Introducing the Broad Markets
You may think the foundation of the United States economy resides inside Fort Knox, where the country holds its billions of dollars in gold, or possibly that it resides in our political center, Washington, D.C. But nope. The country’s true economic center is Wall Street, where billions of dollars change hands each and every day, thousands of companies are traded, and millions of people’s lives are affected.
Stocks are not the only things sold in the broad financial markets. Every day, currencies, futures, options, and bonds also are traded. Although we focus on stock exchanges in this chapter, we first need to briefly explain each type of market.
Stock markets
The stocks of almost every major U.S. corporation and many major foreign corporations are traded on a stock exchange in the United States each day. Today, numerous domestic and international stock exchanges trade stocks in publicly held corporations; moreover, the only major corporations not traded are those held privately — usually by families or original founding partners that choose not to sell shares on the public market. Forbes magazine’s top privately held corporations are Cargill, Koch Industries, Albertsons, Dell, and PricewaterhouseCoopers. Many of the large private corporations that are not traded publicly do have provisions for employee ownership of stock and must report earnings to the Securities and Exchange Commission (SEC), so they straddle the line between public and private corporations.
A share of stock is actually a portion of ownership in a given company. Few stockholders own large enough stakes in a company to play a major decision‐making role. Instead, stockholders purchase stocks hoping that their investments rise in price so that those stocks can be sold at a profit to someone else interested in owning a share of the company sometime in the future. Investors may hold the stock to earn dividends, as well. Traders rarely hold the stock long enough for dividends to be a primary decision factor in whether to buy a stock. Therefore, after the company’s initial sale of stock when it goes public, none of the money involved in stock trades goes directly into that company.
For the majority of this chapter, we focus on the two top stock exchanges in the United States: the New York Stock Exchange (NYSE) Euronext and NASDAQ (the National Association of Securities Dealers Automated Quotation system). We also introduce you to the world of electronic communication networks (ECNs), on which you can trade stocks directly, thus bypassing brokers.
Futures markets
Futures trading actually started in Japan in the 18th century to trade rice and silk. This trading instrument was first used in the United States in the 1850s for trading grains and other agricultural entities. Basically, futures trading means establishing a price for a commodity at the time of writing the financial contract. The commodity must be delivered at a specific time in the future. If you had a working crystal ball, it would be very useful here. This type of trading is done on a commodities exchange. The largest such exchange in the United States today is the CME Group. Commodities include any product that can be bought and sold. Oil, cotton, and minerals are just a few of the products sold on a commodities exchange.
Futures contracts must have a seller (usually the person producing the commodity — a farmer or oil refinery, for example) and a buyer (usually a company that actually uses the commodity). You also can speculate on either side of the contract, basically meaning:
- When you buy a futures contract, you’re agreeing to buy a commodity that is not yet ready for sale or hasn’t yet been produced at a set price at a specific time in the future.
- When you sell a futures contact, you’re agreeing to provide a commodity that is not yet ready for sale or hasn’t yet been produced at a set price at a specific time in the future.
The futures contract states the price at which you agree to pay for or sell a certain amount of this future product when it’s delivered at a specific future date. Although most futures contracts are based on a physical commodity, the highest‐volume futures contracts are based on the future value of stock indexes and other financially related futures.
Unless you’re a commercial consumer who plans to use the commodity, you won’t actually take delivery of or provide the commodity for which you’re trading a futures contract. You’ll more than likely sell the futures contract you bought before you actually have to accept the commodity from a commercial customer. Futures contracts are used as financial instruments by producers, consumers, and speculators. We cover these players and futures contracts in much greater depth in Chapter 19.
