Stock Market Basics
AAA is the highest credit rating given to bonds by bond rating agencies. Moody’s, Standard & Poor’s, and Fitch are rating agencies that give a grade to bonds, indicating their credit quality.
AAA bonds are thought to have no risk of default. Bond credit rating assesses the credit worthiness of a debt issue by either a corporation or the government. The lowest class is CC for Standard & Poor’s and Ca for Moody’s.
Above the Market
Above the market is a type of order to buy or sell a security at a price higher than the current market price. Examples of above the market orders include a limit order to sell, a stop order to buy, or a stop-limit to buy. Traders can place a stop order to buy a security at a price above its resistance level. If the security’s price breaks through the resistance level, there might be a rally that the trader does not want to miss out on.
American Stock Exchange
The American Stock exchange is the third largest stock exchange by trading volume in the U.S., handling about 10% of all securities traded. The other two major exchanges are NYSE and NASDAQ. The exchange is known to be liberal and have the least strict listing requirements among the top three American exchanges. Most of the trading on the NYSE is in small-capitalization stocks, exchange-traded funds (ETFs), and derivatives.
After-hours trading refers to stock trading outside the regular hours of major stock exchanges such as the New York Stock Exchange and the NASDAQ Stock Market. Regular hours are 9:30 a.m. to 4:00 p.m. Eastern Time. Some corporations release their earnings reports after the market closes so after-hours trading allows investors to react quickly to news. However, the after-hours market typically is much more volatile and less liquid than trading during regular hours, and therefore is riskier.
Bear is a term that is associated with investors who have a pessimistic outlook on the stock market and thinks the market will decline. A bear fights with its paw, striking downwards.
If you are bearish on a stock, you will attempt to profit from a decline in the security by going short on it. Bears are the opposite of the market’s bulls, who have an optimistic outlook and think the market will rise.
A bear market means a declining stock market and the trend is down. It is characterized by pessimism that prices will continue to fall. Unless an investor is a short seller, it is hard to make stellar profits in a bear market. This is the opposite of a bull market, where investors are optimistic and the trend is up.
Below the Market
Below the market is a type of order to buy or sell a security at a price lower than the current market price. Examples of below the market orders include a limit order to buy, a stop order to sell, or a stop-limit order to sell. Traders can place a stop order to sell a security at a price below its current market price to limit losses on long positions. The transaction to sell will execute if the price of the security declines to that particular point.
Beta is the relationship between an investment’s return and the market’s return. It is the measure of market risk, or the investment’s nondiversifiable risk. It is this risk that matters for investors who have diversified their portfolio – the risk that cannot be eliminated.
The market has a beta of 1. If a stock has a beta of greater than 1, the stock is more volatile than the market. Likewise, if the stock has a beta less than 1, the stock is less volatile than the market.
A blue chip company is a well established and financially sound company. Their stock sells at a high price and is usually less volatile due to its long record of steady earnings. These companies are known to have weathered downturns and operate profitably during adverse economic times.
The name “blue chip” originated from the game of poker, where the blue-colored chips have the highest value.
Bonds, also known as fixed income investments or debt securities, are a type of debt in which an investor loans money to an entity, such as a corporate. A bond is like an “IOU” from the issuer (borrower) to the bondholder (lender), promising to pay the lender a predetermined and fixed amount of interest each year. The principal is paid at the bond’s maturity date. Unlike stocks, bonds are not only issued by corporations, but also by the federal government, state government, and municipal government.
The book value is the value of an asset as shown on a firm’s balance sheet. It is also referred to as the net worth of the company and can be calculated by subtracting the accumulated depreciation from the total cost of an asset. This is the value of the company’s assets that the company’s investors would receive if the company liquidated.
By comparing the book value to a company’s market value, an investor can determine whether a stock is underpriced or overpriced.
Bull is a term that is associated with investors who have an optimistic outlook on the stock market and thinks the market will rise. When a bull attacks, he has a tendency to lower his horns and strike upwards. If you are bullish on a stock, you will attempt to profit from a rise in the security by going long on it (buying the security). Bulls are the opposite of the market’s bears, who have a pessimistic outlook and think the market will decline.
A bull market means a rising stock market and the trend is up. It is characterized by optimism and investor confidence that prices will continue to rise. This is the opposite of a bear market, where investors are pessimistic and the trend is down. Typically, the duration of a bull market is longer than that of a bear market.
A call option gives its owner the right, but not the obligation, to purchase a given number of an asset at a specified price over a given time period. This is the opposite of a put option, which gives the owner the right to sell shares.
You buy call options if you expect the price of the underlying stock to rise before the option expires. If the stock price rises, you can make a profit because you bought the stock for less and now you can sell it for more if you exercise the option. If the stock price does not rise, you can let the option expire.
