What is Foolsaurus?

It's a glossary of investing terms edited and maintained by our analysts, writers and YOU, our Foolish community. Get Started Now!


List of Risks & Benefits of a Stock

Original post by Slav Fedorov of Demand Media

Stock ownership offers multiple benefits, but comes with risks. Most benefits of stock ownership have a flip side -- a corresponding risk. Stock investors cannot avoid risks, but need to be aware of the pitfalls so as to maximize the benefits while minimizing the risks.

Potential

A stock has unlimited upside potential. No stock price can go up to infinity, but it can increase for as long as a company is growing. On the flip side, any stock can go down to zero at any time.

Liquidity

Liquidity means how easy it is to buy and sell a stock at the current price. Most stocks are very liquid, as they can be bought and sold instantaneously in sufficient quantity. Liquidity is both a benefit and a risk. The ability to buy and sell a stock at any moment is a benefit that allows an investor to make instantaneous decisions in response to changing circumstances, but it can also work against him: market manipulation and the investor's own nervous emotional buying and selling can cause him to lose money even in a rising stock if he buys and sells at the wrong time.

Price Gaps

A price gap occurs when a stock closes at one price and opens the following day at a much higher or lower price, with no trades in between. Companies often release important news after market close. Investor reaction to the news causes buy or sell orders to accumulate by the next day's opening, resulting in a gap up or down. For example, if the news is good, a stock that closed at $20 could open at $30, producing an instant 50-percent profit for the stockholders; if the news is bad, a stock that closed at $20 could open at $10, subjecting the same shareholders to an instant 50-percent loss.

Use of Margin

An investor can buy stocks on a 50-percent margin with money borrowed from a broker, or borrow up to 50 percent of his stock holdings from the broker in an emergency. There is no need to fill out any forms or applications: if a brokerage account is approved for margin, its use is automatic. Margin can magnify both gains and losses. If a margined stock advances, the investor makes more profit with borrowed money; if it declines, the investor can be wiped out even if the stock does not drop to zero.

                   

References

  • "PassTrak Series 7: General Securities Representative License Exam"; Dearborn Financial Services; 2003
  • FINRA: Stocks

About the Author

Based in San Diego, Slav Fedorov started writing for online publications in 2007, specializing in stock trading. He has worked in financial services for more than 20 years, serving as a banker, financial planner and stockbroker. Now working as a professional trader, Fedorov is also the founder of a stock-picking company.

Advertisement