Stocks and the Stock Market

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(explainlikeimfive) : Stocks and the Stock Market Explained!
 * Both the question and the answer are in the submission.

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A number of people have asked questions on ELI5 related to how stocks and stock market work. Here goes:

Part One : Stocks
First, let's imagine that down the street there is a toy store. Mr. Jones owns the toy store, and he has owned it for the last ten years. The toy store is a company which sells toys and all the kids love to get toys from Mr. Jones' toy store.

Let's suppose we wanted to buy Mr. Jones' toy store from him so that all of the kids would buy toys from us instead. Would we be able to buy it for a dollar? No, of course not. It is worth a lot more than that. How about ten dollars? A hundred dollars?

Well, how exactly would we find out how much we need to pay in order to buy Mr. Jones' toy store? The most important thing to consider is simply how much money is the toy store making. If the toy store is making $100 every day, that means it is making roughly $3,000 (30 days of $100) every month, or $36,000 every year (12 months of $3,000). Let's suppose we are able to figure that the toy store should be able to keep making this much for the next ten years. Then we could consider that the entire toy store is worth $360,000 (which is $36,000 for ten years).

Now, in practice this is a lot more complicated. But the basic principle is simply to figure out how much money a company can be expected to make in a certain time frame. Fortunately, we don't have to figure it out ourselves. There are big companies whose job is to figure out how much other companies are worth, and they do all of the hard work for us. They will tell us just how much Mr. Jones' toy store is really worth, and then we can decide to buy it or not.

So, let's consider that the toy store is worth $360,000. If we want to buy it (and if he is willing to sell it), we can pay Mr. Jones that much money and now the toy store is ours!

Now, this is all well and good if we have $360,000 and we want to own the entire company. But let's suppose we only have half that much, we have $180,000. What can we do now? Well, as long as Mr. Jones is willing, we can buy half of his company instead of the whole thing.

This means that we will own 50% or half of the company, and he will own the other half. That means that instead of all of the money from selling toys going to Mr. Jones, half will go to him and the other half to us.

Another way of saying that we own 50% of the company is to say that we own 50% of the stock in a company. When a company is set up in a way that you can buy pieces of it, those pieces are called stock. There are two ways to think about stock: percentages, and shares.

What we just talked about are percentages. We can buy 50% of the shares in Mr. Jones' toy company for $180,000. Similarly, we could buy 10% of the shares in Mr. Jones' toy company for $36,000 (assuming the total value of the company was $360,000), or we could buy 1% of the shares for $3,600, and so on.

When you hear people talk about stocks, you will hear them talk about shares of stock. What exactly does this mean? Well, let's imagine that Mr. Jones has a lot of people who want to buy a piece of his company. What he can do is say "Hey everyone, I have 100 different pieces of my company for sale."

In this example, there are 100 total pieces he has for sale, each one being worth 1% of the stock. To buy all 100 pieces would cost you $360,000 and this would mean you own the entire company. This would mean that whenever the company makes money, you get all of the money. But let's suppose we only have $3,600 to use. This means all we can afford is one piece of his company, but that one piece is worth 1% which means that every time the company makes a hundred dollars, we will get one dollar.

So in this example, Mr. Jones' looks at the situation and realizes it is very hard to find people to buy pieces of his company, because each piece costs $3,600 which is a lot of money. So he decides rather than just have 100 pieces, or shares, he is going to have a thousand pieces! Now it takes ten shares to have 1% of the company, but each share is only $360. That is a lot more affordable. He could even decide to make 10,000 shares which means that you could buy a share for only $36.

So this is the basic concept. Companies cut their value into pieces, or shares, and then sell the shares to people who will buy them. The people who buy shares are called "investors" and the act of buying a share is called "investing". This means that they are buying shares in a company because they think that eventually they will make back more than what they paid, because they are getting a piece of all of the money that the company makes.

When a company is enormous, worth billions of dollars, even a thousand shares is simply not enough. They need to have many, many shares in order to make sure that shares are affordable. Some companies have millions of shares of stock.

Now, we have covered one aspect of what it means to own stock in a company. You are able to keep some of the money the company makes, based on how many shares you own. But when you own part of a company, you don't just get some of the money it makes. You also get to make decisions. Everyone who has shares in a company has the right to vote for what the company will do next. The amount of voting power you have is equal to the percentage of shares you have.

Imagine that a company is owned by three people: Billy, Melissa, and James. Imagine that Billy owns 40% of the total shares, and that Melissa and James each own 30%, which is less than what Billy owns.

Let's suppose that the toy company is trying to decide whether to sell a certain toy. Billy thinks it is a good idea, but Melissa and James think it is a bad idea. Well, even though Billy has more shares of stock in the company, and more voting power, he will still be out voted by both Melissa and James. This is because together Melissa and James have 60% compared to Billy's 40%.

When a company has a lot of share holders (people who own stock in the company), they will have meetings called shareholder meetings. In these meetings, everyone gets to vote based on the shares they own. The company will do whatever the prevailing vote decides.

So then, this brings up a question. What if there are a lot of people who own shares, but one of them owns more than half of all the shares? Would that person be able to out-vote everyone else, no matter how many other people there are?

