April 7

What are stocks exactly? How Do the Stock Market Work For Beginners? (Basics)

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Last Updated on 7 April, 2022 by Samuelsson

Whether it’s from the internet, financial news channels, social media, traditional news media, or even your colleagues at work, it is almost impossible for a day to pass without hearing a thing or two about stocks. While you may be conversant with the stock market and even invested in it, do you know what a stock is?

A stock represents all the shares into which the ownership of a company is divided, while the fractional unit of ownership is known as a share — though, both terms are often used interchangeably. Investing in stocks offers you the right to get dividends from the companies that issue the stocks you bought, and you also gain when the stocks appreciate in market value.

There are a lot of things to learn about stocks, so we prepared this comprehensive guide to teach you the basic things you need to know. In this guide, you will learn the following:

  • The history of stocks
  • What stocks are
  • The difference between penny stocks and normal stocks
  • When and why companies issue stocks
  • What splits and mergers are
  • How to make money from stocks
  • The stock portfolio
  • How to buy stocks
  • How to invest in stock market indexes
  • The difference between stocks and bonds

Table of Contents

History of Stocks

In recent times, stocks are playing huge roles in peoples’ wealth growth plans, but it wasn’t that way in the beginning. Today, we’re going to take a look at how the idea of stocks came about and how it has developed over the years. Hee, we will discuss the history of stocks in three stages:

  • Before the Common Era
  • During the modern era
  • The recent development

Before Common Era

Although it is still debated in some quarters, there seems to be some evidence that there were elements of stock trading in the Roman Republic, which existed between 510 BC and 27 AD. It appeared that the Romans, as at then, had joint-stock companies that the citizen could buy into, directly as individuals or indirectly through cooperatives.

The government of the day would lease out its services to private corporations. Those private companies that hold government contracts were called publicani (as a group) or societas publicanorum (individually), in Latin. The companies were not very different from the types of companies we have now, as they were similar in so many aspects.

For instance, it is believed that they issued shares. There were two types of shares then — partes and particulae. Partes was the name for the type of shares issued to large cooperatives, while particulae was the type of small shares that individuals could buy over the counter. So by being a member of a cooperative group, individuals also had access to partes, though indirectly.

These semblances of stocks traded throughout the Republic, and there was evidence that their prices fluctuated from time to time. Individuals and cooperatives would buy these stocks from the companies and later resell their ownership to other citizens. People were buying those shares to participate in government contracts, and almost all eligible citizens participated in trading those stocks.

In the modern era

The first modern type of stock didn’t arrive until the early part of the 17th century when the Dutch East India Company — one of the most popular joint-stock companies of that time — issued the stock of its company to the public. However, history showed that during the medieval period, there were some forms of modern companies that had stocks.

About the year 1250 at Toulouse in France, Bazacle Milling Company had 96 shares whose value were trading according to the profits made from the company’s mills. Similarly, by 1288, it was documented that the Swedish mining and forestry product company, Stora, made a stock transfer to the bishop of Vasteras.

The company transferred a 12.5% interest in a copper mine (the Great Copper Mountain) it owned to the bishop of Vasteras in exchange for one of the estates owned by the bishop. While the sale may not have happened on a stock exchange, and it may not have been presented in share units, it showed there’s an exchange of part ownership in a company — stock trading.

In the 1600s, the imperial governments in Europe — the British, Dutch, and French — granted charters to companies operating in the East Indies. The British East India Company was granted an English Royal Charter by Queen Elizabeth I on the 31st of December 1600, making it one of the earliest recognized joint-stock company in the post-medieval period. The charter gave the company a monopoly on all trades in the East Indies for 15 years.

The French and Dutch East India companies were formed about the same time. Their business operations involved sailing to the far-away Indian subcontinent, which is associated with a lot of risks — pirates, weather risks, and poor navigation.

On discovering the East Indies and its riches, lots of explorers sailed there, but only a few of the voyages made it back home. Many ships were lost and fortunes squandered. Shipowners realized that they had to do something to reduce the risk of ruining their fortunes when ships are lost. They started forming limited liability companies for each voyage to share their risks and returns with others — those were the precursors of the East India companies.

Related reading: How Do Stocks Make Money?

