What is a Stock Market?
A stock market is a secondary market where shares of listed companies trade. It can be a formal exchange, such as the NYSE or Toronto Stock Market, or an Over-The-Counter Exchange, like the NASDAQ.
Why Stock Markets Exist
Raising Capital
In free-market economies, stock markets (or stock exchanges) are a key component of how corporations access capital to expand their enterprises.
Citizen Participation in the Economy
Stock markets also function as a platform for the public to participate in the economic policies and opportunities that exist in a nation. This is known as a democratization of capital.
How a Stock Market Works
Bid-Ask
On a Stock Exchange, listed companies (companies that meet the Minimum Listing Requirements and are current on their fees and filed financial statements) and funds, such as Closed End Funds or Exchange Traded Funds, trade on an auction basis. This means a would-be purchaser would post his maximum purchase price and number of shares desired (his bid), and a would-be seller would post the minimum selling price and number of shares he is wanting to sell (the ask). The difference between the bid and ask price is the bid-ask spread and is an indicator of liquidity. When the bid and ask price become equivalent a trade is made and those shares change hands at what is the new market equilibrium price. For liquid stocks, this process is repeated throughout the trading day.
Stock Market Trends
Economic Variables
Over time, stock markets tend to appreciate in countries with sound economic policies; however, over shorter periods they can trend up or down based on a number of variables such as, economic outlook, political outlook, monetary policy, fiscal policy, earnings growth and interest rate direction, to name a few.
Bull Market
A market that is trending upwards and is up 20% or more from the low is referred to as a bull market. A market that is up but by less than 20% would be referred to, unofficially, as a bear market correction, until it verifies itself as a bull market by advancing 20% or more.
Bear Market
A market that is trending downwards and is down 20% or more from the low is referred to as a bear market. A market that is down but by less than 20% would be referred to, unofficially, as a bull market correction, until it verifies itself as a bull market by advancing 20% or more.
Dow Theory
Dow Theory is one of the oldest attempts to analyse stock market behavior. The theory breaks stock market behavior into three trends, 1) primary trend 2) intermediate or secondary trend 3) minor trend.
Primary
The Primary trend is the long term, often referred to as the secular trend and is the most important trend as it determines the direction.
Secondary
The Secondary trend is the intermediate trend direction, a cyclical trend. A correction with in an ongoing bull market (secular trend) would be a counter trend movement. The secondary and primary trend are not always aligned, but during a big market move, up or down, they will be aligned.
Minor
The Minor trend is the day to day movement and the least important of the three. The biggest moves will happen when all three trends are aligned.
Global Stock Market Capitalization
Stock markets play an important role in free market economies, and because of this, the market capitalization of the largest markets mirrors the ranking of those nations with the largest Gross Domestic Product. There are 16 exchanges (as of 2016) with market capitalizations greater than $1 Trillion US Dollars.
Largest Global Stock Markets
1) New York Stock Exchange
2) NASDAQ
3) London Stock Exchange
4) Japanese Stock Exchange
5) Shanghai Stock Exchange
6) Hong Kong Stock Exchange
7) EuroNext
8) Shenzhen Stock Exchange
9) Toronto Stock Exchange
10) Deutsche Stock Exchange
11) Bombay Stock Exchange
12) National Stock Exchange of India
13) Swiss Stock Exchange
14) Australian Stock Exchange
15) Korea Stock Exchange
16) OMX Nordic Exchange
Canada is approximately the 10th largest economy in the world, and has the 9th largest stock market. From the list above, some nations have more than one exchange listed, as many developing nations have not consolidated exchanges within their borders and represent the trend of money being invested in emerging economies.
Canadian Stock Markets
There are three Canadian stock markets, sometimes called Canadian markets, all owned by the TMX Group:
1) Toronto Stock Exchange – for mature, large corporations and headquartered in Toronto.
2) TSXVenture Exchange – for early stage corporations and headquartered in Calgary.
3) Montreal Options Exchange – for listed options and corporations headquartered in Montreal.
