Security Definition: How Securities Trading Works

1. Equity securities: An equity security is a share of ownership in a company, trust, or partnership. Equity securities are usually shares of common stock, but can also be preferred stock. When the issuer of equity security generates a profit and retains earnings, the issuer often pays out some earnings to shareholders by way of dividends. Equity securities can increase or decrease in value depending on the performance of the company and the financial markets.

2. Debt securities: Debt securities, also called fixed-income securities, allow governments and corporations to raise money through publicly-traded loans in exchange for regular payments of interest plus the repayment of the principal loan. With debt securities, the investor is the lender and the issuer is the borrower. An investor purchasing debt security receives interest payments from the issuer until the loan reaches its maturity date. At that time, the issuer then repays their initial debt obligation, known as the principal balance. Examples of common debt securities include certificates of deposit (CDs), corporate bonds, and government bonds, which include municipal bonds and treasury bonds. Government bonds typically have a lower interest rate than corporate bonds but have high liquidity, which makes it easy for the investor to potentially resell on the secondary bond market.

3. Hybrid securities: Hybrid securities contain elements of both equity securities and debt securities. One example of a hybrid security is convertible bonds—corporate bonds that can be converted into shares of stock for the issuing company. Another example is preference shares, which are stock shares in a company that entitles the shareholder to receive a fixed dividend before common stock dividends. Preference shares may even grant shareholders voting rights in the company.

4. Derivatives: The value of a derivative security depends on the value of another underlying asset (e.g., a barrel of oil). With derivative securities, both parties involved in the contract are essentially betting on the underlying asset’s value changing in opposite ways. Examples of common derivative securities include futures, forwards, swaps, and options. Self-regulatory organizations, like the Financial Industry Regulatory Authority (FINRA), help regulate derivative securities.

How Securities Trade

Publicly traded securities are listed on stock exchanges, where issuers can seek security listings and attract investors by ensuring a liquid and regulated market in which to trade. Informal electronic trading systems have become more common in recent years, and securities are now often traded “over-the-counter,” or directly among investors either online or over the phone.

An initial public offering (IPO) represents a company’s first major sale of equity securities to the public. Following an IPO, any newly issued stock, while still sold in the primary market, is referred to as a secondary offering. Alternatively, securities may be offered privately to a restricted and qualified group in what is known as a private placement—an important distinction in terms of both company law and securities regulation. Sometimes companies sell stock in a combination of a public and private placement.

In the secondary market, also known as the aftermarket, securities are simply transferred as assets from one investor to another: shareholders can sell their securities to other investors for cash and/or capital gain. The secondary market thus supplements the primary. The secondary market is less liquid for privately placed securities since they are not publicly tradable and can only be transferred among qualified investors.

How Securities Get Issued Through Capital Markets

A business will hire an investment banking firm when it has to go on the capital market. The firm looks at the financials of the business and the total amount of money it needs to raise. The bank then advises the business as to the best way to raise that money, by either issuing stock or bonds. It helps it put together and sell a public offering of the securities.

The newly issued stocks and bonds are offered to public investors through a network of brokerage firms.

Investing in Securities

The entity that creates the securities for sale is known as the issuer, and those who buy them are, of course, investors. Generally, securities represent an investment and a means by which municipalities, companies, and other commercial enterprises can raise new capital. Companies can generate a lot of money when they go public, selling stock in an initial public offering (IPO), for example.

City, state, or county governments can raise funds for a particular project by floating a municipal bond issue. Depending on an institution’s market demand or pricing structure, raising capital through securities can be a preferred alternative to financing through a bank loan.

On the other hand, purchasing securities with borrowed money, an act known as buying on a margin is a popular investment technique. In essence, a company may deliver property rights, in the form of cash or other securities, either at inception or in default, to pay its debt or other obligation to another entity. These collateral arrangements have been growing of late, especially among institutional investors.