The Stock Market

“Only buy something that you'd be perfectly happy to hold if the market shuts down for 10 years”.

Warren Buffett

AgendaKey Success Factors

Risk

Stock exchanges and how stocks are traded

Players

Order Process

Mutual Funds, Index Funds and Afterhours Trading

Alternatives to Stock

Why Trade Stocks?

NYSE Tour (video)

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Key Success Factors Investors must develop

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1. Respect for Risk– people tend to think of investing on the

markets as a gamble– successful investing relies on an investor

´s ability to reason, weigh risks, spot opportunities and make quick decisions

– choosing to take unavoidable risks is simply part of the decision making process

– neglecting to assess risk is definitely a gamble

Key Success Factors Investors must develop

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2. Low-stress investment plan – winners start slow and collect the necessary tools to build a

competitive edge

3. Specializing in one or two markets at a time– specialization allows traders to match winning strategies

with recognizable market conditions

4. Define your limits in terms of the amount of money you can afford to lose– need cash to open a brokerage account– assess your financial capabilities and pinpoint your risk

tolerance

Risk• Frequently misunderstood concept

because it comes in many forms: market risk, opportunity risk and inflation risk– market risk is a catchall phrase for the

inherent risk associated with market forces– opportunity risk involves the economic

sacrifice from having to forgo the benefits of alternative investments

– inflation risks affects all investments – some more than others

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Risk– one of the most important lessons in trading is the concept

of the risk to reward ratio– if you cannot afford the risk, you can´t not afford the

investment– serious risk assessment can reduce the stress inherent in

trading and help you to invest intelligently– the risk of owing stocks is that they can periodically decline

in value

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Stock Exchanges and How Stocks are Traded

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Stock Exchanges and How Stocks are Traded• A stock exchange is an actual physical location or

computerized system• 3 main exchanges in the US: NYSE, AMEX (American Stock

Exchange) and the Nasdaq (National Association of Securities Dealers Automated Quotations system)

• To be an exchange member requires the purchase of a seat on the exchange at a cost upwards of 500K dollars

• Each Exchange has specific requirements – market cap, sales and so on

• Rent booths on the exchange floor to brokerage firms and specialists

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Stock Exchanges and How Stocks are Traded

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• NYSE (Trading floor): – GE, McDonald’s, Citigroup, Coca Cola– founded in 1792– largest and most familiar auction style exchange– list 3,050 companies– average daily turnover is 1 billion shares– corporation overseen by a board of directors,

who set policy, supervising members activities, listing securities and overseen the transfer of members’ seats on the Exchange

Stock Exchanges and How Stocks are Traded• AMEX (American Stock Exchange):– second largest auction style

equities market in the world– private not for profit corporation – handles one fifth of all securities

trades within the United States– most of the companies AMEX

offers are too small to be listed in the NYSE

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Stock Exchanges and How Stocks are Traded• Nasdaq: (National Association of

Securities Dealers Automated Quote System)– not a physical exchange– computerized network that stores

and displays stock price quotes– offers more stocks than any other

Exchange– experienced phenomenal growth

due to the large number of technology companies

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Stock exchanges and how stocks are traded• Nasdaq (cont.):– NASD (National Association of Securities

Dealers) – self regulatory organization regulates Nasdaq and over the counter markets

– stocks on Nasdaq are sometimes referred to as “four letter” stocks

– QQQ: listed on the Nasdaq (100 largest non-financial stocks-(Index Share). One of the most actively traded securities on the AMEX

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Stock Exchanges and How Stocks are Traded• OTCBB (Over The Counter

Bulletin Board): small companies that do not meet the listing requirements. Home to penny stocks, little to no regulation, risky

• Daily price updates are called “Pink Sheets”

• BBV: 99.7% + Fixed Income (Bonds, CD, REPO’s, etc.)

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Stock Exchanges and How Stocks are Traded• SEC (Securities and Exchange Commission)– regulates U.S. exchanges – created during the depression– composed of 5 commissioners– “Rule 144”: executives and insiders are

allowed to sell a portion of stock (not purchased in the open market) every six months after a holding period of 2 years without reporting to the SEC

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Stock Exchanges: Function• …“is a weapon to democratize capital and distribute

the world economy’s wealth”• One of the most important sources for companies to

raise money• Allows business to be publicly traded, raise additional

capital for expansion by selling shares• The liquidity that an exchange provides affords

investors the ability to quickly and easily sell securities

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Stock Exchange: Function• Prices of shares and other assets are an important part

of the dynamics of economic activity• The stock market is often considered the primary

indicator of a country’s economic strength and development

• Share prices affect the wealth of households and their consumption

• Exchanges also act as the clearinghouse • Eliminates the risk to an individual buyer or seller that

the counterparty could default on the transaction

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Stock Exchanges and How Stocks are Traded

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Players• Orders:

– phoned or electronically communicated from the outside world to floor traders, who then take them to trading areas, or trading pits

– the process might seem filled with chaos, but a highly developed, organizational method to the madness actually exists

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Players• Floor traders: execute transactions from the floors of

exchanges for their own accounts• Trading pits: specific areas, where floor traders, market

makers and specialists met to buy and sell the same security

• Margin: the portion of a trade´s value that the customer must pay, with the remainder of the purchase price being borrowed from the broker

• there are three chief players in the stock market today: professional, short term trader and the individual investor

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Players• Professional or institutional investor: trades stocks on

behalf of other people, they are hired to make buying and selling decisions

• Institutional investor: trades large quantities of stock that the trades qualify for special treatment and lower commissions

