is a Stockbroker?
A stockbroker sells or buys stock on behalf of a customer. The stockbroker
works as an agent matching up stock buyers and sellers. A transaction on a
stock exchange must be made between two members of the exchange — a typical
person may not walk into the New York Stock Exchange (for example), and ask to
trade stock. Such an exchange must be done through a broker.
In addition to actually trading stocks for their clients, stockbrokers may
also offer advice to their clients on which stocks, mutual funds, etc. to buy.
Some newer transaction services online in the form of a website interface.
They usually offer low commissions, as low as one or two USD, and fast
transaction rates, up to two seconds.
Philadelphia was the center of American finance during the first forty
years of the new United States. In 1790, the country's first stock exchange
was founded there and Chestnut Street was home to the nation's most powerful
financial institutions. However, in the 1820s a shift to New York City began
and for more than one hundred and fifty years Wall Street has been synonymous
with the stockbrokerage business. A number of firms rose to prominence over
that time with the top-ranked brokerages in the early 1950s being:
|| Merrill Lynch & Co. Inc.
|| E. F. Hutton & Co.
|| Bache & Co.
|| Paine Webber & Company
|| Francis I. DuPont & Co.
|| Dean Witter Co.
|| Goldman Sachs
|| Bear Stearns
Since the 1980s stockbroking firms have also been allowed to be market
makers as long as the appropriate Chinese walls are put in place.
With the advent of automated stockbroking systems on the Internet the
client often has no personal contact with his/her stockbroking firm. The
stockbroker's system performs all the stockbroking functions: it obtains the
best price from the market and executes and settles the trade.
Today, most of the once well-known corporate brand names including
mid-sized firms such as Smith Barney have been swallowed up by global
financial conglomerates. Discount brokers (such as E-Trade, Scottrade, and TD
Ameritrade) have taken a large share of the business by offering highly
discounted commissions, but the companies do not offer investment advice in
return--all they do is execute orders.
Roles similar to that of a stockbroker include investment advisor,
financial advisor, and probably many others. A stockbroker may or may not be
also an investment advisor, and vice versa.
The Certified Financial Planner™ designation initially offered by the
American College in Pennsylvania is considered by many to be the next
educational step a stockbroker can take in order to be considered a legitimate
and ethical financial consultant.
Tips for using a stockbroker
Some people prefer to use and pay for the services of a broker because they
feel more comfortable making decisions about their finances with the
interactive guidance of a licensed professional.
When using a stockbroker for financial guidance, one must be made aware
that they do get paid on a commission, based on the stock/mutual fund they
sell, and also through Class Distinction/Operating Expense Fees/Services
Fees/Shareholder Fees. Thus, a conflict of interest arises concerning a
stockbroker who offers his/her service as a financial planner, because their
revenue is generated as a direct result of your investment in the stock/mutual
fund that they broker to you. Thus your return on investment may not be as
great, and the advice they give you might not be in your best interest.
However, some mutual funds and stocks can only be purchased through a broker:
in such cases their services are required to purchase the financial instrument
A word of warning: If you receive a call offering you shares at what seems
an unfeasibly good deal (e.g., an imminent IPO which will cause the price to
'go through the roof'), then you are probably being contacted by a boiler
room. These are typically not registered with the FSA and could be in a
foreign country where fraud laws are lax. If you suspect that you have been
contacted in this way, see Boiler Room for more information.
The pitch follows this pattern:
|| Privileged information-
this takes the form of a tip, insider knowledge they are not allowed to divulge of a big corporation going to invest in a minnow
or in this case a takeover by a company they are allowed to mention.
|| A good story related to a product in demand: oil, digital video etc.
|| The need to get in early at a privileged price.
|| They will hold the block of shares giving you time to research the
|| There is a 12 month period when you are not allowed to sell.
|| When they phone again they
assume you are going to buy,
asks for your
national insurance number to prove your identity and transfers you to
administrator who takes details for a stock purchase application.
Acting as a principal
Stockbrokers also sometimes or exclusively trade on their own behalf, as a
principal, speculating that a share or other financial instrument will
increase or decline in price. In such cases the term broker makes little sense
and the individuals or firms trading in a principal capacity sometimes call
themselves dealers, stock traders or simply traders.
Transactions by stockbrokers in the US and UK
In the US: When acting as an agent, the stockbroker typically charges the
client a flat fee and/or a percentage-based commission for undertaking the
trade, and the price quoted the client must be the best price available in the
market. When acting as a principal, the trade could be with another market
participant or one of the stockbroker's clients. When trading in a principal
capacity with a client, the broker informs the client and charges the client a
markup or markdown from the prevailing market price.