Bond markets
Bonds are actually loan instruments. Companies and governments sell bonds to borrow cash. If you buy a bond, you’re essentially holding a company’s debt or the debt of a governmental entity. The company or government entity that sells the bond agrees to pay you a certain amount of interest for a specific period of time in exchange for the use of your money. The big difference between stocks and bonds is that bonds are debt obligations and stocks are equity. Stockholders actually own a share of the corporation. Bondholders lend money to the company with no right of ownership. Bonds, however, are considered safer because if a company files bankruptcy, bondholders are paid before stockholders. Bonds are a safety net and not actually a part of the trading world for individual position traders, day traders, and swing traders. Although a greater dollar volume of bonds is traded each day, the primary traders for this venue are large institutional traders. We don’t discuss them any further in this book.
Options markets
An option is a contract that gives the buyer the right, but not the obligation, either to buy or to sell the underlying asset upon which the option is based at a specified price on or before a specified date. Sometime before the option period expires, a purchaser of an option must decide whether to exercise the option and buy (or sell) the asset (most commonly stocks) at the target price. Options also are a type of derivative. We talk more about this investment alternative in Chapter 19.
Reviewing Stock Exchanges
Most of this book covers stock trading, so we obviously concentrate on how the key exchanges — NYSE and NASDAQ — operate and how these operations impact your trading activity.
New York Stock Exchange (NYSE: ICE)
The U.S. stock market actually dates back to May 17, 1792, when 24 brokers signed an agreement under a buttonwood tree at what today is 58 Wall Street. The 24 brokers specifically agreed to sell shares of companies among themselves, charging a commission or fee to buy and sell shares for others who wanted to invest in a company. Yup, the first American stockbrokers were born that day.
A formalized exchange didn’t come into existence until March 8, 1817, when the brokers adopted a formal constitution and named their new entity the New York Stock & Exchange Board. Brokers actually operated outdoors until 1860, when the operations finally were moved inside. The first stock ticker was introduced in 1867, but it wasn’t until 1869 that the NYSE started requiring the registration of securities for companies that wanted to have their stock traded on the exchange. Registration began as a means of preventing the over‐issuance (selling too many shares) of a company’s stock.
From these meager beginnings, the NYSE built itself into the largest stock exchange in the world, with many of the largest companies listed on the exchange. Trading occurs on the floor of the exchange, with specialists and floor traders running the show. Today these specialists and floor traders work electronically, which first became possible when the exchange introduced electronic capabilities for trading in 2004. For traders, the new electronic‐trading capabilities are a more popular tool than working with specialists and floor traders. Electronic‐trading capabilities were enhanced when the NYSE merged with Archipelago Holdings in 2006. The exchange expanded its global trading capabilities after a merger with Euronext in 2007, which made trading in European stocks much easier. NYSE Euronext was bought by Intercontinental Exchange (ICE) in 2013.
You may not realize just how much the concept of supply and demand influences the trading price of a stock. Price swings of a stock are caused by shifts in the supply of shares available for sale and the demand created by the number of buyers wanting to purchase available shares.
The designated market makers
Designated market makers buffer dramatic swings by providing liquidity when needed, such as when news about a company breaks. If news that has a major impact on a stock’s price breaks, designated market makers buy shares or sell the ones they hold in a company to make the trend toward a higher or lower stock price more orderly. For example, if good news breaks, creating more demand for the stock and overwhelming existing supply, the designated market maker becomes a seller of the stock to minimize the impact of a major price increase by increasing supply. The same is true when bad news strikes, creating a situation in which having more sellers than buyers drives the stock price down. In that situation, the designated market maker becomes a buyer of the stock, easing the impact of the drop in price. Designated market makers operate both manually and electronically to facilitate stock trading during market openings, closings, and periods of substantial trading imbalances or instability.
The floor brokers
The guys you see on the floor of the stock exchange, waving their hands wildly to make trades, are the floor brokers. They’re actually members of the NYSE who trade exclusively for their own accounts. Floor brokers also can act as floor brokers for others and sell their services. But over 82 percent of trades take place electronically, so floor trading today is used primarily to trade a small group of extremely high‐priced stocks not traded electronically.
