Speculative Investments
This is fairly brief and focused - I may later integrate it into a more extensive treatment on investment.
Information is collected here on speculative investments, specifically:
These investments are considered "speculative" from the perspective of the average investor, though they may constitute a percentage (usually a small one) of a wealthier investor's portfolio.
EQUITIES
Equities (stocks) are individual ownership shares in corporations that are sold through a number of different exchanges. This most commonly refers to "common stock" as opposed to "preferred stock" (see the section on the latter).
Stocks have a long history as a method of assigning partial ownership in a company to a number of investors, and the open trade of shares of stock is long established, although widespread involvement in the buying and shares by small investors is relatively recent.
Fundamentals
A share of stock is a share of ownership in a company, which entitles the holder to a portion of the profits the company generates. In theory, the annual profits are divided by the number of shares - but in practice, this profit is seldom if ever actually paid out.
Investors who purchase stock earn long-term profits through capital appreciation (the price of a stock rises as the company becomes more valuable) and short-term income through dividends (though some companies pay no dividends at all).
Due to the high degree of fluctuation in stock prices and the expertise needed to evaluate the finances of a corporation and predict its future performance, most investors are dissuaded from getting involved in stocks, and are steered instead toward mutual funds.
Types
Stocks are generally categorized according to the size (market capitalization) of the company they represent, from large-cap through micro-cap. There are various terms in circulation (large-caps stocks are called "blue chip" stocks, small-caps may be termed "penny stock").
None of these names/categories means much from a functional perspective - they are all shares of stock in companies, and there are no differences in the types.
However, it generally holds true that the larger the company, the more stable it is and the less prices will fluctuate over time. There are exceptions to this general rule: large-caps that crash and burn overnight and penny stocks that provide stable returns over many years.
Disseminating Shares
Companies generally define a set number of shares (authorized shares) as governed of their articles of incorporation (which may be amended), and release a number of these shares at their initial public offering (IPO) and retain another proportion in the treasury so that they may be sold later to raise additional capital.
The number of shares outstanding is of extreme interest to shareholders: since the value of each share is the net value divided by the number of shares, issuing additional shares dilutes the value of each share.
The number of shares in circulation may also be increased by splitting shares (fundamentally, one ten dollar share becomes two five-dollar shares) or decreased by consolidation (also called a reverse-spilt, it works the other way around). The reasons for splitting or consolidating shares vary, and are not germane to the topic of investment, except to mention that such things occur.
Stockholder Rights
A corporation is a legal entity, in and of itself, so stockholders have limited rights to use a company's assets. This is seldom significant, and seldom expected, except in cases where a significant majority shareholder (perhaps the person who owned a business before it went corporate) expects the same access and privileges they would have if the business were a proprietorship.
Also, stockholder liabilities are limited - their sole risk is the money they have invested. Except in rare cases, a shareholder is not held liable (criminally or civilly) for the actions of a corporation.
There's much more to be said about corporations, but that's really beside the point.
Return on Investment
There are two sources by which investors receive returns on their investment in stock: dividends and capital gains.
Dividends are actual cash payments from the company's assets - a company can take some portion of its annual income and distribute it to shareholders, or it may distribute the proceeds of liquidated assets, etc. Dividends are preferred by some investors as they provide a stream of income, but avoided by others because they are taxable to the receiver.
It is also possible for an investor to reinvest dividends automatically- such tat any dividend disbursement is immediately used to purchase more shares at the market price rather than taking them as a cash payment. The investor is still liable for taxes on reinvested dividends.
Capital gain is a rise in the value (price) of the stock (discussed separately). Capital gains are "paper" gains until the stock is sold, at which time the investor receives cash proceeds from the sale, and must pay taxes on the profits (difference between the sales proceeds and the price of the stock when they purchased it).
Each company decides its dividend policy and capital gains strategy (there is no universal standard). Capital gains are favored, and few stocks provide dividends on a regular basis, or at all.
Stock Prices
Stock prices are constantly in motion, and the price at which a stock sells is entirely arbitrary, but is generally believed to be based on a number of separate factors.
The book value of a stock (the actually dollar value of assets it represents) is considered a factor, but it is generally a very small percentage of the stock's market price. All the same, it is extremely rare for a stock to sell below its book value.
Supply and demand also affect the price, especially on a daily basis, where sellers and buyers must alter the price they are willing to charge or pay in order to strike a deal. This accounts for daily fluctuations, but the supply and demand curves themselves are subject to buyers' and sellers' evaluation of value, so S&D is itself a derived method of valuation.
