A Comprehensive Introduction to the World of Finance

Stocks

Everyone has a vague understanding of what stocks are. Whether you’re a plumber, a professor, or a Wall Street banker, stocks play a critical role in all our lives. A share of “stock” is an extremely small (really, really, small) claim to ownership of a company. Shares of stock have different classes, such as class A and class C shares. The difference between classes is typically voting rights (although rarely ever do people actually exercise their right to vote). Shares can be bought and sold through the use of a broker (companies that are licensed to trade securities such as Charles Schwab and TD Ameritrade). Companies have varying numbers of shares in circulation and the creation or reduction in shares outstanding are typically voted on by a board of directors and shareholders. You’ll hear terms such as stock-splits and reverse stock-splits, and they take place for various reasons. Stock-splits may take place if a company believes that their price-per-share (PPS) is too high and is discouraging retail investors from purchasing. A stock-split is when a company issues a predetermined number of shares in exchange for the currently outstanding shares. A common stock-split is two-for-one or three-for-one. If a stock-split occurs and you currently hold shares in your brokerage account, the number of shares you have will be multiplied based upon the size of the split. Obviously, if a stock-split occurs, the PPS will change accordingly. If a share of company A is trading at $1,000 and a two-for-one stock-split occurs, if you hold one share in your brokerage account, you will now have two shares that are trading at a price of $500. Contrarily, reverse stock-splits may take place if the PPS is too low; and in some cases, if the PPS is low enough, companies get a delisting notice and may be taken off an exchange. To combat delisting or being deemed a “penny-stock” (the consensus is that stocks with a PPS under $5 are “penny-stocks”) a company may utilize a reverse stock-split by the same principle as before. In a reverse stock-split, typically ten-for-one, sometimes less, sometimes more, companies will recall the shares in circulation and issue new shares at the predetermined ratio. If you hold shares of company A in your brokerage account, and company A is trading at $5 PPS, when company A has a ten-for-one reverse stock-split, the number of shares that you own will be divided by ten, and the PPS will immediately jump to $50 to reflect the split. Dividend yield or the ratio of dividend payments to the PPS typically remain the same after a split so that the move does not disadvantage shareholders (more to come on dividends).

Companies that are successful in turning a profit and building their cash piles often distribute payments known as dividends to shareholders. Dividends are typically paid quarterly and provide valuable streams of income for reinvestment or to pay the bills. For dividend-paying companies, payments are sent to shareholder’s brokerage accounts electronically and some brokers even offer automatic reinvestment plans. These cash flows are highly sought after and should be taken into consideration when building a well-rounded portfolio.

There is a common misconception that share price is correlated with the health, profitability, and financial stability of a company. This is wrong. Investors determine share prices. This is a bit of a tangent; however, I believe that the story will stick with you, and facilitate understanding share prices. In the 1600s, “Tulip Mania” occurred. Tulips became extraordinarily popular for their unique coloration. As a result, traders began bidding up the price for tulip bulbs, and prices soared. Contracts for tulip bulbs eventually reached a peak at which people were willing to trade, for example: two lasts of wheat, four lasts of rye, four fat oxen, twelve fat sheep, two hogsheads of wine, four tuns of beer, two tons of butter, half of a ton of cheese, a complete bed, a suit of clothes, and a silver drinking cup, all for one individual tulip bulb (Mackay). Of course, these prices were not sustainable, and when the sell-off began, crisis ensued. Prices tanked to prior levels, and people lost their life savings. The purpose of this history lesson is to show that the price of tulips, as well as the price of stocks, are driven by what others are willing to pay for them. “Tulip Mania” is one of the earliest examples of an asset bubble. Asset bubbles are very real, massive amounts of wealth do get wiped out, and asset bubbles will continue to plague the markets for the duration of time. To navigate the markets and avoid the potential pitfalls of bubbles, ratios relating to PPS can be invaluable.

