MARKET OVERVIEW



MARKET OVERVIEW

A large part of your success as a stock market trader will be based on the educational foundation that is laid for your trading. In this opening chapter you will learn what a stock market is, what an exchange is and who the major and minor exchanges are, what a “specialist” and “market maker” are, and how to follow the market by watching broad market indicators such as the DOW 30, S&P 500 and various indexes.

One of the first questions to address is, “Why are shares of stock traded?” The answer is really quite simple. As a company grows, there is need for vast amounts of new capital to expand the company or to acquire competitors. One of the ways to do this is to sell shares of stock in the company. Each share of stock that you own represents partial ownership in the company. The company is willing to relinquish that ownership in exchange for the cash generated for selling it. To facilitate the buying and selling of stock, stock exchanges were created. The value of those shares of stock traded on the exchange is based solely on “supply and demand” and the “supply and demand” is driven by a number of factors including; technicals, fundamentals and news. If the perceived value of a company is seen to be increasing due to market growth, good earnings or myriad other reasons; the price of that stock goes up in value based on the demand for the stock. The converse holds true if the stock is perceived to be performing poorly. If the company has poor earnings growth, has accounting problems or other news that reflects badly on the company there will be more supply than demand and the price of the stock will drop accordingly.

An exchange is a physical place or computerized system where the public can accomplish the open trading of stocks. Their operation is strictly regulated to ensure a safe and fair method of trading. All of the major economies of the world have exchanges where stock for their national companies and many foreign companies can be traded. The largest of these world exchanges are based in Japan, Singapore, Germany, France, England, Australia and the United States. The world’s largest and most liquid stock exchange is the New York Stock Exchange that was founded in New York City in 1792. These exchanges are businesses and are in direct competition with one another for the investor’s business; thus they are always striving to improve their position by developing new products and services to be more efficient in the execution of their trade. One of the more recent changes occurred in early 2006 when the New York Stock Exchange took over Archipelago to take part of the exchange’s operations electronic after 213 years of employing the open-outcry system of trading. In the latter part of 2006, the New York Stock Exchange expanded its reach into Europe by merging with Euronext. With this expansion the NYSE now has operations in Paris, Brussels, Amsterdam and London. There has also been talks of the NYSE buying the Deutsche Borse. If this were to occur it would create the largest exchange in history, thus taking a further step in its goal of providing worldwide trading on a 21 hour a day basis. In further expanding its role in the United States, the NYSE completed its acquisition of the AMEX in October of 2008.

Since our dealings are primarily with United States markets we will limit our discourse to the U.S. exchanges and how business is conducted on its various exchanges. There are four major exchanges in the United States for trading stocks.

The New York Stock Exchange or NYSE, is the oldest and most prestigious stock exchange in the United States with its history going back to shortly after the Revolutionary War in 1792. As originally established at that time, it was an auction system where buyers and sellers stood in opposite ends of the trading pit and shouted “bids” and “offers” back and forth at each other until a sale was agreed upon. This was the “open outcry” system of trading that we are all so familiar with as we watch trading on the NYSE on our televisions. Now, much of the trading on the NYSE takes place electronically but part still takes place in the pits with traders yelling back and forth to each other. Only now, instead of trades being recorded on pieces of paper, they carry computers on their hips that record the trades.

There are nearly 3,000 stocks represented on the NYSE, the majority of which are domestic companies and the remainder being foreign companies. Each stock on the exchange is assigned a ticker symbol that represents that stock on the exchange. Stocks on the NYSE have three letters or less in their ticker symbols and it is easy to identify stocks traded on this exchange in this manner. For instance, one of the largest financial institutions on the exchange is Citigroup whose ticker symbol is C. General Motors is represented by the ticker symbol GM and International Business Machines is denoted as IBM.

It is considered very prestigious to be listed on the NYSE and when a company meets its stringent listing requirements it lends a high degree of legitimacy to the value of the company’s stock.

