Stock Study Guide

📖 Core Concepts Stock – Shares that represent fractional ownership of a corporation; each share entitles the holder to a proportion of earnings, liquidation proceeds, and voting power. Common vs. Preferred – Common stock usually carries voting rights; preferred stock typically has no voting rights but receives dividends before common shareholders and has liquidation priority. Convertible Preferred – Preferred shares that can be exchanged for a fixed number of common shares after a set date, granting potential voting rights. Equity Financing – Raising cash by issuing new shares (dilutes existing owners). Debt Financing – Raising cash by issuing bonds; owners keep full equity stake. Primary Market (IPO) – First sale of shares to the public; generates capital for the company. Secondary Market – Ongoing trading of already‑issued shares on exchanges or OTC. Market Capitalization – $ \text{Market Cap} = \text{Share Price} \times \text{Shares Outstanding} $. Efficient Market Hypothesis (EMH) – Prices fully reflect all publicly available information. Behavioral Finance / Greater Fool Theory – Investors may act irrationally, buying overvalued stocks expecting to sell to a “greater fool.” 📌 Must Remember Ownership Rights – Dividends (if declared), voting, claim on assets after creditors. Dilution – New share issuance reduces each existing shareholder’s percentage ownership. Preferred Priority – Dividend → liquidation proceeds > common shareholders. Short‑Sell Risk – Unlimited loss potential because price can rise without bound. Black‑Scholes Variables – $S$ (stock price), $K$ (strike), $T$ (time to expiry), $r$ (risk‑free rate), $\sigma$ (volatility). Margin Requirement – Minimum 50 % of the account value must be equity. Arbitrage – Buy low on one exchange, sell high on another; profit exists only briefly. 🔄 Key Processes Issuing New Shares Board approves issuance → shareholders may authorize → shares are created → sold → ownership percentages adjust (dilution). Stock Buy‑Back Company repurchases its own shares → reduces float → can boost EPS and share price. Converting Preferred to Common Holder exercises conversion right → receives predetermined number of common shares → gains voting rights & potential upside. Short Selling Borrow shares → sell on market → later buy back (cover) → return shares; profit = initial sale price – cover price (minus borrowing costs). Black‑Scholes Valuation (European Call) $$ C = S0 N(d1) - Ke^{-rT} N(d2) $$ where $$ d1 = \frac{\ln(S0/K) + (r + \sigma^2/2)T}{\sigma\sqrt{T}}, \quad d2 = d1 - \sigma\sqrt{T} $$ 🔍 Key Comparisons Common Stock vs. Preferred Stock Voting rights: Common ✔︎ / Preferred ✖︎ Dividend priority: Preferred ✔︎ / Common ✖︎ Liquidation claim: Preferred > Common. Equity Financing vs. Debt Financing Ownership dilution: Equity ✔︎ / Debt ✖︎ Fixed payment obligation: Debt ✔︎ / Equity ✖︎ Tax shield: Debt interest deductible; equity dividends not. Futures vs. Options Obligation: Futures ✔︎ (both parties) / Options ✖︎ (holder only). Right without obligation: Options ✔︎ / Futures ✖︎. ⚠️ Common Misunderstandings “Preferred shares = bonds” – They have bond‑like fixed returns but still represent equity ownership and can convert to common. “Short selling only loses the initial investment” – Losses can exceed the amount invested because the stock price can rise indefinitely. “All shares have voting rights” – Many preferred or special‑class shares have limited or no voting power. “EMH means you can’t beat the market at all” – EMH assumes no consistent excess returns after costs; short‑term anomalies may exist. 🧠 Mental Models / Intuition Ownership = Slice of Pie – More shares = larger slice; issuing new slices makes each existing slice smaller (dilution). Capital Structure Trade‑off – Debt adds a “lever” that amplifies returns (and risk) without giving away ownership; equity gives up ownership but avoids fixed payments. Option Value = Asymmetry – You pay a premium for the right to capture upside while limiting downside to the premium. 🚩 Exceptions & Edge Cases Convertible Preferred – May have conversion ratios that adjust for stock splits or dividends. Multiple Share Classes – Some “Class B” shares have 10× voting rights vs. “Class A.” Regulation – Private‑company shares (OTC) are exempt from SEC registration but still subject to anti‑fraud rules. 📍 When to Use Which Choosing Equity vs. Debt – Use equity when you want to preserve cash flow and accept ownership dilution; use debt when you want tax‑advantaged financing and retain full control. Preferred vs. Common for Investors – Prefer preferred if you seek stable dividend income and lower volatility; choose common for voting influence and higher upside potential. Futures vs. Options for Hedging – Use futures for a must‑hold hedge (e.g., lock‑in price); use options when you want protection without obligating a future transaction. 👀 Patterns to Recognize Price Moves ⇢ Supply/Demand Imbalance – Sudden spikes often follow news that shifts demand sharply. Dividend Announcements → Stock Price Adjustments – Ex‑dividend date typically sees price drop roughly equal to dividend amount. Arbitrage Signals – Same ticker quoted at different prices across exchanges; look for tight spreads that may vanish quickly. 🗂️ Exam Traps “Preferred shares always have voting rights.” – Most lack voting; only special‑class preferred may have it. “Short selling risk is limited to the premium paid.” – Wrong; loss can be unlimited because price can rise indefinitely. “Market cap = share price × float.” – Incorrect; use shares outstanding, not just float. “Black‑Scholes applies to American options.” – The model is for European‑style options; early‑exercise features of American options require other methods. “Buying on margin means you only need 10 % equity.” – Regulation requires at least 50 % equity in the account (initial margin).