To start making any money in the stock market we first have to understand what a stock is and how it works.
How a stock is listed on an exchange
The NYSE and NASDAQ are both exchanges and stocks are “listed” on them to be bought or sold. Recall that stocks represent ownership in something. When you buy shares of stock you are essentially buying ownership. In the old days stock was issued by the voyages so you were buying ownership in the voyage itself. These days stocks that get listed on the exchanges are mostly companies and businesses looking to raise money.
At some point during their lifecycle all businesses will need funding to continue to grow. There are two ways that a company can do that:
- Equity Financing
- Debt Financing
Equity financing is issuing shares of stock to the public. It is a convenient way for them to raise money because they don’t have to pay it back or make interest payments on it like a typical loan.
Debt financing on the other hand is a loan with interest payments. Think of your car loan. You don’t have $25,000 just lying around but need to get a car. You take out a loan on the car from a bank in which you are obligated to pay back with interest.
Let’s say I launch a new business called Happy Tails that primarily sells and rents clothes for dogs.
I start out of my home but quickly move to a storefront from rising sales. After a year, business is booming and I have quickly established multiple store locations across the U.S. Dogs everywhere are now on the covers of GQ and Maxim. I then decide the next best move for the company is to expand overseas but I currently do not have the money to do that. I decide its best for the company to incorporate (be listed on one of the exchanges) and let part ownership in my company be available for purchase by the public. I need to raise 10 million dollars so I will issue out 10 million dollars’ worth of stock. The initial sale of Happy Tails stock to the public is what’s known as the Initial Public Offering or IPO
Before the first sale of stock is made to the public Happy Tails will need to determine what the asking price for 1 share of their stock will be. In this case Happy Tails decides that we are going to issue stock at $25 dollars a share. This means that in order to buy one share of stock it will cost you $25. If you were to go out and buy shares of Happy Tails stock, you would be part owner in the company. Don’t get confused by this though; even though you are technically part-owner you do not have a say in the day-to-day operations of the company itself. You cannot just by one share and start telling me (the CEO) what to do. In the same respect you cannot buy a share of Nike and walk into their store and walk out with a free pair of new sneakers. As part owner you do have voting rights when it comes to certain company decisions but I would not worry about that. The main thing you want to concern yourself with when you buy stock is making money!
How to Make Money
Whenever you buy shares in a company you believe that the value of those shares is going to increase. It’s like buying a baseball card and selling it a later time when it’s worth more. If you were to buy shares of Happy Tails at a price of $25 dollars a share, your thoughts are that the stock is going to rise in value over the time period that you hold it. Let’s say you go out and buy 10 shares for a total cost of $250. In 3 months’ time Happy Tails has expanded into China and has increased their revenue by 100%.
Investors are attracted to the stock because of this and the demand for the stock has caused it to increase to a price of $33 dollars a share. Now your shares that were worth $250 have increase by $80 to a total value of $330 dollars ($33-$25=$8, $8 x 10 shares=$80) If you were to sell those shares at their current price of $33 then you would make a profit of $80 dollars!
You have to consider the other side of the coin as well. Happy Tails share price could just as easily go down in value over that three-month period. Let’s they do expand into China in three-month time frame but revenues are actually down 50% than what was expected. Investors see this as a negative sign and begin to sell the stock. If you bought shares at $25 dollars and three months later they were trading at $20 a share then you would be down in value, losing money on the investment. That is the risk in the stock market and something that is essential to understand. That’s why it’s so important to do your research and due diligence before every trade that you go into which we will talk about in another article.
Once shares are available to the public and listed on the exchange anyone can trade them and their price moves based off of supply and demand. If there are more sellers than buyers the price of the stock will go down and if there are more buyers than sellers the price of the stock would go up. You make money when you buy at a lower price and sell at a higher price.
- Businesses can be financed with Debt or Equity Financing
- Initial Public Offerings are when a company initially lists on an exchange
- When you buy a stock you believe its value is going to go up
Homework: Look up 3 stocks and begin to track their price movement from day to day. You can use sites such as Google finance, Yahoo finance, CNN Money, and Market Watch to look up this information
Check out my article Myth1: Only Experts can Make Money in the Stock Market to start learning the most commonly used terms in the industry