Stock Market Prices

April 1, 2020

SUMMARY:

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.

Competitive prices

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.  

Market Index

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.
market indices, 5y

Chart 1.  The ‘Dow’ represents stock prices of 30 large companies traded in the New York Stock Exchange and Nasdaq market.  The ‘S&P 500’ represents market capitalizations of 500 large companies traded in U.S. exchanges (market capitalization is the sum of prices for all shares of a given stock).  The ‘Nasdaq’ is calculated from market capitalizations of all companies listed in the Nasdaq market.

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.

Trading Orders

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:

  1. Ticker.  The trading symbol of the desired security
  2. Action.  Buy or Sell
  3. Volume.  Quantity of units (shares) to be traded
  4. Type.  Method for filling the order (Market versus conditional)
  5. 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.

trading orders

Chart 2: The Fate of 2 Conditional Orders.  Red and Green symbols represent respective Stop and Limit orders made on March 5th.  The dashed line indicates that both orders remained-in-force until activated and filled on March 9th.  An overnight crash of prices halted trading at the start of the March 9th trading day.

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.

References

  1. Trading orders, Invsetopedia.com
  2. Supply and demand, Investopedia.com
  3. Stock quote, Investopedia.com
  4. DJIA index methodology, Investopedia.com. 
  5. S&P 500 index methodology, Investopedia.com.
  6. 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


Lessons from ”Black Monday”

September 19, 2015

August 24, 2015: Stock prices in China’s Shanghai Exchange had the biggest one-day fall of nearly -9% since 2007, earning that event the title of “Black Monday”. Exchanges around the world followed suit. Next day, the Shanghai crashed below -15% (ref 1,2). Stunned investors worried about sliding into a bear market, then into a recession. Crashes, bear markets, and recessions produce losses of investment earnings. What are they and how do they occur?

Cycles

The stock market is one component of the larger economy. Both systems expand and contract in cycles governed by the net influence of buying and selling in diverse markets. Stock market cycles are gaged by real-time and historical stock prices. The real-time prices fluctuate according to traders’ demands for shares at any moment in time. The historical prices are chosen from four real-time prices: the Open and Close are the first and last prices of the trading day”; the High and Low are maximum and minimum prices of the day; and, the adj Close is an adjustment of the Close to account for a cumulative effect of stock splits and dividends.

Stock prices are compiled into market indices.  A market index measures the collective value of prices from a given group of stocks. The index Close changes from day to day, but when successive Closes are strung together over a period of weeks to months they form an observable trend called a market cycle. In chart 1, the market cycles of two indices are plotted over 25 years. Both plots show that the collective value of stock prices expanded in three “Bull markets” (1990-2000, 2003-2007, and 2009-2015) and contracted in two “Bear markets” (2000-2003 and 2007-2009). Orange circles identify recent trends and events leading up to the writing of this post on September 11, 2015.

chart 1

chart 1

Long market cycles

A long market cycle is comprised of a bull market and bear market (ref 3).
Bull market– a period of rising prices, by 20% for at least 2 months
Bear market– a period of falling prices, by -20% for at least 2 months

Short market cycles and brief events

Short cycles and brief events are tremendously exciting interruptions of the long market cycle. They represent an extraordinary change in market behavior caused by flows of investment capital or responses to influential news.

The short market cycle is either a rally or correction. Both are brief changes in the Close that interrupt a bull or bear market.
rally– an increase in stock prices due to a burst of buying that subsides when the money is spent.
correction– a 10% price decline (ref 3).

Spikes and crashes are brief events . Both are characterized by a large, sudden shift of the index value from its previous Close.
Spike– a large upward or downward price movement (ref 3)
Crash– a 10% decline in market value lasting 1-2 days (ref 4)
Crashes are precipitated by the sellout of inflated stock prices. Chart 2 shows both a correction and a crash of the NASDAQ Composite Index during the six-month period leading into September 11, 2015. Blue squares depict the daily Close of the NASDAQ. There was a 4-week correction of –13.5% (solid black line) from July 17th to August 25th. The 12% crash (dashed red line) occurred between the Close of August 21st and the Low of August 24th (the market was closed on 2 intervening days). August 24th was “Black Monday”.

chart 2

chart 2

Circuit breakers

Circuit breakers are automatic pauses in trading that enable market participants to evaluate their trading orders in a rapidly changing environment. SEC Rule 80B defines the following halt provisions and circuit-breaker levels that impose a pause on trading (ref 5):
• the S&P 500 is the benchmark index for measuring a market decline below the prior day’s closing price
• 7%, 13%, and 20% market-decline percentages initiate trading pauses of 15 min, 15 min, and rest of the trading day.

