Investing > How Do Stocks Work?

How Do Stocks Work?

Stocks can work to grow wealth and protect against inflation in a number of ways.

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Updated March 17, 2021

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If you had invested when the stock market crashed in March 2020, at the start of the Covid pandemic, you likely would’ve made a lot of money.

In fact, we all would’ve. So—why didn’t we?

Prior to the pandemic, 42% of people said they did not invest in stocks. While there were various reasons for not investing, they basically boiled down to this one: not knowing enough about the market. 🤦‍♂️

Even if you don’t plan to invest much capital, it’s crucial to know how stocks work so you can make informed decisions. There are many different types of stocks which have completely different functionalities. Each type of stock typically appeals to a specific investment strategy—like a long-term strategy for retirement, or a riskier, short-term plan.

Keeping your head in the sand regarding the stock market can prevent you from reaching your financial goals. On the other hand, if you dive in without knowing what you’re doing—you could face severe losses. Your future self might regret not investing or learning the market sooner, especially with the high volatility seen in today’s market.

The following guide will provide an overview of what stocks are and how they work. It will also explain the different types of stocks and investment strategies that might be right for you.

Let’s give your future self something to appreciate. It’s time to learn the ins and outs of how stocks work.

What you’ll learn
  • What are Stocks, Exactly?
  • How Stocks are Valued
  • What is the Stock Market?
  • The Different Types of Stocks
  • Approaching Stocks 101
  • Day Trading
  • Stock Options
  • What is Stock Volatility?
  • Benefits and Risks of Stocks
  • Learn More About Stocks

What are Stocks and How Do They Work? 🏗

Companies issue stocks to raise funds to increase growth, create a new product, and/or pay off debt. Once a company reaches a certain threshold, they go from a private company to a public company and make an IPO (aka initial public offering). At this time, the company’s stock can be bought and sold in the open market. 

When an investor buys shares of stock, it means they own a percentage of the underlying company, which is pretty cool for several reasons. Depending on the type of stock purchased, the investor might receive voting rights and earn a regular dividend. 

If the investor does not receive a dividend, there is a good chance the company is in a period of growth. Companies with more room to grow are often those that have bigger stock returns.

How Stocks are Valued 💸

The value of a stock is gauged by many factors including supply and demand and qualitative and quantitative measures. Qualitative measures include: 

  • Public sentiment towards the company
  • Company management
  • History of establishment
  • Market disruption 

Quantitative factors are more straightforward and can be determined by hard numbers. Learning how fundamental analysis works will help you be a better trader. Quantitative measures include: 

  • Revenue
  • Earnings
  • Assets
  • Liabilities
  • Other concrete variables

Calculating a stock’s value is complicated, and there is no magical formula that will provide The Correct valuation, especially when subjective, qualitative factors can influence a stock’s value just as much as, and sometimes more than, quantitative factors. Some economists argue this was the case with recent meme stocks. 

Additionally, a stock’s value is in constant flux. While some stocks have a greater degree of fluctuation than others, this constant change can be unnerving for many investors. For these reasons, an investor should know how to do stock research—and do so before buying them. 

What is the Stock Market? 🏛

The stock market is no longer a centralized place as it was in times of yore, although many people might be familiar with Wall Street, where the New York Stock Exchange is headquartered. However, the stock market dates back much further than Wall Street. 

Historians date stock-type trading back to ancient Greece, when ship captains gave part of their profits to investors. Other nations and cultures followed suit, although many of these markets were highly speculative and based on fictitious devices, such as a device said to turn chickens into sheep.  

Although the modern market is more regulated than markets of the past, the basic concepts are essentially the same. Companies, like the ship captains of ancient Greece, raise funds by selling a cut of their potential profits.

There is another, more complicated way in which historical markets influenced the modern market. Not only were the shares of ancient markets held by royalty, but the foundation of the U.S. stock market was based on the culture of insiders. 

The Buttonwood agreement, the founding document of the New York Stock Exchange, which was made under a sycamore tree near 68 Wall Street in 1792, essentially prevented government and other outside interference. In other words, if someone wanted to buy a stock, they had to hire a stock broker.

Largely due to rapid advances in technology, stock trading is no longer only for insiders or those who can afford a broker. The modern stock market is more regulated, which has its pros and cons. 

