Knowing The Stock Market

By on April 10, 2017

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For someone who has never invested in the American stock market before, the plethora of confusing terms and lingo can make them stop dead in their tracks. There’s no question that the stock market is a complex entity; the many different ways of investing in it make it flexible yet challenging. The best way to get your foot in the door of investing in the U.S. stock market is by learning the basics of some of the most common strategies being used today. Below, we highlight a few of the most popular ways of investing in the stock market, providing simple definitions and easy to understand language so that you can have a better basic understanding of how this complicated phenomenon works.

Normal – Or Basic – Stock Purchases

A stock – or a share – is essentially a small piece of a public company. When you buy a stock, you are buying a tiny fraction of a company. There are two basic ways to buy stock in a company: through a brokerage firm, or through dividend reinvestment plans or direct investment plans. A full service brokerage firm is the more expensive of these options; in this case, the brokerage firm will basically hold your hand through the stock purchasing process, advising you on where to invest your money and offering strategies for doing so. A discount brokerage firm offers many of the same services, but do not offer as much assistance as full service brokerage firms do.

With dividend reinvestment plans (DRIPs) and direct investment plans (DIPs), individual companies allow shareholders to purchase stocks directly from them for a minimal fee. If you have a specific company that you would like to purchase stock in, you can easily find out whether they offer one of these two options and deal directly with them instead of through a brokerage firm – full service or otherwise. Many people feel greater confidence in dealing directly with the company whose shares they are purchasing, although this strategy works best for small amounts of money and isn’t practical for investing larger sums of money.

Stop-Loss Orders

When you are using the services of a brokerage firm, you can direct them to buy or sell a specific stock when it reaches a certain value. The theory behind doing this is that it limits your risk in terms of losing money on the stock market. For example, you can set up a stop-loss order for ten percent below the price at which you purchased a stock; in this case, when the value of that stock falls ten percent below where you purchased it, it is automatically sold. This technique appeals to those who don’t enjoy watching every little movement in the stock market. However, it does come with risks of its own.

On the negative side, a stop-loss order can be placed in such a way that even meaningless fluctuations prompt the sale of one of your stocks. The stock market is a very fluid entity, and individual stocks experience mundane fluctuations on a daily basis. The trick to placing an effective stop-loss order is selecting a sale price or percentage that won’t put it at risk of being bought or sold at importune times. In such cases, any convenience that may be discovered in setting up a stop-loss order is lost due to arbitrary sales of stocks that do not reflect the true state of the stock market in general.

Shorting Stocks

Shorting stocks is a strategy that is used to profit from stocks that are predicted to fall in price; in other words, it is the opposite take on traditional investing, wherein people seek to purchase stocks that are expected to increase in value. Basically, shorting stocks means selling stocks that you do not own; how is this done, though? Investors essentially “borrow” poorly-performing stocks and sell them. Since the stock in question is being borrowed, though, it must be returned. The goal in shorting stocks is to buy them back for less than what you sold them off for originally – that is where the profit is generated.

There are three parties involved in any short stock transaction, as opposed to the traditional two parties involved in regular stock purchases (i.e., buyer and seller): the original owner, the short seller and a new buyer. As the short seller, you would borrow shares from the original owner, then turn around and sell them to a new buyer on the open market. To cover this transaction, you must then go out and buy the same stocks to return to the original owner – preferably at a lower price, now that it has declined appropriately. As with any other stock market transaction, shorting stocks requires a bit of savvy and a lot of planning, and should not be done haphazardly.

Trading Options

Options trading is another popular way to invest in the stock market today. With options, the buyer gets the right – but not an obligation – to buy or sell a stock at a certain price on or before a specific date. The best way to get a handle on what trading options is all about is by understanding the two different types that are commonly available. The two basic types of options are call options and put options.

With call options, you purchase the right to buy a security at a specific price on or before a particular date. This would typically be done if you predicted that an underlying security would be rising before the option reached its expiration date. A good example of this would be purchasing a call option that gives you the right – but not the obligation – to purchase 200 shares of a certain stock at $20 per share on or before a set date; this option is purchased for $200. If the price of the stock goes up enough in the meantime to make doing this profitable, you can opt to buy those 200 shares. If the price has declined or not moved at all, you can take your $200 loss and move on.

Put options are the opposite of call options, and are often compared to shorting stocks. If you believe that the price of a stock will be going down, you can purchase a put option on it. This put option might be for the right to sell 100 shares of stock at $25 a share on or before a certain date; if the price declines in the meantime to $19 a share, you could buy some of it at that price, then use your put option to sell it back at the agreed-upon $25; in doing this, you will be making a nice profit. The different ways of trading options demonstrates how many different choices you have as an investor in the stock market today.

Writing Options – Naked And Covered

Naked call writing refers to the practice of selling a call option without owning any stock. If the underlying stock moves in the direction desired by the investor, very huge profits can be made. On the other hand, if the underlying stock moves in an unfavorable direction, the results can be financially disastrous. Therefore, only very experienced investors tend to get involved in writing naked options. Writing a covered option is far more common – and much less risky, as well.

Writing a covered option means that you are writing it on underlying stock that you own. This strategy is best employed against stocks that are not believed to be going up – or falling down – too much in price. In other words, it is best to attempt to write a covered option on stocks that are steady. It can provide a nice source of additional income, and doesn’t come along with all of the inherent risks involved in naked call writing.

When trying to get a grasp or a handle on the basics of the stock market and how to invest in it, it is best to start off simply and learn a bit as you go. Real experience is the best way to get a true understanding of the American stock market; however, arming yourself with a bit of basic knowledge is never a bad idea. By familiarizing yourself with some of the basic investing strategies in today’s stock market – normal stock purchases, stop-loss orders, shorting stocks, trading options and writing options, among others – you can form the foundation for a successful stock market investment portfolio.

Over time, you may discover that you are a more conservative investor and may opt to steer clear or naked call writing and shorting stocks. On the other hand, you may find those to be lucrative ways to make money. Stop-loss orders could very well become your best friends in the investment world, or you might decide that trading options is your real cup of tea. Either way, getting as much experience as possible is critical – and paying attention is key.

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About Terri A. Kamoto

Senior writer for FSN - Terri is a former financial analyst dedicated to making personal finances, budgeting, investment and insurance advice accessible, up to date and easy to understand. It is hard to find professional advice written in a language someone without a financial background can understand. Terri helps companies synthesize industry lingo and expertise into clear and informative content which builds smarter, financially successful individuals. You can find Terri on !

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