Stock prices are usually driven by expectations of corporate earnings. If stock traders think the company's earnings are high, or will rise further, they are willing to bid up the price of the stock. One way that stockholders make a return on their investment is when they buy a stock low, and sell it high. Conversely, if the company does poorly, then the shares decrease in value, and the stockholders lose part or sometimes even all of their investment when they sell.
A second way that stockholders profit is if the company pays a dividend. These are usually quarterly payments distributed to stockholders on a per share basis. The company's board of directors pays dividends out of earnings. It is a way to reward stockholders, who are the actual owners of the company, for their investment. It's especially important for companies that are profitable, but may not be growing quickly.
Types of Stocks
Corporations issue two types of stock, depending on their cash needs. They are common stocks and preferred stocks. Common stocks are, unsurprisingly, the most common. These are the stocks followed by the Dow Jones Averages and the S&P 500. The value of these stocks depend on how they are traded at any given time. Some also issue dividends. The amount paid depends on corporate earnings. Common stock owners can vote on the corporation's affairs, such as the Board of Directors, mergers and acquisitions and takeovers.Preferred stocks are really a mixture of stocks and bonds. Their value rises and falls along with the common stock. However, they are like bonds in that they pay a fixed amount in the form of a dividend. For that reason, most preferred stockholders don't sell them. Corporations only issue preferred stock as a last resort. That's because they are more expensive than bonds. However, if the company doesn't want to issue more stocks or bonds, they do have certain advantages. The dividends can be suspended, if necessary. They are also used in mergers, because the preferred shareholders will get paid before common shareholders, but after bondholders.
In addition to these two types of stocks, stocks are classified according to the type of company that issues them. For example, there are three types of stocks that are issued according to the company's market capitalization. What's that? It's the total stock market value of the company, or the share price multiplied by the number of shares outstanding. Small cap stocks have a market cap of $2 billion or less. Mid cap stocks have a market value of between $2-$10 billion. Large cap stocks have a market cap of $10 billion or more. (Keep in mind that these category levels vary somewhat depending on who is making the definition.)
Another example is the growth potential of a company. Growth stocks typically don't pay dividends, and the companies they represent may not even have earnings, but they are expected to growth quickly. Value stocks have a low p/e ratio. They may a company or industry that is currently out of favor by investors, but the company itself may be solid and so represents a good value for the stock price. Blue chip stocks are fairly valued, may not be growing quickly, but have proven themselves over the years to be solidly run companies in stable industries. They usually pay dividends, and are considered a safer investment than growth or value stocks. They are also known as income stocks, because they pay a steady income. (Source: Ken Little, About.com Guide to Stocks, Types of Stocks)
Stock Derivatives
Most people make money from stocks by either buying, holding and collecting dividends, or buying low and selling high. However, there is a third, more risky way to profit from stocks, and that's with derivatives. Like the name implies, these investments derive their value from underlying assets, such as stocks and bonds. The most popular are stock options, which give you the option to buy or sell a stock at a certain price by an agreed-upon date. A call option is the right to buy, and you make money when the stock price goes up, you buy it at the lower price and immediately sell it at that day's price. A put option is the right to sell, and you make money when the stock price declines. In that case, you buy it at tomorrow's lower price, and sell it at the agreed-upon higher price.Another way to make money from stocks is the short sale. This is when you borrow a stock from your broker, sell it at today's higher price, and then buy it at tomorrow's lower price and return the stock to your broker. Short-selling is very risky, because if the stock price rises, you are out the difference. There is theoretically no limit to how high the stock price could rise. That's why most financial planners advise individual investors to stick to buying and holding stocks for the long term within a diversified portfolio to gain the highest return for the least risk.