The expectation of future earnings is generally accepted as a basis of valuation, in a stock's price "should" reflect a discounted net present value of future earnings. However "expectations" is the key word: since the future is unknown and ultimately unpredictable, there are various methods of guessing (with various degrees of accuracy.
Speculation is also a major factor: investors may believe, for whatever reason, that a company will be more or less profitable in the future, and be interested in buying (or dumping) a stock before the events that would affect its profitability actually occur.
It has even come to the point where there is speculation on speculation, with individuals guessing at the price that others will be willing to pay for a stock, independent of the actual situation or potential future performance of a firm.
Various sources argue as to which factors are most significant and what methods of valuation are most accurate - suffice to say it's a complete CF and no-one is really sure of what they're doing or what others are thinking when it comes to determining the value of a specific company's stock, but they have some really sophisticated mathematical models to try to cover up this fact.
Stock Markets
A stock market is an auction house where shares of specific companies are bought and sold. Many markets exist worldwide
The markets are, themselves, businesses that turn a profit by charging a fee to individuals who are licensed to trade directly with one another. Specifically, a stock market is not in most cases a government entity, but an independent business.
These individuals, in turn, often trade stock on behalf of others - i.e., they act as brokers, who charge a commission on each transaction. Brokerages turn a profit on commissions (and sale of ancillary services) to the customers who wish to buy and sell stock.
There are traditional brokerage firms that maintain brick-and-mortar offices with personnel who offer a range of associated services, and online brokerages where individuals may place orders to buy or sell shares (all the brokerage does is handle the transaction).
Most transactions are entirely automated these days, though there is still considerable trading that takes place on the exchange floors full of shouting men and physical paperwork.
Voting Rights
An often overlooked aspect of stock is that each shareholder owns part of the company, and has voting rights accordingly. The precise nature of these rights varies , and is spelled out in detail in each company's unique articles of incorporation.
Generally speaking, stockholders elect a board of directors who govern the company - make key decision and hire executive officers to implement them. Some companies allow the stockholders to vote on more granular issues.
Also generally speaking, one share gets one vote, such that the individuals who hold a large percentage of the company have a correspondingly large percentage of control over the decisions. Deviations from this are rare.
Margin Trading
An investor can purchase shares of stock outright, or they can purchase on the margin (borrowing money to buy more shares than they can afford). The loan is secured, at least partially, by the portion of the security the person owns outright, and if the security falls below a certain price (value), the investor must either cough up some dough or liquidate his holdings to pay the loan. Trading on margins is highly speculative, and highly inadvisable.
Options
Options (also called "derivatives") are highly speculative investments, in which an investor buys the right to purchase a stock at a specific price (that may be higher or lower than its current value) until a specific date (at which point, the option expires and becomes worthless).
The legitimate use of options is to hedge against fluctuations in an investment - obtaining guarantees that a stock can be bought or sold at a certain price in the future can help offset unexpected changes in price that would be detrimental to the value of a portfolio. Speculators will dabble in the options market, attracted by the opportunity to make a large profit at a very low price (for a little bit of money, you can get an option to buy a large amount of stock).
Preferred Stock
Preferred stocks are similar to bonds, in that the primary benefit is dividend payment in a percentage of the par value, and that the value of the shares do not fluctuate except in response to the market rate (if dividends pay a higher percentage than market rate, the shares sell at a premium, and vice-versa)
Stock as Investment
For most investors, stock is dismissed as speculation - the process is very much like betting on horses - but investors with substantial portfolios may opt to manage their investments (or hire professionals to do the same) directly, in lieu of using mutual funds as an intermediary.
For these investors, stocks can be a legitimate investment. Direct investment in equities can entail lesser expenses than mutual funds charge, and the manager can better mitigate the tax impact to the individual investor (whereas a mutual fund does not consider individual needs).
OPTIONS
Options (AKA "Stock Futures" or "Derivatives") are contracts that obligate one party to buy or sell a specified quantity of stock at a specific price in the future. The most common arrangement (called the "American" style) gives the contract buyer the ability to purchase the shares at any time before the date specified in the contract, though there is also a contract to buy on the specified date only (called the "European" style).
Types
There are two basic types of option:
A call option gives the buyer the right to purchase a stock at a specified price, regardless of the market price at the time the option is exercised. For the buyer, the potential for profit is realized if the market price is higher than the contract price, enabling him to buy the shares cheaply, sell them immediately on the open market, and profit from the difference.
A put option gives the buyer the right to sell a stock at a specified price, regardless of the market price at the time the option is exercised. The profit potential for the buyer is realized if the market price is lower than the contract price, enabling him to buy shares on the on market and sell them at a higher price.