Supplemental Liquidity Providers
In order to handle the volume of today’s international marketplace, the NYSE established a new class of market participants called Supplemental Liquidity Providers (SLPs). These high‐volume members of the exchange add liquidity to the marketplace. Each SLP is assigned securities for which he or she is obligated to maintain active trading of at least 10 percent in a trading day. SLPs must average 10 million shares exchanged in a day. They help generate more quoting activity to improve pricing and liquidity for stocks.
NASDAQ
NASDAQ, which stands for the National Association of Securities Dealers Automated Quotations, was formed after an SEC study in the early 1960s concluded that the sale of over‐the‐counter (OTC) securities — in other words, securities that aren’t traded on the existing stock exchanges — was fragmented and obscure. The report called for the automation of the OTC market and gave the responsibility for implementing that system to the National Association of Securities Dealers (NASD).
The NASD began construction of the NASDAQ system in 1968, and its first trades were made beginning February 8, 1971, when NASDAQ became the world’s first electronic stock market. In 2007, NASDAQ combined forces with the Scandinavian exchange group OMX. Together, NASDAQ OMX operates 25 securities markets. It also provides trading technology to 70 exchanges in 50 countries.
Market makers
NASDAQ market makers compete with each other to buy and sell the stocks they choose to represent. Nearly 300 member firms act as market makers for NASDAQ. Each uses its own capital, research, and system resources to represent a stock and compete with other market makers.
Market makers compete for customers’ orders by displaying buy and sell quotations on an electronic exchange for a guaranteed number of shares at a specific price. After market makers receive orders, they immediately purchase or sell stock from their own inventories or seek out the other side of the trades so they can be executed, usually in a matter of seconds. The four types of market makers are
- Retail market makers: They serve institutional and individual investors through brokerage networks that provide a continuous flow of orders and sales opportunities.
- Wholesale market makers: They serve primarily institutional clients and other brokers or dealers who aren’t registered market makers in a particular company’s stock but who need to execute orders for their customers.
- Institutional market makers: They execute large block orders for institutional investors, such as pension funds, mutual funds, insurance companies, and asset‐management companies.
- Regional market makers: They serve companies and individuals of a particular region. By focusing regionally, these market makers offer their customers more extensive coverage of the stocks and investors in a particular area of the country.
NASDAQ continues to be the leader in electronic trading. Its system, called the NASDAQ Crossing Network, enables fully anonymous trade execution to minimize the market impact of trading.
Over‐the‐counter and bulletin‐board stocks
Stocks that do not meet the minimum requirements to be listed on NASDAQ are traded as over‐the‐counter or bulletin‐board stocks (OTCBB). The OTCBB is a regulated quotation service that displays real‐time quotes, last‐sale prices, and volume information for the stocks traded OTCBB. These stocks generally don’t meet the listing qualifications for NASDAQ or other national securities exchanges, and fewer than two (and sometimes zero) market makers trade in these stocks, making buying and selling them more difficult.
Amex (now NYSE MKT LLC)
When the NYSE moved indoors, some stocks still weren’t good enough to be sold on the exchange. Those stocks were called curb traders and ultimately made up what became known as the American Stock Exchange (Amex), which moved indoors in 1921. Amex lists stocks that are smaller in size than those on the NYSE yet still have a national following. Many firms that first list on Amex work to meet the listing requirements of the NYSE and then switch over.
The Amex trading system was integrated into the NYSE trading system after the merger with the NYSE was completed in 2008, and its named changed to the NYSE Alternext. Then in 2009, the name was changed to NYSE Amex Equities. In May 2012, the name changed again to NYSE MKT LLC.
Electronic communications networks (ECNs)
Many traders look for ways to get around dealing with a traditional broker. Instead they access trades using a direct‐access broker. We talk more about the differences in Chapter 3. A new system of electronic trading that is developing is called the electronic communications network (ECN).
ECNs enable buyers and sellers to meet electronically to execute trades. The trades are entered into the ECN systems by market makers at one of the exchanges or by an OTC market maker. Transactions are completed without a broker‐dealer, saving users the cost of commissions normally charged for more traditional forms of trading.