While it’s great that brokers no longer draw their guns when negotiating a trade, many wonder who actually benefits from regulations. This question is why the hearings with key figures in the GameStop short squeeze were so important.  

Different Types of Stocks (Explained) 👇

There are many different types of stocks that can serve different investment purposes. Depending on an investor’s risk tolerance, an investor might prefer some stocks over others.

Common Stocks 📈

Common stocks are the most bought and sold type of stock. When an investor buys a common stock, they own a share of the company, which typically comes with the right to vote for board members and on company policies. 

Common stocks usually don’t pay regular dividends, but they do on occasion. They are also sometimes called capital stock because they have high returns. 

While common stocks are more risky than CDs (certificate of deposit), preferred stocks, and bonds, they tend to outperform less risky investments, especially over the long term. However, if the underlying company of a common stock goes bankrupt, shareholders will not receive a return unless there is anything left over after paying creditors and bondholders.

Preferred Stocks ✅

Although there are similarities, there are key differences between common and preferred stocks. Like a common stock, preferred stocks give the shareholder ownership in the company, although stockholders do not vote on company policies. 

Preferred stocks usually pay regular dividends, and if the underlying company liquidates, preferred shareholders are paid before common shareholders, but after creditors and bondholders. Preferred stocks are less of a risk than common stocks and tend to have a better yield than bonds.

Because preferred stocks typically pay regular dividends, you might want to learn how dividend investing works. Many people enjoy the rewards of a passive income or the long-term payoff of reinvesting dividends into the underlying company. 

There are some preferred stocks that do not pay dividends. These are called zero-dividend preferred stocks, and the holders of these stocks are still given priority to company assets.

Penny Stocks 💰

Penny stocks are cheap, speculative stocks that come with a lot of risk. They are usually issued by start-up companies with little revenue, which is why it is rare for penny stocks to turn into high-earning stocks. Those that do succeed, however, have high returns.

Therefore, investors in penny stocks are risk takers and day traders who can take advantage of price fluctuation. Also, some safe, long-term investors devote a small chink of their portfolio to buy cheap penny stocks just in case one or two of them end up becoming serious companies with valuable stocks.

Since the GameStop frenzy, penny stocks are under the scrutiny of the SEC, the Securities and Exchange Committee that regulates the market. After SpectraScience Inc. gained 633%, the SEC suspended it from trade.

Blue Chip Stocks 🔵

Blue chip stocks are issued by large companies that are stable and profit year after year. Although the growth of these stocks is slow, they are low risk. There are many blue chip stocks that are great for retirement. They are also more expensive than other stocks and have a large market cap in the billions—they are also listed on the Dow Jones Industrial Average. 

Because the growth rate of these stocks is slow and limited, dividends are issued to compensate. Blue chip stocks are for investors who don’t want a lot of risk but want higher returns than bonds. 

Growth Stocks 📈

Growth stocks are issued by companies who want to expand, which means these stocks can have high earnings, but they usually don’t pay dividends. Instead, the earnings are reinvested into the company. 

The capital growth of these stocks can have high returns, but only if the company does well. Growth stocks are for investors who don’t mind a bit of risk and who would rather have higher returns on growth than dividend stocks. 

Value Stocks 💵

Value stocks are considered undervalued at the moment, which means that buying them now is profitable, as they are going to reach their “real” value soon. For example, hedge fund manager Keith Meister argues MGM is undervalued. Since the companies that issue these kinds of stocks have assets that exceed the stock price, investors can buy at a lower price, assuming the company has the ability to improve their valuation. You can find undervalued stocks to add to your portfolio. 

The difference between growth and value stocks, explained
There are several key differences between growth and value stocks.

Defensive Stocks 💪

Defensive stocks are resistant to economic decline, which is something we witnessed during the Covid-19 pandemic. While some companies did not do well, other companies were able to thrive, such as Walmart. Defensive stocks are for investors who want to limit their risk during economic downturns.

Cyclical Stocks 🔄

These stocks tend to be issued by companies that offer luxury items, or commodities that an average person can only afford during times of economic prosperity. Thus, the price of these stocks is lower during economic decline and higher when the economy recovers. Cyclical stocks are for investors who don’t mind buying and selling as the economy shifts. 