The NYSE uses the “specialist” system to determine the pricing of stocks represented on the exchange. This person or company determines the “bid” and “ask” prices for each stock represented. This is a very powerful and lucrative position and more details of the “specialist’s” duties will be outlined later.

The NASDAQ, which stands for the National Association of Securities Dealers Automated Quote system, was established in 1971 in New York City. The NASDAQ is a 100% computerized trading system that transmits stock quotes directly to the computer monitors of market participants via the internet. This is a much more modern and efficient means for the execution of stock trades since it allows a trader to transact business directly by computer from anywhere in the world. Since its origin, the NASDAQ has grown to be one of the largest exchanges in the world representing over 3200 stocks. It has the reputation of being the exchange where the “action” is because a large percentage of the stocks it represents are in the technology field or in an emerging industry. Because it has the reputation of being the birthplace of companies with new technologies and bright futures there is a high degree of volatility related to many of the stocks traded on the exchange. The stocks traded on the NASDAQ attract a lot of attention and this results in more trading volume per day than any exchange in the world. For those traders who know how to capture that volatility it provides incredible opportunities to profit.

Not to be left behind by the NYSE, the NASDAQ is pursuing its own course of global expansion. It holds a large percentage of ownership in the Dubai Stock Exchange and operates eight European stock exchanges.

Stocks that are traded on the NASDAQ can easily be recognized by the four letters in their ticker symbol. For instance, the ticker symbol for Intel is INTC and that of Microsoft is MSFT.

Unlike the NYSE where one person or company called a “specialist” determines pricing of a stock, the NASDAQ uses the “market maker” system that has several individuals or companies that facilitate a fair and equitable market in a stock by establishing its bid and ask prices. With multiple “market makers” competing for your business, a stock’s pricing tends to be more fluid and in many ways more representative of its true perceived value. The role of the “market maker” will also be developed in more detail in a later chapter.

The last major exchange we are going to talk about is the Chicago Board of Options Exchange or CBOE. The CBOE was established in 1973 and was the world’s first listed options exchange. Options were originally devised as a means for “hedging” or protecting one’s stock portfolio but soon developed into a major trading strategy all their own. An “option” is a means of proxy investing that allows you to control a stock by having the right to buy or sell that stock at a pre-determined price instead of owning the stock itself. Since its inception, the CBOE has become the single largest options exchange in the world with nearly half of the listed options transactions taking place on it. The CBOE uses a combined system for placing orders. About 95% of its orders are transacted electronically with the remaining 5% being transacted via the open outcry system on the trading floor. These trades that take place on the floor are primarily large institutional trades where the institutions are looking for the expertise of the floor trader to get them a better deal.

A stock that has options quoted against it can have those options quoted on as many as six different exchanges. The fact that options on the same underlying security can now be listed on multiple exchanges has opened a whole new level of flexibility in option trading because it often happens that the options on a particular stock have different quotes on different exchanges. The power is that as an investor you can buy on one exchange and sell on another taking advantage of the best option pricing by looking at the ticker symbol of the exchange where the best prices are quoted and either buying or selling on that particular exchange. Many online trading platforms have made it even easier for a trader to now get the best pricing on options by automatically routing their trade to the exchange that posts the “best bid or ask” quote.

The last market that we will talk about is the Over-The-Counter market or as it is more commonly called, the OTC. There are literally tens of thousands of publicly traded stocks that do not meet the requirements necessary to be listed on one of the larger exchanges. These reasons could include the fact that they may not have the necessary number of available shares of stock or the stock may not be trading at a sufficient daily volume or price. Trading the OTC market is often considered highly speculative because the information regarding companies listed on the “pink sheets” is most often provided by the companies themselves. And as such, the information typically is only of a glowing nature. Few stock analysts follow these companies and many of the reports on the companies are generated by people best positioned to benefit by the reports that they make. A word of caution would be to “let the buyer beware”. You have to do your own in-depth research in order to find the pearls among the sand. The good news is that every so often one of these little companies becomes the star of the future and if you are fortunate enough to be in the trade early you stand to make incredible profits.