The answer is yes. If a single person owns more than half of all the shares, then they have what is called "controlling interest" in the company. This means that they can decide anything for the company and outvote everyone else.

Part Two : The Stock Market
So by now you should have a pretty good idea of what stock is. Now let's imagine that there is also a video game company owned by Mr. Smith. Now, Mr. Smith's company is doing a lot better than Mr. Jones'. We had said that Mr. Jones' company is worth $360,000 based on how much it is expected to make over ten years, but Mr. Smith's is worth twice that! His video game company is worth $720,000.

Let's imagine that Mr. Jones' company has 100 total shares of stock, each valued at $3,600 per share. Let's also imagine that Mr. Smith's company also has 100 total shares of stock, each valued at $7,200 per share. This means that if we had $7,200 we could choose to either buy two shares in Mr. Jones' toy company, or one share in Mr. Smith's video game company.

Let's suppose that we already own two shares of stock in Mr. Jones' toy company. Our two shares are worth $7,200 which is enough to buy one share of stock in Mr. Smith's company. We looked at both companies, and we decided that Mr. Smith's company seems like it is doing the best, so we decide to sell our two shares in Mr. Jones' toy company, and buy one share of stock in Mr. Smith's company. And this is the basics of stock trading.

Now here is where things get interesting. How much a company is really worth changes constantly. Mr. Jones' company has been making $100 every day for ten years, but all of last year his company was only making $50 per day! Is it still worth $360,000 ? Maybe it is losing value, or maybe it is just going through a rough period. If we owned stock in the company, we would have to decide which it is. If we decide the company is losing value, then we will probably want to sell our stocks and buy stocks in a company that is doing better.

There are a lot of reasons to assume that a company is doing better, or worse. We might have heard a rumor that Mr. Jones' toy company, even though it has only been making $50/day is about to start selling a really, really cool toy. We say "Wow, if he sells that toy lots of kids will buy it!" and so we decide to buy a lot of stock because we think that the stock is actually worth more than Mr. Jones says.

Similarly, we might have heard a rumor that an even better toy company is going to be opening up a store right next door to Mr. Jones' toy store. In this case, we might say "Oh no, we have a lot of shares of stock in Mr. Jones' toy company, and we better sell it fast! If we don't, we will lose money because the kids will all shop at the new toy store instead." You can see that emotion plays a big role in this.

Now let's imagine that instead of two companies (Mr. Jones' Toy Company, and Mr. Smith's Video Game Company), there are hundreds of companies. Let's also imagine there are thousands of people all trading stock in each company at the same time. Now you have what is called a stock exchange. If you take the value of all of the companies and add them together, and then divide that by the total number of companies in your stock exchange, you get an average that you can track over time to see how well on average all of the companies are doing.

Let's suppose that all of the companies combined are worth a million dollars, and that there are only ten total companies in the stock exchange. Then we would say that the average value is a million divided by ten which is $100,000. Remember though that how much companies are worth changes over time, so the very next day it might turn out that all ten companies combined are now worth two million dollars, which means our average is now $200,000.

If we keep track of this average over time, we can create a graph. We can watch this graph to get a good feel for how the companies in the stock exchange are doing. This can also help us decide whether or not investing in more companies is a good idea, or a bad idea.

There you have it, the basics of stocks and the stock market. I hope you enjoyed it.

Contributions
There are many interesting questions and answers regarding this topic in the Reddit thread.

/u/omfgpuma

 * >now someone needs to explain futures, options and derivatives

Futures: the obligation to buy a fixed amount of a specified good at a set date in the future. Say you are a farmer and are worried that the price of corn is going to go down, you can purchase a futures contract to deliver a set amount of your crop at a predetermined price, thus reducing uncertainty.

Options: similar to futures, except as the name indicates, options are the right, but not the obligation to buy or sell a fixed quantity at or before a certain date in the future. Corporate executives are often paid in stock options which have a strike price (the price at which you would pay for the stock on delivery) above the current price, which gives them the incentive to act in the best interest in the shareholders. For example: XYZ Corp's stock is at $15/share and the company wants to design a new compensation plan. They grant the CEO call options (the right to purchase shares at a given price) at, say, $20/share. If the CEO doesn't improve the company's share value above $20/share, those options are worthless. There are many different types of options: Put, Call, American, European, etc. Put is the right to sell at a given price, offering protection from a decline in share value. Call is the right, but not the obligation, to purchase at a given price. American options can be exercised at any point until they expire, whereas European options can only be exercised at specified dates. Many people use options as a means of limiting their risk for loss while offering a lot of reward. If you spend $100 on options on 100 shares that end up worthless, you lose $100 and walk away. If you buy 100 shares for $10 a piece, you have a much higher up front cost, and you have a lot more risk for loss - up to $1,000.

Derivatives: Options and futures both fall under the umbrella of derivatives. A derivative is a financial instrument which is valued based off an underlying asset. An option's value is based on the underlying share's current price and the likelihood it will change in value. A stock that is known for big upward moves will have expensive call options because it is likely they will be worth a lot of money, whereas steady stocks like GE aren't prone to big swings so call options that are far away from the current price are very cheap.

Source.