The financiers would seek investors who would contribute money for a voyage in return for a percentage of the profits from the voyage. Realizing how dangerous it was to put all their investment on one voyage, investors started betting on several of those voyages at the same time, to improve the odds of making profits. For instance, let’s assume that a voyage had a 35% chance of being lost. Rather than staking all his money in one company, an investor would invest in four or more companies at the same time. So if one of the ships could not make it back home, the investor would still make some profit from the others.

The formation of the British, French, and Dutch East India companies changed the entire business model. In 1602, the Dutch East India Company, for the first time, issued its shares to the public on the Amsterdam Stock Exchange, thereby becoming the first publicly traded company in the world.

Soon after, other East India companies also issued their stocks and bonds to willing investors. Rather than sharing profits voyage by voyage, these companies issued their companies’ shares and paid dividends to their stockholder on all the voyages the companies undertook. The East India companies, therefore, became the first modern joint-stock companies, and with the type of monopoly they enjoyed, they grew very big and build larger ships — growing the value of their stocks.

The stock certificates of those companies were handwritten on a piece of paper, so investors were able to trade these papers with other investors in coffee shops. Since there no physical exchange buildings in England as at then, an investor would have to look for a broker to conduct a trade. Most times, an investor would get a broker in a coffee shop, and they would conduct their transactions there. With time, a few coffee shops in London became associated with stock trading. Stock papers would be written and posted on coffee shops’ doors, and investors would come there to trade their stocks.

In those days, people were still new to the idea of stock trading, and there’s no regulations or requirement before issuing stocks — no way to distinguish a legitimate company from fraudulent ones. Anyone could set up a business and issue stocks for nonexistent voyages, making thousands of pounds. Unfortunately, the financial bubble burst as companies couldn’t meet up with their dividend promises, and the government of England outlawed issuing of stocks until 1825.

Meanwhile, the Amsterdam Stock Exchange was still thriving, and new bourses were established in Paris and other parts of the world. The Paris Stock Exchange was founded in 1724; the Philadelphia Stock Exchange was established in 1790; and despite the ban on issuing stocks in London, the London Stock Exchange was established in 1801.

Finally, in 1817, the New York Stock Exchange (NYSE) was formed and quickly rose to become the biggest stock exchange in the world. With its office in Wall Street — which is at the heart of the business district of Lower Manhattan — the NYSE attracted a lot of companies very early and became the most influential stock exchange in the US.

Recent developments

With the establishment of regulated exchanges, the stock market grew rapidly to become a very important part of the global financial system that countries depend on for economic growth. Owing to the growing importance of the stock market, efforts are continually made to improve the efficiency of the market and make stock trading much easier. While there have been many innovations in the market since its inception, we will focus on these three:

  • Stock indexes
  • Stock derivatives
  • Trading platforms

Stock indexes

Equity indexes are carefully weighted baskets of stocks that represent a segment or the entire stock market. Investors use them to measure the performance of an entire stock market or a section of it. The first equity index published for stocks on the NYSE was the Dow Jones Industrial Average, which was first calculated on May 26, 1896. It measures the performance of 30 large-cap companies in the U.S. stock market.

The precursor for the S&P 500 was a 90-stock index first computed by the Standard Statistics Company in 1926. When the company merged with the Poor’s Publishing to form the Standard and Poor’s in 1941, the index became known as the S&P 90 Index. It later expanded to its current 500 stocks on the 4th of March 1957 and became known as the S&P 500 Index.

Stock derivatives

Despite how early derivative trading started in the commodity markets, equity derivatives would not start trading in the U.S. markets until the second part of the 20th century. Equity futures, especially equity index futures, made their debut in the U.S. market in 1972. Single stocks futures started trading many years after. Options trading on equity indexes only started in 1983.

Trading platforms

Initially, stock trading was carried out only at the exchanges, where traders used the open-outcry system to interact. Buyers and sellers stay on the trading floor and yell their bid and offer prices. A trade occurs when any two parties agree on a price.

The advent of the internet and the development of online trading platforms made it possible for stocks to be traded via electronic trading systems, where computers match the buy and sell orders. An example of an electronic marketplace is the NASDAQ.

Buy limit and sell limit orders are queued up in the computer — the sell limit order with the lowest price will be the current ask price, while the buy limit order with the highest price will be the bid price. The difference between the current ask price and the bid price is known as the spread. A trade occurs whenever a buy market order matches the ask price or a sell market order matches a bid price.