As indicated earlier, the different exchanges are closely regulated to assure the execution of “fair and equitable” trade. The government agency assigned this oversight duty is the Securities and Exchange Commission or SEC. It was created shortly after the market crash of 1929 that ushered in the “Great Depression” in the United States and was established to address the abuses in the market that took place at that time. This agency has broad and far-reaching powers to oversee current regulations, establish new ones and investigate any irregular business practices by an exchange, brokerage firm or company whose stock is traded on an exchange. Investor protection is paramount in the duties of this agency. With the abuses that occurred in the market in 2008, exemplified by the lack of oversight of Fannie May and Freddie Mac, with the collapse of the housing market and the resulting melt-down of Bear Stearns, Lehman Brothers and Merrill Lynch, there is some well placed concern that the agency is too “familiar” with the players on Wall Street to execute its duties in an unbiased fashion. There will undoubtedly be ongoing regulatory changes take place that extend the SEC’s oversight and most certainly will re-direct their operation.

Having discussed some of the markets where we can trade, it is now appropriate that we discuss some of the ways that we can assess market performance and some of the ways we can profit from that assessment. There are some “broad market indicators” that every serious investor or trader should be aware of. For the most part, money does not leave the market, it simply moves around within it. Sometimes the large-cap stocks will be outperforming the small and mid-cap stocks. Sometimes the oil companies will be showing incredible strength while the pharmaceuticals companies are dropping like rocks. The investor or trader who can recognize these trends will be well positioned to profit from this knowledge.

One of the first ways to assess the market is to look at it in relationship to market capitalization. “Market Capitalization” can be defined as a company’s size determined by multiplying its price per share times its number of shares. Doing this sorts most companies into one of four size categories.

Large-Cap Stocks are stocks with a market capitalization in excess of $5 billion dollars. Many of these companies are recognized as “blue chip” companies; companies that are financially sound, who have been in business for some time and have a proven track record, who are well diversified and have in-roads to world-wide markets. These companies are often considered safer investments because they are so well established and are less likely to go out of business in market downtrends. These are companies that lend themselves well to the buy and hold investor who seeks that level of safety, who is willing to accept the slow and sometimes predictable growth these companies display and is happy to collect the dividends most of them pay to their shareholders. A classic example of a true blue chip, large-cap company would be General Electric (GE). General Electric owns financial institutions, manufactures jet engines, has a large energy division, and builds many of the appliances we have in our homes and much, much more.

Mid-Cap Stocks are stocks with a market capitalization between $500 million and $5 billion dollars. Typically, companies that fall into this category are also mature companies that tend to be the leaders within a particular area of the market but lack the diversification of a large-cap company such as a GE. You would recognize many of the companies that fall into this category because they too are often “name brands” that you would readily recognize. Companies that fall into this category are companies like Pep Boys (PBY) and P. F. Chang’s (PFCB). Many mid-cap stocks also pay dividends to their shareholders.

Small-Cap Stocks are stocks with a market cap between $150 million and $500 million. These are sometimes the growth stock of the future and sometimes the next big “bust”. Many of the small caps can be characterized as new companies or companies in an emerging technology. Most of these companies are less expensive than the large and mid cap stocks and most do not provide the level of investment security provided by the larger companies. For the savvy investor however, they do provide the opportunity to realize tremendous profits by capturing the next rising star. Seldom do companies of this size pay dividends.

The last category is the Micro-Cap Stocks, stocks with less than $150 million market cap. These companies fall into the realm of highly speculative trading. Because of their size, they run the risk of running out of operating capital before they are “discovered” or they die of poor management. They rarely have the advantage of having any credible, unbiased information available on them so the investor has to do his homework extremely well before buying stock in companies of this size. Many small-cap companies are commonly called “penny stocks” or are traded Over The Counter and should be invested in as such; the hope of having your pennies become dollars and also the reality that your pennies can disappear.

Now that you understand what a company’s market cap is and the four major divisions of market capitalization, you will now be introduced to some indexes that will allow you to see which of these divisions is outperforming the others. Being able to do this can alert you to changes in market trends so that you can position yourself on the right side of the market.