In the UK: Stockbrokers act the same in the UK as in the US, except that
when trading in a principal capacity with a client, the broker is obliged to
inform the client and no commission is charged.
Other jurisdictions are thought to have similar rules.
What is a Boiler Room?
The term boiler room in business refers to a busy center of
activity, often telemarketing or other types of sales. It typically refers to
a room where tele-marketers work, often selling stocks, and using unfair,
dishonest sales tactics, sometimes selling fraudulent stocks. The term carries
a negative connotation, and is often used to imply high-pressure sales tactics
and sometimes, poor working conditions.
A boiler room usually has an undisclosed relationship with the company
being promoted or undisclosed profit from the sale of the house stock they are
A boiler room promotes (via telephone calls to brokerage clients or spam
email) thinly traded stocks. The boiler room usually holds a large position in
the stock and plans to dump it on brokerage clients at a high price.
The boiler room usually has close ties to or the same owners of the company
whose stock is being promoted.
Some traits of a boiler room include presenting only good news about the
stock to be sold, and discouraging outside research by customers or brokers
They often use phrases such as:
||"opportunities like this happen once in a lifetime"
||"it's a sure thing"
||"our brokerage has inside information that something big is about
to happen with this stock"
The term is likely to have originated from the cheap, hastily arranged
office space used by such firms, often just a few desks in a the basement or
utility room of an existing office building. The term is a fitting analogy
due to the secretive nature of these firms, the connections with the company
they are promoting and the high-pressure nature of their activities.
How to Find a Good Stockbroker
Finding the right stockbroker is an important decision. What exactly does
a stockbroker do?
A stockbroker invests in the stock market for individuals or corporations.
Only members of the stock exchange can conduct transactions, so whenever
individuals or corporations want to buy or sell stocks they must go through a
brokerage house. Stockbrokers often advise and counsel their clients on
appropriate investments. Brokers explain the workings of the stock exchange to
their clients and gather information from them about their needs and financial
ability, and then determine the best investments for them. The broker then
sends the order out to the floor of the securities exchange by computer or by
phone. When the transaction has been made, the broker supplies the client with
the price. The buyer pays for the stock and the broker transfers the title of
the stock to the client and performs clearing and settlement procedures.
Now that you know what a stockbroker does, the next question you need to ask
yourself is: Do I want a full service or discount broker? A full service
stockbroker will give you recommendations for securities that you should buy.
A discount broker only places the order that you give. You need to determine
if you want the professional advice from a stockbroker or do your own research
and just place orders.
People use full service brokers for many reasons which include helping you
diversify your portfolio, helping you get in on that hot stock tip, getting
the rare stocks from the international markets and to give you the most up to
date information on your investments.
Check with your stockbroker about the following:
||Experience, licenses, certifications, commissions, fees, or flat fees.
||How are they approaching investing?
||What are their criteria for making decisions?
||Ask if they have an interest or stake in any company whose products or
services they recommend.
||And finally, drop by their office and check it out!
Stockbrokers must be dedicated to achieving the financial goals of their
clients by understanding their needs, by providing research, analysis, advice
and opportunities and fast, accurate and superior service!
Contact your state or provincial securities agency in order to verify the
employment and disciplinary history of a securities salesperson and the
salesperson's firm; find out if the investment is permitted to be sold; or
file a complaint. You can find contact
information for your securities regulator here.
Stockbrokers Were Selected
Consumers’ Research Council of America has compiled a list of Top
Stockbrokers throughout the United States by utilizing a point value
system. This method uses a point value for criteria that we deemed
valuable in determining the best stockbrokers.
The criteria that was used and assessed a point value is as follows:
||Each year the
Stockbroker has been in practice
||Education and continuing
education. Holding various ‘Series" licenses. (IE: Series
7, 63-65,8,24 etc.)
||Member of professional
securities industry associations and organizations
||We use third party data
creating a proprietary sophisticated grid that enables us to
determine the highest producing stockbrokers. These stockbrokers
have won awards at their firms and been recognized for
put, stockbrokers that have accumulated a certain amount of points
qualified for the list. This does not mean that stockbrokers that did
not accumulate enough points are not good stockbrokers, they merely did
not qualify for this list because of the points needed for
Similar studies have been done with other professions using a survey
system. This type of study would ask fellow professionals whom they
would recommend. We found this method to be more of a popularity
contest; For instance, professionals who work in a large office have
much more of a chance of being mentioned as opposed to a professional
who has a small private practice. In addition, many professionals have a
financial arrangement for back-and-forth referrals. For these reasons,
we developed the point value system.