With electronic trading, investors can buy and sell share online through their online brokers’ platforms in a matter of seconds, unlike before when one had to dial the broker to place a trade order. In fact, day trading in the stock market became possible because of the availability of electronic trading platforms.

What are stocks?

Stocks are the type of investment that represents proportionate ownership in the companies that issued the stocks. Also known as equity, a stock refers to the shares of a company trading on a stock exchange. In other words, when you buy any number of shares of a company, you have bought the stock of that company, and when you buy shares in various companies, you can say you bought stocks of various companies.

Although the term stocks and shares are often used to mean the same thing, especially in the US, a share is the basic unit of ownership that can be bought in a company, while a stock is the collection of shares of a company. For example, if you buy 100 shares of Company A, you have bought just one stock — Company A stock. But if you buy 40 shares of Company A, 35 shares of Company B, and 25 shares of Company C, then, you have a portfolio of three stocks — Company A, Company B, and Company C stocks.

Buying the stock of a company entitles you to a portion of the company’s earnings and the proceeds from its assets (in the event of liquidation) — in accordance with the percentage of ownership you have in the company. The percentage of ownership you have in a company depends on the number of shares of the company you own relative to the total number of the company’s shares.

For instance, if the company has 100,000 shares outstanding and you own 5000 of those shares, you effectively have a 5% stake in the company, so you are entitled to 5% of the company’s distributed earnings. And if the company liquidates, you can claim 5% of the proceed from the company’s assets, after creditors and preference shareholders have been paid.

In addition to all those, owing a stock may give you the right to vote in the general meetings of the company’s shareholders — depending on the type of stock you own. The voting right offers you the opportunity to influence how the company is run, but the level of influence you can exert depends on the number of shares you own.

The primary reason people buy stocks is to earn a return on their investment. Generally, the return comes in the form of capital appreciation, whereby the price of the stock rises higher than what it was bought at, and dividend income, which is the portion of the company’s earnings shared to stockholders according to their stakes in the company.

With an average annual return of about 10%, stock investments have historically performed better than most other investment vehicles. However, you should note that the 10% average historical return is for the S&P 500 Index, which is a basket of 500 biggest stocks in the U.S. stock market. Individual stocks may post different kinds of returns — some higher, others lower.

For the most part, companies issue stocks to raise funds to run their businesses. When it comes to raising funds to finance their projects, companies have two options: borrow (in the form of bonds or bank loans) or issues stocks and share their ownership with willing investors. Companies that are still in their growth stages tend to prefer the stock option because it doesn’t come with the burden of debt servicing or a payback period.

Where to buy stocks: the primary and secondary markets

The capital market — the part of the financial system through which corporation can raise capital from stocks and bonds — is generally divided into two sections: the primary market and the secondary market. New securities are created in the primary market, while existing securities are traded in the secondary market. An investor can buy stocks from both the primary and secondary markets.

Primary market

Also known as the new issue market, the primary market is where a company creates shares, bonds, or debentures and sells to the public. It is in the primary market that companies offer their stocks and bonds to the public for the first time — thus, an initial public offering (IPO) is done in the primary market.

Apart from IPOs, other issues companies make in the primary market include right offering, issue of IDR, bonus issue, offer for sale, and others. The key thing about the primary market is that companies, through their appointed representatives (underwriters), directly sell their securities to the investors. In the case of an IPO, the issuing company is known as the issuer, and the underwriters are mostly investment banks.

For instance, let’s say company RT wants to raise money from the public to expand its business, and it decides to do so via an IPO. It can hire about three underwriting banks to determine the appropriate price for the stock. The underwriting firms may fix the issue price at $30 and sell all the stipulated shares directly to the investors at that fixed price.

By buying stocks from the primary market, investors contribute capital to the issuing company. The funds a company generates from the sale of its shares on the primary market make up its equity capital. If the company wishes to raise additional equity capital after its IPO, it can do that through a right offering or private placement.

Secondary market

The secondary market is what we refer to as the stock exchanges or the stock market. Examples include the New York Stock Exchange, NASDAQ, London Stock Exchange, and all stock exchanges in the world. The secondary market is where existing stocks, bonds, debentures, and other securities are traded.

One main feature of the secondary market is that investors trade previously issued stocks without the direct involvement of the companies that issued the stocks. So investors buy and sell the stocks among themselves — existing stockholders sell their stocks to raise money for personal needs while aspiring investors buy to gain part ownership in the companies that issued the stocks.