• Trader vs. investor: – investor is someone like Warren Buffet: a classic buy and

hold kind of guy– trader buys and sells often, looking for price swings,

trends, trend reversals, breakouts and all matter of stock movements

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Order Process• Trader places an order with his broker (electronically,

phone or fax)• Broker submits the order to be executed electronically

or transmits it to the exchange floor, where a floor ticket is prepared and then passed along to the floor broker

• Floor broker takes it to appropriate trading pit and uses the open outcry to try to find another floor broker

• if the floor broker can not fill the order then it is left with a specialist – he is in essence a floor broker’s broker

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Order Process• Market makers trade for themselves or for a firm– They provide liquidity, if there isn’t much action on the pit,

they are obliged to make the market happen– They make their money by mastering the bid/ask spread,

they are experts at hedging their positions for protection

• bid: the highest price at which a floor broker, trader or dealer is willing to buy a stock or commodity for a specified time

• ask: the lowest price at which market makers or traders are willing to sell a security, a price at which an investor can buy it from a broker-dealer

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Mutual Funds• Investment vehicles operated by

investment companies• Heavily regulated by the SEC• An investment company that pools

investor’s money to invest in a variety of stocks, bonds or other securities

• Mutual fund shares are bought through the investment company

• They are divided into open-ended and closed ended funds

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Mutual Funds• The market value of the portfolio is called the NAV

(Net Asset Value)• Closed-ended fund has a fixed number of shares• An open-ended fund continually issues new shares• Closed-ended funds trade on an exchange and the

price of the shares is determined by supply and demand – might be greater or less than the NAV

• Open-ended fund never trades at a premium or discount to its NAV and are load (typically 4 to 8%) or no-load funds – its capitalization is not fixed

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Mutual Funds• Load and No Load Funds– load funds: • class A – pay up front• class B – pay when you withdraw the money (sliding fee)• class C – pay as you go (trailing commissions known as

12(b)-1– each fund’s portfolio matches the objective stated in the

firms prospectus– you are picking the manager not the fund– portfolio turnover indicates how much the fund trades, a

high percentage indicates here indicates an aggressive stance

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Index Funds• A group of stocks that make up a

portfolio in which performance can be monitored based upon one calculation

• Simply an average of a group of stock, i.e. “The Dow Jones Industrial Average” is an index fund that monitors 30 stocks, including Intel and Procter and Gamble, HP and others

• Stocks within the fund mirror the index

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Index Funds• Index funds have no front-end sales charge and no

management fee unlike the mutual funds• Index shares mirror the performance of a market

average- i.e. SPDR’s (spiders), which track the S&P 500 index. Barclay’s launched 50 index shares called iShares– unlike index funds, iShares are bought in an exchange

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After Hours Trading• Advances in technology and electronic trading have

made after-hours trading possible• Many brokers offer the ability to trade a limited

number of Nasdaq issues. It is the only big exchange that can facilitate after hours trading

• ECN’s (Electronic Communications Networks) provide execution services to after hours brokers who funneled orders through their respective systems

• Gap down occurs when a stock price opens much lower than it closed on the previous day

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Alternative to Stocks• Cash equivalents: offer investors a slightly lower fixed

rates of return without any risk of loss• The three most common are:

– CD’s: fixed income securities in minimum denominations of 1,000 with maturity terms of 1 to 6 years

– Treasury Bills: short term securities issued by the U.S. Government, minimum amounts of 10,000 with maturities of 13, 26, and 52 weeks

– Money market funds: funds organized to buy short term high quality securities like CD’s, treasuries and short term commercial paper

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Alternative to Stocks• Commodities: 5 categories: grains, metals, energies,

raw foods and meats– can be very leveraged investments: a small amount of cash

can control many times its face value in commodity contracts and can also create huge potential wins or losses

– due to its high risk nature, this instrument is utilized mostly by professionals

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Alternative to Stocks• Commodities are traded as future contracts

• future contract: an agreement from a buyer to accept delivery (or for a seller to make delivery) of a specific commodity, currency, or financial instrument at a future date• future markets: consist of a variety of financial

instruments such as, bonds, treasury notes and currencies• farmers and producers initially used future contracts to

lock in a price of a certain crop or product cycle

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Alternative to Stocks• Commodities: – most futures contracts are bought on speculation of future

prices and most future traders are speculators– future contracts expire on a certain date and this adds a

new dimension to the trading process – they need to predict when a price will be higher or lower

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RISK

REW

ARD

cash equivalent

bond

stock mutual fund

technology stock

futures contract

Alternative to Stocks• Bonds: are highly popular debt obligations that pay

periodic interest at a fixed rate and promise payment of principal at maturity– bond issuers: • U.S. Federal government: treasury bonds (+ 10

years), treasury notes (1 to 10 years), treasury bills (no more than a year)• Municipal bonds – varies• Corporate bonds – varies

– when interest rates fall, bond prices go up and viceversa

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Alternative to Stocks• Bonds:– municipal and corporate bonds are rated according to the

credit worthiness of the issuer and range from high grade bonds to junk bonds

– when investors talk about the bond market, they are referring to the 30 year old bond market

– economy affects bond prices, which in turn affect stock prices • example – economy gets hot > leads to higher rates to

cool off inflation > leads to people taking money from the stock market and put it in the bond market

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Alternative to Stocks• Bonds: agencies and ratings

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Why Trade Stocks?• Some stocks have a liquidity risk (they are easy to

buy but difficult to sell)• If trading volume is light there might be a liquidity

risk – this stock is said to be thinly traded• The fewer shares outstanding, the more volatile the

stock might be

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Why Trade Stocks• Business risk – companies continually face new

competition and difficulties• Given the myriad of risks, why bother trading stocks?

– because, stocks have historically offered the best returns of any investment vehicles over time

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NYSE Tour

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THANK YOU VERY MUCH