What Are Equities?

An equity, or share, is a fractional ownership claim on a company. Owning one entitles you to a share of the profits, usually a vote, and a claim on whatever is left over if the company is wound up.

That last phrase is the important one. Equity is a residual claim: shareholders are paid after employees, suppliers, tax authorities and every class of debt holder. Everything distinctive about how equities behave follows from standing last in the queue.

What follows from being last

Higher risk, higher expected return. Debt holders get paid first, so their outcome is more certain and their expected return lower. Equity bears the leftover uncertainty and is compensated with a higher expected return, the equity risk premium.

Limited liability, unlimited upside. You can lose your investment and no more, no matter how much the company owes. But the upside is uncapped.

That combination gives an equity the payoff shape of a call option on the firm's assets, struck at the value of its debt. If assets exceed debt, shareholders keep the difference; if not, they get nothing but owe nothing. This is not a loose analogy, it is the basis of structural credit models, and it explains why equity in a heavily indebted company behaves like a far out-of-the-money option: mostly worthless, occasionally spectacular.

Where returns come from

Capital gains, when the price rises, and dividends, a distribution of earnings. Total return is the sum, and comparing price charts alone systematically understates the return on dividend-paying stocks.

Not all companies pay dividends. Retaining earnings to reinvest is an alternative way of delivering value, and whether it is better depends entirely on whether the company can earn more on that capital than shareholders could elsewhere.

Common and preferred

Common shares carry votes and full exposure to the upside.

Preferred shares typically pay a fixed dividend, rank ahead of common in liquidation and usually carry no vote. They sit between debt and equity in the capital structure and behave more like bonds.

Why traders care

Equities are the most liquid and heavily traded asset class, the natural starting point for a market maker, and the underlying for the largest options market in the world.

Two properties matter operationally. Equities are subject to corporate actions, which mechanically change price and share count and will break any model that ignores them. And they carry idiosyncratic risk that can be hedged away with index products, leaving the stock-specific exposure a trader may actually want.