Tesla has performed oddly for a cyclical stock, as it has actually gone up in value during the pandemic. However, there is some evidence to suggest Tesla is overvalued and is due for a correction. 

How to Approach Stocks 🎯

There are various ways to make money off stocks, and your risk tolerance might help you decide which investment strategy is best for you. The most common strategies are dividend investing, long-term investing, and day trading—dividend trading being the least risky and day trading being the riskiest. 

Having a diverse portfolio is also helpful for limiting risk. Investing in different stocks helps create a balance between stocks that perform well and those that don’t perform so well. In other words, don’t put all your eggs in one basket.

Dividend Investing 💲

Dividend investing is a way to see a return on your investment more quickly than long-term investment. When you invest in a company that pays dividends, you get a portion of the company’s earnings on a regular basis. By holding on to stocks that pay good dividends, you can generate a passive income. 

Companies that don’t offer regular dividends might issue a special, one-time dividend to shareholders, however this is rare. Special dividends are typically given after a particularly profitable year. 

Long-Term Investments (3 Types) 📆

Long-term investment is a slow-growth strategy that has limited risk. While a long-term strategy can be as simple as holding on to a stock or other asset for a long time, more sophisticated long-term strategies, such as investing in an index fund, mutual fund, or exchange-traded fund, might have a bigger return. 

1. Index Funds

Index funds are long-term investments that are popular for retirement accounts because they allow an investor to create a portfolio that mirrors a market index, such as the S&P 500, in order to be inherently diversified and perform as well as that index. Additionally, since the index fund is not actively managed, investment costs are lower, making an index fund a solid passive strategy for the average investor.

2. Mutual Funds

Think of a mutual fund as a group of people who pool their money in order to buy stocks in a variety of companies, which makes their investment diversified. Because mutual funds are known to commonly increase their value by 11%, it would be smart to know how to approach mutual funds.

Infographic explaining the key differences between mutual funds and stocks.
If you’re pursuing a safer, long-term investment strategy, mutual funds might be preferred.

Mutual funds attempt to perform better than the comparable index market, which also means the fund’s securities are chosen by a manager and can change regularly. Because the fund is managed, the cost to invest is steeper than investing in index funds and ETFs. 

3. Exchange-Traded Funds (EFTs)

ETFs, or exchange-traded funds, are similar to stock indices and mutual funds in that they are inherently diversified, but ETFs are managed very differently. ETFs are traded like stocks and also have the advantage of low-cost, passive management.  

Day Trading ☀️

Day trading was once only practiced by stockbrokers, but thanks to the top online brokerages, anyone with a bit of money and a bank account can be a day trader. However, the risks are high, especially if you don’t know what you’re doing.

A day trader basically follows the fluctuations in the prices of stocks and their trajectories to decide what and how to buy and/or sell stocks. These are typically aggressive moves that occur within the day, thus “day trading,” and are done in order to turn a quick profit. Although the profits might be small, they add up over time, and many small profits in a day can be lucrative, especially with riskier options. 

Unless you are playing with money you can lose, day trading might not be the way to go, especially because it takes time to learn how to do it well. Moreover, you need to have at least $25,000 to be legally able to day trade in the US (which is defined as the buying and selling of a stock on the same day more than three times in a five-day period), so this can hardly be considered a hobby—it takes time and resources, which is why it is important to learn more about day trading and options

Buying Stock Options 🧾

There are different types of stock options that have different advantages and risks than simply trading stocks, which is why understanding the basics of options trading is crucial. While there is a European option style, it is used less frequently than the American style, which is the focus here. 

Basically, purchasing options gives a trader the right, but not obligation, to buy or sell a stock at an agreed-upon price by a certain date. A call option is a trader’s right to buy shares of stock, whereas a put option is a trader’s right to sell shares of stock. In both cases, there is a premium (the cost of the option), an expiration date (when the contract will end), and a strike price (the agreed-upon price the stock will be bought or sold). 

If the strike price is not reached before the expiration date, the option expires without value. In this case, the purchasing trader loses the paid premium, which is a small loss compared to directly investing in a stock and then seeing that stock drastically drop in value.