Subscribers to ECNs include retail investors, institutional investors, market makers, and broker‐dealers. ECNs are accessed through a custom terminal or by direct Internet connection. Orders are posted by the ECN for subscribers to view. The ECN then matches orders for execution. In most cases, buyers and sellers maintain their anonymity and do not list identifiable information in their buy or sell orders.
In the last few years, ECNs have gone through consolidation. Inet was acquired by NASDAQ. Archipelago now operates under the NYSE umbrella as NYSE Arca Options. Instinet, which serves primarily institutional traders, has an agreement for after‐hours trading with E*Trade.
Understanding Order Types
Buying a share of stock can be as easy as calling a broker and saying that you want to buy such and such a stock — but you can place an order in a number of other ways that give you better protections. Most orders are placed as day orders, but you can choose to place them as good‐’til‐canceled orders. The four basic types of orders you can place are market orders, limit orders, stop orders, and stop‐limit orders.
Understanding the language and using it to protect your assets and the way you trade are critical to your success as a trader. The next few sections explain the nuances of placing orders so you don’t make a potentially costly mistake by placing a market order when you intended to place a limit order. Putting a stop‐limit order in place may sound like the safest way to go; however, doing so may not help you in a rapidly changing market.
Market order
When you place a market order, you’re essentially telling a broker to buy or sell a stock at the current market price. A market order is the way your broker normally places an order unless you give him or her different instructions. The advantage of a market order is that you’re almost always guaranteed that your order is executed as long as willing buyers and sellers are in the marketplace. Generally speaking, buy orders are filled at the ask price (the price at which the holder of the stock is willing to sell), and sell orders are filled at the bid price (the price at which a buyer is willing to buy). If, however, you’re working with a broker who has a smart‐order routing system, which looks for the best bid/ask prices, you sometimes can get a better price on the NASDAQ.
The disadvantage of a market order is that you’re stuck paying the price when the order is executed — possibly not at the price you expected when you placed the order. Brokers and real‐time quote services quote you prices, but because the markets move fast, with deals taking place in seconds, you’ll probably find that the price you’re quoted rarely is the same as the execution price. Whenever you place a market order, especially if you’re seeking a large number of shares, the probability is even greater that you’ll receive different prices for parts of the order — 100 shares at $25 and 100 shares at $25.05, for example.
Limit order
If you want to avoid buying or selling stock at a price higher or lower than you intend, you must place a limit order instead of a market order. When placing a limit order, you specify the price at which you’ll buy or sell. You can place either a buy limit order or a sell limit order. Buy limit orders can be executed only when a seller is willing to sell the stock you’re buying at the limit price or lower. A sell limit order can be executed only when a buyer is willing to pay your limit price or higher. In other words, you set the parameters for the price that you’ll accept. You can’t do that with a market order.
The risk that you take when placing a limit order is that the order may never be filled. For example, a hot stock piques your interest when it’s selling for $10, so you decide to place a limit order to buy the stock at $10.50. By the time you call your broker or input the order into your trading system, the price already has moved above $10.50 and never drops back to that level — thus, your order won’t be filled. On the good side, if the stock is so hot that its price skyrockets to $75, you also won’t be stuck as the owner of the stock after purchasing near the $75 high. That high will likely be a temporary top that quickly drops back to reality, which would force you to sell the stock at a significant loss at some point in the future.
Some firms charge more for executing a limit order than they do for a market order. Be sure that you understand the fee and commission structures if you intend to use limit orders. If your broker charges for limit orders, you may want to change brokers.
Stop order
You may also consider placing your order as a stop order, which means that whenever the stock reaches a price that you specify, it automatically becomes a market order. Investors who buy using a stop order usually do so to limit potential losses or protect a profit. Buy stop orders are always entered at a stop price that is above the current market price.
