The Mystery of Stocks Explained
The Role of a Stock Exchange
Why did businessmen in the 1500s and 1600s gather themselves into exchanges? Such an organization brings with it the advantage of uniform guidelines, regulations and third-party observations to reduce chances of fraud or deceit. A stock market serves to bring people together who want to buy and sell investments such as stocks, bonds and currencies in a fair and open system.
If you are looking for a book, you have a better chance finding what you want in a bookstore rather than calling out the title as you roam the street hoping to find a seller. Similarly, the early exchanges were a place to concentrate buyers and sellers in an era where advanced communication technology consisted of looking somebody in the eye. Such concentration also allows for the establishment of ground rules by which everybody will agree to abide.
The Mysterious and Magical Share
Since stocks represent ownership in a company, you can imagine that there are different types of ownership. In the case of stocks, shares can be voting, non-voting, common, preferred, or one of many other permutations.
Common stock is almost always voting stock, that is, shares that carry with them voting rights, proportional to the number of shares owned, for events such as the election of the Board of Directors. But common stocks give holders, in the event a company liquidates, rights to the company’s assets only after debt holders, bond holders and preferred stock holders have been satisfied. So common stock gives you the right to vote for directors who will lead the company wisely, but if they don’t, you are last in line to get your money.
Preferred stock, obviously, takes precedence over common stock. But preferred stock owners typically do not enjoy the voting rights of common stockholders; also, preferred stock pays a fixed dividend that does not fluctuate, which is either bad or good depending on what the fluctuating dividend is doing. The company can cease payment of the dividend if financial constraints demand such, but preferred stockholders always receive their dividends first. Preferred stock comes in four varieties: cumulative, non-cumulative, participating and convertible.
Cumulative preferred stock, the kind of preferred shares most often issued, is stock on which dividends accrue to the stockholder in the event that the company does not make timely dividend payments.
Logically then, non-cumulative preferred stocks are shares which unpaid dividends do not accrue to the shareholder.
Participating preferred stocks are those that benefit not only from a regular dividend, but which also receive a bonus dividend when the underlying common stock dividends exceed some pre-determined amount.
Convertible preferred stocks are shares that can be converted into a specified amount of common stock at the stockholder’s option.
As a practical matter, as a small individual investor, you will almost certainly be buying common stock. Wall Street does not think you are important enough to warrant preferred stock. Even from the beginning the odds are stacked against small investors.
Placing Value on Stocks
Stocks have two types of valuations, but neither is a perfect reflection of underlying worth. The fundamental valuation is created using cash flow, sales or earnings analysis in an attempt to correlate stock value with the intrinsic value of the issuing company. The most common metric for this type of analysis is the Price to Earnings Ratio, known on the street as the P/E ratio. By using this measure analysts try to assign stock value based on some measurable and supposedly objective attributes, including historic performance. The idea is that a high ratio, meaning the price of the stock is high relative to the company’s earnings, is an indication that the stock might be overpriced. Inversely, a low ratio might indicate a good opportunity to buy below true market value. This form of valuation is typically what drives long-term stock prices because this is what analysts have decided is important. Whatever. As you would learn in my book, I have little respect for this type of analysis as a means of choosing stocks.
The simple rules of supply and demand dictate the other type of value. How much an investor is willing to pay for a stock (and obviously how much other investors are willing to sell a stock for) indicate real market value at any given time. The more people who want to buy a particular stock (the greater the demand), the higher the price will be that the stock will command. Conversely, if more people want to sell than buy, the price will be lower. This form of valuation is volatile, and is what tends to drive short-term stock market trends, including those driven by “irrational exuberance.”
Trading Mechanics
You open and fund an account with XTRADE with a check for $5000. XTRADE deposits the check into a trading account listed under your name. You log onto XTRADE and place an order to buy 100 shares of a stock in Wild Widgets, Inc., which is currently trading at $2.50. XTRADE uses its network to tell the appropriate exchange (NASDAQ for example) that there is demand for 100 shares of Wild Widget’s stock. The exchange plays its proper role by finding someone willing to sell 100 shares of that stock. When they do, the exchange instantaneously executes the trade between you (the buyer) and the seller. The details of this trade are sent to a clearinghouse, where the information is processed (see below). At the clearinghouse shares will now be registered to you in your name. The clearinghouse simply designates 100 shares of Wild Widget stock to XTRADE, which in turn promptly designates those 100 shares as yours, placing them in your account.
Unlike in the old days, the actual stock certificates are typically held by the broker with a designation indicating your ownership. You can request that the stock certificates be transferred to your name, but that is rarely done. How do you prove you own the stock? The same way you prove you have money in your bank account - with your account statement. Just as you don’t demand a certificate proving ownership of the money in your bank account, there is no need to demand a certificate proving ownership of the stock in your account. You do, however, want to deal only with reputable brokerage houses.
