Understanding stocks, how they work, and what basic strategies traders use to profit is essential for all trading beginners. Even if you want to work with options, your knowledge of the market, including stocks, is the foundation on which you’ll build your options trading strategy.
Therefore, in this article, we’ll talk about stock essentials every trader should know. We’ll discuss various stock types, and most importantly, we’ll inform you about the link between stock and options contracts and how crucial the understanding of stock for trading options is.
What Are Stocks?
Stocks are securities that represent ownership. The person who owns stocks in a particular company, in fact, owns a part of that company. Of course, the size of their part depends on the amount of stock they have.
Traders and investors buy and sell stocks mainly on stock exchanges, like the Nasdaq Stock Market and NYSE (New York Stock Exchange).
It’s important to mention that companies usually issue stocks when they want to raise funds and continue operating their business. The investor that buys shares and automatically owns a fraction of the business may profit in multiple ways.
Let’s dive a little deeper.
How do shareholders profit?
A shareholder is a firm, institution, or individual who owns shares of a particular company. To be a shareholder, the investor must own at least one share of the company’s stock.
Owning stock of a particular firm comes with benefits and potential risks. The shareholder has multiple rights (depending on the number of shares they hold) and responsibilities.
For instance, the shareholder can use their right to vote when the firm selects members of the board of directors. The investor can also vote for dividend distributions or for or against merging. The shareholder also has the right to check the company’s records and books and attend meetings important to the future of the company.
When it comes to profit, investors can earn profits from multiple sources. For starters, if the business goes well, the company may announce dividend payments. Depending on the payment schedule, the shareholder may earn a pre-announced percentage of their shares.
Furthermore, the price of the company’s stock may increase. In cases where the price goes higher than the amount the shareholder initially spent, they can decide whether to sell their shares and profit from the difference.
However, you should also know that in case of bankruptcy, the shareholder can lose their entire investment.
Types of Stocks
In this section, we’ve covered multiple types of stocks because it’s very important for stock beginners to understand the differences between these types. You should keep in mind that a suitable stock for trading options can be of any type.
Common stock for trading
As the name suggests, common stocks, often referred to as ordinary shares, are the first of the two main stock types. For new investors, the common stocks are the most attractive, as they’re available and easy to understand.
If you own ordinary shares, it means that you have several rights, such as the right to vote on key matters. Additionally, it means that you have a right to the company’s profit, usually paid through dividends.
Preferred stock for trading
The other main type of stock is preferred stock. These two groups are very similar. For example, buying preferred shares in a company will represent ownership of a part of that company.
If the company issues stock to raise funds, the shares may be sold at a lower price. Let’s say there's a rumor about merging. In that case, you may have the opportunity to buy the stock at a low price. Then, after the merger or after the company gets stable, you can sell the shares at a higher price, thus making a profit.
The main difference between ordinary and preference shares is that by owning the latter, you don’t have a say in the company. You won’t have the right to vote on key corporate matters or vote for members of the board of directors.
However, although preferred stocks don’t grant voting rights, they come with other benefits. For example, you’ll be entitled to regular dividend payments. Even if the common shareholder gets dividend payments, the company must first pay dividends to the preferred shareholders.
Furthermore, as a preferred shareholder, you’ll be repaid before common shareholders if the company enters bankruptcy.
That being said, preferred stock is the perfect stock type for those interested in passive income.
Growth stocks
The market’s anticipation and traders’ beliefs based on various historical analyses have a huge impact on the assets’ prices. These expectations may boost or lower the price, and often the market price isn’t the same as the exact value of the asset.
Growth stocks can be any stocks that are expected to grow. Not only to go up but to increase at a rate that’s much higher than the average growth rate for the market.
There’s one crucial thing to keep in mind - growth stock for trading is a risky choice. They don’t offer dividends, and the only way you can earn money is by selling the shares.
You may gain an excellent profit if the company that issued the stock raises funds and continues to grow. However, if the company doesn’t do well, you may lose all of your investment.
Value stocks
These stock types are generally considered the opposite of the type we discussed above. Value stocks are shares trading at what appear to be lower prices than their true value based on their fundamentals.
The fundamentals of a stock are its dividends, earnings, sales, and other perimeters. The fundamentals shape the value of the stock. Now, if the stock price in the market is below the expected price relative to the stock fundamentals, the stock is known as a value stock.
