Category: Stock

What is a short sale?

Today, people generally think of a “short sale” as a real estate transaction in which the home owner sells his property for less than the mortgage.   Before the housing crisis, “short sale” referred to a transaction in the stock market. So what does it mean when we sell a stock “short.”

Borrowing a security from a broker and selling it, with the understanding that it must later be bought back (hopefully at a lower price) and returned to the broker.

Short selling (or “selling short”) is a technique used by investors who try to profit from the falling price of a stock. For example, consider an investor who wants to sell short 100 shares of a company, believing it is overpriced and will fall. The investor’s broker will borrow the shares from someone who owns them with the promise that the investor will return them later. The investor immediately sells the borrowed shares at the current market price. If the price of the shares drops, he/she “covers the short position” by buying back the shares, and his/her broker returns them to the lender. The profit is the difference between the price at which the stock was sold and the cost to buy it back, minus commissions and expenses for borrowing the stock.

But if the price of the shares increase, the potential losses are unlimited. The company’s shares may go up and up, but at some point the investor has to replace the 100 shares he/she sold. In that case, the losses can mount without limit until the short position is covered. For this reason, short selling is a very risky technique.

What is an option?

An option is a contract to buy or sell a specific financial product officially known as the option’s underlying instrument or underlying interest. For equity options, the underlying instrument is a stock, exchange-traded fund (ETF), or similar product. The contract itself is very precise. It establishes a specific price, called the strike price, at which the contract may be exercised, or acted on. And it has an expiration date. When an option expires, it no longer has value and no longer exists.

Options come in two varieties, calls and puts, and you can buy or sell either type. You make those choices – whether to buy or sell and whether to choose a call or a put – based on what you want to achieve as an options investor.

Options can be used to generate added income from securities, like stocks that you already own. The most common of these are “covered call options.”   They can also be used as a temporary insurance policy against a decline in the price of a stock or the market as a whole.  The most common of these are known as “protective puts.”

Options are complex instruments that require a sophisticated understanding of securities, and while some options can be used to reduce risk, others can create large amounts of risk.

What is a preferred stock?

From Investopedia:

A class of ownership in a corporation that has a higher claim on the assets and earnings than common stock. Preferred stock generally has a dividend that must be paid out before dividends to common stockholders and the shares usually do not have voting rights.

Why are investors interested in preferred stock?  It’s all about income.  “Preferreds” (as they are generally referred to) usually pay higher dividends than common stock and have a higher yield than the same company’s bonds.  If the company gets into financial trouble preferred dividends have to be paid before common dividends can be paid.  If a company is liquidated, preferred stock holders are ahead of common stockholders if there are any assets  left to be distributed.

What are the downsides of Preferreds?  They do not have voting rights.  They rank below bank loans, bond holders and most other obligations of corporations except for common stock.  Most “retail class” preferred stocks are issued at $25 per share and usually have “call” provisions.  That means that the issuer can redeem them for “par” ($25) after a number of years.  This “call” is usually not exercise-able for 5 years, but can be exercised by the issuer any time after that.   This means that the price of a preferred stock can drop if the company that issued it gets into financial trouble, but will not rise much above $25 during it’s lifetime.

Bottom line, common stock is purchased for growth, preferred stock is purchased for income.  Choosing Preferreds requires a sophisticated knowledge of that particular market.  If you are interested, be sure to work with an RIA who know this market.

What is common stock?

A share of common stock represents partial ownership in a corporation.

When people get together to form a company one of the issues to be decided is who owns how much of the company.  For example, let’s say three people form a company.  Person “A” puts in $500, “B” puts in $300 and “C” puts in $200.  If the company is formed as a corporation, “A” would get half the shares, “B” would get 30% and “C” would get 20%.   The number of total shares that are issued is largely arbitrary.  The owners can decide that the corporation will issue a million shares.  If that’s the case, “A” would get 500,000 shares, “B” 300,000 and “C” 200,000.

Generally in small companies the people who put up the money receive shares in the company and then form a “Board of Directors.”  The board makes the policy decisions for the corporation which the company’s management is directed to carry out.

Each shareholder gets one vote for every share of stock he owns when voting on issues coming before the board.

As the company gets larger it may decide to “go public.”  That means that it will allow the general public to buy an ownership stake in the corporation.  To “go public” requires the company to jump through many regulatory hoops to be legally allowed to sell some of its shares in what is called an “initial public offering.”  Once the decision is made, the company also has to decide where its shares should be traded.  The most common markets are the New York Stock Exchange (NYSE) or the NASDAQ (the “over the counter market”).  While the NYSE is the most prestigious  the NASDAQ  is where some of the biggest companies – like Microsoft and Apple –  are traded.   It is  easier to get listed on the NASDAQ so most companies “go public” there.

Once a company is “publicly traded” the owners of these shares have the same voting rights as the founders, one vote for every share they own.

Owners of common stock reap most of the benefits if a company is successful and have the most to lose if a company fails.  But that is an issue for another day.

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