Stock Market 101
Before you even think about investing, read this article to make sure you know what you're getting into.
Stock Market
In a stock market, both stocks (shares of a publically traded company) and derivatives (like swaps, futures and options) are traded. The most important distinction between these two categories of financial instrument is that stocks have an actual value, tied to the success or failure of a particular company, and derivatives have only a notional (a theoretical, agreed-upon) value. That's why, in October 2008, the total world stock market was estimated at $36.6 trillion, and the total world derivatives market was far larger, $791 trillion. This is 11 times the size of the entire world economy.
- Stock exchanges may be physical, like the New York Stock Exchange, or entirely virtual, like the NASDAQ.
- There are many individual investors, but the dominant investors are institutions such as hedge funds, mutual funds and investment banks. These institutions represent the financial interests of many individuals bundled together.
Mutual Funds and Hedge Funds
Mutual funds and hedge funds are often confused with one another.
- A mutual fund is a professionally managed collective investment scheme. Legally, in the U.S., a mutual fund must distribute nearly all of its gains, if any, to its investors annually.
- Hedge funds also represent pools of investors, but are less regulated and follow a more diverse range of investment strategies, such as "shorting" or "straddling" stock. They may hold opposing positions on the same company using different financial instruments; in this case, they are "hedging" their bets, which is where the name comes from. To invest in a hedge fund in the U.S., you usually need to be fairly wealthy already, or meeet other criteria.
Shorting
"Shorting," or short selling a stock, is where an investor sells assets, such as securities, that have been borrowed from a broker. The investor has the obligation to return identical assets to the lender by an agreed-upon date. The short seller is betting that the value of the assets will decline, resulting in a profit. If the assets increase in value, the investor loses money. Essentially, a short seller is betting that a stock or security will go down in price, making this the opposite of the more traditional "long" investment, where the investor hopes for a company's success.
Straddling
"Straddling" is a strategy of purchasing or selling option derivatives in which the investor is betting on how much the derivative will move, without being particular about the direction. They can be a good idea when investors expect a volatile market.
These are just some of the many terms and concepts that underpin modern finance and the stock market.