What are stocks?

Let us take a fictional company called X that has a fantastic new product. The fast growing demand for the new product requires the building of an additional factory.

Unfortunately, the company can’t afford to spend large amounts of money, leading the managers to consider request a loan from the bank. However, they figure out that it will take years to pay back the entire loan, not to mention the high interest payments. They therefore decided to look for another option.

A good way to raise the capitals needed for the constructions would be to offer a part of the business to the public, or in other words- for investment in the business the public can become a partner. This can be done by offering some of the company’s shares (also called stocks) to investors through the stock market (like the NASDAQ), also known as Exchange. Each investor pays the company for the amount of stocks that she is interested (and can afford) buying, and in return she gets a fractional ownership of the business. If for example you are one of the company shareholders, and you bought 5% of its stocks, you now own 5% of the business and if the company is profitable you are entitled to 5% of its dividends (the excess profits that the company chooses to distribute among its shareholders).

How are stocks traded

The company decides to issue stocks or “go public”. After the company goes public, by a procedure called Initial Public Offering (IPO), its stocks are now traded daily in one of the exchanges in the stock market, like the NASDAQ, AMEX, NYSE, or other exchanges around the globe. Shareholders can offer new investors to buy their piece of the business by selling them part of their stocks. The negotiation between the two sides is carried out through computerized system activated by the brokers, who are individuals or firms that charge commissions for executing investors buy and sell orders. If there is a match between the seller and the buyer offers, the order is executed. In this case, the seller gets the cash for the sell while the buyer receives the seller’s stocks. The buyer now owns a share of the company, equal to the percentage of stocks she has relative to the total number of shares the company has issued.

The bottom line is seems simple: buy low, sell high; buy your stocks at relatively cheap price, wait for the price to rise, and sell at the higher price. The difference between the price you paid to buy and the price you receive when you sell is your profit. The most important question is how to make this profit large as possible. First we have to understand how the price of a stock is determined.

What determines the price of a stock

Stock prices are determined by a combination of factors that no analyst or other market expert can consistently predict. In general, the prices reflect the long-term earnings potential of companies. Investors are attracted to stocks of companies they expect will create substantial profits in the future. Therefore, many people wish to buy stocks of such companies, raising the demand for the stocks, leading their prices to rise. On the other hand, investors hesitate to purchase stocks of companies that present prospect for poor earnings. Because fewer people wish to buy and more wish to sell these stocks, demand is low and prices fall down.

On the short term, stocks tend to be very volatile, especially due to today’s instantaneous availability of easily-obtained large amounts of online information. Economic events, company-specific news and even the illogical whims of investor sentiment can send the stock price into various levels of turmoil and celebration every day.
Picking winning stocks

Trading is about trying to figure out what will be the future price of a stock in the next hour, day, week, quarter, and even 15 years from now. Since this is not an easy task, how can you choose the right stocks, those with the potential for highest price increase?

This could be a complicated task. Each investor has his own techniques to search for the winners. Some investors, so-called value investors, consider the general business climate and outlook and the financial conditions and prospects of the individual companies in which they consider investing. They also try to analyze whether stock prices relative to the company’s earnings already are above or below acceptable norms. Other investors use technical (analysis) methods which rely in part on the trend in swings of the price to predict mainly its short-term future behavior. There are many other methods as well.