Which best describes how an investor makes money from an equity investment? This was a question we received during one of our webinars this week from a new perspective 16-year-old student.
It is great as always to see young people getting interested in financial markets and more specifically getting interested in manage their finances.
If this is the first time you are reading this blog, please know that we hate Wall Street. We hate that their end game is to gather assets and charge fees. Because of this, our goal at Stony Book Securities is to empower the individual investor and give them every tool they need to succeed in the markets.
We are more than happy to field questions like this and also to publically answer them in the form of a blog post. This should be a fun one as the answer to the question “which best describes how an investor makes money from an equity investment?” maybe isn’t as obvious as everyone thinks. And again, thank you very much to that young man who asked this question! He is well on his way to becoming a rock star investor.
What is an Equity Investment?
An equity investment is a specific type of investment which involves becoming a part owner in a publically traded company. Let’s look at a quick example.
Apple Inc. is currently trading for $140.64 a share. If we have a spare $140.64 lying around somewhere and a brokerage account, we can go ahead and purchase one share of Apple. In doing this, we are buying equity and part ownership in the company. Now, we aren’t a large owner in the company but an equity holder nonetheless.
If we buy one share of stock, we will become a 1/5,246,540,000th owner in the company! Regardless of how small of an investment size, when we buy stock in a publically traded company, we become a part owner!
As we stated earlier, this article is to help out one of our youngest students understand exactly how to make money from equity investments. We will show everyone the three different ways we can profit.
The most obvious way we can make money from an equity investment is by assets appreciation. We buy a stock and sell that same stock when the shares have reached a higher price. This is the simplest way to make money from equity investments.
Let’s look at a few simple examples of where we would have made money on an equity investment by asset appreciation.
Since we are on the Apple train, we “could” have purchased Apple stock any time over the last year and made money as the stock is currently at its one-year high.
Now, buying stock and watching it go up in price and thus in your account isn’t a layup. There are plenty of stocks and ETF’s that do not only go up and to the right like Apple did.
For example, UVXY looks to be almost the complete opposite.
Hopefully, we never invest in stocks that look like UVXY, though!
Another way we can make money through equity investments is by purchasing equity stocks that pay out dividends.
Dividends are a share of profits from the publically traded company to its shareholders. Remember, buying the stock is buying equity and part ownership. And because you are a part owner of a dividend paying stock, we are the rightful recipient of dividend payouts.
These dividends usually come quarterly in the form of a cash payment into shareholders brokerage accounts. In most cases, these dividends from equities are qualified dividends and can be taxed at capital gains levels (18%) if we have been a shareholders for more than 60 days.
Since we are speaking about Apple here, Apple currently has a $2.28 dividend.
This means that every three months or so if we are a shareholder of Apple stock, we will receive cash payments into our brokerage account to the tune of $0.57 per share.
If we have 100 shares, that means, four times a year we will be receiving $57.
If Apple’s stock does not move one penny higher or lower of the course of the next year, we will be $2.28 winners per share. This is the second way investors can make money from an equity investment.
The final way investors can make money through an equity investment it through options. Every option is worth 100 shares of stock. If we have 100 shares of stock, we can cover our position with one option.
This allows us to make money from equity investments in a less traditional way.
Let’s go back to our friend Apple for this example as well.
Right now, we have $100 shares of $AAPL…awesome! And because we have 100 shares, we can cover those shares with one option. This is called a covered call.
To complete this covered call, we will sell the $141 call that expires in 26 days. This allows us to collect $2.05 in premium on this trade.
This means that similar to dividends if Apple’s stock does not go higher or lower in the next 26 days, we will have made money from this equity investment because we collected $2.05 per share when we covered our stock by selling this call.
And since we have 100 shares, the total amount of money collected was $205. This number is almost equivalent to the dividend that we would receive over the course of the full year. Not bad for just 26 days.
Which Best Describes How an Investor Makes Money From an Equity Investment?
And there you have it, my friends. The three different ways investors can make money from an equity investment. Remember, it isn’t just about selling a stock at a higher price than we bought it for. Here are three ways we spoke about:
- Selling an equity investment at a higher price than we bought it for
- Collecting the dividend for holding an equity investment
- Selling an option to cover our equity position
Not bad. There is always more to it that meets the eye. Combining all three of these strategies is the most efficient and profitable way to make money from and equity investment.
Buy low, collect the dividend, cover your position, and sell high. That’s the name of the game.