Clearinghouses
A clearinghouse is a vital cog in the wheel of stock trading. The clearinghouse acts as a third party to every transaction and is the guarantor of every trade. Basically, a clearinghouse acts as the bank for stock brokerage firms, carrying the liability of the stock purchase until funds are collected and transferred to the brokerage firm. In another analogy, a clearinghouse is like an escrow company in a real estate transaction: the buyer puts up the money for the house, but first places his money with the escrow company for safe keeping. Only when the buyer and seller have fully satisfied their contractual obligations does the escrow company transfer funds to the seller’s account. The clearinghouse basically does the same thing for those buying and selling stock.
This function is essential to ensure that the markets function with integrity. At the end of each session, the clearinghouse must reconcile the stocks bought and sold, and settle each trader’s account to the market. As a trader you will have no direct contact with a clearinghouse, but without it your trades would be vulnerable to theft, loss or error.
A clearinghouse functions by pooling the risk of default or error with clearing member margin deposits, called clearing margins. These margins are essentially a guarantee fund supported by member deposits, that is, the exchanges that are members of the clearinghouse. These procedures and guarantee funds provide the necessary financial support to ensure integrity in the market.
Trade Executions: Open Outcry and Electronic Trading
I implied above that when you bought your first share of Wild Widgets, Inc. you did so through electronic trading by logging onto your account and placing your order over the Internet. If you are happy pushing a button and getting the result, that is OK; but you might want to understand exactly what really happens when XTRADE matches a seller to you as a buyer. And what happens depends on where your stocks are traded.
New York Stock Exchange
The NYSE trades in a continuous auction format. There is one specific location on the trading floor where each listed stock trades. Exchange members interested in buying and selling a particular stock on behalf of investors gather around the appropriate post where a specialist broker acts as an auctioneer in an open outcry auction market environment to bring buyers and sellers together and to manage the actual auction. You will recognize this from the chaotic shouting and pushing you see in movies that depict the stock market as a frenzied commotion of outstretched arms and strained vocal chords.
Each specialist (auctioneer) conducts the stock trading for one big company, such as IBM, or a number of companies with lighter trading volumes. Each trading post has a computer terminal on a pedestal, surrounded by “floor brokers” representing the big brokerage houses.
Each floor broker wears a different color jacket so that the specialist knows what firm he represents. As soon as the market opens, the colored jackets start yelling what their clients want to buy and the price they are bidding, and others yell out what their customers have to sell, along with the price they are asking. The buyer and seller each of course want to get the best possible price. With all the noise, hand signals soon became an important means of communication, and are now an important part of floor culture.
This style of trading is designed to produce the fairest price for both parties. Supporters of open outcry emphasize the human interaction and expert judgment that is incorporated into the system. However, over the past decade this floor auction system using human traders has been under heavy competitive pressure from the all-electronic NASDAQ Stock Market (see below) and other electronic trading platforms. While the NYSE is proud of its auction system, which in fact helps reduce price volatility, modern stock traders have been drawn more and more to the higher transaction speed made possible with electronic trading.
Right now, when you place an order for a stock traded on the NYSE, even if you execute your order electronically, the order is still delivered to the floor, ultimately executed the old fashioned way through the floor brokers. But in order to stay competitive, the NYSE is heading toward true electronic trading. In February 2006, Federal regulators approved the merger of the New York Stock Exchange with electronic rival Archipelago Holdings Inc. Time will tell how competition between the exchanges ultimately shakes out.
National Association of Securities Dealers (NASDAQ)
The NASDAQ owes its existence to the large size of the NYSE and the American Stock Exchange. Companies that were too small to be listed and traded on the big exchanges were bought and sold by securities dealers in a market known as “over the counter” or OTC, so named because they were not traded on the “floor” of an exchange.
If an investor asked his or her broker to buy shares in a company, the broker would call a few dealers to find the lowest price for his customer. If the investor wanted to sell his shares, the broker would call the same dealers trying to get the highest price for his client. This was not horribly efficient. So in 1971, the National Association of Securities Dealers unveiled a computerized quote system in which each dealer could post his buy and sell prices. Initially only 100 companies were automated in the new exchange.
Each dealer changes his prices throughout the day, depending on the changing volume and ratio of buyers to sellers. He quickly changes his prices to adjust for the buying or selling trend at any given moment. The system is actually very simple. The dealers buy at the lowest competitive price, and sell to you at the highest price you are willing to pay.