An index is nothing more than a basket of stocks that can represent broad segments of the market such as the DOW 30, the S&P 500, the Russell 2000, the S&P Mid-Cap 400 or the NASDAQ Composite. An index can also be a basket of stocks that represent a specific industry or sector of the market. The Dow Jones Transportation Average is such an index.

The oldest and possibly most recognized index is the Dow Jones Industrial Average ($INDU). This index was originated by Charles Dow in 1884 when he would publish in a daily newsletter the average closing prices of 11 companies. Over the years more stocks were added until today, this index of 30 of the largest companies in the United States represents most of the market’s major industries. It has evolved into arguably the most recognized barometer of the strength of the US market. The components of the DOW have changed in recent years to reflect the growing influence of the technology sector in the marketplace with the addition of companies like Microsoft, Intel, Hewlett Packard and Verizon. Even though this index is composed of just 30 stocks it is what the US public and many people around the world have become accustomed to using to measure the strength or weakness of our domestic market and as an investor it merits your watchful consideration.

A possibly more accurate index of the health of the stock market is the Standard and Poor’s 500, more commonly called the S&P 500 ($SPX). This index is made up of 500 of the largest companies in the United States. It is considered by most to be a more true indication of the condition of the market because of the fact that it uses 500 companies to determine its average as opposed to the 30 used to determine that of the Dow 30. It is not uncommon for large price moves of just one stock to radically move the DOW. It is much more difficult for a large price move of just one stock to dramatically move the S&P 500. Even so, it is uncanny how closely the charts of the Dow 30 and S&P 500 resemble each other.

To follow the performance of mid-cap stocks one would watch the S&P Mid-Cap 400 Index ($MID). It is composed of primarily industrial companies and inclusion on this index is predicated upon the company’s fundamentals and its popularity as expressed by its daily trade volume.

The Russell 2000 Small-Cap Index measures the performance of 3000 of the most actively traded companies listed on the New York Stock Exchange and the NASDAQ. Your question is probably then, “Why is it not called the Russell 3000?” The answer is that to establish the index, they take out 1,000 of the largest companies to bring the number down to 2000. It is sometimes difficult to see the shift from large-cap to mid-cap stocks, but the movement of investment dollars from large-cap to small- cap stocks is much more evident. For a time in early 2000 when confidence in large-cap stocks was faltering it was evident that investment dollars continued to flow into the small-cap stocks for several months before confidence in these companies also waned. A savvy investor could have profited well with this knowledge.

The NASDAQ Composite Index ($COMPQ) is an index based on ALL the stocks that trade on the NASDAQ. This is a really broad-based index and as such; to keep the smaller companies from wielding an influence greater than their overall importance to the index, it has become a market-cap-weighted index. That is to say, a company such as Microsoft would be assigned a percentage weight much higher than a company the size of Flamel Technologies.

Indexes can also be determined by economic sectors. An economic sector being defined as a grouping of companies which provide the same product or service. Examples of this would be the pharmaceutical sector, the airline sectors, chemicals sector, the semiconductor sector, etc. Since companies within a given sector most often mirror each other’s price movement, by watching sector indexes one can often profit by early determination of when a particular sector is either coming into or going out of favor. Some of the more familiar sector indexes include some of the following:

Airlines $XAL

Banking $BIX

Biotechnology $BTK

Chemicals $CEX

Computers $BMX

Insurance $IUX

Internet $INX

Healthcare $HCX

Oil $XOI

Pharmaceutical $DRG

Retail $RLX

Semiconductors $SOX

Transportation $TRAN

Utilities $UTY

In a later part of the text we will explore how to trade sectors as a trading strategy when we learn about Exchange Traded Funds.

What has been shared in these few short pages is a lot to digest. But when you gain an understanding of where and how the market is traded and how you as an investor can keep your finger on the pulse of the market your chances of success will be greatly multiplied over the investor that trades blindly on the advice of his broker or on the latest hot tip provided by his brother-in-law. This foundational information will place you on a firm footing to building your investing program.

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