What is the Stock Market?

What is the Stock Market and how does it work?

The stock market is always on the news. When it rallies (goes up).

When it crashes (goes down).  Yet very few people know what it is and how it works. Let’s cover the basics first.

What is a stock?

A stock (or share) is a share, a proportionate piece of ownership, of a public company. A public company is a company that is owned by the public; investors. Anyone who can afford to buy the stock (or shares) of the company becomes a shareholder of the company. As a shareholder, you are part of the company, a partner, and you must share in the profit and losses of the company. The stocks enter the market when the owner of a corporation issues shares of his/her own companies to public investors.

The owner might issue shares for many reasons. They might want to develop the company and make it larger or simply take advantage of the stock’s trading price to generate capital. When the company owner issues or sells their shares, they get money in return for the shares they sell. On the other side, the investor gets a share (a percentage) of the company. In other words, he becomes part (or a partner) of the company. With the money issued by the owner, they in turn develop the company.

Or maybe the owner might use that money to survive. Perhaps the company is running at a loss or needs to raise workers wage. In the case of the company running at a loss, it shows the investors that the company is not a well-managed company. Therefore, its stock value (the price that a shareholder can sell the shares at) will be lower. The company may still be worth something because of the equipment, assets, etc.

A stock market is basically where the common shares (or stocks) of the public companies are traded. It is basically a location for the public companies to trade, it can be a corporation on its own self. The three major stock exchanges that are located in North America are: NYSE, NASDAQ and TSX. Most stock markets in the western countries are open every weekday for about six to seven hours (in Canada and the US, 9:30 AM EST – 4:00 PM EST).

History of the Stock Market

NYSE

The modern stock market had not been established until the 17th century with the creation of the New York Stock Exchange (NYSE). The history of the U.S. Investment market goes back to the 1790’s, when the U.S. Government issued its first bonds. The U.S. Government issued just over $80 million of bonds then to repay the cost of the American Revolutionary War.

The history of the NYSE begins on May 17, 1792 when the twenty four Wall Street stock brokers signed the Buttonwood Agreement. The Buttonwood Agreement was an agreement that allowed the brokers only to trade securities (such as, stocks and bonds) with each other on a commission basis. During this period, only government bonds and banking stocks were traded by the brokers.

** The first ever stock that was to be listed on the NYSE was Bank of America. **

By 1817, about 30 stocks were being traded on NYSE. As more and more companies began trading, regulations became tighter. On March of 1817, the Buttonwood Agreement was organized and the New York Stock and Exchange Board was officially formed. Anthony Stockholm was named to be the first NYSE president. As the years progressed, so did the the NYSE. Soon after, the NYSE location was moved to accommodate all the trading volume that was being handled daily.

Today, the NYSE is the largest stock market in the world, in terms of market capitalization, with over $21 Trillion USD in value. It is located in the financial capital of the world, New York City, Lower Manhattan. Over 2,800 publically-owned companies are traded daily.

NASDAQ

In the 1960s, trading of over-the-counter (OTC) derivatives were difficult for a typical investor to invest his money in. Also, many of the OTC securities (in this case, company stocks) were not allowed to trade on the NYSE (the well-known market at that time). The Securities and Exchange Commission (SEC) was told to make OTC securities more accessible for investors. National Association of Securities Dealers Automated Quotations, or more widely known as NASDAQ, was founded in 1971 by National Association of Securities Dealers (NASD).

In 1971, it was the worlds first and only stock market that was being traded electronically and through telecommunication. In other words, NASDAQ does not have a physical trading floor in which traders trade shares. Instead, telephones and computers execute buy and sell orders. Prior to the 1987 market crash, orders were only executed via telephones. As technological advancement took place, actual computers were used. This is the feature that makes NASDAQ one of the respected electronic stock exchanges in the world.

**In 1994, NASDAQ became the worlds largest stock market in terms of trading volume (number of public shares being traded).**

**Although NASDAQ does not have a floor for traders, it does have a MarketSite in Times Square where there is 24 hour up-to-date news and a studio for news reporters.

TSX

The history of the Toronto Stock Exchange (TSX) can be traced back all the way to 1852. Until the mid-1850s, financial needs in Canada were fulfilled by the government of Britain. London, England was the financial capital for Canada. Even the shares of the oldest Canadian retail store chain, the Hudson Bay Company, were being traded in London. But as the government started borrowing money to build the railroad, stock brokers became in demand. This marked the beginning of the finance in Canada.

