to find the “right” mutual fund as the right stock. Essentially, a money manager takes over the role of selecting stocks and charges a fee for doing so.
The advantage of mutual funds is that an investor can get exposure to a number of stocks in a fund or family of funds with a small amount of money. They are usually a longer-term investment and not a trading vehicle although movement among funds is allowed by some firms. The disadvantage of mutual funds is their relatively high fee structure and the limit on purchasing and redeeming holdings to only one time and one price per day.
Index funds duplicate the makeup of a stock index, holding stocks in the same way the index does. When someone asks how the stock market did today, the answer is often, “The Dow was up (or down) X points.” The S&P 500 Index is another benchmark. The fund performance matches the index, minus fees charged by the manager. Options are also available on index funds.
Exchange-traded funds (ETFs) have become one of the hottest trading items since they were introduced in 1993. ETFs are available on many markets, from commodities to various stock sectors. They trade like a stock through brokers and cover many of the same categories as mutual funds but with lower fees and much more flexibility, including the ability to go short as easily as going long.
Stock index futures trade on futures exchanges as standardized contracts and provide another way to add leverage to stock trading without actually owning any of the individual stocks. They have also become very actively traded instruments since being introduced in 1982, especially the electronically traded S&P 500 Index e-mini futures contract.
