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


Stop losing value from a declining price

March 4, 2017

background

The market value of your stock equals your principal (i.e., the amount you invested) plus any profit or loss from price fluctuation. The market price that moves below what you paid to purchase the stock will produce a loss of principal if you sell the investment. Here are several risk factors that may drive stock prices downward:

  1. Company performance. ‘Good’ companies attract investors. Conversely, ‘distressed’ companies repel investors.
  2. Industry performance. Business cycles can affect the sales of products from an entire industry. For example, sales of new automobiles declined during the Recession of 2008.
  3. Market cycles. Aside from business performance, the entire stock market is subject to periods of declining prices due to massive selloffs by investors.

The risk of an extreme loss can be prevented by setting a stop-loss price (“stop”) to sell part or all of your shares.

ways of setting the stop

The systematic way is quite simple. If the market value is below your invested principal, then select an absolute loss or a fraction of the principal. Examples:

  1. Absolute loss. Suppose you invest $5,000 in 100 shares of stock (i.e., $50/share) and you can tolerate a loss of $1,000 should the price start to fall. Regardless of future prices, you choose to stop the decline at $1,000 below the original $5,000 value. In this example, the stop would be $40/share [stop = (value – loss)/shares = ($5,000 – $1,000)/100].
  2. Fraction of value. Suppose you can tolerate a 10% loss from an investment originally valued at $5,000 for 100 shares.  Ten percent is one-tenth of 100, which is equivalent to a decimal number of 0.10. The stop would be $45/share [stop = (1.00 – decimal)*value/shares = (1.00 – 0.10)*$5,000/100].

The technical way is based on the stock’s historical prices. If you want to minimize the chance of a sale, set the stop at the lowest price from the past 5-10 years. Beware that setting the stop at a historical low may incur a steep loss. Other ways involve the more complicated analyses of trendlines, moving-average lines, or price statistics.

Another way is to adjust the price gap (gap = market price – stop) to the growth of capital gains. As the market price increases over time, choose a narrow gap to protect the capital gain or a wide gap to reduce the chance of a trade. Generally speaking, widening the price gap will reduce the chance of a trade at the risk of incurring a bigger loss.

add a limit price (“limit”) for extra protection

A brokerage firm will enforce your stop order for 30-90 days depending on the firm’s trading platform. The firm’s computer activates the order when the latest market price reaches the stop. The order is then filled at the next available price. In a chaotic market, the price could plunge below your stop to an exceptionally low value at the next available trade, resulting in a bigger loss than you planned. You might be able to prevent this result by setting a limit slightly below the stop. The trading order would be filled somewhere within the stop-limit price zone unless the transaction is cancelled, unfilled, when the next available price dips below the limit. The limit helps protect the extent of your loss.

who should worry about an extreme loss?

Nobody’s immune, but long-time investors have the least concern. Investment strategies such as dollar-cost-averaging and automatic-dividend-reinvestment plans will help protect against damages from periodic bear markets. Short- and intermediate-time investors are at greater risk for incurring an extreme loss from market down-cycles. For example, families who are saving to pay college fees or to buy a home risk big losses from a bear market.

conclusion

Stop orders are used to set the price for buying or selling exchange-traded products such as stocks, ETFs, and REITs. This article discussed the use of a stop-limit order to sell a stock in a declining market. Brokerage firms may restrict the duration of stop-limit orders to 30-90 days after which the order is cancelled without a transaction until you renew the order. Periodic renewals allow you to reconsider your strategy in light of the prevailing price trend. In a downtrend, simply renew the order. In an uptrend, you may wish to protect a growing profit by resetting the stop-limit order to higher prices. Click on this link to skimming a profit for another perspective on protecting a growing profit.

Copyright © 2017 Douglas R. Knight


#Bracket orders

January 28, 2014

[updated the bracket order calculator on 6/25/2014.  Updated the text on 7/18/2014]

The bracket order is a trading order to buy a stock or other exchange-traded security while also placing an advanced order to sell the entire purchase at a future profit or loss.  The profit and loss exits are the brackets.  Some brokerage firms offer the bracket order to individual investors (1).  I use it to limit the loss that I might incur any time after buying the stock for a long position.  The bracket order has 4 elements: 1) Entry share price for buying the stock from the market. 2) Quantity of shares to buy. 3) Profit exit share price for selling the stock at a capital gain. 4) Stop loss exit share price for selling the stock at a limited capital loss.  Click on this link to the bracket order calculator worksheet to follow the discussion or plan your automated trade.

Taking the long position

Taking the ‘long position’ means to purchase a stock with the idea of selling it at a higher price.  But if the price falls, you suffer a loss in proportion to the size of the investment.   You can manage the risk of a loss by deciding how much money to sacrifice and using the bracket order to limit your loss.  Some investors typically plan to lose between 1% and 3% of their capital in a single trade.

Bracket order’s prices

LongPositions

The chart shows price movements for two imaginary stocks during a recent time period.  The wavy black lines are series of historical stock prices that end at the latest price on the right hand side.  Assuming that prices will continue to behave in the same way, the future prices will fluctuate between the levels of support (red dashed line) and resistance (green dashed line) until a substantial event dictates a change.  The support is the price ‘floor’ and the resistance is the price ‘ceiling’.   In between are the opportunities for profit and loss.  The ideal situation is to buy any stock near its support level and then sell near its resistance level, repeating the process over many trades to accumulate wealth.  The bracket order helps plan for these outcomes.

Suppose the latest price is suitable for investment.  Then plan to purchase the stock at approximately the latest price by placing either a market order to trade immediately at the current price or a limit order to trade at a specified or better price. Your desired purchase price is called the entry (yellow circle on the chart).   Your bail-out price is called the stop loss exit (red square), an automated order to sell the stock at a planned loss.  Your price for earning a profit is the profit exit (green square), an automated order to sell the stock for a capital gain.

Bracket order’s quantity

The final step is to calculate the quantity of shares to purchase.  The quantity is constrained to the planned loss on a per-share basis.

  • “Planned loss” is the amount of money you are willing to lose from a trade in the event of a market downturn
  • (loss/share) = entry – stop loss exit
  • quantity = planned loss / (loss/share)

The planned loss is typically less than the principal amount spent to purchase the shares (principal = entry x quantity).  You may choose to reduce the quantity in order to lower the principal.

Comments

CAUTION:  There’s no guarantee that the stop loss exit can prevent losing more than the planned loss when market prices are exceptionally volatile.  Prices typically move in small increments except in rare instances when they might plunge below the stop loss exit by several points to create a deep loss.  That’s why the SEC recently enacted “circuit breaker” rules to stop trading for any stock whose price changes sharply within a five-minute period (3).

RECOMMENDATION:  The future prices of any stock are uncertain.  Put more effort into determining the stop loss exit than in determining the profit exit by using historical prices to select a safe level of support (red square in the chart).  The profit exit reflects how quickly you want to sell for a gain; it’s better to think high and wait longer unless you’re a bonafide day trader.   Expect a longer holding period for the higher profit exit. If your brokerage firm’s trading platform allows changes, you can update the bracket order to protect gains and reduce losses as the prices rise with time.

Consider using the bracket order calculator to plan your automated trade.  If the program inspires your investing to support the betterment of society, consider making a tax-deductible contribution to your favorite charity or my favorite charity.

References

1.       Jean Folger. The pros and cons of automated trading systems.  Investopedia.com, August 24, 2011.  © 2014, Investopedia US, A Division of IAC.

2.       Investor Bulletin: New Measures to Address Market Volatility, SEC.gov, 4/9/2013.


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