Financial advisors and fund managers utilize ratios when considering how “pricey” an individual stock is. Common ratios include price-to-earnings, price-to-book, return on equity, and dividend yield. Price-to-earnings (P/E) for example, is calculated by dividing share price by the earnings per share. P/E ratios vary vastly among sectors, with tech and biotech companies typically having higher ratios and consumer goods typically falling on the lower end of the spectrum. As a rule of thumb, for a relatively risk-averse portfolio, companies with a P/E ratio over 20 should have their financial statements thoroughly combed before investing.

There are two types of trading strategy: fundamental and technical. Fundamental trading is exactly as it sounds—buying and selling stocks based upon what the fundamental outlook of a company appears to be. For example: if it’s the year 2005 and I believe that Google is going to become the most powerful search engine and generate billions of dollars in ad revenue, I am going to buy GOOG (the ticker symbol for Alphabet—the parent company of Google now). The second trading strategy is technical trading (explaining this in itself would be a thirty-page article so I am not going to go into depth). Technical trading is the utilization of stock chart patterns and an understanding of algorithmic trading, in an attempt to “time” the entry and exit of positions in a stock. Day-traders (individuals who make a career trading in and out of stocks multiple times in a single day) examine volatility in share price and execute trades based upon movements or “price-action.” Day-trading is extremely risky, as commissions (fees paid to brokers for executing trades) accrue quickly, and most day-traders trade on margin; though there are a select few of gifted individuals that experience long-term success doing so.

Warren Buffett, nicknamed the “Oracle of Omaha,” is a practitioner of fundamental investing and preaches that trying to “time the market” is not the recipe for success. In this case, Warren Buffett is wrong (yes, I said it). In the world of investing, understanding the psychology of the masses is the recipe for success. However, as of late, high frequency trading (HFT) and algorithmic trading have thrown a wrench into the works. When you understand what is going through the minds of retail investors (individuals who purchase securities for their personal account and not for an organization) and hedge-funders, the house no longer has the advantage.

Stocks belong to different indices, are traded on different markets, and different exchanges. Indices, such as the Dow Jones Industrial Average, the S&P 500, the Wilshire 5000, and the Russell 2000 to name a few, track the performance of a collection of companies that share some sort of characteristic. For example, the S&P 500 is an index that tracks the 500 most widely traded stocks in the US. The S&P alone represents about 80% of the value of stocks in the US. The Wilshire 5000 for example, also referred to as the “total market index,” is an index that tracks an extremely diverse range of companies from every sector. By tracking indices, understanding what sectors are hot and where the money is going, traders can find opportunity to profit, and investors can get a consensus of how individual sectors and the overall market is doing. With higher trading volumes, volatility typically increases, providing opportunity to profit from trading.

There are two different types of markets: the primary market and the secondary market. The primary market is where securities (another name for stocks) are created through initial public offerings (IPOs). IPOs are when a company wishes to become publicly traded, and with the use of issuing-companies, shares are priced and issued for trading (more on IPOs later). The secondary market is where individuals trade previously issued securities without involvement of the company itself. When people refer to the stock market, they are referring to the secondary market.

