Business Finance

Understanding Equity Transactions: Stock Contracts I

Written by Bennet Grill for Gaebler Ventures

In order to understand the capitalization structure of a company, it is important to know what the different types of contracts are to purchase and sell stock of the company. This is the first of two articles on stock contracts.

Understanding equity transactions is essential for any entrepreneur that hopes to raise investment money or have a financial exit of any kind.

Here are a few key concepts regarding equity transactions that you should understand.

Stock Contracts I

The language regarding stock contracts can often be complex and at some times confusing. While instruments such as options and warrants are often issued by companies as forms of compensation to employees, stock brokers use contracts such as long and short put and call options to hedge their investment opportunities. This article seeks to explain the different types of stock contracts and their uses in the market.

Calls and Puts

A call is a financial contract which gives the right to purchase a stock or security at a specified price until a certain date in the future. A put is a contract giving the right to sell a stock or security at a specified price until a certain date in the future.

The specified price is called the strike price and the contract is able to be exercised until the expiration. The price paid for a call or put contract is called the premium.

"Going Long" vs. "Going Short"

When investors talk of "going long" or "going short," they are generally referring to an investment strategy which either hopes that the stock value will increase or decrease, respectively.

If an investor is going long, then they purchase the stock and hold onto it until its price increases to a point at which they are willing to sell. If an investor is shorting a stock, then they borrow a certain number of shares of the stock, sell the stock, wait for the price of the stock to drop, buy the shares back at a lower price and return the shares to the original lender.

While going long carries only the risk of losing the original value of the stock, going short carries the risk of potentially unlimited losses

If an investor borrows and sells stock and then the price of the stock increases, he must purchase the stock at a higher price to cover his losses and return the shares to the lender.

Parallel to the ideas of "going long" or "going short" are the concepts of a bearish and bullish investing attitude. Investors who have a bullish attitude generally expect the market to grow in value and are optimistic that stock prices will rise. Contrarily, an investor with a bearish attitude expects the market to decrease in value and expects the prices of stocks to fall. These two animals serve as the central metaphor for the market dynamics of Wall Street.

Hopefully this article has provided a decent explanation of the types of stock contracts and the resulting transactions with certain market dynamics. For a more detailed explanation of stock contracts, please see the second article in this series.

Bennet Grill is a writer who has a passion for business and finance. He is currently an Economics major at Duke University in North Carolina.

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