There are other options and various options strategies for beginners. In the following, we provide an overview of put and call options. 

Put Options 🐻

Put options are usually purchased to lower one’s risk or to profit from a stock that is falling in price. In the first case, the put option acts as a type of insurance policy akin to a stop loss order, which limits a trader’s losses. In the second case, the put option is sort of like shorting a stock in that the trader is betting the price of the stock will fall. 

For example, let’s say a trader bought a hundred shares of stock for $1,500 ($15/share) but after the price went to up to $20/share, the trader feared market volatility would cause the price of the stock to fall. To alleviate risk, the trader spends $100 for a 30-day put option with a strike price of $18.

If the price drops below the strike price, the trader can choose to use the option. If the stock fell to $0/share, the trader could still sell at $18/share. In other words, the put option ensured that the trader would get a $200 net return on their investment. 

In the event the stock went up instead of down, the trader would lose the cost of the premium but would still be making a return on their investment.

Traders can also purchase put options without owning stock. Since the option doesn’t make the trader obliged to sell, the trader can instead sell the put option, which gains in value the lower the underlying stock falls. The trader can also choose to buy the stock at market price and then in turn exercise the put and sell the stock at the strike price. 

Because of their complexity, you might want to learn more about put options. Examining more examples of put options can be useful before you exercise the strategy. 

Call Options 🐂

Traders purchase call options for several reasons such as generating income, speculation, and tax management. In order to understand why someone might buy a call option, it is important to know how a call option works. 

Let’s say a trader wants to buy a stock that costs $15/share. To buy 100 shares, it will cost $1500. Instead of buying the stock, the trader spends $150 to buy a 30-day call option with a strike price of $16/share.

If the stock increases to $16/share, the trader can choose to exercise the call option. But why pay $150 for an option that lets you buy the stock for $1,600 when you could have bought the same stock for $1,500? 

Some might see buying in at $1,600 is still buying at a point of value, and some investors like to buy in during a period of upward momentum (buy high sell higher). 

It is also important to consider the call option as a kind of insurance policy. For example, if the stock went from $15/share to $5/share, the owner of the call option doesn’t have to buy the stock. This means instead of losing $500 in stock value plus the call option premium, they only lose the premium, totalling $150.

But let’s say the stock price didn’t fall and the holder of the option didn’t exercise their right to buy at the strike price of $16. If the stock climbed to $20/share before the expiration date, the trader could exercise the option to buy at the strike price of $16. In this case, the trader only pays $1,600 (not counting the premium) for stocks valued at $2,000. 

Before moving on, let’s quickly recap the difference between put and call options:

Infographic explaining how put and call options work
Put and call options have several key differences.

Selling Options

Selling options can be a lucrative, although selling a naked call, meaning you are selling an option of a stock you don’t own, has unlimited risk. This was demonstrated through Christian Iovin, the plaintiff who initiated the class-action lawsuit against GameStop-loving Keith Gill (aka DFV, aka Roaring Kitty) knows all too well.

Iovin took out $200,000 in collateral to sell call options for GameStop while the price was well below $100. When the price of GME neared the moon, Iovin had to buy back his options for as much as $350 each. 

What is Stock Volatility? 📊

Volatility basically means a situation is liable to change quickly in unpredictable ways. A volatile stock is one that rapidly increases and/or decreases in value. Investing in a rapidly rising stock can have high returns, but it can also be a risk if the trader doesn’t know when to sell.

Stocks With Low and High Volatility

Because of their slow and steady growth and proclivity to pay dividends, blue chip stocks are less volatile than other types of stocks. Defensive stocks are also less volatile than other types of stocks because they usually carry value in times of economic downturn. Generally speaking, stocks that have slower growth are less volatile than stocks that have quick growth, such as penny stocks or those issued by a new company. 

Buying a Volatile Stock ⚠️

Buying a volatile stock comes with a lot of risk, but this practice is popular with day traders who want to make a quick return. Because volatility and unpredictability work in tandem, there is significant potential to lose the principal investment. Analysts warn investors that recent surge in volatility could be followed by a dramatic fall

Benefits and Risks of Stocks ⚖️

There are plenty of benefits to investing in stocks, which is why it is a popular investment strategy for different people with varying financial goals. For long term investors, investing in stocks can help fund retirement or other expenses. Since stocks generally increase in value over time, particularly less volatile stocks, the return is better than savings accounts and CDs.  

