Basics of Stock Trading (34 lessons)
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How Stocks Work – From a First Graders Perspective

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How does the Stock Market Work?

Stocks, oh where do we begin?  Let me first commend you for taking the time to try and understand how the stock market works.  When researching this topic you will notice a lot of people attempting to sound super smart.  Far too often the explanations for how stocks work are overly involved or just don’t make much sense.

Think about it.  You just typed into Google or Bing the phrase “How Stocks Work”.  This tells me that you want a straight forward explanation and not the overly complex mumbo jumbo.  So, with that in mind, I am going to explain how the stock market works in such a way that your 5-year old will walk away with a firm understanding .

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How Stocks Work

How Stocks Work

What are Stocks?

A stock is a right of ownership in a company.  Just as you can purchase a home or a car, you can also purchase a piece of a company.  The one difference is that unlike a car where maybe you or one other person are the owners, when it comes to stocks, there could be thousands of people that own the same company.

Explanation to a First Grader:

how the stock market works for kids

You like Coca-Cola right?  Well if you want to buy the company that makes Coca-Cola then you buy stock.

Remember how you received a certificate when you graduated from kindergarten, which was proof you finished all of your lessons?  Well, when you buy stock from Coca-Cola they give you what is called a stock certificate which proves you are the owner of their company.

How do Stocks Work?

Companies will sell their stock over what is called exchanges.  These exchanges provide the means for buyers and sellers to exchange cash or equity for the company’s stock.  In order to sell your stock on an exchange, the company will need the help of an investment banking firm.

The investment banking firm will help the company file all of the necessary paperwork with the Securities Exchange Commission and the regulatory agencies to ensure the company is a legitimate business.

Once everything is cleared, the company will have an initial public offering or IPO and the shares are presented to the public for trading.  Based on the company’s projected earnings, and assets, the investment banking firm will set a price for each share or stock which will be the opening price when the company begins trading.  After the IPO, the free market which is the representation of the collective man’s hopes, dreams and fears will now determine the value of the stock on a day-to-day basis.


Explanation to a First Grader:

Well you know how you see Daddy on the internet looking at the charts with the green and red candles?  Well Daddy can buy a incy wincy piece of Coca-Cola by clicking the buy button on the screen.

Why do companies sell their stock?

For Sale

For Sale

This was the hardest concept for me to learn how the stock market works.  You have a great company, things are going well and you are making consistent money.  Why take on the headache of hiring an investment banking firm, filing with the SEC every quarter and having to answer to investors?

The simple answer, going public or selling stock in your company gives you access to more cash.  Let’s say you have a great yogurt shop.  People from all over your local town line up to eat your yogurt.  You realize that if your yogurt can touch people locally, what about people in the next county, state or even country.

In order to expand your business, it is going to take money.  Money to buy machines, money to hire people, and the list goes on and on.  If the company takes out a loan, then the bank will want interest and a guarantee on that money.

But if you sell stock in your company to the public, then you receive the cash without any strings attached to the investor.  Let’s pause for a second there, because you have to grasp this concept, so let’s break it down a little further.

Yogurt Shop

# of shares available to the public – 5 Million

Value per share – $10

Amount Raised from IPO $50 Million

Now I could bore you with the fees you need to pay the investment firm and the fact employees and owners are often restricted from selling their shares for a period of time (a.k.a holding period), but I think you get the point.

A price is set, the public pays that price if they see value and the company receives cash in hand.

Explanation to a First Grader:

Coca-Cola wants to sell Coca-Cola to little kids all over the world and in order to do so, Daddy is helping Coca-Cola by investing or giving them money to make more Coca-Cola.  This will make other little kids happy just like you are when you get that special treat of drinking Coca-Cola.

What if the company needs more cash?

Cash

Cash

If the company needs more cash, then they simply issue more stock.  The issue with this is depending on the health of the company offering more shares could dilute the company’s value.

Explanation to a First Grader:

(Let’s not complicate things with why Coca-Cola would need more money).  It’s Coca-Cola for heavens sake.

Why do Companies Care About the Stock after the IPO?

So, the companies have the money from the IPO, why do they care?  Well for a number of reasons.

Founders Care

The company’s founders often do not sell their stock because they want investors to see they are still believers of their own company.  Therefore their net worth is still heavily tied up in the company.  An example of this are Zuckerberg and Facebook.

Also, if the stock is under performing, the board of directors can have you removed as CEO.  Imagine how this must feel.  You started the company, but are later forced to give up your baby.  This actually happened to Steve Jobs at Apple, before the company brought him back on in the late 90s.

Employee Compensation

As part of employee compensation, stock is often issued as part of the total pay package.  If the company does well, then the value of the stock increases, which means employees are wealthier.  This makes the company more attractive to top talent.

Assets

The company can use the value of the stock against future deals.  Meaning if another company hopes to buy your yogurt shop, you can say that our 10 million shares are now worth $100, so in order to buy this company you need to offer $100 million dollars at a minimum.