For the seller, the profit is fixed at the price of the contract (called the "premium"). If the stock does not rise or fall in a way that is profitable to the buyer, the option will not be exercised (by any sane holder), and the seller keeps the premium and is freed from his obligation after the contract date.
Additional Information
Additional information on options has been moved to a separate document.
COMMODITIES
At core, a commodity is exactly what it sounds like: a physical good that is produced in quality, in units that are largely identical. Examples include crops (wheat, oats, rice, cocoa, sugar), livestock (cattle, pork bellies), metals and minerals (gold, copper, tin, zinc), and related products (wool, rubber, ethanol, etc.)
Trade in commodities generally deals with contracts to purchase a specific quantity at a specific price at a future date. Selling such contracts allowed producers to obtain future payment for goods that have not been produced, as a way of financing their production.
Legitimate Usage
The legitimate use of futures markets is by corporations that need certain goods for their own manufacturing operations and wish to lock in a purchase price or purchase options to hedge against future market fluctuations.
Large companies may purchase goods for several years in advance in order to stabilize their operating expenses. By paying in advance, they avoid the risk that prices of materials will rise in the future, but they also forego the benefits should prices decline.
Generally, the price of a future contact is adjusted according to expectations of future prices, with the difference split between buyer and seller (if wheat sells for $25 now but is expected to go for $35 in the future, the contract may be sold at $30 rather than the current market price)
Basics of Value
A commodities contract gains value when the good it represents rises in value: if you have contracted to obtain a ton of wheat for $50 and the price of wheat rises to $75, you can make $25 on exchange (buy from the producer who sold to the contract, then sell the goods at market price) - though most often, the investor sells the contract to a buyer rather than handling the goods themselves.
However, the contract is also binding upon the buyer, such that if the market price falls, the buyer has already paid a higher price for goods that can now be obtained more cheaply. He may sell the contract at a loss, or take delivery of the goods he has contracted to buy.
An inherent value of a contract, even if there is no difference in price, is that it "reserves" a certain quantity of a good for purchase.
Options
Another type of commodities contract is the option, in which the buyer doesn't purchase the goods, but merely pays a fee to have the option to purchase them. Unlike actual contracts, the buyer isn't required to take delivery of the goods, or even to actually purchase them.
These options represent a compromise between buyer and seller: the buyer does not get a guaranteed sale, but makes money just for agreeing to fix a price in advance. The seller is not obliged to buy the goods, and may choose not to exercise the option if prices fall and the goods can be had more cheaply in the market.
Speculation on options is more common than speculation on futures: a speculator can purchase an option with the expectation of either allowing it to expire or selling it to a buyer who needs the goods (an option at lower than market price allows them to obtain the goods more cheaply).
Commodities Markets
Commodities markets (often called "mercantile exchanges") function much the same as stock markets: the market itself is a business that charges a fee to brokers, who in turn charge commissions to customers for buying and selling goods.
There are speculators in the commodities market, but speculation is less widespread in commodities than it is in stocks.
CURRENCY
The FOREX (foreign exchange) market buys and sells currencies from various countries. Functionally, participants in exchange are "buying" foreign currency for domestic at the current exchange rates.
Legitimate Uses
The legitimate use of foreign currency exchange is for businesses to be able to obtain foreign currency today to pay future obligations, thereby insulating themselves against the risk of exchange-rate fluctuations.
In the past, individuals would invest in foreign currency to ensure that the collapse of a nation (and the debasement of its currency) would not wipe out their fortunes.
It is still quite common for individuals in unstable countries to wish to convert their assets into the currency of more stable nations, in order to preserve their wealth in times of economic hardship.
Covert Uses
Because the supply of money has a direct effect on price inflation an interest rates in a country, it has been posited that it is possible to engage in economic warfare against a nation by manipulating the supply and demand for its currency in world markets.
There have been incidences in which individual traders (George Soros) have devastated the economies of nations (albeit small ones), through entirely legal means, by accumulating and shorting the national currency. However, it is generally believed that these maneuvers have been motivated by a desire for profit rather than political reasons.
Exchanges and Futures
An exchange is an actual purchase of foreign currency, immediately transferring funds from one currency to another, whereas an option locks in an exchange rate for future purchase, in exchange for a fee. In many ways, this is similar to commodities, except hat an exchange is an immediate purchase rather than payment in advance for a future delivery.
It is worth noting that most exchanges convert foreign currencies into our out of US dollars. Trades that convert currencies of other countries (euros to yen, for example) constitute less than 12% of transactions worldwide.
Investment
Foreign Exchange can be seen as an investment in a country (similar to the way that stock is an investment in a company). Investment in foreign currency is not as common as stock, but somewhat more common (especially among speculators) than commodities.