Unlike the NYSE, the NASDAQ is not a physical entity, a point most traders fail to understand. Yes, the exchange has its well-known Market Site in Times Square, but the fact is that little is done there relevant to trading. Because the NASDAQ is an OTC market that depends on market makers (dealers) rather than specialists and floor brokers, there is no need for a physical location to bring together buyers and sellers. NASDAQ is really nothing more than a vast communications network of computers linked together to match buyers and sellers, virtually instantaneously. Instead of brokers calling out orders, dealers place their name on a list of buyers and sellers, which is distributed by the exchange instantaneously to thousands of other computers. If you want buy a stock that trades on the NASDAQ, your broker will either call up a dealer with the information of your trade or enter your order directly into a NASDAQ-sponsored online execution system. Because the transaction can be entirely electronic, the time to execute the trade is significantly shorter than what is seen in an open outcry system.
While electronic trading lacks the romance and excitement of open cry trading, that is offset by efficiency and speed. For that very reason, many institutional traders such as pension funds and mutual funds prefer electronic trading. Also, given its more recent history and emphasis on modern means of electronic trading, NASDAQ is now home to technology giants such as Microsoft, Cisco, Intel, Oracle, and Sun Microsystems.
For you as an individual investor, electronic trading provides the benefit of almost instant confirmations on your trades. You have more control over the execution of your trades because you are one step closer to the market. Unfortunately, you still need a broker to handle your trades. Entrenched self-interests prevent individuals from having direct access to electronic markets. Instead, your broker accesses the exchange network on your behalf when you place an order; but at least all those steps are electronic.
For more information, go to www.mytradingstocks.com
About the Author
Dr. Schneider is a recognized expert in building personal wealth, with his best selling books “Beyond No Money Down” and “Trading Futures: Only One Way to Win” and Beat The Street: How to Make Millions in the Stock Market With No Risk.” Practicing what he preaches, he now lives in a beautiful waterfront home in central Texas, and owns and operates his own jet.
Once you`ve put the time and effort into coming up with a sound trading plan for your stock trades, and have found a good trading opportunity, it makes sense to start the trade right. Finding a good point to enter into a position involves several issues. Fist, you must know the time frame of your trade. For a particular trend stock trades, for example, you might know that you should enter no earlier than a week before the event creating the trend. Next, you must examine charts to see where the stock trades have been and where its support and resistance levels are, and think about it`s psychological support and resistance levels as well. Last, you should wait for a pullback in price if you believe that the price is temporarily high and that it will drop and create a better buying opportunity for you.
The way to make sure you enter where you plan to is to use a limit order. A limit order is an order that can execute only at the stated price or better. Limit orders sometimes make you wait behind others who placed their orders at the same price before you did, but in most situations, placing a reasonable limit order is the only smart way to enter a position. In certain situations, it may make sense to stagger your entry by buying half the shares you want at a price you think may be the lowest the stock trades will reach, and then waiting to buy the other half either when the price does get better, averaging down, or when the stock trades starts to move, adding on strength.
The wrong way to enter a position is to chase moving stock trades. Chasing stocks is a form of panic, and it practically guarantees that you`ll pay too much for the stock. Why is it so bad to pay too much? The more you pay for stock trades, the further your risk to reward ratio is shifted away from reward and toward risk. This happens because your upside has decreased due to the high price of the stock, and because the probability of the run ending increases as the stock gets more and more expensive.
There are two ways to look at the decrease in your upside: First of all, you`ll capture less of the stock`s movement, so your percentage return will be less; second, the more the stock trades costs per share, the fewer shares you`ll be able to buy. Which means that any return you get will be multiplied by fewer shares. Remember, it doesn`t matter if you miss a trade or a position because the entry price has gotten too high. It`s not the last good trade in the market. There will always be more stock trades to make. It`s much better to miss a trade than to chase a stock and end up with a loss.
Morning gaps down present good opportunities to buy stocks you want. Buying a gap down is an excellent way to enter a position, since when a stock gaps down, it often opens near what will turn out to be the low of the day. On the other hand, buying a gap up is one of the worst stock trades you can make. The gap up generally reflects the top of the market`s level of interest in the stock. Any good news from overnight has generally been priced in, so the stock`s opening price and volatility on a gap up often establishes the stock`s high of the day. Therefore, buying, or really chasing, the gap up means that you will likely buy the stock for top dollar. A good trader buys stocks that have an upside that hasn`t been priced into the stock.
Entering a short position on a gap up is a great plan, though shorting a gap down is foolish. The opening price and volatility on a gap down often establishes the stock`s low of the day, so shorting at the lowest point would be a poor trade to make. However, if you keep these guidelines in mind, you will be able to find a safe entry point for your trade. One that fits with your trading plan, and puts you on the path to consistent trading success.
About the Author
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