Episode #2 of the course Introduction to capital markets by Doha Soliman, CFA
Welcome back! Today, we’ll cover equities.
As mentioned yesterday, equities, commonly known as “stocks,” refer to investors buying shares of a company and claiming ownership of a portion of that company. By doing so, an investor has a right to the company’s earnings and assets. For instance, if a company is worth $100 million and has issued one million shares, each share is worth $100. Let’s examine how shares get issued in an initial public offering.
Initial Public Offering
As an organization grows and reaches a certain threshold, its management can opt to have an initial public offering, or IPO, to raise funds and trade it publicly on a given stock exchange. The process of going public is officially called the underwriting process and is completed by a team of investment bankers and corporate lawyers. Once a company officially trades on a stock exchange, it is referred to as a public company. As discussed yesterday, the IPO occurs in the primary market; once the stocks are publicly traded on the exchange, it is then referred to as the secondary market, where any investor can purchase the stock.
Fundamental vs. Technical Analysis
Yesterday, we concluded that analysts play a large role in valuing public corporations. Basically, there are two types of analyses that are common in capital markets, and investors are free to choose either method or both.
The first method is fundamental analysis, which assesses a corporation’s intrinsic value or net worth. This process is completed by evaluating a corporation’s financial statements, which are publicly available for investors. As analysts find discrepancies between the market price and a stock’s intrinsic value, they tend to trade accordingly. As these trades occur, discrepancies in the market become less common.
The second method is technical analysis, which assesses an ideal entry (buying opportunity) and exit (selling opportunity) point. This refers to analyzing a stock’s historical trading patterns to predict future movements. Let’s take a look at an example:
Company ABC is trading at $100/share. As supply and demand changes, the stock has been trading on a range of $85-$105. This does not reflect the true price of ABC, but rather its perception in the market. In this case, fundamental analysts could have determined that ABC’s stock is truly worth $110. They would thus purchase the stock, as it is undervalued in the market. Technical analysts would be more concerned with estimating when the stock will drop again in order to purchase it at a bargain.
Going Long vs. Short
Now let’s take a look at positions that investor can take in a stock. When an investor expects a stock to appreciate, they can take a long position in a stock (buy it) or a short position if they expect a price decline. Going short simply means borrowing a stock from an opposing party and selling it in the future. There are four steps to completing such a trade.
1. Borrow the stock from a counterparty through the help of a broker.
2. Sell the shares borrowed.
3. If the stocks drop in price, buy the shares back at the lower price. If the stock goes up, buy the shares back at the higher price.
4. Return the borrowed stocks to the broker, and pocket the gain or pay the difference in prices.
5. It is important to note that short selling can expose investors to significant losses.
To start trading, you’ll need to open a brokerage account, which be found through your financial institution and online brokers. After your account is set up, you can then buy or sell stocks, mutual funds, and bonds. Considerations in choosing the ideal account include:
• commission fees
• tax situation
• investments available
• accessibility of the online platform
• availability of equity research
While trading is certainly exciting, it is important to be cautious in starting an investment portfolio. A good place to start is to create a mock portfolio online (e.g. you can use Investopedia) to gain some confidence in picking stocks and maintaining investments.
Tomorrow, we’ll look at different types of bonds, how they are created, and how you can add them to your portfolio.
The Intelligent Investor by Benjamin Graham: for more information on the stock market or equities in general
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