Since this is a subjective call, there is no study that is 100%
accurate. As with any profession, there will be some degree of variance
in opinion. If you survey 100 clients from a particular stockbrokerage
company on their satisfaction, you will undoubtedly hear variances in
their level of satisfaction. This is really quite normal.
We feel that a point value system takes out the personal and
emotional factor and deals with factual criteria. We have made certain
assumptions. For example, we feel that more years in practice is better
than less years in practice; more education is better than less
education and completing a rigorous course to obtain various
"Series" licenses is better that not having done so.
The stockbrokers list that we have compiled is current as of a
certain date and other stockbrokers may have qualified since that date.
Nonetheless, we feel that the list of the top stockbrokers is a good
starting point for you to find a qualified specialist.
No fees, donations, sponsorships or advertising are accepted from any
individuals, professionals, securities firms, brokerage firms, financial
institutions, corporations or associations. This policy is strictly
adhered to insure an unbiased selection.
Front office: This is a
description of the part of a brokerage firm that is "client
facing". The sales staff, brokers and traders are part of the front
office. Functions of the front office include acquisition and entry of
orders, fulfillment of the orders, and all the regulatory reporting for
office: The back office is where the clearance processing of
the trades is done. Transfer of securities and money and the tracking of
"failure to deliver" is handled. Securities lending for a
brokerage firm, wherein shares of a security that is being sold short
are located to ensure they can be delivered, is usually included in the
back office as well.
Prime brokerage: A service sold
by investment banks to "hedge funds." (A hedge fund is a
private investment fund charging a performance fee and typically open to
only a limited number of investors, e.g., those in the United States,
hedge funds are largely open to accredited investors only. Hedge Funds
have grown in size and influence on the public securities and private
The following "core services" are typically bundled into
the Prime Brokerage package:
Global custody (including clearing, custody, and asset servicing)
facilitate leverage of client assets)
(provide hedge fund managers with portfolio reporting needed to
effectively manage money)
(prime brokers act as a hedge fund's primary operations contact
with all other broker dealers)
In addition, certain prime brokers provide additional
"value-added" services, which may include some or all of the
Capital Introduction - A process whereby the prime broker
attempts to introduce its hedge fund clients to qualified hedge fund
investors who have an interest in exploring new opportunities to make
hedge fund investments.
||Office Space Leasing and
Servicing - Certain prime brokers lease commercial real
estate, and then sublease blocks of space to hedge fund tenants.
These prime brokers typically provide a suite of on-site
services for clients who utilize their space.
||Risk Management Advisory
Services - The provision of risk analytic technology,
sometimes supplemented by consulting by senior risk
||Consulting Services -
A range of consulting / advisory services, typically provided to
"start-up" hedge funds, and focused on issues
associated with regulatory establishment requirements in the
jurisdiction where the hedge fund manager will be resident, as
well as in the jurisdiction(s) where the fund itself will be
Retail broker: A retail broker
is a brokerage firm that caters to the average investor or, in other
words, the retail sector of investors - as opposed to the institutional
sector of investors.
Both discount and full-service firms are retail brokers. The majority of
brokers who advertise on TV are retail brokers.
Low cost broker:
A low cost brokerage can be considered to be a special case
of a discount brokerage which functions in a similar way to a dividend
reinvestment program. ShareBuilder, BUYandHOLD, and FolioFN are the
better known examples of such low cost brokers.
Low cost brokers are generally less expensive for an investor who
invests in small amounts (say, fixed dollar amounts) and who is not
particular that the stock trade must happen in real time.
Low cost brokers execute orders only a few times a day by aggregating
orders from a large number of small investors into one or more block
trades which are made at certain specific times during the day. Such
block trades are also sometimes referred to as window trades. Window
trades help lower costs in two ways:
||By matching buy and sell
orders within the firms order book the overall quantity of
stock to be traded can be reduced thus reducing commissions.
||The broker can split the
bid-ask spread with the investor when matching buy and sell
orders - a win-win situation in most cases
Since investor money is pooled before stocks are bought or sold, it
enables investors to contribute small amounts of cash using which
fractional shares of specific stocks can be purchased. This is usually
not possible with a regular stock broker.
