1. The Stock Market
“Only buy something that you'd be perfectly happy
to hold if the market shuts down for 10 years”.
Warren Buffett
2. Agenda
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Key Success Factors
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Risk
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Stock exchanges and how stocks are traded
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Players
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Order Process
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Mutual Funds, Index Funds and Afterhours Trading
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Alternatives to Stock
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Why Trade Stocks?
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NYSE Tour (video)
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Key Success Factors Investors must develop
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
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Key Success Factors Investors must develop
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
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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
• 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
• 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
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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 nonfinancial 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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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
REWARD
futures contract
technology stock
stock mutual fund
bond
cash equivalent
RISK
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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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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