The TSX was officially created nine years later on October 25th, 1861. At that time, only 18 securities were being traded with low average daily volume. The exchange had daily half-hour sessions during which time traders traded. As the exchange expanded and moved into its first location at King Street East in 1878, the seat values increased. The cost to purchase a membership was only $250 in 1871. In no less than 30 years, the value of one seat increased by just about 4,800% to $12,000.

In 1914 the exchange was halted for three months as the World War One began. In 1934, a key merging took place. The Standard Stock and Mining Exchange merged with the Toronto Stock Exchange. By 1977, technological advancements forced the stock exchange to adopt the worlds first Computer Assisted Trading System (CATS). In 1983, the Toronto Stock Exchange relocated to its location to its current location, in Downtown Toronto. In the late 1990’s the exchanges floor was removed. Everything is done via computers and electronic systems.

What affects the Stock Market?

There are many reasons why the stock market moves up or down. The most obvious reason would be the health of the economy. Economic news reveals the economic condition almost every trading day of the week. Consumer confidence, consumer sentiment, employment situation, retail sales are just some of the economic news that show a reading of the economy. Comments from economic analysts and economist also affect the stock markets movement, both positively and negatively.

For example: if a reputable economist or investor (Warren Buffet) says that the economy is not good, then it is possible for the stocks to go down as investors become cautious. Stocks also move up when brokerage firms, Bank of America-Merrill Lynch, Goldman Sachs, Citigroup and others change their views on a particular stock or a sector and, perhaps, even the whole broader market. Brokerage firms upgrade and downgrade stocks all the time, all most every single trading day. They show their view by giving it a Buy, Sell or Neutral. Some firms also use terms like underweight, equal weight and overweight.

Underweight is when an analyst is saying that the investor should reduce their position in that stock due to the lower percentage of return in that stock compared to its peers (other companies/stocks in that same sector).

Overweight is when an analyst is saying that the investor should reduce their position in that stock.

Equalweight is similar to neutral, the stock has equal opportunities when compared to its peers.

Rating terms like this are used every day in Wall Street and Bay Street to predict a stocks future performance. Stocks are not the only way to make money (or lose money) in the world of investing. There are bonds and Forex which are less risky while the rewards are also limited compared to stocks. There are also other forms of investing which use the performance of stocks as the underlying asset.

Derivatives such as, options, etfs (exchange-traded-funds), futures, gain and lose value based on the underlying asset (usually company stocks, indicies, bonds, sector, etc.)

Bonds and stocks are so much different as both can help you make or lose money. Unlike stocks, bonds are not traded on exchanges. Bonds are known to be traded over-the-counter (OTC). Bonds belong to the fixed income category of investing. This means that the bond creditor gets a fixed amount of return.

As mentioned before, bonds are less risky yet they still have some risk because the borrower might not be able to repay the principal. Bonds are basically a type of loan issued by the borrower. The borrower sets a contract with the lender, which includes the maturity date, coupon amount, coupon date and price. The maturity date is when the borrower is obligated to pay the principal money to the lender. The coupon is the interest that is to be paid by the borrower to the lender on specific dates. The coupon is usually paid semi-annually (every six months). The price of the bond is simply the price at which the bond was bought. It is approximately the principal amount. The borrower pays the lender a certain amount each month or every three/six months as a coupon or interest. The bond price is basically calculated using the bond maturity date compared to the price of par (100.00).

Bonds have prices so that if a bond investor is interested in cashing-in before the maturity date, he is able to. Bond prices are also used to day-trade them. Sell them at a high price and buy back at a lower price. Bond prices also can be used calculate the yield of the investment. Like stocks, bonds can be traded. Bonds are traded through the spread action.

A spread is basically the difference between the price at which you buy and sell the bonds. You buy the bond at a low price and sell at a higher price. Buy low and sell high, you make a profit. Do the opposite, and you make a loss. Because bonds are less volatile compared to stocks, bonds tend to be less risky. When there is less risk involved, there is less profit.

* Bonds move inversely compared to stocks. Investors jump into bonds when stocks are dangerous (goes down).*

Forex

Forex, formally known as foreign exchange market, is when a countrys currency is traded against another countrys currency. Forex is probably one of the simplest investing tools. The concept: you buy a countrys currency and then sell the currency when it gains some value. The margins for profit in Forex are very low due to the currencys movements. But profits (and loses) can be large with larger volumes of trade.

