Part 1 – Stock Basics

Before picking companies and purchasing stock, you must understand what you are doing. There are a lot of terms when it comes to stocks and it can be hard to know what’s relevant. Let’s start by answering some basic questions about stocks.

What is a stock?

In its simplest form, a stock is a tiny piece of ownership of a company. When a company is (or decides to become) a publicly traded company, it allows the public to buy ownership of the company. When you buy a share of stock, you have essentially become an owner of that company (albeit at a very tiny fraction of a percentage owner). This can come with certain benefits such as voting rights, dividends, and stock splits, all of which we will discuss later.

How do I buy and sell stock?

Most people will purchase and sell stocks through a broker (Robinhood, Fidelity, etc.) instead of doing so directly through the company. If you want to buy a stock, you will need to find out which ticker symbol it trades under. Once you have found that, you can place an order with your broker to purchase. You can either select a price you want to buy (this is called a limit order) or buy it at its current trading price (this is called a market order). Similarly, if you own a stock, you can sell it at a certain price or at whatever the market price currently is.

What determines a stock’s price?

There are a lot of different things that go into a stock’s price. Supply and demand play a part, and so do fear and greed. For this, we will talk about the basics that determine a stock’s price. Let’s say you own a share of stock that you want to sell. You place an order to sell that share at 100$. Now I want to buy a share of that same stock, so I put in a buy order at 90$. At this point, nothing happens and neither of our orders gets filled. Now if we both changed our price and agreed to buy and sell that stock at 95$ our order would be fulfilled, and that stock would be valued at 95$ a share. Now imagine this same scenario playing out but with hundreds, sometimes thousands of people all trying to buy and sell stock at the same time. This is how a stock price can go up and down as sellers are constantly trying to get the highest price for their stock while buyers are constantly trying to get the lowest price.

What should I do with a stock once I’ve bought it?

There are a lot of different opinions on this question. Some people try to buy a stock for a low price in the hopes that it will quickly rise in price so they can sell it for a nice profit. Others will hold onto a stock for years because they believe in the company and feel like they will continue to become more valuable over time. Some stocks will pay out a dividend to anyone who owns them. This is a payment they make to their shareholders, typically with profits from running the business, that can either be used to purchase more of the same stock or can be cash deposited into your account. This is usually based on the number of shares you currently own (Ex: a company may announce they will pay 1$ for every share you own so if you own 100 shares, they will send you 100$). People typically get into stocks to make money one way or another. Make sure you do your research and make the decisions that make you the most comfortable when it comes to selling or holding a stock.

Part 2 – Should I Buy Stocks?

So you’ve learned a little about stocks and wondered if you should jump in and buy some shares. Before you go and dump your life savings into the stock market hoping to strike it rich, let’s talk about some things to consider ensuring our investment strategies match our financial goals.

What are you trying to do?

Many people think the stock market is an easy way to get rich or to create passive income. While sometimes this is true, the opposite is true way more often. There is a saying in stock trading that goes “Bears make money, bulls make money, but pigs get slaughtered”. Understanding a couple of things is important before you start dumping money into the market. What is your risk tolerance? How will you react if your portfolio drops 10% in a day… Will you panic and sell, or will you ride it out? How long are you willing to keep your money in the market? Are you trying to save for retirement or looking to spend money on a new car? These should be answered before you start putting money into the market.

Do you have extra money to buy stocks?

You are probably here because you can pay your bills consistently and are starting to have a little extra check at the end of your month. While this is a great place to be financially, it does not mean you are ready to start buying stocks. Consider the following prior to your first purchase: Have you matched all employer programs (401k, stock plans, etc.)? Do you have a safety net for unexpected expenses (some say you should have up to 6 months’ worth of expenses saved up)? Stocks should be one of the last things you start to dabble in after you have taken advantage of other programs and already have a decent-sized nest egg. Until you know what you are doing, never buy more in stocks than you would be willing to lose.

Are there alternatives I should consider besides individual stocks?