Low cost brokers also provide real-time trades but these are usually
(but not necessarily) charged a higher commission
What is a Stock
Stock investors purchase stocks with the intention of holding for an
extended period of time, usually several months to years. They rely
primarily on fundamental analysis for their investment decisions and
fully recognize stock shares as part-ownership in the company. Many
investors believe in the Buy-and-Hold strategy, which as the name
suggests, implies that investors will hold stocks for the very long
term, generally measured in years. This strategy was made popular in the
equity bull market of the 1980s and 90s where buy-and-hold investors
rode out short-term market declines and volatility and continued to hold
as the market returned to its previous highs and beyond. However, during
the 2001-2003 equity bear market, the buy-and-hold strategy lost some
followers as broader market indexes like the NASDAQ saw their values
decline by over 60%. On the other hand, stock traders usually try to
profit from short-term price volatility with trades lasting anywhere
from several seconds to several weeks. Some try to rely upon the
psychology of other stock market agents (buyers and sellers), and
privileged or confidential information, in order to take their capital
gain (see speculation and insider trading). In modern days, a number of
truly committed full time traders are usually technical analysis (or
Individuals or firms trading as their principal capacity are called
stock traders or simply traders. The stock trader is usually a
professional. However, many people across the world can call themselves
stock traders/investors or part-time stock traders/investors, despite
having another profession in parallel with their regular trading
activities in the financial markets. When a stock trader/investor has
clients, and acts as a money manager or adviser with the intention of
adding value to his clients finances, he is also called a financial
adviser or manager. In this case, the financial manager could be an
independent professional or a large bank corporation employee. This may
include managers dealing with investment funds, hedge funds, mutual
funds, and pension funds, or other professionals in equity investment,
fund management, and wealth management. A very active stock trader who
holds positions for a very short time and makes several trades each day
is a day trader.
Several different types of stock trading or investing exist including
day trading, swing trading, market making, trend following, scalping
(trading), momentum trading, short-term countertrend trading, trading
the news, and arbitrage. In the case of longer-term trend following,
some trades may last longer than several months.
Stock traders/investors usually need a stockbroker, such as a bank or
a brokerage firm, as an intermediate. Since the spread of the Internet
banking, it is usual to use an Internet connection to manage their own
financial portfolios, including ordering the sell/buying orders, set
stop losses prices and define buying/selling prices. Using the Internet,
specialized software and a personal computer, stock traders/investors
make use of technical analysis and fundamental analysis to help them in
the decision process. They utilize also several advising and information
resources based on the Internet and the media, such as
financial/business news and data firms (Reuters, Bloomberg, Financial
Times, Yahoo! Finance, MSN Money, AFX News, Newratings, Forbes,
BusinessWeek, Hoover's). They exclusively trade on their own behalf, as
a principal, investing money on a share or other financial instrument,
which they believe will increase in price aiming to sell it later with
Expenses, costs and risk
Trading activities are not free. First of all, they have a
considerably high level of risk, uncertainty and complexity, especially
for unwise and inexperienced stock traders/investors seeking for an easy
way to make money quickly. In addition, stock traders/investors face
several costs such as commissions, taxes and fees to be paid for the
brokerage and other services, like the buying/selling orders placed at
the stock exchange. According to each National or State legislation, a
large array of fiscal obligations must be respected, and taxes are
charged by the State over the transactions and earnings. Beyond these
costs, the opportunity costs of money and time, the currency risk, the
financial risk, and all the Internet Service Provider, data and news
agency services and electricity consumption expenses must be added.
Although many companies offer courses in stock picking, and numerous
experts report success through Technical Analysis and Fundamental
Analysis, many economists and academics state that because of Efficient
market theory it is unlikely that any amount of analysis can help an
investor make any gains above the stock market itself. In a normal
distribution of investors, many academics believe that the richest are
simply outliers in such a distribution (e.g. in a game of chance, they
have flipped heads twenty years in a row).
For this reason most academics and economists recommend that
investors invest in funds that follow an index in the market, i.e.
long-term and well-diversified investments.
Dart Board Method
Financial journals and newspapers such as the Wall Street Journal
have done articles on stock picking in the past. One famous article
involved a stock picking contest between a panel of Wall Street experts,
the public and a dart board. One member was elected to throw darts at
the Journal's stock page in order to select a portfolio. At the end of
the experiment, the public and the dart board both beat the board of
Wall Street experts. Was the dart board more savvy? The dart board's
triumph over the Wall Street experts can be attributed to chance (one
could also attribute the dart board losing to the experts to chance as
Day trading refers to the practice of buying and selling financial
instruments within the same trading day such that all positions will
usually (not necessarily always) be closed before the market close of
the trading day. Traders that participate in day trading are called day
Some of the more commonly day-traded financial instruments are
stocks, stock options, currencies, and a host of futures contracts such
as equity index futures, interest rate futures, and commodity futures.
Day trading used to be the preserve of financial firms and
professional investors and speculators. Many day traders are bank or
investment firms employees working as specialists in equity investment
and fund management. However, day trading has become increasingly
popular among casual traders due to advances in technology, changes in
legislation, and the popularity of the Internet.
