One of the most popular ways in which an individual can participate in the financial markets is through the purchase of "stock." A stock is an equity investment in a corporation which entitles the owner to a portion of that corporation's earnings and assets. Stocks are denominated in "shares," with each share representing a small portion of ownership in a company. When one purchases a share of a specific company's stock, he or she acquires a partial interest in that company.
Stock ownership rates among Americans are substantial. As of April 2015, 55% of all American adults owned stock, with nearly 90% of Americans who earned more than US$75,000 annually owning corporate stocks. Purchasing and owning stock is also popular among international investors. The vast equities marketplace of China boasts more than 90 million individual domestic stockholders.
The motivations driving the purchase of a specific company's stock range from short-term speculation to long-term capital investment. Investors and traders purchase stocks in an attempt to profit from the future capital appreciation of the stock's price. Fixed-income investors and company employees buy stock for potential dividend payments, or in conjunction with company-sponsored retirement plans. Institutional investors buy large blocks of corporate stock as a means of obtaining influence over company policy.
Methods Of Purchase
There are several methods of purchasing and trading stock. An individual can buy stock directly from a corporation through enrollment in a Direct Stock Purchase Plan, or on the open market through a brokerage firm. Stocks can also be traded in derivative form through "contracts of difference" (CFD). The motivation and perspective of the investor will have substantial bearing on which company's stock to buy and which method of purchase is the best fit.
Direct Stock Purchase Plan (DSPP)
One of the ways in which an individual can purchase stock is through a Direct Stock Purchase Plan (DSPP). A DSPP is a company-specific program regulated by the SEC that enables a company to sell shares of stock directly to investors. Purchasing stock through a DSPP enables the investor to avoid the fees and commissions associated with brokerage firms.
The process of acquiring corporate stock via DSPP is straightforward. First, the investor must enroll in the selected company's DSPP. After enrollment, an account is opened with the offering company's plan agent. The plan agent conducts all monetary transactions between investor and company. Lastly, an amount of investment capital is designated by the investor for purchase of stock, and the plan agent facilitates the transaction.
Enrollment in a DSPP affords the investor several advantages and drawbacks. The elimination of brokerage fees and the convenience of investing are the largest advantages. Regulated investment horizons, initial setup fees, and fees upon the sale of stock can be substantial disadvantages, depending on the individual company's policies.
Contract For Difference: CFD
One method of trading stocks without actually purchasing and owning individual shares is through a "contract for difference", known as a "CFD." A CFD is an agreement between two parties engaged in active speculation concerning the value of an underlying security. Stocks, commodities, currencies and indices can be traded via contracts for difference. A CFD is considered a derivative financial product as its value is based on the pricing of an underlying asset over a given period of time.
For instance, if the underlying asset of a CFD is a share of corporate stock, the value of the CFD fluctuates in concert with the individual stock's pricing. In the event the stock price rises, the buyer of the CFD enjoys a financial benefit from the stock's appreciation. Short sellers of the CFD realise a loss and are responsible for paying the difference between the contract price and the actual stock price to their CFD dealer. Conversely, if the price of the underlying security is to fall, the seller of the CFD realises the gain while the buyer of the CFD loses value and is responsible for repayment of the difference.
CFDs are purchased or sold on margin, with only a small amount of the underlying asset's value needed from the trader to initiate the trade. Often, only 1% of asset value is required by the CFD dealer to facilitate the trade, with the trader realising gains on 100% of the total asset value. For investors that lack the trading capital to buy substantial shares of stock outright, CFDs provide the ability to implement increased leverage, and to realise large gains from small investments. Trading on margin carries a high level of risk and losses can exceed the amount deposited.
Brokerage Firms: Full-Service Brokerage
One of the most traditional methods of purchasing stock is through the use of a full-service brokerage firm. A "full-service broker" is someone who executes trades at the direction of a client, while also providing additional services such as market research, retirement planning, tax assistance and investment advice.
To buy stock using a full-service broker, the investor must first open an account with the brokerage firm. Brokerage firms have specific requirements that need to be satisfied for a client account to be opened. Client net worth, employment status, investment objectives and personal identification information are collected and evaluated ahead of opening a new investment account. Upon the broker's approval of the client, a "client disclosure agreement" is completed. The client disclosure clearly defines the terms by which transactions will be handled and the account will be managed. After the client disclosure agreement is processed, the account is then ready for business.
Full-service brokerage affords the client numerous advantages. Access to market research, financial planning and advice, and managed investment portfolios are a few services that can be of benefit to the investor. On the downside, the cost of using a full-service broker is substantial. A greater required minimum account balance in addition to a higher fee and commission structure are factors to consider before opening a full-service brokerage account. If the need for personal attention and financial advisement is great, then the additional cost is warranted.
Brokerage Firms: Discount Brokerage
The advent of electronic trading has given rise to a large number of discount brokerage options. A "discount broker" is a stockbroker who charges a reduced commission to execute trades on the client's behalf. Through the offering of limited services, discount brokerage firms are able to greatly reduce transaction costs while providing market access to the client.
The procedure of opening a discount brokerage account is similar to that of a full-service brokerage account. However, due to the fact that discount brokerages look to profit from lower fees applied to a larger number of clients, the requirements for opening an account are relaxed. The same anti-money laundering and Know Your Client (KYC) procedures do still apply though. Smaller account minimums and limited capital requirements can increase the chance of an investor's account application being completed and processed more quickly.
Advances in internet technology have provided the investor a vast array of online discount brokerage options and the ability to independently place trades. Technology has streamlined the order entry process, enabling brokerage firms to offer "deep discount" commissions and fee structures. As of this writing (April 2016), fees for placing trades via online discount brokerage firms are as low as US$5 per trade.
Several advantages are present when an investor buys stock through a discount brokerage. Lower transaction costs, smaller required account balances and a streamlined process for placing orders all cater to the independent trader or investor. However, discount brokerages are not in the business of providing the client with education and guidance. Without substantial market experience, a novice trader may find the "do it yourself" theme of a discount brokerage undesirable.
Placing The Order
The last step in buying a share of stock is the placing of the order. Whether an investor is giving instruction over the phone to a broker or is buying stock online through the click of a mouse, the order is eventually placed at the exchange and executed. No matter the type of brokerage being used, orders for the purchase of stock come in two forms: market orders and limit orders.
A market order is an order to buy (or sell, if engaged in "shorting") a stock at the best available price at a given time. Market orders are executed immediately upon submission to the exchange. In fast-moving volatile markets, it is common for the price of the filled order to differ from the original market order price. The discrepancy between the market order price and the filled order price is known as "slippage."
The second type of order, a limit order is an order to buy (or sell) a stock at a specific price or better. For instance, a buy limit order is only executed at the designated buy price or lower. Unlike a market order, a limit order is not executed immediately upon submission to the marketplace. The limit order is held in queue at the exchange, and if the limit price is not hit, the order is not executed. Limit orders are used in cases where the investor does not want to pay more than a predetermined price, or when the investor is concerned with potential slippage.
As outlined above, the process of buying a share of stock or trading a contract of difference consists of several distinct steps, requiring the individual investor to spend time in the performance of due diligence, and come to a prudent decision that is best suited to his or her financial situation.
Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. FXCM will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…