Table of Contents
What are stocks?
A stock is a share in ownership in one or more companies. The owner of the shares, who is known as a shareholder, has a claim on the assets and earnings of the company through dividend payments, as well as voting rights attached to the stock. The stocks are traded on stock exchanges. A shareholder is not involved in the daily operation of the company. Instead, each share represents a vote to elect the board of directors at annual meetings.
The management of a company has the mandate to increase the value of the firm of its shareholders. Profits are paid out in the form of dividends. The more shares you own, the larger the portion of profits allocated. The claim on assets can only be made if the company goes bankrupt.
The overall performance of a stock is the company’s growth. A share’s value will vary depending on whether you’re looking at its fair value or market value. The fair value is agreed upon by the buyer and the seller. It is also referred to as the value that is fair to the buyer and will not put the seller on loss. The market value is the amount that individuals are currently willing to pay for the stock.
Advantages of stocks:
- Diversification – a diversified stock portfolio has a higher likelihood of earning a high return, as well as lower risk compared to individual investments. It also reduces the impact of market volatility. Diversification can also be done by packaging stocks in mutual or exchange-traded funds.
- Investment gains – Some stocks earn dividends as well as capital gains. Historical data suggest that stock markets have always risen in value over a period of time, even though individual prices of stock prices fluctuate on a daily basis.
- Liquidity – Stocks are classified as liquid assets in that they can easily be converted to cash, and there are many potential buyers whenever the market is open.
- Investing in smaller amounts – for those who are new to stocks or do not have much in terms of capital, they can start with small investments by buying small-cap or mid-cap stocks.
Disadvantages of stocks
- Fluctuation – stock prices rise and fall with the company’s performance, making research and analysis for the right stock quite difficult.
- Risk – if an organization’s performance is poor, the investors will sell, hence making the stocks lose value. When you sell, you will lose your initial investment.
- Stockholders are paid last – in case a company goes into bankruptcy, preferred stockholder, bondholders and creditors are given priority of claims on the assets.
What are Options?
Options are derivative contracts between two parties giving the holders the right, but not the obligation, to buy or sell an underlying asset at a certain price with a specified amount of time.
There are two types of options:
- Call option – this gives the buyer the right, but not the obligation to buy the underlying asset at the strike price specified in the options contract.
- Put option – it allows the investor to sell a particular stock by a certain date at a specified price. Investors who buy put options generally expect the actual price of the stock on the market to be lower than their option price to allow them to sell above market value.
Benefits of Options
- Risk-reward ratio – this trading strategy allows an investor to have unlimited upside with limited downside.
- Flexibility and versatility – options can be bought and sold on a wide variety of underlying assets. One can speculate on price movement of stocks, indices, commodities and foreign currencies; a large number of identifiable opportunities for profitable trades.
- Capital Outlay and Cost Efficiency – this is an ideal investment opportunity with little starting capital. The potential for huge profits with little investment is largely due to the use of leverage.
Disadvantages of Options
- Investment complexity – even with the potential of earning huge profits, there is a steep learning curve to fully grasp how options work. The complexities can seem overwhelming and intimidating. This is where experts on the subject are most valuable.
- Potentially unlimited losses – if the market moves against your position, losses can escalate quickly. Writing options if you do not own the underlying security is risky as you will have to provide the underlying securities if you are exercised against.