A commission is a service fee paid to the brokerage firm for facilitating a transaction, such as the buying or selling of securities. It is what investors pay to enter and exit a trade. Commissions vary from brokerage to brokerage. Full-service brokerages offer personalized investment advice so their commissions are higher. Discount brokerages offer no advice and thus have lower commissions.
Owning common stocks represent ownership in a corporation. In the event of a company bankruptcy, common stockholders are on the bottom of the priority ladder to receive the company’s assets. They will not receive their money until after bondholders, and preferred stockholders have been paid in full. This makes common stock riskier than bonds or preferred stocks. However, common stock often receives a higher return than bonds and preferred stocks in the long run.
A currency swap is an arrangement in which parties exchange debt obligations in different currencies. Unlike an interest rate swap, in a currency swap, interest payments on the cash flows and the principal are both exchanged in full. Many times, a currency swap involves the exchange of a fixed interest rate for a floating exchange rate. At the swap’s maturity, the principal amounts are exchanged back.
Unlike bank loans, currency swaps are not usually disclosed on the company’s balance sheet.
Derivatives refer to a general class of investments, rather than a specific type of investment like stocks or bonds. Derivatives are securities whose price is dependent upon or derived from one or more underlying assets. They are generally used as an instrument to hedge risk or for speculative purposes. Investing in derivatives is more complex and riskier than investing in stocks or bonds.
The most common types of derivatives are futures contracts, forward contracts, options and swaps.
A discount bond is a bond that is selling below its par value. An important relationship is that as the maturity date of a bond draws near, the market value of a bond approaches its par value. Thus, the discount bond will rise in price as maturity approaches.
If you are comfortable with making your own investment decisions, you should get a discount broker. Discount brokerages charge lower fees than full-service brokerages because they do not offer the many services that full-service brokerages do. Examples of such brokers include Charles Schwab, Fidelity Brokerage Services and TD Waterhouse. For those investors who have the knowledge and experience, getting a discount broker is an ideal arrangement because the fees are lower. In fact, you really only need someone to execute your transactions. These salespeople are paid by salary, not commissions.
Dow Jones Industrial Average (DJIA)
The Dow Jones Industrial Average is a stock market index invented by Charles Dow in 1896. It is the oldest and most watched index. The Dow measures the performance of 30 large companies traded on the NYSE and NASDAQ. It is now largely owned by the CME Group. When we say “the market is up today,” we generally refer to the Dow.
Efficient Market Hypothesis
This theory states that it is impossible to beat the market because whatever information is available about a stock to one investor is available to everyone. According to this theory, the price of a security should reflect all available information and since everyone has the same information about a stock, no investor can outperform the market. There would be no way he/she would know something that isn’t already reflected in the stock’s price.
This hypothesis states that stocks always trade at their fair value, making it impossible for investors to make profit by purchasing undervalued stocks or sell stocks at inflated prices.
Exchange Traded Fund (ETF)
Exchange-traded funds (ETF) are investment companies that are legally classified as open-ended companies. Most ETFs seek to achieve the same return as a particular market index. Advantages of owning an ETF include the diversification of an index fund and lower expense ratios than those of an average mutual fund. One type of EFT is known as Spiders or SPDRS, which invests in all of the stocks contained in the S&P 500 Composite Stock Price Index.
Full-service brokers, such as Merrill Lynch, provide a variety of services such as offering research reports, investment advice, and retirement planning. They offer more products than discount brokers and are more expensive. If you rather pay someone else to do your research and answer your questions, then you might want to pay the extra money for a full-service broker.
Fundamental analysis is the study of economic and financial forces that cause the prices of securities to move higher, lower, or stay the same. This method of valuation includes examining financial statements, such as a company’s balance sheet and income statement. It uses revenues, earnings, return on equity and other data to determine the value of a company. This method can be used to figure out if the security is underpriced or overpriced. One of the most famous fundamental analysts is Warren Buffett.
Fundamental analysis is different from technical analysis, which studies market action and past charts.
A futures contract is a contract to buy or sell a stated commodity (such as soybeans) or a financial instrument (such as a U.S. Treasury bond) at a predetermined price at some future, specified time. They are used to lock in future prices of raw materials, interest rates, or exchange rates, and thereby eliminate one source of risk.
Unlike an options contract where the buyer has the right but not the obligation to exercise the option, a futures contract is binding on both the buyer and the seller.
The Glass-Steagall Act was passed by Congress during the Great Depression in 1933 and prohibited commercial banks from engaging in investment banking activities. Commercial banks were no longer able to underwrite securities and investment banks could not participate in the business of receiving deposits.
Gramm-Leach-Bliley Act of 1999
The Gramm-Leach-Bliley Act made significant changes to the Glass-Steagall Act that was passed by Congress during the Great Depression in 1933. This act repealed the Glass-Steagall Act’s restriction on the separation between investment banks and commercial banks. It allowed banking institutions to provide underwriting and insurance-related services.