There are many different securities exchanges that vary in type as well as what companies trade on them. The most notable exchange in the world is in New York City; the New York Stock Exchange (NYSE), also known as the “Big Board,” was founded in 1792 by the Buttonwood Agreement. Companies that trade on the NYSE currently are GE, McDonalds, Walmart, Coca-Cola, and many others. Most trading takes place on the trading floor. The NYSE is classified as a listed exchange. Orders come in from brokers and are relayed to floor traders. Floor traders then go to a specific location on the trading floor and work with a specialist that specializes in connecting buyers with sellers. When a price is agreed upon by a buyer and seller, the order is executed, and the confirmation details are sent to the brokerage firm to relay to their client. The “bid” is the highest price that a buyer is willing to pay for the security; while the “ask” is the lowest price that a seller is willing to accept for the security (more on bids and asks later). Another type of exchange is virtual, most notably: the Nasdaq. In these types of exchanges, there is no trading floor. All trades are executed virtually through computers and a network of dealers. Before the tech boom in the 90s, most big companies were exclusively traded on the NYSE, while smaller companies traded on alternative exchanges. Today, Microsoft, Cisco, Dell, and plenty of other large-cap companies are traded on the Nasdaq (more to come on “caps”). The last notable exchange in the US is the American Stock Exchange (AMEX). The AMEX is alternative to the Nasdaq, although today most shares traded on the AMEX are from small-cap companies. Shares that are not listed on an exchange are trade “over-the-counter” on the over-the-counter bulletin board (OTCBB). The major exchanges are heavily regulated and have stringent requirements for companies to be listed with them. The OTCBB is where very small companies are traded, penny stocks. Penny stocks have received quite a bit of publicity after the release of one of my favorite movies of all time, “The Wolf of Wall Street.” Penny stocks are extremely risky as they have very little regulation and are heavily manipulated by pump-and-dump schemes. A pump-and-dump is when share prices surge, typically by heavy buying volume, and much like Tulip Mania, prices tank when profit taking occurs, leaving “bag-holders.” Bag-holders is slang for someone that is left “holding the bag” (ie. unrealized losses). Most countries around the world have multiple exchanges of their own, with notable exchanges in London and Hong Kong.

Brokerages on the Nasdaq act as “market-makers” and provide continuous bid and ask prices within a prescribed percentage spread in order to make a market. The “spread” is defined as the difference between the bid and ask price. Market-makers match up buyers and sellers, and maintain an inventory of shares to meet investor demand. When stocks have higher trading volume, they typically have very small spreads (usually one or two cents). Additionally, stocks with higher PPS typically have larger spreads.

The mechanization of stock trading after the tech boom has made trading easier with the use of online brokerage accounts. Clients can place orders, track their portfolios, research companies, and analyze financial statements without the need for phone calls and labor-intensive trade executions. Unfortunately, with the use of incredibly powerful algorithms and computers, stocks can be manipulated through high frequency trading. HFT is the purchase and sale of large volumes of shares over very short time horizons, executed automatically, using algorithms and large financial data. HFT is used to capture pennies, and intuitively if orders are large enough, very profitable. Some of the best performing hedge funds in the world utilize HFT. Regulation has stepped up in recent years, after cases of fraud, including spoofing, layering, and quote stuffing occurred. Spoofing is a type of disruptive algorithmic trading employed by traders to manipulate market optimism. Orders are placed with the intent of canceling prior to execution. These tactics led to the “flash crash” in 2010. On May 6, 2010 the US stock market experienced a trillion dollar crash beginning at 2:32 pm and lasting approximately 36 minutes. During that time, stock indexes such as the S&P 500, DJIA, and Nasdaq all fell and rebounded rapidly. The whole fiasco was perpetrated by a lone trader: Navinder Singh Sarao. Sarao used spoofing algorithms to place thousands of E-mini S&P 500 stock index futures contracts which were replaced or modified 19,000 times. To the public this appeared to be millions of dollars worth of bets that the market would fall. Five years after his crimes, Sarao was charged with 22 criminal counts of fraud and market manipulation. Sarao asserted in April 2015 that traders can still manipulate and impact markets despite regulators new and improved automated monitoring systems (believe me, they do).

Investors and hedge funds make decisions to purchase and sell stocks using a variety of methods. One such method is to calculate the intrinsic value of a security, and purchase if the current share price is below the intrinsic value, or sell shares if the share price is above the intrinsic value. The book value is essentially the intrinsic value. It is calculated by subtracting a companies’ intangible assets and liabilities from its assets. This value shows what shareholders would theoretically receive if the company were to be liquidated, and is used to determine if a company is overpriced or undervalued. As mentioned earlier in the Tulip Mania example, ratios such as P/E and price-to-book (P/B), are not indicative of the direction of share prices in the future. As I said, the recipe for success in the market is to understand the mindset of the market participants. If we have reason to believe that there are market participants that will be willing to pay a higher price for shares in the future, the time to buy is now. Contrarily if we have reason to believe that market participants will not be willing to pay current prices in the future, the time to sell or even short shares is now.

