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The Stock Market (session 1)
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
2
Risk
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Stock exchanges and how stocks are traded
4
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