Whenever you invest money there is usually a correlation between the risk you take and the potential reward. Stocks are typically rated as a higher risk as well as potentially higher reward type of investment. Perhaps you are not ready to jump into it just yet. There are a couple of other investments you could try. You could buy an ETF (Exchange-traded fund) such as VOO or SPY which is a fund that owns multiple different companies and therefore less likely to have big swings up or down. You could also look at things like bonds which are loans you give to the government or corporations in exchange for interest once paid back (unlike stocks, bonds do not give you ownership of a company). You can also look at CDs (certificates of deposit) which will pay you out an agreed-upon rate depending on the amount and time you agree to keep the money with that bank. While no investment is without risk completely, these options are generally less risky than buying individual stocks and should be considered as part of your overall portfolio depending on your investment goals.

Part 3 – Advanced Stock Terms

By now you have purchased some stocks (maybe sold some as well) and have likely explored index funds or mutual funds. Maybe you dabbled in bonds and CDs a little bit, but these things just aren’t making you the money you thought they would. You want to explore some of the more lucrative types of trading you have maybe heard about in movies or from friends in the business. While these things are available to you, it’s important to understand that the higher the potential reward the higher the risk you put yourself into. We in no way encourage any specific type of trading but believe everyone should be well-informed before jumping into risky trades. To get started let’s discuss a few common terms.

Margin

This is a term used when buying stocks or other investment options using money that you are “borrowing”. There are certain types of trades that you can only do on margin. Most brokers will give you a multiple of whatever cash you have on your account as a margin (Ex: if you have $30k in your trading account you may be offered $60k in margin). This works similarly to a loan, and you must pay interest on any funds you use to buy or sell on margin.

Pattern Day Trader

If you are buying and selling stocks multiple times daily, you may run across this term. You can avoid pattern-day trading violations if you have over $25k in your trading account. If you have under this, you will want to wait until the funds clear after each sale prior to buying more stock (which can take several days between trades).

“Shorting”

This term is used to describe selling something you do not currently own with the expectation of replacing the thing you “sold.” If you believe a stock will go down in value in the immediate future, you could sell that stock short. Imagine it this way: Your friend has a PS5 that he isn’t using, and PS5s currently sell for around $500. You tell your friend you want to sell their PS5 today for $500 and you promise to give them another PS5 in a couple of months when the price drops. He agrees and when the price of the PS5 drops down to $400 you buy him a new one and you just made an easy $100. Shorting stocks is slightly more complicated than this but essentially works the same way.

Risks of these types of investments

When you buy a stock normally, the most you are risking is whatever the cost of the stock is. If I buy a stock for $100 and that company goes bankrupt, I can only lose $100. With margin and shorting those losses have no maximum loss. Let’s look at the unique risks of margin trades and shorting:

Margin risks

When you are trading with borrowed money, you risk not only losing the money that you have put into your account but also having to pay back whatever you borrowed. If you put in $100 and your broker gives you $200 on margin this essentially gives you $300 in buying power. Let’s say you decide to buy $300 worth of stock. You start accruing interest immediately on the $200 you are using that isn’t yours. Now let’s say that company goes bankrupt. You have now lost your initial $100 and you now owe your broker $200 plus any interest for as long as you borrowed that money. While your broker may loan you the money on margin, they expect you to get paid back regardless if you lose money or not. There is also the chance of a margin call. Let’s say in that same scenario the $300 worth of stock you bought dropped in value and was now only worth $50. You may believe in the company and that the stock will rise in value if you wait long enough, however, your broker says they will no longer loan you the money since your account has dropped and require you to put more money into your account or force you to sell out of your position so they can recoup some of their losses.

Shorting risks

Shorting a stock leverages margin in most cases so you automatically have the risk of paying interest on any amount you short while you are waiting for the stock to drop. Shorting stocks also have limited upside. If I short a stock that is currently trading at $100 a share, the most I can make from shorting that stock is $100 (if I short the stock and it goes to $0 then I’ve maxed out what I can make on that short). However, if stock prices go up instead of down, you can find yourself owing a lot of money. Imagine the same example with your friend and the PS5. In this example though let’s say that instead of the PS5 prices going down to $400, there is a shortage in supply and the price goes up to $1,000. You owe your friend a PS5 no matter what they cost so now you must go and spend $1,000 and buy him one so you have essentially lost $500. Margin calls can also force you to put more money in to hold onto your positions or force you to buy out of them if you end up going into the red too much. This is exactly what happened with stocks like GameStop and AMC. Many traders lost millions because they shorted stocks that skyrocketed and they were forced to pay outrageous prices to buy those stocks back.