There are many types of orders that can be placed regarding stocks. Market, limit, stop-loss, and trailing stop-loss are a few. Market orders are entered and essentially give the broker the authority to buy or sell shares at the prevailing market price (the current ask for buying and the current bid for selling). Limit orders are placed and convey to the broker that you would like to buy shares if the price is at or below a specific level, or to sell shares if the price is at or above a specific level. Stop-loss orders are used to protect investors by instructing the broker to sell shares at the prevailing market price if prices fall a specified percentage. Trailing stop-loss orders are a great way to “let your winners run.” A trailing stop-loss is the same as a standard stop-loss, however, if share prices increase, the stop-loss moves up with the share price. For example: a trailing stop-loss is entered at half of a percent, if at any point the price falls by half of a percent, then the shares are sold at the market prevailing price. This allows investors to lock in profits if share prices are going up, and protect profits if prices begin to fall.

Bonds

Bonds are debt financial instruments in which the purchaser is a creditor to the issuer. Companies and governments issue bonds to finance projects and activities. The purchaser of a bond essentially loans money to the issuer for an agreed fixed or variable rate of interest. They are referred to as “fixed-income securities” and can be used to manage the level of risk in a portfolio. The “face value” of a bond is the price at which the creditor will be paid upon maturity. A bond reaches maturity at a predetermined point in time. The issue price is the price at which the issuer originally issues the bonds. The market price of a bond is the price at which the bond is traded either on an exchange or over-the-counter. There are quite a few factors that go into determining the market price. The credit quality of the issuer, time to maturity, and the coupon rate are all factors to take into consideration.

Much like how credit scores gives banks insight into individual’s credit-worthiness, issuers of bonds have ratings. Credit rating agencies calculate and issue a rating on bonds. These ratings span from AAA to DDD, with AAA being the highest rating and DDD signifying default. Ratings vary slightly among rating agencies; however, they are generally very similar. Ratings are tied to the market price because of risk. Bonds with higher credit ratings are more secure, therefore they will have a lower interest rate (determined by subtracting market price from face value and dividing by the market price). Contrarily, bonds with very poor credit ratings inherently have higher risk associated with them (bankruptcy or insolvency) and should provide a higher rate of return. Bonds are classified by their credit rating, with BBB or better being considered “investment grade” and BB and below being considered “junk bonds.” Investing in junk bonds can be rewarding with higher rates of return, however, as the name suggests, they can be a gamble and add considerable risk to a portfolio.

There are three main categories of bonds: corporate bonds, municipal bonds, and treasury notes known as “treasuries.” Companies issue corporate bonds. Municipalities and states can issue municipal bonds which can offer tax-free coupon income for residents of those municipalities. Finally, the US treasury issues treasuries in the form of bonds that have longer times to maturity (10 years or greater), notes that have medium time horizons (1-10 years), and bills that have shorter times to maturity (less than one year).

There are a few varieties of bonds: coupon, zero-coupon, convertible, and callable. Coupon bonds pay income to the creditor in the form of coupon payments prior to maturity. Zero-coupon bonds, also known as “bullet bonds,” do not pay any income and simply trade at a discount until the face value is paid upon maturity. Convertible bonds have an embedded call option (more on options later) and can be converted into shares of stock if the share prices rise and prove to be an attractive conversion. Callable bonds are relatively rare in today’s markets and allow the issuer to call the bonds back from debtholders (those who purchased the bonds) if interest rates fall significantly. There are also “premium” bonds which trade above their par value (face value). Bonds trade in this manner if the coupon rate is higher than prevailing interest rates. Prices are bid up because investors want higher yield and are willing to pay “premium” for them.