For example, if you buy Apple stock (AAPL) on the NYSE or NASDAQ through your broker, you are buying from another investor who owns Apple shares, and Apple Inc. is not involved in that transaction.

Generally, the secondary market is of two types: the auction market and the dealer market. In the auction market, the trading members of an exchange come together on the floor of the exchange to announce their buy and sell prices — the open-outcry system. The NYSE is a good example. On the other hand, trading in the dealer market is carried out through electronic networks. An example is the NASDAQ.

Difference between primary and secondary markets

Basis Primary market Secondary market
Meaning This is the market where stocks are created and sold to the public via initial public offerings, rights issues, bonus issues, and private placement. Often referred to as the stock exchange, this is where a stock can be traded after the issuing company has sold its shares on the primary market.
Other names Because it is the market where new stocks are issued, it is also called the new issue market. Since stock trade here after it has been issued by the company, it is called the after market. Generally, it is referred to as the stock exchange or, simply, the stock market.
Function It helps the issuing company to raise funds to finance its business projects. It helps existing stockholders to raise money to solve their personal needs.
How many times does trading happen? Generally, trading happens only once, but a company can raise funds again from the market through a rights offer. Trading happens all the time, as long as there are stockholders, who are willing to sell their stocks, and investors willing to buy the stocks.
Parties to the transaction The investors buy shares directly from the issuing company. Here, the investors buy and sell stocks among themselves
intermediary The underwriters (investment bankers) act on behalf of the issuing company. Investors trade stocks through their brokers.
Nature of price Investors buy at the price fixed by the underwriters. That is, the price of the stock is fixed. Stock prices fluctuate all the time, based on the levels of demand and supply
The marketplace There is no physical marketplace where the stocks are transacted. There are physical marketplaces for trading stocks, such as the NYSE, NASDAQ, and the London Stock Exchange.
Regulations Stock market regulators, such as the Security and Exchange Commission (SEC), provide strict criteria for companies that want to issue stocks to the public, and only the companies that meet the criteria are allowed to sell to the public. Companies whose stocks are trading here are required to report their earnings quarterly and also make public all significant events that concern their operations.

What does it mean to be a stockholder?

As a stockholder, you do not own the assets of the company whose stock you have acquired; you only own the shares of the company. Any publicly traded companies is a C corporation, so it has a separate legal identity from its owners. That is to say that a corporation can file its taxes, be sued as an entity, can borrow money in its name, and is able to acquire assets and properties for itself.

The law sees a corporation as a legal person with the above-listed rights, including the right to keep its own properties. So the computers in a company’s office belong to the company and not the stockholders. A company’s assets and properties belong to it throughout the life of the company.

The fact that stockholders are entitled to portions of a company’s assets comes to effect after winding up. It is only at liquidation that a corporation loses those legal rights. When a company is liquidated, shareholders are entitled to proportionate amounts of the company’s asset (or rather proceeds from the assets).

It is very important that you get this distinction clearly — corporations are separate legal entities from the shareholders, and each person’s liabilities are limited to that person. If a corporation is highly indebted, its assets may be sold, but shareholders personal assets cannot be touched. Similarly, if a shareholder is in need of money, he can’t sell the company’s assets to raise money.

Types of stocks

Stocks are usually classified into two main groups, namely:

  • Common stock
  • Preferred stock

Common stocks

Also known as equity share, voting share, or ordinary share, common stock is the type of corporate equity ownership that gives the stockholder the right to vote in shareholders general meetings, in addition to the right to share in the company’s earnings.

Generally speaking, holders of common stocks can vote on matters that have to do with policy and altering the composition of the members of the board of directors. Through their votes, these investors can influence how the company is managed. The level of influence a shareholder can have depends on his voting rights which, in turn, is dependent on the type and number of shares he has.

Unlike preferred stocks, which are usually arranged between a company and an investor, common stocks are traded freely on the exchanges. Common stockholders can make money when the stock appreciates in value. They also earn when the company shares dividends, but they don’t get paid dividends until all preferred stock dividends have been fully paid.

Furthermore, in the event of liquidation, holders of common stocks are the last to receive payment from the proceeds of liquidation. Employees, creditors (including bondholders), and preferred stockholders are paid first, and whatever is left, is shared to the common stockholders.