Simply put, a value stock trades lower than the company’s performance. Therefore, a value stock has several characteristics. Those characteristics include a low P/B ratio (price-to-book ratio), a high dividend yield, and a low P/E ratio (price-to-earnings ratio).
Income stocks
Another type of stock is income stocks. Usually, these stocks, as their name suggests, provide the stockholder with regular income. The income typically comes from dividends.
Even though many factors make the difference between income stocks, this type, as a group, usually has a low level of volatility compared to the overall stock market. Moreover, this type usually comes with higher-than-average yields from dividends.
Investors and traders can find income stocks in any industry. However, they usually come from real estate, natural resources, financial institutions, utilities, and energy sectors.
Blue-chip stock
Blue-chip stocks are something like successful celebrities among stock types. These shares come from large, respectable companies that have long records of successful operations. We’re talking about companies with a market capital that’s counting in billions and are, most likely, reputable market leaders in their sectors.
The long track of success and the companies’ reputation makes blue-chip stocks some of the most popular ones for investors. Another reason for their popularity is the fact that many blue-chip stocks have survived market challenges over the years.
It’s important to mention that even though paying dividends isn’t necessary for a company to be a blue chip, most of these firms have a long history of stable dividend payments and even rising dividends.
Penny stocks
Here it’s an opposite situation from the one we discussed above. A penny stock is a stock of a small company that trades for less than $5. Shares of penny stock usually trade over the counter and can be found on the OTCBB (over-the-counter bulletin board).
Penny stocks generally come from small companies, meaning they have very low liquidity. Therefore, there aren’t many investors interested in buying, and even if someone makes a purchase, they may not be able to find another buyer to sell their shares.
Because of this, it’s difficult to find a suitable market price for penny stocks, making the shares highly speculative.
So, what's the trick with the penny stock for trading?
The price of this stock type is the main reason why various investors are interested in buying. However, the price is also the reason why investors have to invest larger amounts of money to gain profits.
Of course, this can yield large profits. But it doesn’t mean that it’s risk-free. On the contrary, investors may lose their investments if the penny shares aren’t stable.
Cyclical stocks
Cyclical stocks are a stock type that’s largely influenced by the current economic situation and various systematic changes.
As the name suggests, these shares follow economic cycles and change their value accordingly. By economic cycles, we’re referring to overall economic changes, such as recession, recovery, expansion, or the period where we have a booming economy.
It’s easy to guess which industries and companies have stocks that belong to this group. By definition, most cyclical shares come from firms that sell or produce various consumer products. The demand for these products reaches its peak during good-economy periods and significantly decreases during a recession. To give you an example, airlines, hotels, car and motorbike manufacturers, and restaurants, to name a few, are companies that usually have cyclical stocks.
This stock type is recognizable by its increased volatility. They’re stable during one period and unstable during another. Therefore, some investors avoid including them in their portfolios by all means.
However, cyclical stocks also come with great potential for growth and profit. During periods of economic strength, these stocks can easily outperform the market and lead to large gains.
Non-cyclical stocks
Here’s another comparison - non-cyclical or defensive stocks are often considered the opposite of the type we discussed above. The obvious difference is that defensive stocks have good performance regardless of the economic period.
Unlike cyclical stocks, most defensive stocks come from companies that produce or sell products that are in constant demand, which results in stable earnings regardless of the business cycle phase.
These shares are very attractive and popular among investors, especially those who want to stabilize and protect their portfolios during a weak economy. That’s because non-cyclical stocks have strong cash flows, stability, and low volatility and usually provide regular dividends.
On the other hand, defensive stocks may not be the best choice for investors who want to take advantage of bull markets because of their low volatility.
Difference Between Stocks and Options
Stocks and options come with their own advantages and weaknesses. For starters, they successfully diversify the investor’s portfolio, which is great because a rich portfolio containing multiple asset types leads to stability and security.
The main difference between stocks and options is that stocks are assets, and options are derivatives. This means the stock value comes from the company’s performance, market changes, and the overall economy. Options derive their price from an underlying asset.
This significant difference is what makes stocks more expensive than options. To buy stock in a company, the investor must own the necessary amount of money equal to the number of shares they want to buy. With options, the investors only buy the right to buy shares, but they’re not obligated to exercise the option.
If you want to include a particular stock for trading options, you have to carefully analyze the market before deciding. You have to find the right company to ensure that the stock is good to be the underlying asset for an options contract.