While day traders take on bigger risk than long-term investors, no investment is risk free, which is why it is important to learn about all your investment options such as commodities, bonds, and cryptocurrencies that are popular for long-term investors

How to Learn More About Stocks 🎓

You can learn more about stocks by reading more articles like this, but you can also find the leading stock brokers for inexperienced investors. The best of the best will offer free educational resources, courses, ebooks, and more. Most brokers also have demo accounts that allow traders to invest virtual money so they can practice their investment strategies.

There are many trading apps and most of them include literature and video tutorials that explain the concepts and trading strategies. Try out a few of the best trading apps, and be sure to read and/or watch the tutorials they provide. This will get you started down the road to becoming an investment wiz. 

To master trading, you will also want to keep current on market and financial news from various outlets, even social media. The market can change fast, so you don’t want to be left behind.

🏎 Are you constantly on the go? Leveraging one of the most popular stock market apps could be just what you need.

What Happened to Stocks During COVID-19? 

In February 2020, just as the COVID-19 pandemic was gaining momentum, the S&P 500 peaked, gaining 15.8%, before taking a drastic plunge due to mass shutdowns. A year later, economists see a market that closely resembles that of 2020

The market drop of March 2020 impacted sectors across the board, and fear surrounding the pandemic and the market led investors to sell off large quantities of top-stock below value. While defensive stocks like Walmart stayed strong, tech stocks like Apple fell by 20%. As the market began to recover, however, tech stocks like Netflix, seemed to get a covid bump.  

Now, February 2021, the S&P 500 has rebounded and has been up 15.9% for the past six months. Some market watchers believe this rebound, coupled with stocks that soared beyond their value, suggests a market correction, if not a plunge, is on the horizon

Others, however, see a few key differences in last year’s market and this year’s market and think the bullish run can last a bit longer. Not only are vaccines helping people feel less panicked about COVID-19, but it is unlikely today’s market will experience a comparable external shock as COVID-19. 

Moreover, the U.S. Fed took major steps to implement debt-financed relief efforts to increase aggregate demand growth, which many economists argue has been done more effectively than in 2009.   

Another difference between the 2020 and 2021 markets is the rise of the small investor.  Since the pandemic has kept many people out of work or working from home, more people began trading on apps like Robinhood.

How these investors will play a role in the future of the market is uncertain, but their impact on the market is undeniable. Perhaps we will soon see how traders will use $1,400 stimulus checks to blow up the market

How Stocks Work: FAQs

  • How Do Beginners Buy Stocks?

    A beginner can buy stock by opening a free online brokerage account and download their app to buy stocks. Moreover, beginners can use their trading platform’s demo account to trade with virtual funds before investing real money.

  • What is "Float" in Stocks?

    In the world of stock trading, the term "Float" represents the number of shares a specific stock has to sell in an open market. If a stock has a float, it is likely that it is more volatile than larger float stocks. Low float stocks can also be more difficult to buy and/or sell.

  • How Much Do You Get Taxed on Stocks?

    When you sell stock you’ve had for more than a year, depending on your level of income, you will get taxed accordingly—either 0%, 15%, or 20%. If you sell a stock you’ve had less than a year, you will be required to pay a capital gains tax, which is taxed the same as income tax and the amount depends on which of the seven tax brackets you are in.

  • How Do You Make Money in the Stock Market?

    The idea is simple: You make money in the stock market by buying a stock now, for a certain price, and selling the stock later, when the price has increased. Naturally, finding a stock whose value will increase is not so easy. Every transaction involving stocks—or other financial instruments—includes risk. It's important to remember that all of one's capital, and sometimes even more, can be lost.

  • Is it Worth Buying 10 Shares of Stock?

    Buying ten shares of stock can be worth, under the right circumstances. However, a better metric to focus on is the amount of different stocks in your portfolio. Most experts suggest you should have 10-15 different stocks (at a minimum). This results in diversification—instead of putting all of your eggs in one basket, you have spread your investment into different stocks. Theoretically, this helps to protect you against losses, resulting in a defensively stronger portfolio.

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All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.

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