Due to the high profits (and losses) that day trading makes possible,
these traders are sometimes portrayed as "bandits" or
"gamblers" by other investors.
The price of financial instruments (here, stocks) can vary greatly
within the same trading day
Although collectively called day trading, there are many sub-trading
styles within the whole "day trading" tree. A day trader is
not necessarily very active. Depending on one's trading strategy, the
number of trades made in a day may vary from a few to hundreds.
Some day traders focus on very short or short-term trading, in which
a trade may last seconds to a few minutes. They buy and sell many times
in a day, trading very high volumes daily and therefore receiving big
discounts from the brokerage.
Some day traders focus only on momenta or trends. They are more
patient and wait for a ride on the strong move which may occur on that
day. They make far fewer trades than the aforementioned traders.
Traditionally it is suggested day traders should always settle their
positions before the market close of the trading day to avoid the risk
of price gaps (differences between the previous day's close and the next
day's open price) at the open. Some day traders consider this to be a
golden rule to be obeyed at all times. However, some day traders believe
it is acceptable to stay with a position after the market closes as long
as it is still following a favorable trend.
Day traders often borrow money to trade. Since margin interests are
typically only charged on overnight balances, the extra costs discourage
them from holding positions overnight.
Profit and risks
Due to the nature of financial leverage and the rapid returns that
are possible, day trading can be extremely profitable, and high-risk
profile traders can generate huge percentage returns. Some day traders
manage to earn millions per year solely by day trading.
Nevertheless day trading can become very risky, especially if one has
poor discipline, risk or money management. The common use of buying
on margin (using borrowed funds) amplifies gains and losses, such that
substantial losses or gains can occur in a very short period of time. In
addition, brokers usually allow bigger margins for day traders. Where
overnight margins required to hold a stock position are normally 50% of
the stock's value, many brokers allow pattern day trader accounts to use
levels as low as 25% for intraday purchases. This means a day trader
with the legal minimum $25,000 in his account can buy $100,000 worth of
stock during the day, as long as half of those positions are exited
before the market close. Because of the high risk of margin use, and of
other day trading practices, a day trader will often have to exit a
losing position very quickly, in order to prevent a greater,
unacceptable loss, or even a disastrous loss, much larger than his
original investment, or even larger than his total assets.
Even when a position has made a profit, the trader has to offset the
transaction costs and the interest on the margin. It is commonly stated
that 80-90% of day traders lose money. An analysis of the Taiwanese
stock market suggests that "less than 20% of day traders earn
profits net of transaction costs".
Originally, the most important U.S. stocks were traded on the New
York Stock Exchange. A trader would contact a stockbroker, who would
relay the order to a specialist on the floor of the NYSE. These
specialists would each make markets in only a handful of stocks. The
specialist would match the purchaser with another broker's seller; write
up physical tickets that, once processed, would effectively transfer the
stock; and relay the information back to both brokers. Brokerage
commissions were fixed at 1% of the amount of the trade, i.e. to
purchase $10,000 worth of stock cost the buyer $100 in commissions.
One of the first steps to make day trading of shares potentially
profitable was the change in the commission scheme. In 1975, the
Securities and Exchange Commission made fixed commissions illegal,
giving rise to discount brokers offering much reduced commission rates.
Financial settlement periods used to be much longer: Before the early
1990s at the London Stock Exchange, for example, stock could be paid for
up to 10 working days after it was bought, allowing traders to buy (or
sell) shares at the beginning of a settlement period only to sell (or
buy) them before the end of the period hoping for a rise (or fall) in
price. This activity was identical to modern day trading, but for the
longer duration of the settlement period. Nowadays, to reduce market
risk, the settlement period is typically less than a working day.
Reducing the settlement period reduces the likelihood of default, but
was impossible before the advent of electronic ownership transfer.
Electronic Communication Networks
The systems by which stocks are traded have also evolved, the second
half of the twentieth century having seen the advent of Electronic
Communication Networks (ECNs). These are essentially large proprietary
computer networks on which brokers could list a certain amount of
securities to sell at a certain price (the asking price or
"ask") or offer to buy a certain amount of securities at a
certain price (the "bid"). The first of these was Instinet.
Instinet or "inet" (ECNs and exchanges are usually known to
traders by a three- or four-letter designators, which identify the ECN
or exchange on Level II stock screens) was founded in 1969 as a way for
major institutions to bypass the increasingly cumbersome and expensive
NYSE, also allowing them to trade during hours when the exchanges were
closed. Early ECNs such as Instinet were very unfriendly to small
investors, because they tended to give large institutions better prices
than were available to the public. This resulted in a fragmented and
sometimes illiquid market.