Hedging is a risk management method where an investment is made to reduce losses from adverse price movements, such as fluctuations in the price of an asset. This can be done by taking an offsetting position in a related security. Investors hedge when they are unsure about market conditions.
An index fund is a type of mutual fund with a portfolio that tries to mimic the performance of a particular market index, such as the S&P 500. It typically tries to invest in the same securities as a selected index.
An index fund is usually passively managed, unlike a mutual fund which is actively managed. This is because portfolio decisions are usually automatic. They have lower operating expenses than actively managed funds because of their infrequent transactions. Index funds usually outperform a majority of mutual funds.
Institutional Buyout (IBO)
An institutional buyout (IBO) is when an institutional investor, such as a private equity firm or a venture capitalist firm acquires a majority stake in a company. Institutional buyouts are the opposite of management buyouts (MBO), where a business’s current management acquires a large part of the company.
Junk bonds are rated BBB or below by credit rating agencies, such as Moody’s and Standard & Poor’s. They are high-risk debt and have a high chance of default. Junk bonds are also called high-yield bonds for their high interest rates. They typically have an interest rate of between 3 to 5 percent more than AAA grade bonds.
To leverage is to use debt to finance a company’s assets. A highly leveraged firm has considerably more debt than equity. This makes the company more prone to risk, because in the event that the company cannot pay off their debt, it might go bankrupt. Leveraging can also be used to increase the shareholders’ return on investment. In these ways, leverage can help both the investor and the firm.
Leverage magnifies both gains and losses.
Leveraged Buyout (LBO)
A leveraged buyout (LBO) is the acquisition of another company where a substantial percentage of the purchase price is financed through leverage, or borrowed funds. The assets of the acquired company are typically used as collateral to secure the debt, along with the assets of the acquiring company. The purpose of an LBO is to allow firms to make large acquisitions without having to commit a lot of capital. One of the largest LBO is the acquisition of RJR Nabisco by private equity firm, Kohlberg Kravis Roberts & Co. (KKR) in 1989.
Management Buyout (MBO)
A management buyout (MBO) is when a business’s current management acquires a large part of the company. In many cases, the management may purchase all the outstanding shares and then take the company private because they feel they have the expertise to grow the business better if they take full ownership. This is the opposite of an institutional buyout (IBO), where an institutional investor such as a private equity firm acquires a controlling interest in a company.
Market capitalization, or market cap for short, is one of the many ways to value a company where its value is determined by the market. It is calculated by multiplying the current market price of a company’s shares by the number of stocks outstanding. For example, if company ABC’s stock is selling for $20 per share and there are 1,000 shares issued by the company, then the market cap for the company ABC is $20,000. Since the stock price varies daily, the market cap for a company also varies from day to day.
A mutual fund is a type of investment that pools money from many individual investors. It is professionally managed by a mutual fund manager, who buys and sells the fund’s investments that are in accordance with the fund’s investment objectives. Think of the fund as a collection of diversified stocks and/or bonds.
Mutual funds invest in a wide range of securities, such as stocks, bonds and money market securities. This diversification helps reduce risk for the investors.
Nominal Interest Rate
The nominal interest rate is the stated rate of interest on the contract. Unlike the real interest rate, the nominal interest rate is unadjusted for inflation.
Nominal Interest Rate = Real Interest Rate + Inflation Rate
An option contract gives its owner the right, not the obligation, to buy or sell a specified number of shares of a stock at a fixed price within a specific time frame. There are only two types of options: puts and calls.
The options market is often referred to as a zero-sum game. This means that in order for someone to make money, someone must lose money. If all the profits and losses were added up, the total for all options would equal zero.
Penny stocks tend to look attractive because they trade at a relatively low price. However, because they are cheap, they are generally considered to be very risky due to their lack of liquidity and large bid-ask spreads. Many penny stocks trade over the counter.
Preferred stocks, also called hybrid investment, pays a regular dividend that is not directly fixed to the market, like the common stock. That means that if the company grows, you would receive the same amount of dividends. In the event of a company bankruptcy, preferred stockholders have a right to the company’s assets before common stockholders, but only after bondholders.
Preferred stockholders usually do not have voting rights. They can only vote on certain issues such as if the company wants to merge, liquidate assets, or issue more bonds or preferred stocks. There are 4 types of preferred stocks: cumulative preferred, non-cumulative preferred, participating preferred, and convertible preferred.
The primary market is where investors buy new securities directly from the issuing company. The cash proceeds go to that underlying entity, which then uses it to fund or expand their business. Primary markets are facilitated by underwriting groups that determine a begin inning selling price for a given security. After the initial sale is finished, securities are traded between investors on the secondary market.