Stock Market Options
Stock options, sometimes referred to as stock market options, are a derivative financial instrument. They are referred to as derivatives because they derive their value from an underlying investment instrument. There are several different kinds, outlined below.
Call Option
A call option, or call, is the right (but not the obligation) to buy a stock at a certain price for a certain period of time. An in the money call option has the strike price (the price the owner of a call has the right to buy at) at less than the current market price. An out of the money (OTM) call option is one where the call price is above the current market price. An investor would buy an out of the money call option with the expectation that the price would rise above the strike price. A call option represents buying 100 shares of the underlying stock. The investor pays a premium to gain control, or leverage, over the shares. The premium is the maximum loss.
Put Option
A put option, or put, is the right (but not the obligation) to sell a stock at a certain price for a certain period of time. An in the money put option has the strike price (the price the owner of a put has the right to sell at) above the current market price. An out of the money put option is one where the put price is below the current market price. An investor would buy an out of the money put option with the expectation that the price would decline below the strike price. A put option represents buying 100 shares of the underlying stock. The investor pays a premium to gain control, or leverage, over the shares. The premium is the maximum loss.
Writing or Selling Options
The examples outlined above represent buying options. Writing or selling options has a different risk profile and should be discussed with a financial advisor before attempting.
Reasons for Buying Calls and Puts
The reasons an investor would purchase a stock option, call or put, is to hedge a stock position, as an entry or exit strategy or to speculate on the market.
· To Hedge a Portfolio
An investor who does not want to sell a portfolio of stocks can hedge his or her portfolio by purchasing put options below the market. If the market were to decline and the value of stocks contract with it, the value of the put position would increase and help minimize the loss.
· An Entry or Exit Strategy
Selling a call option on a stock position currently owned allows an investor to create an exit strategy while receiving the income from the selling of the call. Selling a put would be the reverse strategy, where an investor gets paid from the put premium to establish a potential entry price on a stock an investor wants to own.
Please note: When an investor sells a call option and it is exercised, you must sell the stock at that price. If the call option was naked, the investor is required to buy the stock in the open market and this would entail a loss. When an investor sells a put and it is exercised, the seller of the put must buy the stock. Sellers of options create obligations.
· To Speculate
Investors who want to speculate on a rising or falling market with little money down can buy and sell calls or puts. This allows an investor or trader to acquire large potential portfolios with little money risked (the premium).
Stock Market Strategies
There are numerous specific strategies investors use to attempt to make money in the stock market; too many to list. However, all stock market strategies can be broken down based on the amount of time a market participant holds an investment. Essentially, there are five types of market participants:
1) High Frequency Traders (HFT)
2) Day Traders
3) Swing Traders
4) Buy and Hold Investors
5) Special situation, hedgers, and arbitrageurs
High Frequency Traders
These are very short term traders; often measured in milliseconds. These traders use sophisticated algorithms to profit off the small difference in the bid-ask spread repeatedly over the day. It is a controversial style of trading, but tends to offer liquidity.
Day Trader
A day trader is a market operator that opens and closes positions intraday and attempts to profit on daily moves in the market.
Swing Trader
A swing trader has a slightly longer timeframe than a day trader, measuring in the days to weeks. A swing trader attempts to profit from trending movements in the market with the goal of riding the trend until completion.
Buy and Hold Investor
These investors are long term investors and are not concerned with the day to day movements of markets. They rely on buying quality assets below their market value and holding them until that value is realized.
Special Situation, Hedgers, Arbitrageurs
Theses stock market participants use specific strategies to exploit situations they are mandated to attempt to exploit, mergers and acquisitions or market anomalies.
Stock Market Advice
Stock market tips or advice can come from a multitude of areas, from business partners, family members, newsletters, websites, blogs, as well as investment professionals. Even with the greater dissemination of information, traditional advisors are still an important part of acquiring accurate investment advice. Due diligence on who is providing you with stock market advice is as important as the advice you receive.
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