The next important step in facilitating day trading was the founding
in 1971 of NASDAQ -- a virtual stock exchange on which orders were
transmitted electronically. Moving from paper share certificates and
written share registers to "dematerialized" shares,
computerized trading and registration required not only extensive
changes to legislation but also the development of the necessary
technology: online and real time systems rather than batch; electronic
communications rather than the postal service, telex or the physical
shipment of computer tapes, and the development of secure cryptographic
These developments heralded the appearance of "market
makers": the NASDAQ equivalent of a NYSE specialist. A market maker
has an inventory of stocks to buy and sell, and simultaneously offers to
buy and sell the same stock. Obviously, it will offer to sell stock at a
higher price than the price at which it offers to buy. This difference
is known as the "spread". It is of no importance to the
market-maker whether the price of a stock goes up or down, as it has
enough stock and capital to constantly buy for less than it sells. Today
there are about 500 firms who participate as market-makers on ECNs, each
generally making a market in four to forty different stocks. Without any
legal obligations, market-makers were free to offer smaller spreads on
ECNs than on the NASDAQ. A small investor might have to pay a $0.25
spread (e.g. he might have to pay $10.50 to buy a share of stock but
could only get $10.25 for selling it), while an institution would only
pay a $0.05 spread (buying at $10.40 and selling at $10.35).
Technology bubble (1997–2000)
In 1997, the SEC adopted "Order Handling Rules" which
required market-makers to publish their best bid and ask on the NASDAQ.
Another reform made during this period was the "Small Order
Execution System", or "SOES", which required market
makers to buy or sell, immediately, small orders (up to 1000 shares) at
the MM's listed bid or ask. A defect in the system gave rise to
arbitrage by a small group of traders known as the "SOES
bandits", who made fortunes buying and selling small orders to
market makers. The existing ECNs began to offer their services to small
investors. New brokerage firms which specialized in serving online
traders who wanted to trade on the ECNs emerged. New ECNs also arose,
most importantly Archipelago (arca) and Island (isld). Archipelago
eventually became a stock exchange and in 2005 was purchased by the NYSE
(At this time, the NYSE has proposed merging Archipelago with itself,
although some resistance has arisen from NYSE members). Commissions
plummeted: in an extreme example (1000 shares of Google), in 2005 an
online trader might buy $300,000 of stock at a commission of about $10,
as opposed to the $3,000 commission he would have paid in 1974.
Moreover, the trader would be able to buy the stock almost instantly and
would get it at a cheaper price.
ECNs are in constant flux. New ones are formed, while existing ones
are bought or merge. As of the end of 2006, the most important ECNs to
the individual trader are Instinet (which bought Island in 2005),
Archipelago (although technically it is now an exchange rather than an
ECN), and The Brass Utility ("brut"), as well as the SuperDot
electronic system now used by the NYSE.
The evolution of average NASDAQ share prices between 1994 and 2004
This combination of factors has made day trading in stocks and stock
derivatives (such as ETFs) possible. The low commission rates allow an
individual or small firm to make a large numbers of trades during a
single day. The liquidity and small spreads provided by ECNs allow an
individual to make near-instantaneous trades and to get favorable
pricing. High-volume issues such as Intel or Microsoft generally have a
spread of only $0.01, so the price only needs to move a few pennies for
the trader to cover his commission costs and show a profit.
The ability for individuals to day trade coincided with the extreme
bull market in technical issues from 1997 to early 2000, known as the
Dot-com bubble. From 1997 to 2000, the NASDAQ rose from 1200 to 5000.
Many naive investors with little market experience made huge profits
buying these stocks in the morning and selling them in the afternoon, at
400% margin rates.
Adding to the day-trading frenzy were the enormous profits made by
the "SOES bandits". (Unlike the new day traders, these
individuals were highly-experienced professional traders able to exploit
the arbitrage opportunity created by SOES.)
In March, 2000, this bubble burst, and a large number of
less-experienced day traders began to lose money as fast, or faster,
than they had made during the buying frenzy. The NASDAQ crashed from
5000 back to 1200; many of the less-experienced traders went broke.
There are several basic strategies by which day traders attempt to
make a profit: Trend following, playing news events, range trading, and
scalping. In addition to (or instead of) these, some day traders also
use Contrarian (reverse) strategies (more commonly seen in algorithmic
trading) to trade specifically against irrational behavior from day
traders using these approaches.
Some of these approaches require shorting stocks instead of buying
them normally: the trader borrows stock from his broker and sells the
borrowed stock, hoping that the price will fall and he will be able to
purchase the shares at a lower price. There are several technical
problems with short sales: the broker may not have shares to lend in a
specific issue, some short sales can only be made if the stock price or
bid has just risen (known as an "uptick"), and the broker can
call for return of its shares at any time. Some of these restrictions
(in particular the uptick rule) don't apply to trades of stocks that are
actually shares of an exchange-traded fund (ETF).