* Currencies move with the countrys economy. If a countrys economy is good, it currency gains value. Currencies also move on FOMC days (when the U.S. Federal Reserve announces it policy changes).*

* The U.S. Dollar (USD) usually tends to fall when stocks rise and the USD rises when the stock market.

The S&P 500

The S&P 500 is the performance of 500 companies that are comprised into an index to track the performance of the stock market. About 40% of the S&P companies get their revenue from outside the U.S. When the dollar loses value, the foreign currencies become more valuable. So when those companies convert their Yens, Euros, Pounds, CADs, etc. into USD, it makes the illusion of the companies having a higher profit/revenue.

Another reason why the stock market tends to gain on dollar weakness is because of the fact that most, if not all, the commodities are valued in USD. Therefore, when the dollar falls, the price of the commodity (in USD) needs to rise in order to compensate with the weakness in value of the dollar.

Options

An option is simple contract between the buyer and seller. The contract gives the buyer the right to buy or sell a specific underlying asset at a specific price before a specific date. Before the option contract is bought by the buyer, he agrees with the seller that he will buy/sell the underlying stocks for the options at a specific price if it hits the price before the expiration date.

For example: It is November 30th 2011 today. December option contracts expire on December 18th. Investor Bob has 15 trading days. MSFT (Microsoft) is trading at $24. Bob decides to buy contracts of MSFT DEC09 CALLS 25 for $1.00 (this is the premium). This means that Bobs contract writer is obligated to sell the MSFT shares if it goes above $25 before December 18th for the price of $25 to Bob.

If the stock price is less than $25 by expiration, the options expires and is worthless. In other words, if MSFT is above $26 ($25 plus the premium) before expiration, Bob makes a profit. If MSFT is less than $25 by expiration, the option expires worthless and Bob loses the $1.00 premium he paid. If MSFT is less than $26 but above $25, then Bob can exercise (convert the option contracts into shares) but he must wait until it goes above $26 ($25 plus $1.00 premium) to make a profit on this trade.

NOTE: AN OPTION CONTRACT IS EQUIVALENT TO 100 SHARES OF THE UNDERLYING ASSET (STOCK).

Why would traders use this derivative to play the market?

As you can tell, the premiums of options are much cheaper than the actual shares of the company. Shares of MSFT cost $24 but the option only costs $1.00. Therefore, less money is involved. But it is more risky percentage wise.

If MSFT shares dont reach the $25 (even if it goes to $24.99) before the expiration, then the whole contract is worthless. If you had the actual share, you could sell it at $24.99 and minimize your loss. However, in options, you lose the whole premium. Also, if MSFT drops $5 from $25, then the whole option, once again, becomes worthless, which means you lose 100%. But if you owned the share, then would have lost only 20% of your principal, compared to over 75% loss of your principal with options.

The problem with owning actual shares is that it deals with a large amount of money, as a result, a small percentage of loss would be equivalent to a large loss.

Exchange Traded Funds

Exchange Traded Funds, or more commonly known as ETFs, are traded like stocks on stock exchanges. ETFs consist of assets (stocks, bonds, futures contract, etc.) that are held by a fund. ETFs are valued at the approximate value of its net-asset. They track the daily movements of the assets, when the basket of the stocks that is in the ETF move up, the value of the ETF also moves up. Theortically, ETFs are supposed to trade at the approximate value its net-asset in the market. In reality, ETFs dont properly track their underlying asset.

Examples of some ETFs:

NYSE:SPY or SPDR S&P500 is the most popular ETF, in terms of average volume and market capitilization. The SPDR etf tracks the approximate value of the S&P500. In other words, with the money one pays to buy the etf, the fund manager (SPDR) buys S&P500 stocks. Due to its high volume, this etf is pretty accurate in tracking the movements of the S&P500.

NYSE:USO or United States Oil Fund LP is an ETF that simply tracks the movements of Light, Sweet crude oil. So basically, as the price of Light, Sweet crude oil moves 1% up, the etf (USO) also moves up approximately 1%. When the underlying asset, in this case commodity, moves down 1%, then USE moves down approximately 1%.

HSU.TO or HBP S&P 500® Bull Plus is a leveraged ETF, which means that it has 2X the exposure. It tracks the S&P500. So, if the S&P500 moves 1% a day, the HSU.TO moves 2% (2X leveraged).

HSD.TO or HBP S&P 500® Bear Plus is also a leveraged ETF, it a bear ETF. Like the HSU.TO, it tracks the movement of S&P500 but it tracks inversely. So, if the S&P500 gains 1%, this ETF would lose 2% of its etf value.