Future Offerings

As we discussed previously, if the company wants to have future offerings of its stock, the more money the stock is worth the more cash paid out to the company.

Mutual Funds

You may be asking yourself, what do mutual funds have to do with an individual stock?  Well if a stock performs extremely well and is added to such coveted indicies as the S&P 500 or the Nasdaq 100 or the Dow 30, then mutual funds will begin to purchase these shares as the stock is viewed as more valuable.

See how the belief in a stock can turn into real dollars?

Explanation to a First Grader:

You know how Mommy and Daddy want you to do a good job in school so you can go to college and get a great job or start your own business.  Well how do Mommy and Daddy know if you are doing a good job?  That’s right, from your grades.

Remember how Daddy gave Coca-Cola money to make more soda for other children in the world?  Well, Coca-Cola needs to get good grades as well, by showing Daddy that they are making the best soda in the world.  This way Daddy knows our money is still safe and sound.

What are your rights as a shareholder?

Shareholders Meeting

Shareholders Meeting

As a shareholder you have the right to vote on major company decisions such as electing the board members that provide the strategic direction for the company.  Generally there is an annual shareholder meeting where you can come to voice your concerns about the company’s performance and also vote on resolutions.

The number of shares you own dictates the weight of your vote. Most people have little say, but if you are a whale investor like billionaire Carl Icahn, you could be a deciding factor.

Explanation to a First Grader:

You know how you and your little brothers voted with Mommy and Daddy to decide if we were going to Disneyland or Disneyworld?  But remember how Mommy and Daddy still had to plan all the details like what plane to take, our hotel and where we would eat.

Well Coca-Cola does the same thing.  Daddy can vote on what Coca-Cola should do to sell more soda, but it’s the decision of the leaders at Coca-Cola on the details of how they will sell more soda.

How does investing in stocks work?

People buy stock because they don’t believe they will lose their money. Investors believe that a company will be worth more tomorrow than it is today.  This is where the “belief” system comes into the play with the market.

The free market is the representation of the beliefs of thousands of people.  If more people believe a stock is valuable then the stock goes up.  If more people believe the stock is overpriced, then the stock will lost its value.

From an investor’s point of view, buying stock just makes since.  For example, investors only have a limited number of places to invest their money.  There are money market funds, savings accounts, CDs, bonds, housing, etc.

While these are all considered investments, when an investor wants to make an above average return they turn to stocks.  So, while the other investments may average 2 or 4% per year, investing in your local yogurt shop could yield a return of 10%, 20% or even 100%.

To the investor, the lack of a guarantee is okay, because they are willing to accept the risk because the potential return is great.

In order for the investor to make money they have to sell the stock at some point.  Most people forget this part of the equation.  While paper profits are great, the internet boom of the late 90s saw a lot of paper millionaires watch their fortunes evaporate overnight.

In addition to the appreciation of the stock, some larger corporations will provide a stock dividend, where the corporation will share the company’s profits with the shareholders.  So, for each share of stock you own, you will receive “x” dollars in the return without having to sell any of your shares.

Explanation to a First Grader:

Since Daddy sees Coca-Cola machines at your gymnasium in your school, at the movie theatre and at Red Robin, I believe Coca-Cola is here to stay.

Stocks and Taxes

The Government can’t let us have all this fun without getting involved.  So, just how you are taxed at your job for the earnings you make, your investments are taxed as well.  In the US, if you hold your stock for longer than 1-year, then decide to sell, your profits are taxed as a long-term investment at a rate of 20%.

If you buy and sell a stock in the same 12-month period, then the profits are taxed as ordinary income at your respective tax bracket (28%, 35%, etc.).

Explanation to a First Grader:

Daddy has to pay a portion of the money  he makes from selling Coca-Cola stock to the Government.  This money is used to pay for your school, the roads and Army.  This way we make sure we keep America safe and strong.

In summary

Learning how the stock market works is not a game and should be something you discuss with your children at an early age.  This may seem a bit awkward to explain how the stock market works to a kid, but believe it or not, your kids will understand these key principles.  My kids are seeing stocks at the age of 3 and can look at a chart and tell if you if the stock is making or losing money (a.k.a if it’s going up or down).  May not sound like much, but you would be surprised at how many adults have no idea how stock trading works, yet are investing their hard earned money in the market.

If you are looking to see how to invest your money without taking any risk, please go over to our Tradingsim homepage to see our offerings.  This offer is especially important if you are trying to understand how penny stocks work as these securities have increased volatility and risk.

Lastly, if you are looking for information on how stock options work, please visit this article - Understanding Options with Technical Analysis.

Photos

Stock Market Street Sign by 401(k)2012

1st Grade Book by Spencer Fornaciari

Cash by Simon Cunningham

For Sale Sign by Ben Satterlee

Shareholders Meeting by Walmart

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