Trend following, a strategy used in all trading time frames, assumes
that financial instruments which have been rising steadily will continue
to rise, and vice versa. The trend follower buys an instrument which has
been rising, or short-sells a falling one, in the expectation that the
trend will continue.
Playing news is primarily the realm of the day trader. The basic
strategy is to buy a stock which has just announced good news, or short
sell on bad news. Such events provide enormous volatility in a stock and
therefore the greatest chance for quick profits (or losses). Determining
whether news is "good" or "bad" must be determined
by the price action of the stock, because the market reaction may not
match tone of the news itself. The most common cause for this is when
rumors or estimates of the event (like those issued by market and
industry analysts) were already circulated before the official release,
and prices have already moved in anticipation. The news is said to be
already "priced-in" to the stock price.
A range trader watches a stock that has been rising off a support
price and falling off a resistance price. That is, every time the stock
hits a high, it falls back to the low, and vice versa. Such a stock is
said to be "trading in a range", which is the opposite of
trending. The range trader therefore buys the stock at or near the low
price, and sells (and possibly short sells) at the high. A related
approach to range trading is looking for moves outside of an established
range, called a breakout (price moves up) or a breakdown (price moves
down), and assume that once the range has been broken prices will
continue in that direction for some time.
Scalping originally referred to spread trading. Scalping is a trading
style where small price gaps created by the bid-ask spread are
exploited. It normally involves establishing and liquidating a position
quickly, usually within minutes or even seconds.
Scalping highly liquid instruments for off the floor daytraders
involves taking quick profits while minimizing risk (lose exposure). It
applies technical analysis concepts such as over/under bought, support
& resistance zones as well as trendline, trading channel to enter
the market at key points and take quick profits from small moves. The
basic idea of scalping is to exploit the inefficiency of the market when
volatility increases and the trading range expands.
Some day trading strategies (including scalping and arbitrage)
require relatively sophisticated trading systems and software. Many day
traders use multiple monitors or even multiple computers to execute
their orders. A fast Internet connection, such as broadband, is
essential for day trading.
Day traders do not use retail brokers, slow to execute trades, and
with higher commissions than direct access brokers, who allow the trader
to send their orders directly to the ECNs instead of indirectly through
brokers. Direct access trading offers substantial improvements in
transaction speed and will usually result in better trade execution
prices (reducing the costs of trading).
Commissions for direct-access brokers are calculated based on volume.
The more one trades, the cheaper the commission is. Where a retail
broker might charge $10 or more per trade regardless of size, a typical
direct-access broker can charge as cheap as $0.004 per share traded, or
$0.25 per futures contract. A scalper can cover that cost with even a
As for the calculation method, some use pro-rata to calculate
commissions and charges, where each tier of volumes charge different
commissions. Other brokers use a flat-rate, where all commissions
charges are based on which volume threshold one reaches.
Real-time market data is necessary for day traders, rather than using
the delayed (by anything from 10 to 60 minutes, per exchange rules)
market data that is available for free. A real-time data feed requires
paying fees to the respective stock exchanges, usually combined with the
broker's charges; these fees are usually very low compared to the other
costs of trading. The fees may be waived for promotional purposes or for
customers meeting a minimum monthly volume of trades. Even a moderately
active day trader can expect to meet these requirements, making the
basic data feed essentially "free".
In addition to the raw market data, some traders purchase more
advanced data feeds that include historical data and features such as
scanning large numbers of stocks in the live market for unusual
activity. Complicated analysis and charting software are other popular
additions. These types of systems can cost from tens to hundreds of
dollars per month to access.
Regulations and restrictions
Day trading is considered a risky trading style, and regulations
require brokerage firms to ask whether the clients understand the risks
of day trading and whether they have prior trading experience before
entering the market.
In addition, NASD and SEC further restrict the entry by means of
"pattern day trader" amendments. Pattern day trader is a term
defined by the Securities and Exchange Commission to describe any trader
who buys and sells a particular security in the same trading day (day
trades), and does this four or more times in any five consecutive
business day period. A pattern day trader is subject to special rules.
The main rule being that in order to engage in pattern day trading the
trader must maintain an equity balance of at least $25,000 in a margin
A stock market is a market for the trading of company stock, and
derivatives of same; both of these are securities listed on a stock
exchange as well as those only traded privately.