When placing a sell stop order, you do so to avoid further losses or to protect a profit that exists in case the stock continues on a downward trend. The sell stop price is always placed below the current market price. For example, if a stock you bought for $10 is now selling for $25, you can decide to protect most of that profit by placing a sell stop order that specifies that stock be sold when the market price falls to $20, thus guaranteeing a $10 gain.
You don’t have to watch the stock market every second; instead, when the market price drops to $20, your stop order automatically switches to a market order and is executed.
The big disadvantage of a stop order is that if for some reason the stock market gets a shock during the news day that affects all stocks, it can temporarily send prices lower, activating your stop price. If it turns out that the downturn is merely a short‐term fluctuation and not an indication that the stock you hold is a bad choice or that you risk losing your profit, your stock may sell before you ever have time to react.
The bottom can fall out of your stock’s pricing. After your stop price is reached, a stop order automatically becomes a market order, and the price that you actually receive can differ greatly from your stop price, especially in a rapidly fluctuating market. You can avoid this problem by placing a stop‐limit order, which we discuss in the next section.
Stop orders are not officially supported on the NASDAQ. However, most brokers offer a service to simulate a stop order. If you want to enter a stop order for a NASDAQ stock, your broker must watch the market and enter the market or limit order you designate as a stop when the stock reaches your specified sale price. Some broker‐dealers won’t accept a stop order on some securities and almost never accept a stop order for OTC stocks. If you intend to use stop orders, make sure that you
- Check with the brokers you’re planning to use to ensure that they accept stop orders.
- Find out what your brokers charge for stop orders.
- Review how your broker’s stop orders work, so you don’t run into surprises.
After all, you don’t want to execute a stop order and end up selling a stock that you didn’t intend to sell or at a price you find unacceptable.
Stop‐limit order
You can protect yourself from any buying or selling surprises by placing a stop‐limit order. This type of order combines the features of both a stop order and a limit order. When your stop price is reached, the stop order becomes a limit order rather than a market order.
A stop‐limit order gives you the most control over the price at which you will trade your stock. You can avoid a purchase or sale of your stock at a price that differs significantly from what you intend. But you do risk the possibility that the stop‐limit order may never be executed, which can happen in fast‐moving markets where prices fluctuate wildly.
For example, you may find that deploying stop‐limit orders is particularly dangerous to your portfolio, especially when bad news breaks about a stock you’re holding and its price drops rapidly. Although you have a stop‐limit order in place, and the stop price is met, the movement in the market may happen so rapidly that the price limit you set is missed. In this case, the limit side of the order actually prevents the sale of the stock, and you risk riding it all the way down until you change your order. For example, say you purchased a stock at $8 near its peak. On the day the company’s CEO and CFO were fired, the stock dropped to $4.05. You may have had a stop‐limit order in place to sell at $5, but on the day of the firing, the price dropped so rapidly after the company announced the firing that your stop‐limit order could not be filled at your limit price.
Stop‐limit orders, like stop orders, are more commonly used when trading on an exchange than in an OTC market. Broker‐dealers likewise can limit the securities on which stop‐limit orders can be placed. If you want to use stop‐limit orders, be sure to review the rules with your broker before trying to execute them.
Good‐’til‐canceled order
You can avoid having to replace an order time and again by using a good‐’til‐canceled (GTC) order. GTC orders are placed at a limit or stop price and last until the order actually is executed or you decide to cancel it. A GTC order won’t be executed until the limit price is reached, regardless of how many days or weeks it takes.
You can choose to use this type of order whenever you want to set a limit price that differs significantly from the current market price. Many brokerage firms limit how much time a GTC order can remain in place, and most of them charge more for executing this type of order.
Other order types
Less commonly used order methods include contingent, all‐or‐none, and fill‐or‐kill orders. Contingent orders are placed on the contingency that another one of your stock holdings is sold before the order is placed. An all‐or‐none order specifies that all the shares of a stock be bought according to the terms indicated or that none of the stock should be purchased. A fill‐or‐kill order must be filled immediately upon placement or be killed.
Explaining the different types of markets