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


Language of the Stock Market

February 29, 2020

Summary: New investors might find it helpful to understand the basic language of the Stock Market.  In this article I discuss the basic vocabulary as it relates to practical ideas for personal investing.  Links are provided for further reading about a particular topic.

Investment returns

An investment is the payment of capital to earn a return.  The return is a gain (or loss) of value in the investment.  Taxes on returns are regulated by the Internal Revenue Service (I.R.S.) and local governments.   

  • Principal: the amount of money invested.
  • Capital: the cash or goods used to generate income.
  • Capital gain (or loss): the increase (or decrease) in cash value of an asset.
  • Dividend: a company’s cash payment to its stockowners.   
  • Interest: the borrower’s cash payment to the lender that is added to the principal of the  loan.

Investment portfolio

Financial assets are potential sources of income for investors.  Asset classes are groupings of assets that earn income in uniquely different ways.  The most popular asset classes are Equities and Fixed Income Securities.  Equities earn income by the sale of a security (e.g., shares of a Stock).  Fixed Income Securities earn guaranteed interest (e.g., bonds) or guaranteed dividends (e.g., preferred stocks).  Securities and investors are regulated by the Securities & Exchange Commission (S.E.C.). 

  • Securities: contracts that require an investment of money to generate profits from the efforts of other people. 
  • Stock: a security that represents part ownership of a company.  
  • Common stock: a security that entitles its owner to vote on important issues, collect dividends, and earn capital gains from the stock market.   
  • Preferred stock: a security that entitles its owner to receive dividends before dividends are paid to owners of the company’s common stock.  Preferred stockowners have no voting rights.    
  • Bond: the debt that requires a company to return an investor’s principal, plus interest, by the date of maturity.    

A Portfolio is the investor’s collection of financial assets called holdings.  By comparison, an Investment Fund is a portfolio of financial securities which are professionally managed on behalf of the fund’s investors.  Famous examples are mutual funds and exchange-traded funds (ETFs).  An actively managed portfolio generally seeks to earn higher returns than one which is passively managed.  The passively managed portfolio seeks to duplicate the returns of a market index.  

Glossary:

  • Market index: a hypothetical portfolio designed to measure the value of a market or market segment. 
  • ETF: an Investment Fund that sells shares of the fund in the stock market.  Index ETFs are passively managed. 

Stock market

A new stock is issued in its primary market.  The primary market is a private assembly of the company’s founders, venture capitalists, and third parties such as banks and advisors.  The stock may later be sold by public auction in the secondary market.  The secondary market is the familiar stock market where millions of investors, —like us!—,  trade cash for stocks and other exchange-traded securities (e.g., ETFs). 

Trading orders

The stock market participants include Investors who make offers, Brokers who generate orders, and Traders who finalize orders.  The broker’s trading platform is a computer program that assists investors with placing trading orders.  The platform provides a market “quote” comprised of the current purchasing price (the “bid”), sales price (the “ask”), last-traded price, and latest number of traded shares (the “volume”).   On any day there may be millions of orders to buy and sell in the stock market.  Orders are filled at the market price determined by an auction of shares conducted by the broker’s trader.  Brokers and traders often charge a fee for their services.  Custodians are hired by brokers to store traded securities in electronic accounts on behalf of investors.   

The simplest trading order, a MARKET ORDER, specifies the number of shares to be traded.  Market orders are filled immediately provided the shares are available; otherwise, the order remains open until shares are available.  Conditional limit- and stop orders are stored in computers until activated or expired at the end of a period called the time-in-force.  The LIMIT ORDER requires an investor to specify a preferred price for the trade.  Limit orders are activated when the market price reaches the preferred price and then filled at the preferred price or a better price. Please be aware that a sudden market event could displace the market price outside the limit range of an activated order, in which case the limit order is cancelled unfilled. The STOP ORDER is activated at a specified price after which it is converted to a market order to be filled immediately regardless of the next available price. 

Stock market index

Analysts like to follow the price trend of stocks by graphing a representative number called the stock market index.  The index rises and falls at any moment according to fluctuations in share prices during stock market transactions.  An influential sales surge moves prices downward and a buying surge generally sends prices upward.

Daily index values are strung together to form an observable trend called the market cycle.  The long market cycle is comprised of a “bull” market followed by a “bear” market.  The short market cycle is either a rally or a correction. Spikes and crashes are brief events caused by a sudden, large change of the index (chart 1).  

  • Bull market: a 20% rise of the market index over 2 months or more.
  • Bear market: a 20% fall of the market index over 2 months or more.  
  • Rally: a rise of the market index due to a burst of buying that subsides after the money is spent.
  • Correction: a 10% decline of the market index over 2-10 days.
  • Spike: a sudden large upward or downward price movement.
  • Crash: a sudden correction that lasts 1-2 days.
  • Circuit breakers: programmed halts of trading designed to offset a downward plunge of stock prices.  

Chart 1. Long and short cycles of the Dow Jones Industrial Average (“DOW”).

market cycles, DJIA

In chart 1, the vertical scale shows values of the DOW Index during a 20 year time period shown by the horizontal scale.  The jagged line represents daily fluctuations of market prices. Green, red, and black symbols illustrate the timing of various market cycles and events.  The horizontal line of green and red segments portrays 4 long cycles of the DOW Index.  After the partial 1st cycle (Jan 2000-Jul. 2001), the complete 2nd (Oct. 2001-Aug. 2002) and 3rd cycles (Sep. 2002-Mar. 2009) show orderly sequences of bull and bear markets.  The nearly complete 4th cycle began with a very long bull market of eleven years (Mar. 2009- Jan. 2020) that recently reverted to a bear market at the time of this writing.  Chart 1 also shows short cycles of rallies (green triangles) and corrections (red triangles).  A few market crashes (black triangles) in Nov. 2008 and Mar. 2020 represent 1-2 day periods of a 10% drop in the Index.  Rapid declines of the Index by 7% in one day triggered temporary halts of trading (black circles) known as “circuit breakers”.

Diversification

Stocks are high risk investments with respect to potential capital gains (upside risk) and losses (downside risk).  Capital loss occurs when the company declares bankruptcy or its share prices decline.  Stock diversification, dollar cost averaging, and dividend reinvestment plans (DRIPs) are effective strategies for managing the common risks of stocks.  Monthly purchases of a Stock-index Fund accomplish these strategies.  Chart 2 illustrates the potential capital gains from investing in a Stock-index Fund that duplicates a broad market index such as the S&P 500.

Chart 2.  Historical prices of the S&P 500 Index.

dividend reinvestment

Assuming that the Fund matches the performance of the S&P 500 Indexthe difference between holding the original investment in the Fund without further action (red graph) and augmenting the holding with reinvested shares (blue graph) illustrates the potential benefit of a dividend reinvestment plan.  In this example, the benefit became ‘significant’ after 6 years.       

Postscript

Stock investing is a time-consuming process that might not interest many people who wish to put their money in the market.  They can save time (and money) by investing in a Stock-index Fund that provides an instant portfolio of diversified stocks for long term investment.

Stocks are one of several investable asset classes.  People with short term goals should consider diversifying their portfolio with different asset classes.

Copyright © 2020 Douglas R. Knight 


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