Different classes of common stock

While common stocks carry voting rights, not all common stocks have the same voting right in some companies. In certain companies, different classes of common stocks are created to concentrate the voting power to a select group of investors. So, depending on the number of voting right assigned to a stock, common stocks may be divided into:

  • Class A stock
  • Class B stock

Class A stock: Class A stock is a group of common shares that carry a higher number of voting rights. A company may decide to assign 10 voting rights per Class A share, while a Class B share has only one voting right. There is no specific rule on how to classify common stock; each company is at liberty to structure its stock the way it wants.

Class B stock: Class B stock refers to common shares that carry less number of voting right. Shares in Class B stock may carry one voting right each, compared to Class A shares that carry 10 voting rights. But there is no hard and fast rule about this; a company can structure its stock as it pleases.

Apart from the aspect of voting rights, the different classes of common stock entitle the holders the same right to share in the company’s earnings. Most investors don’t even bother about the voting rights, provided the people who have the majority voting rights are leading the company in the right direction.

A good example of a company that designates its common shares into Class A and Class B stock is the Berkshire Hathaway, the company run by one of the greatest investors of all times — Warren Buffett. The Class B stock of the Berkshire Hathaway has 1/1500th voting power and value of the Class A stock.

While designating common stocks into different classes may be common in the US, it may not be allowed in some countries where there are laws against such.

Preferred stock

Preferred stock is the type of stock a company issues to certain investors, which usually come with fixed dividend payments but carry no voting rights. So, holders of preferred stock cannot influence how the company is run or who the company can employ as a director.

In fact, preferred stock is considered a hybrid instrument, with the features of both an equity and a debt instrument. The common features of preferred stock include the following:

  • A fixed dividend that is paid before common stocks are paid
  • Settled ahead of common stocks, in event of bankruptcy
  • Can be converted to common stocks
  • No voting right
  • A par value that is affected by interest rates — increases when interest rate decreases and declines when interest rate increases
  • Higher dividend yields
  • Redeemable after a predetermined date

There are different types of preferred stocks, and these are some of them:

Prior preferred stock: Some companies issue different series of preferred stocks, and one of them is designated highest-priority preferred stock. When it is time to pay dividends, the prior preferred stockholders are paid first before others.

Preference preferred stock: On a seniority basis, the preference preferred stock is the next in line after the prior preferred stock. Holders of this type of preferred stock get preference over other types, with the exception of prior preferred stock.

Exchangeable preferred stock: This is the type of preferred stock that comes with an embedded option, which the holder can exercise to exchange the preferred stock with another security, such as bonds, debentures, or other stocks.

Convertible preferred stock: This type of preferred stock can be exchanged for a given number of the company’s common shares. The investor is at liberty to exchange the preferred stock to common stock at any time of his choosing, but once exchanged, the common stock cannot be converted back to preferred stock.

Perpetual preferred stock: In this type of preferred stock, there is no fixed date on which the capital will be returned to the shareholder. The company has the right to redeem the preferred stock, but the redemption date is not fixed.

Cumulative preferred stock: In this type, whenever the dividend is not paid as scheduled, it will accumulate with interest to be paid on a future date.

Non-cumulative preferred stock: For the non-cumulative type of preferred stock, the dividends will not accumulate if they are not paid. This is common in bank preferred stock because the BIS (Bank for International Settlements) rules stipulate that preferred stock must be non-cumulative to be included in Tier 1 capital.

Putable preferred stock: This type of preferred stock carries a ‘put’ option, so the holder of such preferred stock can, in certain situations, force the issuing corporation to redeem the stock.

Participating preferred stock: With this type of preferred stock, the holder can receive extra dividends if the company meets a predetermined financial goal. The regular dividends are paid regardless of how the company performed, but when it performs up to the predetermined level, it pays extra dividends to the holders of this type of preferred stock.

Monthly income preferred stock (MIPS): This type combines the features of preferred stock with those of subordinated debt. It is structured in a way that the borrower services it as a debt (interest payment from pretax income), but the investors receive the payment as dividends.

Private company stocks vs. public company stocks

A private company is a company that is owned and managed by its founders, alone or in conjunction with a few other private investors. Depending on the corporate structure, a private company can issue stock and have a limited number of shareholders. Stocks in private companies differ from those of public companies in so many ways, and these are some of them:

Where the stock is traded

One of the main differences between stocks in private and public companies is where they are traded. To buy the stock of a private company, a qualified investor has to directly buy the stock from the company through private placement or buy directly from individuals who own shares in the private company — over the counter. In other words, there are no exchanges where an investor can buy the stock of a private company.