Commodities

Commodities such as coffee, cocoa, crude oil, orange juice, natural gas, and precious metals are all traded in spot (real-time) and futures (options) markets. Most commodity trading takes place in futures markets. Commodities trading is typically highly leveraged, as they trade in large contracts. For this reason, most retail investors do not have the funds to trade them. Contracts are traded at the CME group in the US. The CME group was created when the Chicago Mercantile Exchange and the Chicago Board of Trade merged in 2006.

There are four categories that commodities fall under: energy, metals, livestock and meat, and agricultural. Energy includes crude oil, heating oil, natural gas, and gasoline. Metals includes gold, silver, platinum, and copper. Livestock and meat consists of lean hogs, pork bellies, live cattle, and feeder cattle. Finally, agriculture consists of coffee, cocoa, cotton, corn, soybeans, wheat, rice, and sugar. The trading of commodities is driven by basic economic principles, lower supply equates to higher prices. Cold weather can drive natural gas and heating oil prices, as consumers of these commodities are using more of the goods to heat their homes and workplaces. Investment in infrastructure abroad may drive the price of metals up. High temperatures or low rainfall can kill crop yields and drive the price of agricultural commodities up. If the economy looks as though it’s going to take a plunge, precious metals become a profitable holding.

Different commodities have different stipulations. For instance, soybean contracts represent 5,000 bushels of soybeans. The contract states deliverable grades in the instance that the purchaser wants the physical commodity. Price quotes are specified such as cents per bushel, or per barrel. Tick sizes are stated as well as daily price fluctuation limits. Commodities trade on margin, and the margin is determined by market volatility as well as the face value of the contract. The face value of the contract is calculated by multiplying the market price of one unit of the commodity by the size of the contract. For instance, if soybeans are hypothetically trading at $14 per bushel, and a contract in soybeans is 5,000 bushels, the face value one contract would be $70,000.

Futures

Futures are financial contracts that obligate buyers and sellers to buy or sell an asset at a predetermined date in the future as well as a price. They are considered one of the oldest financial derivatives, which means that they derive their value from a move in the price of the underlying asset. The contracts are standardized for trade on a futures exchange, and detail the quality and quantity of the underlying asset. In some instances, futures contracts may call for the physical delivery of the underlying asset, others are settled in cash. Futures are used to hedge or speculate on the underlying asset. The underlying asset of a futures contract can vary widely, from interest rates and foreign exchange to commodities and equity indices. Contract sizes vary as well and can be very expensive. For example, a euro FOREX contract denotes that the contract size is 125,000 euros. In order for retail investors to comfortably trade futures, the exchanges have created E-mini contracts that are typically a fifth of the size of a standard contract.

Profits and losses are calculated daily on futures contracts. At the end of the day, the exchange calculates the value to be deducted from one parties account and credited to the other party. Since futures are highly leveraged and offer high risk/ high reward, risk management is critical in the trading of futures. With settlements taking place daily, in a leveraged position, a margin call can happen relatively quickly. Limiting exposure or reducing the size of your bets is good risk management practice. An E-mini S&P 500 futures contract for example is one fifth of the size of a standard S&P 500 futures contract. These E-mini contracts provide a means for less exposure than the standard contract.

In the example of an E-mini S&P 500 contract, the contract states that each unit is $50 multiplied by the size of the daily movement of the S&P 500 index. The contract also states the months that the contract is traded, settlement methods and procedures, position limits, and when trading is terminated. The exchange sets forth a maintenance account balance for entering a specific contract. In the case of the E-mini S&P 500 contract, the daily account maintenance is $5,000.

Hedging with futures is a popular strategy for companies. For example, a large commercial agriculture group might want to lock in a price for the corn that they will deliver in the future. If the price of corn goes down, the agriculture group is a winner because they have already locked in a higher price. However, if the price of corn were to rise, the group would be losing because they’re obligated to sell their corn at a lower price. This example is why options are arguably the best method for hedging.

