What are Stocks, and How Do They Work?

Stocks are financial instruments that represent fractional ownership of a company. Equities is another name for stocks. Units of stock are called shares. Being the owner of a company’s stock may have various benefits, including the following:

• Capital gains. If you purchase the stock of a company and its price rises, you can profit from the increase in the value of the shares. 
• Dividends. Some stocks pay dividends, which can come in the form of more stock or cash. In the UK, companies usually pay dividends quarterly or every six months.
• Voting rights. Owning a company’s shares may grant you the right to vote at annual shareholder meetings.

There are two major kinds of stock: common stock and preferred stock (also called preference shares or preferred shares). 

Common stock owners can vote on corporate policies and elect the board of directors. Common stockholders may also receive dividends. Common stockholders receive their money after preferred stockholders when a company goes bankrupt. Most investors in stocks are buying common stock. 

Preferred stock owners usually don’t have voting rights, but they receive dividend payments before common stockholders and may receive payments at a higher dividend yield. They also have a priority claim on assets in the event of the company going bankrupt. The trade in preference shares in the UK is considerably lower than in the US.

There are several types of preferred stock. 

• Callable shares are preferred shares that the issuing company has the right to buy back at a pre-set price in the future. 
• Convertible shares are preferred shares that have the option to be exchanged for common shares after a defined date. 
• Cumulative shares are preferred stock requiring that the company pay any unpaid dividends to preferred shareholders before common shareholders. 
• Participatory preference shares have a fixed dividend rate and pay additional dividends if the issuing company achieves predetermined financial goals.

It is also helpful to understand these other common categories for stocks: 

• Growth stocks are stocks of companies whose revenues and earnings are expected to increase faster than average. Growth stocks often have high price-to-earnings (P/E) ratios and usually don’t pay dividends.
• Income stocks are stocks of companies that pay regular, reliable, and relatively high dividends. They are also usually less volatile than growth stocks.
• Value stocks are stocks of companies with a price that seems low relative to the company’s financial performance. This may be reflected in a low P/E ratio. 
• Blue-chip stocks are stocks of long-established, stable, and well-known companies. AstraZeneca (AZN) is an example a of blue-chip company.
• Large-cap stocks are stocks of companies with a market capitalization of more than $10 billion in the US. In the UK, large caps are generally considered to be those that are listed in the FTSE 100 index. These are often viewed as relatively safe and stable due to the sheer size of the companies they represent. 
• Mid-cap stocks are stocks of companies with a market capitalization of between $2 billion and $10 billion, listed in the UK on the FTSE 250 index. Mid-cap stocks are viewed as having a combination of stability and growth potential.
• Small-cap stocks are stocks of companies with a market capitalization of between about $300 million to $2 billion, listed in the UK on the FTSE Small Cap index. Small-cap stocks have high growth potential but can be volatile and risky.
• Penny stocks are stocks of companies that trade for less than £1 per share. These stocks represent high potential risk and reward for investors. Penny stocks have a low market capitalization, are illiquid, and trade outside of major stock market exchanges.

Stock market sectors describe the different types of stock investments. There are over 30 stock market sectors in the UK. Some of the main sectors include:

• The Banking Sector covers companies that are involved in the banking business, including private UK banks, international banks, and building societies. Barclays (BARC) and HSBC Holdings (HSBA) are examples of companies in the banking sector.
• The Beverages Sector includes companies involved in the production and distribution of drinks. Diageo (DGE) and Fevertree (FEVR) are examples of companies in the beverages sector.
• The Fossil Fuels Sector includes companies that produce and supply the main fossil fuels – coal, oil and gas. BP (BP) and Petrofac (PFC) are examples of fossil fuels sector companies.
• The Media Sector contains companies that share the production, publication, and distribution of media texts. ITV (ITV) and Pearson (PSON) are examples of companies in the media sector.
• The Medicine and Biotech Sector is composed of companies focusing on drug development and clinical research aimed at treating diseases and medical conditions. AstraZeneca (AZN) and Glazosmithkline (GSK) are examples of leading companies in the medicine and biotech sector.
• The Retailers Sector is made up of companies that sell products directly to the end consumer. Marks and Spencer (MKS) and WH Smith (SMWH) are examples of companies in the retailers sector.  
• The Telecommunications Sector covers companies concerned with keeping customers connected. BT Group (BT) and Vodafone (VOD) are examples of companies in the telecommunications sector.
• The Tobacco Sector contains companies making cigarette and tobacco products. British American Tobacco (BATS) and Imperial Brands (IMB) dominate the tobacco sector.

IPO stands for initial public offering and describes the process (also called floating or going public) of a company issuing stock for the first time. Money raised from an IPO is used to help a company cover operating expenses, pay off debt, and grow its business. IPOs allow early investors in the company to profit from their investments. Companies also benefit from a high level of publicity during their IPOs. When a company decides to go public, investment banks such as Goldman Sachs or Morgan Stanley provide underwriting services for new stock issues. After an IPO, a company’s shares are mainly traded on the London Stock Exchange, making them available for purchase by the general public. 

Stock prices rise or fall in value based on supply and demand. When there are more buyers, stock prices are driven higher, and when there are more sellers prices are pushed lower. The bid/offer price represents the best price available to buy or sell a stock. 

When placing a stock trade through an online brokerage account, your order is sent over the internet to your broker. On receiving the order, the broker decides how to route it to be executed. It may be sent to an exchange, a market maker, or an electronic communications network (ECN). The broker owes a duty of best execution to retail and professional clients, which obligates a broker to take care to execute a customer’s order in a way that gets the best result for the customer.

There are many types of trading in the stock market. Traders focused on technical analysis look at a stock’s price movement and trading volume to inform their decisions. These traders may look for chart patterns such as ‘Head and Shoulders’ or moving average crossovers as signals to enter a trade.

Meanwhile, traders using fundamental analysis draw from sources such as the company’s balance sheet and income statement in their strategy. These traders may also look to economic data such as the employment report or GDP to make trading decisions.

Beyond analysis, traders often specialise in trading in a specific timeframe. Day traders buy and sell stocks within a day in the hopes of capturing profits from short-term price moves. Swing traders hold stock positions for days, weeks, or months and long-term investors hold their positions for over a year. 

Investors typically buy and sell stocks through a brokerage firm, such as eToro or Plus500. These brokers provide them with access to major stock exchanges. Amid intense competition within the industry, online brokers have made it very easy to get started. Many UK brokers have low or $0 minimums for the initial deposit to open an account. Commission-free trading has also become available among  UK online stock brokers. Fractional share trading now makes it possible to invest in companies with high price stocks, even if you have a low account balance.

Alternatively, it is possible to bypass using a broker when investing in stocks. Many companies allow the purchase of their stock directly via a direct stock purchase plan (DSPP). Buying stocks through a DSPP has the advantage of saving broker fees, which in the past have been substantial. However, with broker fees now slashed to a minimum, the appeal of DSPPs is diminished.