The Stock Market is a place where professional traders arrange cash-for-stock transactions between buyers and sellers. Other securities are sold in the Market, but stocks occupy the vast majority of listed securities—(securities are investment contracts worth money, of which stocks represent shares of ownership in companies).
Every transaction is called a Trade. Regular trades involve the buyer’s payment of cash for securities offered by the seller. Buyers and sellers propose trades to their brokers who then send the proposals (orders) to professional traders. Market rules require traders to fill orders at the next available price, either the highest Bid of a buyer or lowest Ask of a seller, depending on the type of trade. The general trend of prices among many trades is calculated as the Market Index. Investors should prepare trading orders carefully with awareness of the potential consequences.
The Stock Market is designed to set prices for securities at an agreeable price among competitive Bids and Asks –(the buyer’s price is called a Bid and the seller’s price is an Ask). The agreed price varies according to the prevailing action of trading orders in which Buy orders are filled at the lowest available Ask and Sell orders are filled at the highest available Bid. In a ‘seller’s market’, the buyers’ surplus demand for securities raises prices for the sellers. Examples include the rising prices in rallies and bull markets. In the ‘buyer’s market’, the sellers’ surplus supply of securities lowers prices for the buyers. Examples include the falling prices in corrections and bear markets.
The Market Index is a singular value which represents the prices of many securities traded in stock exchanges [see index methodology in the appendix]. Graphs of the market index display daily fluctuations (volatility), trends, and market cycles. The trend of a market index is useful in several ways:
- Analysis of supply-and-demand: An increased demand for shares drives prices upward and conversely, an increased supply of shares drives prices downward. The index follows the price trends.
- Benchmark: Investors like to know if the prices of their holdings are performing better or worse than the market index.
- Passive management: Index funds (e.g. ETFs) are investment portfolios designed to match the performance of an index.
Chart 1 displays the parallel behavior of 3 popular indices; they are broad market indices by virtue of describing the price volatility and trends of many stocks listed in the Market. Small fluctuations represent daily values reported at the close of the trading day. Large fluctuations display short and long cycles of market activity. A long market cycle consists of one “bull” and “bear” market in succession. Long bull markets create a general upward trend of market prices that endures several market cycles.
In contrast to the market index, which represents many stocks, the quote represents one stock. Quotes are widely published in the media and brokerage firms. A typical broker’s quote shows the last traded price, traded volume, and opposing prices (bid & ask).
Investors place a trading order by consulting their broker or employing the broker’s online trading platform. In a trading platform, the investor completes an order form with the following information:
- Ticker. The trading symbol of the desired security
- Action. Buy or Sell
- Volume. Quantity of units (shares) to be traded
- Type. Method for filling the order (Market versus conditional)
- Price. conditional or Market.
The basic types of orders are Market and conditional. Market orders are filled immediately at the next available price, but the investor is unable to specify the price. Conditional orders enable the investor to specify the price of a future trade within a period called the “time-in-force” (typically 60 days). Conditional trades are activated at the specified price and filled at the next available price.
Limit and Stop are two types of conditional orders available to most stock investors. A Limit is the preferred price for a Buy or Sell order. The Limit order is activated when a future market price matches the Limit price. The activated trade is then filled at the same price or a more favorable price; but, if the next available price becomes unfavorable due to price fluctuation, the Limit order is cancelled unfilled. A Stop is the specified price of a Sell order. The Stop order is activated at the specified price and then filled by a Market order. The seller has no control of the price after a Stop order is activated.
A Trading Story
Two fictional investors named ‘Green’ and ‘Red’ decided to place opposite trading orders for the same security on March 5th when the quoted price was $49. ‘Green’ thought the price would eventually drop and wanted to buy 100 shares for a bargain at the Limit of $45. The intended bargain was a $400 reduction of investment cost. ‘Red’, who owned 100 shares, thought the future price would drop for a loss. “Red’ wanted to prevent a deep loss by selling 100 share at the $45 Stop. ‘Red’ would be happy if the Stop order were never activated, but just in case prices declined, the loss of $400 could be tolerated. The outcomes are illustrated in Chart 2.
On March 9th, a market crash activated both orders at the moment trading was halted by a circuit breaker. When trading resumed, ‘Green’ bought 100 shares at the very favorable price of $41, even $4 cheaper than the intended $45 Limit. ‘Green’s’ bargain was $800 instead of $400. ‘Red’ sold 100 shares at the very unfavorable price of $41, $4 below the intended $45 Stop. ‘Red’s’ original market value of $4,900 dropped by $800 instead of $400 after the activated Market order filled at the next available price of $41.
–Lesson: Limit orders protect a preferred range of transaction prices. Market and Stop orders don’t protect the transaction price.
- Trading orders, Invsetopedia.com
- Supply and demand, Investopedia.com
- Stock quote, Investopedia.com
- DJIA index methodology, Investopedia.com.
- S&P 500 index methodology, Investopedia.com.
- Do ‘Circuit Breakers’ Calm Markets or Panic Them?: QuickTake. Nick Baker & Sam Mamudi. The Washington Post 3/19/20, WashingtonPost.com
Appendix: Index methodology
The stock Index is a special sum of weighted prices for many stocks, (w * Price) of many, listed in the stock market. The sum is divided by a special divisor, D.
Index = (w * Price) of many ÷ D
The stocks, their weighting factor (w), and the divisor (D) are proprietary definitions of the Index provider. Repeated calculations of the Index create a string of values that reveal the general volatility and trend of stock prices.
Copyright © 2020 Douglas R. Knight