Understanding Stock Markets and Trading

Posted on May 1, 2024 in Economy

Markets

A market is a place where people come together to buy and sell goods or services. In the context of finance, a stock market is specifically a platform where equity claims of companies are traded.

Stock Market Functions

  • Connects individuals and organizations with excess capital to those needing capital.
  • Facilitates the issuance and trading of equity claim instruments (stocks).

Types of Orders

  • Market Order: An order to buy or sell a stock immediately at the current market price. Execution is guaranteed, but the exact price may vary slightly.
  • Limit Order: An order to buy or sell a stock only if the market price reaches a specified price or better. The price is guaranteed, but execution is not.
  • Order Information: When placing an order, you need to specify the stock, number of shares, buy or sell direction, and either price or time.

Types of Investors

  • Retail Investors: Individual investors who typically hold less than 1,000 shares of a company’s stock. They represent about one-third of all listed corporate stock ownership in the US.
  • Institutional Investors: Large organizations such as mutual funds, pension funds, and insurance companies that invest on behalf of their clients. They hold about two-thirds of all listed corporate stock in the US and often trade in larger blocks.

Types of Stock Quotes

  • Bid: The price at which a dealer or individual is willing to buy the stock from you.
  • Ask: The price at which a dealer or individual is willing to sell the stock to you.
  • Bid-Ask Spread: The difference between the highest bid and the lowest ask price. Dealers profit from this spread.

Types of Markets

  • Major Markets: These are the primary exchanges where companies list their stocks and are governed by specific regulations. Examples include NASDAQ and the New York Stock Exchange (NYSE).
  • Other Markets: These markets facilitate trading of stocks but may not be the primary listing exchange. Examples include regional exchanges, electronic communication networks (ECNs), and dark pools.
  • Dealer vs. Auction Markets:
    • Dealer Market (NASDAQ): Most orders are filled by dealers who act as intermediaries between buyers and sellers. There is no physical trading floor, and transactions occur electronically.
    • Auction Market (NYSE): Buyers and sellers directly interact with each other through a central order book. The NYSE has a physical trading floor in New York City, but also allows electronic trading.
  • Dark Pools: Private exchanges where trading activity is not publicly displayed. They account for a significant portion of equity trading volume and offer anonymity to participants.

Markets in 2017

  • Multiple stock markets exist globally and compete for order flow.
  • Trading platforms are becoming more integrated and technologically advanced.
  • New trading mechanisms are emerging, moving away from traditional auction markets and dealers towards electronic order execution.

How are Stock Prices Determined?

  • Discounted Cash Flow Analysis: This method estimates a company’s intrinsic value by analyzing its expected future cash flows and discounting them to present value.
  • Information and Expectations: Stock prices are influenced by various factors, including company-specific news, economic conditions, and investor sentiment.

Types of Shareholders and Their Impact

  • Institutional vs. Individual Shareholders: The composition of a company’s shareholder base can affect its stock price volatility. Institutional investors, with their larger trading volumes, can contribute to increased volatility.
  • Turnover and Trading Frequency: Different types of shareholders have varying trading frequencies. High turnover rates, as seen with hedge funds, can lead to greater stock price fluctuations.
  • Short Sellers: Investors who borrow shares and sell them, hoping to buy them back at a lower price in the future. Short interest can put downward pressure on a company’s stock price.
  • High-Frequency Trading (HFT): Algorithmic trading strategies that use high-speed computers to exploit small price discrepancies in the market. HFT can contribute to increased liquidity but also raises concerns about market manipulation.