On the other hand, public company stocks are actively traded on popular public stock exchanges, such as the NYSE and LSE. So any investor can buy or sell the stocks on any of the exchanges through a broker. Being on a public exchange means that the transactions are made public.

Ease of valuations

Since the transactions in privately-held stocks are not made public, it is very difficult to know the last price the stocks traded at. An investor trying to buy the stock will find it tough to determine its market value. Moreover, being private also means that the company has no duty to release its balance sheet and income statement and does not report its quarterly earnings. So, it is almost impossible to calculate the intrinsic value of the stock.

On the other hand, it is far easier to make an informed decision when trading public company stock. All the transactions are public, and the companies are obligated to release their financial statements and report any events that affect their business operations. Thus, a prospective investor can estimate the value of the stocks.

Level of liquidity

Because the stocks of private companies don’t trade on the exchanges, buyers and sellers are not readily available. An investor who wants to buy a private company stock may find it difficult to find a willing seller, and a stockholder who needs money may find it difficult to get a willing buyer.

The situation is different for the stocks of public companies which trade on popular exchanges. Such stocks exchange hands several times in a minute, so the issue of illiquidity does not arise. Investors buy and sell stocks all the time on the exchanges.

Degree of volatility

Owing to the fact that buyers and sellers are not easily available for stocks of private companies, the prices can be very volatile. Moreover, the transactions are negotiated privately, so a desperate seller can be made to accept a ridiculously lower price, while a determined buyer may be forced to pay more.

The volatility in publicly traded stocks is relatively less because there are many willing buyers and sellers ready to transact at a fair price. While there may be price swings, it happens in accordance with the market value of the stock.

Dividends

While private company stockholders can get some handsome dividends sometimes, the decision to pay or not to pay dividends may rest only on the management. They may not be consistent with their dividend policy, and since their operations are conducted privately, some of the stockholders may be shortchanged.

On the contrary, public companies tend to have a more consistent approach to dividend payments, and the shareholders are carried along in the decision-making process. Their operations and every decision are open to the public. Each share in a class of shares is entitled to the same dividend — no cheating.

Proxy appointment

Since private companies conduct their dealings privately and are under minimal regulations by the authorities, they may not allow a stockholder, who is unable to attend a stockholders’ meeting, to appoint a proxy to vote for him.

Public companies, on the other hand, are mandated to allow a stockholder appoint a proxy to vote for him in a shareholders’ meeting. A public company has no grounds to refuse a stockholder to exercise that right.

Share transfer

If a stockholder in a private company wants to transfer his shares to someone else, say a relative or spouse, the directors of the private company may refuse to register a transfer of shares.

However, this is unlikely to happen in a publicly traded company. Unless the stock exchange and the regulators allow it, a publicly traded company cannot enforce such kind of restrictions on share transfers. A shareholder can transfer his shares to whomever he wants and get it registered.

Penny stocks vs. normal stocks

A normal stock is a stock that is trading at $5 and above, on one of the major stock exchanges, such as the NYSE, NASDAQ, or the American Stock Exchange (AMEX). They are popular and usually well-capitalized.

A penny stock, on the other hand, is currently defined as a stock that is trading at less than $5 per share. In the past, it was considered any stock trading below $1 per share, but the SEC modified the definition to include all stocks trading for less than $5.

In addition, most penny stocks are traded over the counter on electronic trading marketplaces, such as the OTC Bulletin Board (OTCBB) and the Pink OTC Markets Inc. There are many ways in which normal stocks differ from penny stocks, and these are some of them:

Information

Normal stocks are often well known, and people usually talk about them — analysts discuss them on financial news channels, and traders talk about them on their blogs. Moreover, the exchanges and the SEC often mandate them to make public their financial statements and other necessary information about them.

Penny stocks, on the other hand, are relatively unknown, and you don’t get to hear about them and what they do. Popular financial analysts don’t talk about them. You don’t get to see their earnings reports, balance sheet, and other financial statements. And you need the information to make an informed decision about investing in the stocks.

Track record

Most normal stocks that trade on the major exchanges have been in existence for a reasonable period of time; some have been around for many decades and even centuries. For those kinds of stocks, their record is there for everyone to see, and it speaks for them. To have lasted that long, the companies must have been doing something right.