NOTE: LEVERAGED ETFS ARE DANGEROUS DUE TO DECAY.

Decay occurs commonly on leveraged etfs overtime. The most well-known leveraged etf that has died to decay is the NYSE:FAZ or Direxion Daily Finan. Bear 3X Shs. This ETF tracks the Russell 1000 Financial Services, which is composed of 1000 financial assets.

Dangers

The stock market is just about the most dangerous game in the planet. You can make millions in the stock market but at the same time, you can lose it all the next day. Millions of people have made fortunes on the stock market but at the same time, a lot more has loosen with the stock market. You can make money either way in the stock market. For that reason, when you make money someone else loses money. This goes the other way too, when you lose money, someone else makes money.

For example: You are long the shares of ABC and someone else is short ABC. SO if the stock goes down tomorrow, you lose money but the shorter makes money. But again, if the stock goes down twice the amount and recovers its losses the day after, then you will make the money while the shorter loses money (assuming he did not cover his short position).

In short, the stock market is dangerous if you are not in the right side of the trade. That is why it takes years and years of experience in order to get it right, even experts dont get all their trades right. That is why even Warren Buffet loses money. But he diversifies, and gains his loses from another share. As a result, his net-profit stays positive.

If you invested $100 on GRH the day before and if you look at your investment the day after, you would have lost about $18.65. You will end up having about $81.35 the next day. Some stocks have gone down 95% in one day. These were not companies that went bankrupt like GM. These were good, well-managed companies. But at the same time, you can make fortunes.

If you invested $100 the day before and looked at your investment the next day, you would have made $46.22. In the end, you will end up having $146.22 in your brokerage account. Typically, a 3-5% return in a short period of time is pretty good. So this 46% must obviously be an excellent trade.

Get Started!

There are many websites online that offer free practice accounts on which you can trade using “fake” or virtual money. Stock brokers allow their new clients to use practice account so they get used to trading stocks. Professionals use practice accounts to try out new strategies. Brokers don’t want their clients to lose money, so they offer this feature for free. If they lose money, they won’t trade and if they don’t trade, brokers don’t get commissions. Brokers take commissions even if you lose money.

Here are some possible websites that offer practice accounts:

Offering free practice accounts has become a real feature that many of these brokers use to advertise.

These websites also run contests, on which you win REAL MONEY if you make the most virtual money.

Financial Terms

Ever try to read a business article and felt lost half way through because of all the financial terms the writer used? Wall Street lingo can be quite perplexing if you are new to the stock market. In this investment arena, the term bear market does not allude to a trade of large furry mammals. Neither does black Monday refer to the coach-firing day following the final Sunday of the NFL season. Wall Street is a fierce arena. Theres quite a learning curve. So dont jump into it until you at least understand the stock market basics. You won’t turn you into a pro investor overnight but you can better understand some interesting Wall Street terms that all beginning investors should know.

To categorize it academically, this is probably Wall Street 101, lesson 1.

Automatic Dividend Reinvestment A stock investment plan in which shareholders allow their dividends to be automatically used to purchase more shares of stock instead of receiving a cash dividend payment.

Bear Market A declining market with a sharp, prolonged plunge in the price of stocks.

Big Board Nickname for the New York Stock Exchange.

Black Friday – The day after Thanksgiving (largest shopping day in the U.S. to predict retail holiday sales)

Black Monday October 19, 1987 when the Dow Jones dropped over 500 points.

Blue Chip The common stock of a reputable company with a history of earnings growth and dividend increases, a company that is considered to be a strong and safe company to invest in.

Bonds – are part of the fixed income category. Simply loans borrowed by

Corporation (corporate bonds) and governments (government bonds). The money is borrowed from bond investors, who get interest (coupon) in return.

Broker – The corporation/bank that communicates between you and the stock exchange to buy or sell a stock that you wish.

Bull Market A thriving market with a huge, continuous rise in the price of stocks.

Diversify – A wise investing strategy that is commonly used to reduce the risk of losing your principal investment amount. Institutions try to keep their investments as wide as possible. They tend to invest in different sectors. For example: an institution invests 80% of its principal in the Coal sector. The government might introduce a Carbon-Tax, which could potentially make the Coal sector crash. The institution will be in big trouble, and its clients will definitely begin to sue it. If the institution diversified, then it could have possible saved a lot of amount. This is also an important strategy that is recommended for retail investors (investors who trade at home with their RRSP and 401k accounts in the US). The general rule is to not invest more than 3-5% for institutions and more than 20% for retail investors.

