3 Types of Securities Investments Explained
Investing can be a great way to make money. But there is more than one way to invest. There are a few different types of securities you can put your money into, each with their own risks and benefits. By understanding the securities you can invest in, you’ll have a better idea of where you want to put your money.
What Is a Security?
Securities are financial instruments that can be traded on financial exchanges. There are exchanges around the world, such as Nasdaq, Euronext and, maybe the most famous, the New York Stock Exchange (NYSE).
Securities can be broken down into three general categories:
Each category is explained below.
What Are Stocks?
Stocks are equity securities. They represent ownership in a company. And with that ownership, you usually get voting rights. Also, some companies issue dividends to share their profits with stockholders. But not all companies do this. If a stock doesn’t pay dividends, investors can make a profit by selling their shares at a higher price.
Companies issue stock when they need to raise money. This is called an initial public offering, or IPO. Once the shares hit the public market, investors buy the stock. The original stock price depends on the assessed value of the company. After that, the stock’s value is influenced by the market and the performance of the company. If the company is doing well, the stock price should increase. If the company performs poorly, it will cause the stock’s value to decrease.
What Are Bonds?
Bonds are debt securities. When a company or the government needs money, they might issue bonds. When an investor buys a bond, they are “lending” their money. The entity must pay back the principal amount (what you paid) plus interest by a certain date. This is referred to as the maturity date.
Bonds are usually considered a less risky investment compared with stocks. While stocks’ value depends on the market and company performance, bonds have a fixed value. But companies can go bankrupt, so bonds aren’t always a guaranteed win.
What Are Derivatives?
A derivative’s value is derived (hence the name derivative) from the value of the underlying asset. In one common example, you can own the right to trade a security at a pre-agreed upon price with an expiration date or deadline.
There a few different types of derivative securities, but this article is going to explain two common types: options and futures.
An options contract is exactly what the name implies – an option. Here, an investor can buy a contract that gives them the option to buy (call option) or sell (put option) an asset (i.e., stock) at a specific price by a specific date.
For example, let’s say you’re looking to buy stock in a company. Currently, its stock is worth $95. But you think the price will go up. You then find an option contract that allows you to buy the stock at $100 within the next month. This is called a call option. The contract costs $3, so you decide to buy it. Now, let’s say the share price goes up to $110. You choose to exercise your right to buy shares at $100 even though their value is $110. In total, you spend $103, making a profit of $7. If the price goes down, you are not obligated to purchase the stock and can choose not to.
Another type of option is a put option. For example, if a seller is afraid the value of their shares will fall, they can purchase a put option that sets a selling price. Let’s take the example from above. You have shares worth $95. Because you think the price will fall, but you aren’t certain, you buy a put option that lets you sell your shares for $95. If the price falls below $95 before or on the expiration date, you can use your option and sell your share for $95. If the price rises, you don’t have to use the option.
It’s important to note that options usually represent 100 shares. This means you would have to multiply the price of $95 by the 100 shares ($9,500). When getting involved in any contract, make sure to read it through and understand what you’re agreeing to.
A futures contract is similar to an option with one key difference — it’s an obligation, not a choice. Perhaps the best example would be between two companies.
Company A purchases oil from Company B. Company A is worried that the price of oil will increase in the next month. So it enters a futures contract with company B to purchase oil at $40 per barrel. When the contract expires, Company B must deliver oil to Company A at $40 a barrel, regardless of price. If prices did rise, Company A made a profitable deal. But if the price decreases, Company B ends up making a profit by selling the product for more than its worth.
Derivatives can be useful and a great way to invest. But they aren’t always simple and can come with a lot of risk. If you have any questions or concerns, it’s a good idea to talk to a professional.
You now have a better understanding of the different types of securities. To learn more about how you can start investing, check out Investment 101. And don’t forget to sign up for our free e-letter below. It’s packed with useful information.