Business cycles

Business Cycles are broad fluctuations of business activity that affect the entire economy. The total value of business production is measured by the gross domestic product (GDP). The Real GDP is “the value of the goods and services produced by the nation’s economy less the value of the goods and services used up in production, adjusted for price changes” (ref 6). The main components of GDP are personal spending, investment (e.g., the stock market), net exports, and government spending (ref 3). Swings of the GDP are produced by the net buying and selling within these business categories. An upswing signifies economic expansion and a downswing signifies economic recession. Expansion is the default mode of the economy that typically outlasts a recession and ends when overproduction leads to general economic decline. Recession (ref 3) is the decline in economic activity lasting about 6-18 months. Interest rates usually fall during a recession and stimulate the next expansion by easing the cost of borrowing money. In technical terms, a recession is 2 consecutive quarters of decline in the GDP (Chart 3).

chart 3

chart 3

While a recession occurs with every business cycle, depressions happen very infrequently. A depression is an extreme fall in economic activity lasting for a number of years. In a depression, consumer confidence and investments decrease as the economy collapses (ref 3).

Economic Recovery is the period of increasing business activity signaling the end of a recession (ref 3). Similar to a recession, an economic recovery may be unrecognizable for the first several months. The stock market may be a leading indicator of economic recovery because stocks are priced on the basis of future expectations. Unemployment often remains high in early recovery until employers determine the long-term need for hiring.

Conclusion

Market sentiment is “the overall attitude of investors toward a particular security or larger financial market” (ref 3). Investors become optimistic (“bullish”) during a bull market and pessimistic (“bearish”) during a bear market. Optimism encourages stock purchases and pessimism stimulates stock sales. Crashes generate panic and a rush to sell stocks in the declining market.

Opportunistic investors incur an upside risk and downside risk when timing the market cycle for profitable trades. The upside risk is a gain in profit by selling shares at a high price and buying them at a low price at the appropriate time. But don’t bet on it, especially not with big bets. Successful timing requires a big dose of good luck and crashes are always unpredictable. Conditional trading orders may be helpful in timing the market if a limit price is included in the order; otherwise, any unexpected market event could trigger an undesired order. The best upside risk in a bear market or economic recession is taken by buying good stocks of financially stable companies at low prices.

The famous downside risks of a recession are speculative buying and frustrated selling. Speculators, beware of the falling share prices of high-risk stocks. The worst possible outcome is to suffer a steep capital loss by repeatedly purchasing shares until the recession drives an unstable company into bankruptcy (I know from personal experience). Some frustrated investors suffer a steep loss by selling out a good stock at bottom prices, only to miss the eventual recovery of their investment earnings after the recession.

Copyright © 2014 Douglas R. Knight

References

1. Financial markets. The Great Fall of China. The Economist, page 11, Aug 29th 2015 |
2. Briefing, China and the world economy. Taking a tumble. The Economist. Pages 19-22, Aug 29th 2015.
3. Investopedia Dictionary. www . Investopedia . com / terms. © 2015, Investopedia, LLC.
4. Kimberly Amadeo. Stock Market Crash. What Not to Do in a Stock Market Crash. © 2015 About.com. http://useconomy.about.com/od/glossary/g/Market_Crash.htm
5. SECURITIES AND EXCHANGE COMMISSION. (Release No. 34-68784; File No. SR-NYSE-2013-10), January 31, 2013. https://www.sec.gov/rules/sro/nyse/2013/34-68784.pdf
6. U.S. Department of Commerce. Bureau of Economic Analysis. Gross Domestic Product. http://www.bea.gov/


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