Stocks & Shares (1/2)

In this lesson, you’re expected to learn about:
– how shares are exchanged
– types of orders
– the difference between long and short stocks

By knowing a few simple things about how bonds are traded, the different options available and what influences share prices, you can incorporate shares into your investing strategies and portfolios.

Exchanging Shares 

Exchanges in shares take place by different methods that facilitate the purchase and sale of equities between two or more people who otherwise have no contact with each other. Exchanges are made through three primary methods, each considered to be a separate market for shares:

1) Stock exchanges: the most commonly known market for the exchange of shares. These large, centralized exchanges are usually located in major cities around the world, where brokers, dealers, broker-dealers and others involved in the exchange of shares congregate.

2) Electronic computer networks: ECNs are computer networks that link traders, brokers, dealers and even stock exchanges in order to facilitate the trade of equities. They have greatly increased in use over the past few decades and have made share trading more much accessible to non-professionals.

3) Over-the-counter markets: OTC markets are a less popular method of exchanging shares but they often include access to shares that aren’t available in any other way. They include any system other than stock exchanges or ECNs that facilitates the trade in equities. They’re usually networks of brokers and dealers communicating outside exchanges. As a result, they experience far less volume and don’t tend to attract as many investors.

Types of orders

When you want to buy or sell shares, you have to decide on the type of buy or sell order you want to place, the price at which you want the transaction to take place and the timing of the transaction. You can control all these factors by managing your transaction order.

Suppose that you want to buy 10 shares in ABC Company for $10 per share and you want the transaction to take place as soon as a seller of that many shares at that price becomes available. All you have to do is give that order to your broker or set it up online using your brokerage account. Whether your order is fulfilled or not depends on whether a seller can be found who’s willing to sell 10 shares at that particular price.

Pricing of Equities 

Pricing is performed in a sort of dual-auction system, where potential buyers and sellers negotiate back and forth on price until a price is established that allows a transaction to take place. This compromise is reached through fluctuations in the bid price and ask price of the shares.

Ask price: the price of a share for which the people who own the share are willing to sell it. When the owners of a share want to sell their shares, they must ask for a price that buyers are willing to pay or else they’re unable to sell their shares.

Bid price: the price that buyers are willing to pay to purchase the shares. The buyers must pay a price that sellers are willing to sell their shares for.

Spread: the difference between the ask and bid prices.

The price of a share is established when two people find a compromise in the spread whereby the buyer is willing to pay a particular price and the seller is willing to accept that price.

– the price of a share increases when buyers are willing to compromise more, paying the ask price or even more.
– the price decreases when the sellers are willing to settle for a lower price, accepting the bid price or even less.

The different types of orders available are meant to manage the intersection between the bid price, the ask price and the spread.

1) Market Order

– the simplest type of order for the purchase or sale of equity.
– the investor simply accepts the price set by the other side of the transaction.
– if the person setting the market order is a buyer, the price established automatically becomes the ask price and the exchange happens almost instantly since the buyer isn’t waiting for the seller to come down in price.
– if the person setting the market order is the seller, the price automatically becomes the bid price.

2) Stop and Limit Orders 

Stop and limit orders are used to manage the price at which a transaction takes place. For example, an investor may want to place an order whereby shares aren’t purchased until prices drop below or rise above a certain level.

When the trigger on which the order is dependent occurs, it automatically takes place, assuming that a partner to the exchange is available at a given price. The same can apply to selling shares – someone may place an order to sell a specified number of shares only if and when the price of the shares increases or decreases by a predetermined amount.

The motivation behind this strategy depends on the order and the price. Here are four options:

– someone sets an order to sell shares when they drop below a certain price.
– someone wants to sell shares after the price increases.
– an investor wants to purchase shares after they drop below a specified price.
– an investor wants to purchase shares after the price increases beyond a certain point.

The price that the order is set at isn’t necessarily the price at which the transaction takes place. These types of orders are typically ‘at price or higher’ or ‘at price or lower’, and so market gaps can occur that cause the transaction to occur at a price that exceeds the milestone price.

For example, say that someone owns shares priced at $15 per share and wants to sell those shares when they reach a price of $10 per share or lower in order to help limit risk. If no one is willing to pay even $10 per share, causing a gap in the spread, the order occurs at the next transaction price, even if that’s below $10 per share.

It seems that stop and limit orders are basically the same thing so then why the differentiation?

– Stop orders are orders to sell shares when they drop below a certain price, stopping the amount of potential loss that may be experienced.
– Limit orders are orders to purchase shares when they drop below a certain price or to sell shares when they exceed the trigger price.

However, in computer-automated trading, stop and limit orders are treated the same.

3) Pegged Orders

pegged order is similar to a stop or limit order in that the exchange doesn’t take place until the trigger price is reached. But in a pegged order that trigger price changes along with the value of some other variable, such as an index or economic measure. When that variable reaches a particular value, the peg fluctuations stop and the order is set.

4) Time-Contingent Orders 

An order can also be contingent on time. For example, some orders are delayed for a predetermined amount of time before they’re entered into the market. Other orders are canceled if they’re not fulfilled before a certain period of time. Day orders are time-contingent orders because they’re canceled at the end of the trading day if they’re not filled by then.

Comparing Long and Short Stocks

Buying Long 

When people think about buying shares, the majority of the time they’re thinking about buying long. This means that you own the shares you’re buying immediately after the transaction takes place, and you continue to own those shares until you sell them.

– People buy long with the intention of keeping the shares for at least a short period of time before eventually reselling them.
– the exact length of time that you own the shares doesn’t impact whether the position is considered short or long – the ownership is what matters.
– when people buy long, they believe that the value of the shares is going to increase while they’re in their possession. So they buy the shares, allow the value to appreciate and then sell them when the value is high enough.

Buying long theoretically has limited loss potential but unlimited gain potential. When you buy shares for $10, the worst thing that can happen is the company goes bust and you lose the whole amount. On the other hand, that $10 may increase in value by an unlimited amount.

In reality, the chances of it increasing are volatile, leaving you with a significant risk of loss. In other words, the gain potential exists but the reality is often somewhere within the range of -10% to +10% annual change.

Margin Trading 

Purchasing shares using ‘margin trading’ means that you borrowed money to buy them. Most often, this approach involves opening a margin account with your stockbroker, whereby the broker or an associated financial institution lends you money usually with relatively low interest rates, in order to buy shares.

Typically, buying on margin involves maintaining a minimum balance in the account as collateral.
– investors need to be very careful when buying on margin: stock investing tends to yield volatile and risky returns whereas the interest you have to pay by borrowing on margin is a guaranteed cost.
– buying on margin limits your potential gains while exacerbating any potential losses, because you have to pay interest on the borrowed funds.

Selling Short 

You’re selling shares that aren’t currently in your possession to someone else with the obligation to purchase those shares from that person at a later date. People sell short when they believe that the value of the shares is going to fall. They’re able to make money when the share price performs poorly by selling short.

How does selling short work?

The investor borrows a number of shares in a company from a broker and sells them to someone for the revenue.

– if the share price goes down during the period that the investor shorted the shares, when he repurchases them, he pays less than he earned from the sale. This generates a profit.
– if the value of the shares rises during the shorted period, the investor must pay more to repurchase them than he generated in revenue from the sale, meaning that he loses money.
– short selling is one method that investors use to generate income and returns even when investments are performing poorly.
– it can be very risky: when you sell shares and are obligated to rebuy them, the potential for financial loss is unlimited.

[Optional] Understanding Long and Short Terms in Stock Market Trading
Watch this 4-minute video to learn more:
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