A put option gives its owner the right, but not the obligation, to sell a given number of an asset at a specified price over a given time period. A put purchaser bets that the price of the underlying asset will drop. This is the opposite of a call option, which gives the owner the right to buy shares.
You buy put options if you expect the price of the underlying stock to decline before the option expires. If the stock price declines, you can make a profit if you exercise the option because you have the right to sell the stock at a higher price. Put options are similar to having a short position on a stock.
Quantitative easing is a form of monetary policy used by central banks to increase the money supply in an economy when interest rates are near 0%. This is done through open market operations by purchasing financial assets, such as government bonds and corporate bonds.
Quantitative easing may eventually lead to higher inflation. Economies that have attempted this policy include Japan in the early 2000s, and the United States and United Kingdom during the global financial crisis of 2008-2009.
Random Walk Theory
The random walk theory states that price movements do not follow any patterns and that past price movements cannot be used to predict its future movements. Therefore, it is impossible to predict where the market will move at any point. This is the idea that stocks take an unpredictable path and is consistent with the efficient market hypothesis. Supporters of this theory also do not believe that fundamental analysis or technical analysis have any validity.
Real Interest Rate
Unlike the nominal interest rate, the real interest rate is adjusted for inflation. This represents the actual purchasing power to the investor. For example, if you are earning 5% interest in your savings account but inflation is 3%, then your real interest rate, or real value of your savings, is only 2%.
Real Interest Rate = Nominal Interest Rate – Inflation Rate.
Reverse Stock Split
A reverse stock split has the opposite effect of a normal split. This company action decreases the number of shares outstanding and increases its stock price but the total market capitalization, or the total market value of the shares, remains the same. A reverse stock split is not usually looked upon favorably by many investors, partially because the shares of current investors will decrease, causing them to feel like they have less ownership in the company. A company may also do a reverse stock split to avoid being delisted from the exchange on which it trades.
A secondary market is where investors buy previously issued securities from other investors, rather than from the issuing company directly. The cash proceeds from these transactions go to investors instead of the issuing companies themselves. A newly issued IPO is an example of a primary market trade where the shares are purchased by investors directly from the investment bank. After that, all trades are conducted between investors and traded on the secondary market.
The national exchanges, such as the New York Stock Exchange and the NASDAQ are secondary markets.
Slippage is the difference between the price at which you place your order, or the expected price, and the price the trade actually executes at. Slippage often occurs during higher volatility and when market orders are used. To reduce slippage, you can use limit orders, buying and selling only at a specified price. However, limit orders may only be filled at your price or not at all.
Stocks are equity investments. Owning shares of this security indicate ownership in the corporation and a claim on part of the corporation’s assets and earnings. There are two main types of stocks: common and preferred. In the event of a company bankruptcy, preferred stockholders have a higher priority to its assets than common stockholders.
A stop-limit order is an order to buy or sell a stock that combines the features of a stop order and a limit order. This combination gives the trader greater precision in controlling the price at which the order can be executed. Once the given stop price is reached, a stop-limit order will be executed and become a limit order to buy or sell at a specified price (or better).
A stop order, also referred to as a stop-loss order, is an order to buy or sell a stock once its price reaches a specified price, known as the stop price. If the stop price is reached, the stop order becomes a market order. Many traders use a stop order if they are unable to monitor their portfolio for an extended period of time or cannot control their emotional decision-making.
A sell stop order is an order entered below the current market price and will be executed if the price of the security falls to that level. Traders generally use a sell stop order to limit losses or protect profits on a stock that they own.
A buy stop order is an order entered above the current market price and will be executed if the price of the security reaches to that level. Traders generally use a buy stop order to limit losses or to protect a profit on a stock that they have sold short.
A stock split is an action companies decide to do to split their existing shares into multiple shares. A stock split would increase the number of stocks outstanding and decrease its stock price but the total market capitalization, or the total market value of the shares, remains the same. If Company XYZ has decided on a 3-for-1 split, it means that the number of outstanding shares would triple and that each stockholder receives an additional 2 shares for each share that he/she already holds. This is the opposite of a reverse stock split.
A tender offer is an offer to purchase some a portion or all of the shareholders’ shares, usually at a premium over the current market price. Under the Securities Exchange Act of 1934, any individual or corporation acquiring over 5% of a company needs to disclose relevant information.
A yield curve shows the relationship between bond yields and maturity dates. A normal yield curve shows a positive slope that trend upward as the maturity of a bond increases. The reasoning behind this is because bonds with longer maturities are considered riskier and thus, have higher yields. This indicates that interest rates for long-term debt securities are higher than short-term debt securities. There is also an inverted and flat yield curve.
These bonds are issued at a large discount from their par value. They typically make only one payment at maturity and pay no or little interest.
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