Dividend A portion of the companys profits usually rewarded to shareholders on a quarterly basis.

DJIA Dow Jones Industrial Average. The average of the stock prices, calculated from the prices of the 30 leading industrial stocks.

Earnings Per Share A companys net income divided by the number of outstanding shares.

Forex – is the Foreign Exchange market. It is the market where one country’s currencies are traded. Currencies are traded in order to take advantage of the spreads and make profit.

Futures – is part of the derivatives market. Indices are the underlying asset and they are traded based on the value of the underlying share values of an index.

Index A statistical benchmark that measures a whole market based on a representative selection of stocks or bonds.

In-The-Money – For Calls, it is when the strike price of an option contract is below the current trading stock price. For Puts, it is when the strike price of an option contract is above the current trading stock price.

IPO Initial public offering, aka new issue. A companys offering of stock for sale to the public for the first time.

Liquid Asset Cash or any types of asset that can be quickly and conveniently converted into cash.

Margin A collateral or deposit a client gives to a broker in order to borrow from the broker to buy stocks.

Market Order An order to buy or sell a certain number of shares as soon as possible, at the best available current price.

Options – is part of the derivatives market. They are basically contracts between the writer and contract buyer to buy or sell a specific share at a specific price before a specific date.

Out-The-Money – For Calls, it is when the strike price of an option contract is above the current trading stock price. For Puts, it is when the strike price of an option contract is above below the current trading stock price.

Outstanding Shares Stock shares that have been purchased and held by investors (either the companys insiders or the public), but not the shares that have been repurchased by the company.

Point A yardstick for measuring a price change. For a stock, 1 point means it moves up or down by $1. For a bond, on the other hand, 1 point indicates a higher amount of dollars. For example, 1 point for a bond with a face value of $1000 actually means a $10 price change.

P/E – Price/Earnings ratio is a common ratio that is used to calculate the company’s fair stock price. It is calculated with the current price of the stock price and its current quarter earnings. This just gives a general fair price for the stock. But growth rate and Forward P/E must also be considered before giving a stock its fair value.

Prosperity – Booming period, stock market usually rises. An economy that is expanding without any negative growth is considered to be in prosperity. Unemployment decreases.

Recession – Downturn, stock market usually falls. An economy is officially in a recession when the GDP reading of the economy is negative for two consecutive quarters. Unemployment increases.

SEC Securities and Exchange Commission, a federal agency that oversees the sale of stocks, mutual fund shares, stockbrokers and financial advisers, etc.

Spread The difference between an investors bid and an issuers requested price.

Stock Split Division of outstanding shares of stock, made by the companys board of directors. For example, in a 2 for 1 stock split, a shareholder with 1 share will get one additional share whereas a shareholder with 2 shares will end up with 4 shares. Accordingly, the price for each share will be halved. Many companies do this when they think their share price has become too high.

Stocks – (also known as shares) are basically a small ownership of a company. When a share is bought, you become part of the companys partner.

Stock Exchange – were stocks of companies are traded by large investing firms.

• NYSE – (New York Stock Exchange) is the largest stock exchange in the world by market cap. It is also the oldest stock exchange in North America

• NASDAQ – is the largest stock exchange in the world by the number of companies traded

• AMEX – is the third-largest stock exchange by trading volume in the United States

• TSX – (Toronto Stock Exchange) is the largest Stock Exchange in Canada. It is situated in Toronto, Ontario

• OTC – (OTCBB) is the Over-the Counter Exchange for small-cap companies

Stock Symbol Its also known as a ticker symbol, which is a series of letters, numbers or combinations of both assigned to a stock on a particular stock market for trading purposes. For example, in the U.S. stock market, the ticker symbol for Apple Inc. is AAPL, whereas the one for Microsoft is MSFT.

Street Name Stocks that are held in the brokers name rather than the customers.

Treasury Shares Stock shares that have been repurchased by the company that had issued them in order to decrease the number of outstanding shares on the open market.

Writing Options – The person who writes the contracts to buy or sell the shares at a specific price before expiration. (Also called as Shorting Options – Calls and Puts)

Underwriter An investment banker who buys shares of a new issue of stocks and sells them to investors in order to make a profit on the spread.

Yield AKA a dividend yield. Its a way to measure how much cash flow you are receiving from your investment on a stock. To calculate a dividend yield, divide the annual dividend per share by the price per share.

Last updated by Aim High Alerts at December 6, 2011 .