On the other hand, most of the companies behind penny stocks are newly formed private companies that could not meet the criteria for registering on the major exchanges. Some of them are close to bankruptcy. In essence, most penny stocks are stocks of companies with a poor track record or no track record at all.

Liquidity

The fact that normal stocks trade on popular exchanges, where buyers and sellers congregate on a daily basis to transact, means that the issue of liquidity may not be a problem for them. Normal stocks attract big institutional investors, as well as many retail traders who speculate on the short-term price movements.

For penny stocks, the story is different. Only a couple of thousand shares are traded each day. Institutional investors and big retail traders are not attracted to the market because of poor liquidity. There are not be enough orders to meet their normal trading volume.

Volatility

The volatility in normal stocks is often a reflection of the market value of the stocks and the changing sentiments in the market. Because the market is very liquid, there are enough orders in the market, so prices don’t swing widely. In other words, normal stocks have normal volatility.

Penny stocks, on the other hand, are extremely volatile, and it is often as a result of illiquidity. Since the trading volume is small, any relatively large order can make the price spike in the direction of the trade. With price swinging up and down, it becomes difficult to technically analyze their charts.

Spread

This is another thing that contributes to volatility. The spread is the difference between the sellers’ lowest ask price and the buyers’ highest bid price. It tends to be high when the liquidity is low and volatility is high. Since there are few traders in the penny stock market, price quotes are often far apart, making the spread to be very wide. In addition, there are no market makers to provide more liquidity to the market.

Normal stocks, on the other hand, usually have lower spread, and the spread tends to be more stable since there are market makers to provide liquidity.

Speculation

While several short-term traders play the normal stock market for speculative purposes, most of the trading that occur in normal stocks are carried out by investors, who wish to grow their wealth, along with the underlying companies, over the long term.

On the other hand, the majority of the players in the penny stock market are there for speculation only. But who would blame the traders? There is no way to estimate the values of those stock with the little or no information available, so they are not good for investment purposes.

Regulatory oversight

The SEC, as well as the exchanges themselves, has a set of criteria a company must meet before offering its stock to the public. And when the stock is trading on the exchange, the company is required to report its earnings quarterly and provide the public with all the information about its operations, else it will be suspended.

Penny stocks that trade on the OTC marketplaces don’t have such regulations. The SEC pays little or no attention to them, and the platforms they trade on don’t have a minimum standard that a stock must keep to. Penny stock companies don’t make their financial situation public.

Manipulation and scams

Since normal stocks are highly regulated, the incidence of scams and manipulations are minimized. Also, the huge liquidity in normal stocks makes it difficult for individual traders to manipulate the activities in the market.

On the other hand, penny stocks are associated with all sorts of scams and manipulations. Because of the low liquidity and lack of regulation, they are very easy to manipulate. One of the popular scam schemes in penny stocks is the pump and dump scheme. Fraudulent traders would buy a penny stock and then promote it to lure unsuspecting investors. When enough investors come in to buy the stock, they dump their shares and move on. Other scams associated with penny stocks include chop stock, dump and dilute, and know it all.

Brokers

You can trade normal stocks through a traditional and online broker. Traditional brokers have no issues with trading normal stocks, provided you meet all the requirements.

Penny stocks, on the other hand, can only be traded through a few online brokers that allow them. Most traditional brokers don’t allow their clients to trade penny stocks.

Other differences

Required capital

Because normal stocks are priced higher than penny stocks, investing in normal stocks requires more capital than trading penny stocks. A small investor can acquire thousands of shares in a penny stock with a few hundred dollars.

Potential returns

While trading penny stock may be very risky, it has the potential to generate huge profits in a shorter period than what is obtainable in normal stocks. Because they are lowly priced, it is easier for them to double or triple in price than normal stocks.

For example, it is easier for a $0.5 stock to rise to $1 or $1.5 than a $50 stock to get to $100 or $150. Moreover, due to high volatility, penny stocks can make their moves in a few hours to days, unlike normal stocks that will take weeks or months to appreciate.

When and why do companies issue stocks?

Companies issue stocks when they need to raise money to finance their businesses. There are so many aspects of a company’s operations that can make it want to seek fund outside, and they include some of the following:

  • Developing new products
  • Acquiring new equipment