Part 4 – Stock Options

Understanding option trading could take up several textbooks on the nuances and strategies needed to trade these. I will help you understand the basics of option trading to see if it fits in with your overall investment strategy.

What is an option?

When you buy a stock, you are buying a piece of that company. You own something that you can sell and should retain some level of value (outside of the company filing for bankruptcy). An option is a contract to either buy or sell a stock at a certain price within a given timeframe. By itself, an option is not ownership of a stock but rather the right to buy/sell that stock. It may help to think of options as stock insurance. If you had a large amount of a stock (Ex: you own $100k worth of a stock) you could buy an option as a safety net. Someone could agree to buy that $100k worth of stock from you for $80k any time in the next 2 years. In exchange for this “option”, you agree to pay them a premium of $10k. How does anyone make money in this example? Well the person who offered to buy your stocks for $80k just made $10k from you and they hope that the stocks never drop below that price, so they got $10k for free. Let’s say the company has a terrible year and the stock price drops where that stock is only worth $20k now. You can exercise your option and force the sale of the stock at the agreed-upon $80k which would minimize your losses substantially.

There are a couple of components to know about regarding options. You can either buy or sell the option to purchase stock at a certain price, or you can buy/sell an option to sell a stock at a certain price. These are “calls” and “puts”. Every option has a “strike” price (the amount the contract would be exercised for) and an expiration date (the date the contract will come to an end). It is also important to note that every options contract is for 100 shares of whichever stock it is associated with. It doesn’t matter if that stock trades for $10 or $1,000, all options are good for 100 shares.

What are the advantages of options vs. trading regular stocks?

Trading options allow you to bet on whether you think a stock price will go up or down. In traditional stock trading, if I think a stock will increase in value, I buy as much of that stock as I can. If I spend $10k buying stocks and it goes up 10%, I just made $1,000. In that same example though, if I had spent that $10k on an option for that same stock and it went up 10%, I could make 10’s of thousands of dollars depending on the option and price of the stock. Think of it like a casino. I could spend millions of dollars and open a casino and make a nice return every year of 10% OR I could take those same millions and bet it all on black at the roulette table. If I bet right, I will make a ton more money but I’m also taking a much bigger risk at the same time because if my bet is wrong, I lose all my money. If I spent that money on building a casino and it didn’t succeed, I could probably still sell the casino and make back a decent portion of my investment.

What makes an option price go up or down in value?

When looking at the “strike” price of an option, the further “in the money” you are, the more expensive it will be. The money refers to the strike price being better than the price the stock currently trades at. You also must look at the likelihood of the stock price going up or down within the timeframe it’s set for. Going past earnings dates will naturally increase the value of an option as those can cause stocks to drop or gain significantly. Typically, the longer an option has until it expires, the more valuable it will be. Options that are coming close to their expiration date and “out of the money” will likely decrease in value quickly as they are unlikely to be exercised and therefore not worth anything. To simplify things, you must look at how likely is the option to be exercised and how far “in the money” is it/ will it be when exercised to get a good idea of its value.

Are options worth trading?

Just like any investment strategy, option trading has its pros and cons. It is a higher-risk strategy because you are essentially “betting” if a stock will go up or down within a certain timeframe. The main difference with options is that you can’t just hold them forever and hope their value will go up. They will typically lose value over time if they are not close to the strike price. Option prices can also drop or increase in value much quicker than a stock can. Depending on the option, a stock may only drop 10% but the option attached to that stock could drop over 90% in value. Of course, the opposite is true and a stock that increased 10% in value could raise an option attached to over 100%. As always, never invest more in an option than you would be willing to lose, and set a stop loss to avoid losing your entire investment.