Trading For Dummies. Lita Epstein
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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 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.
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.
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.
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.
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