Options

Options are an extremely versatile financial instrument. They allow investors to adapt their positions to account for any situation that may arise. The two basic options are call and puts. Call options give the holder the right, but not the obligation, to purchase the underlying asset at a certain price and time. The purchaser of a call option is bullish on the underlying asset (they believe the price of the underlying will rise). Put options give the holder the right, but not the obligation, to sell the underlying asset at a certain price and time. The purchaser of a put option is bearish on the underlying asset (they believe the price of the underlying will fall). Unlike futures contracts, those who purchase calls or puts are not obligated to do anything at any point in the future, they can simply sell their options or let them expire. Options are listed on exchanges like stocks, however, the price of an option is determined by a plethora of factors. The price of the underlying asset, the strike price, time remaining until expiration, and volatility of the underlying asset all factor into the premium (total cost of an option). The price of an option can be calculated with all of the aforementioned inputs with the help of a model known as Black Scholes. The model was developed by Fisher Black, Rob Merton, and Myron Scholes in 1973 and is still widely used today.

There are two types of options as well: American and European. European options are rather clean-cut, these options can only be exercised at the end of their life. American options are a bit more complex. These options can be exercised at any point in time, prior to expiration. American options tend to trade at a higher premium than Europeans because they offer a lot more flexibility.

The seller of an option, be it a call or a put, is known as the writer. The writer collects the premium when they write the option. Similar to futures contracts, the writer of an option is obligated to fulfill their promise to either buy or sell the underlying asset, should the strike price be reached. The strike price is the price at which the underlying asset must reach in order for the option to be exercised. Call options are said to be “in the money” if the price of the underlying asset is above the strike price. Put options are in the money if the price of the underlying is below the strike price. For calls, if the strike price is above the current price the option is said to be “out of the money.” For puts, if the strike is below the current price, the option is out of the money.

Options are useful instruments for hedging, as they can essentially be used as insurance. If an individual has a large stake in a company, say for instance the CEO who receives shares of stock as compensation, it is in the CEO’s best interest for his shares to be protected, should the share prices fall. To protect from a decline in share price, the CEO might hedge his position by purchasing puts. For options in which the underlying asset is stocks, one contract entitles the holder to the purchase or sale of one hundred shares of stock. In order to offset the cost of buying enough puts to hedge his position, the CEO in this instance might opt to write a call option with a higher strike price and apply the premium he receives toward the purchase of puts. The ownership of the underlying asset and purchase of enough puts to cover those holdings is known as a married put strategy. There are many different options strategies that exist, too numerous to discuss in this article, however I will cover some of the basics.

A bull call spread is the purchase of a call and the simultaneous writing of a higher strike call. A bear put spread is the purchase of a put while simultaneously writing a put with a lower strike. These two strategies are known as vertical spreads. If investors expect extreme volatility such as during earnings season, they might purchase a straddle. A straddle is the purchase of a call and put with the same strike price. If the opposite is the case, and investors expect the underlying asset to remain stagnate, they may write a straddle and collect the premiums. Other strategies include the butterfly spread, covered call, zero-cost collar, and many others.

Regulation

All the aforementioned investments change hands millions of times a day. With billions of transactions a year in the United States, regulatory groups certainly have their work cut out for them. The Securities and Exchange Commission (SEC) is tasked with regulating securities trading at the federal level. Futures and some derivatives regulation is handled by the Commodity Futures Trading Commission (CFTC). The SEC has a commitment to protect investors, maintain fair and orderly markets, and to facilitate capital formation. They do so by investigating possible violations of the securities laws, require companies to file quarterly and semi-annual reports, and mandate company executives provide a narrative known as “management discussion and analysis” (MD&A). Quarterly earnings reports are critical for investors to see what sort of progress company management is making. The MD&A provides an analysis of company performance over the course of the year as well as transparency for company goals and standings relative to their competition. These regulations have been invaluable at protecting investor interests and keeping the markets fair and as best as possible, void of corruption and fraud. If you would like to learn more, the SEC has plenty of information available to the public online as well as company filings and executive transactions.

This concludes my segment. If you learned something (which would have been hard not to), great. If you have any commentary, I’d love to hear back. Thanks


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