The term 'the stock market' is a concept for the mechanism that enables
the trading of company stocks (collective shares), other securities, and
derivatives. Bonds are still traditionally traded in an informal,
over-the-counter market known as the bond market. Commodities are traded
in commodities markets, and derivatives are traded in a variety of markets
(but, like bonds, mostly 'over-the-counter').
The size of the worldwide 'bond market' is estimated at $45 trillion.
The size of the 'stock market' is estimated as about half that. The world
derivatives market has been estimated at about $300 trillion. The major
U.S. Banks alone are said to account for about $100 trillion. It must be
noted though that the derivatives market, because it is stated in terms of
notional outstanding amounts, cannot be directly compared to a stock or
fixed income market, which refers to actual value.
The stocks are listed and traded on stock exchanges which are entities
(a corporation or mutual organization) specialized in the business of
bringing buyers and sellers of stocks and securities together. The stock
market in the United States includes the trading of all securities listed
on the NYSE, the NASDAQ, the Amex, as well as on the many regional
exchanges, the OTCBB, and Pink Sheets. European examples of stock
exchanges include the Paris Bourse (now part of Euronext), the London
Stock Exchange and the Deutsche Börse. The BSE & NSE are Stock
Markets that have arisen from India. These are also working on a very
Participants in the stock market range from small individual stock
investors to large hedge fund traders, who can be based anywhere. Their
orders usually end up with a professional at a stock exchange, who
executes the order.
Some exchanges are physical locations where transactions are carried
out on a trading floor, by a method known as open outcry. This type
of auction is used in stock exchanges and commodity exchanges where
traders may enter "verbal" bids and offers simultaneously. The
other type of exchange is a virtual kind, composed of a network of
computers where trades are made electronically via traders at computer
Actual trades are based on an auction market paradigm where a potential
buyer bids a specific price for a stock and a potential seller asks a
specific price for the stock. (Buying or selling at market means you will
accept any bid price or ask price for the stock.) When the bid and ask
prices match, a sale takes place on a first come first served basis if
there are multiple bidders or askers at a given price.
The purpose of a stock exchange is to facilitate the exchange of
securities between buyers and sellers, thus providing a marketplace
(virtual or real). The exchanges provide real-time trading information on
the listed securities, facilitating price discovery.
The New York Stock Exchange is a physical exchange, where much
of the trading is done face-to-face on a trading floor. This is also
referred to as a "listed" exchange (because only stocks listed
with the exchange may be traded). Orders enter by way of brokerage firms
that are members of the exchange and flow down to floor brokers who go to
a specific spot on the floor where the stock trades. At this location,
known as the trading post, there is a specific person known as the
specialist whose job is to match buy orders and sell orders. Prices are
determined using an auction method known as "open outcry": the
current bid price is the highest amount any buyer is willing to pay and
the current ask price is the lowest price at which someone is willing to
sell; if there is a spread, no trade takes place. For a trade to take
place, there must be a matching bid and ask price. (If a spread exists,
the specialist is supposed to use his own resources of money or stock to
close the difference, after some time.) Once a trade has been made, the
details are reported on the "tape" and sent back to the
brokerage firm, who then notifies the investor who placed the order.
Although there is a significant amount of direct human contact in this
process, computers do play a huge role in the process, especially for
so-called "program trading".
The Nasdaq is a virtual (listed) exchange, where all of the
trading is done over a computer network. The process is similar to the
above, in that the seller provides an asking price and the buyer provides
a bidding price. However, buyers and sellers are electronically matched.
One or more Nasdaq market makers will always provide a bid and ask price
at which they will always purchase or sell 'their' stock.
The Paris Bourse, now part of Euronext, is an
order-driven, electronic stock exchange. It was automated in the late
1980s. Before, it consisted of an open outcry exchange. Stockbrokers met
in the trading floor or the Palais Brongniart. In 1986, the CATS
trading system was introduced, and the order matching process was fully
From time to time, active trading (especially in large blocks of
securities) have moved away from the 'active' exchanges. Securities firms,
led by UBS AG, Goldman Sachs Group Inc. and Credit Suisse Group, already
steer 12 percent of U.S. security trades away from the exchanges to their
internal systems. That share probably will increase to 18 percent by 2010
as more investment banks bypass the NYSE and Nasdaq and pair buyers and
sellers of securities themselves, according to data compiled by
Boston-based Aite Group LLC, a brokerage-industry consultant.
Now that computers have eliminated the need for trading floors like the
Big Board's, the balance of power in equity markets is shifting. By
bringing more orders in-house, where clients can move big blocks of stock
anonymously, brokers pay the exchanges less in fees and capture a bigger
share of the $11 billion a year that institutional investors pay in
Many years ago, worldwide, buyers and sellers were individual
investors, such as wealthy businessmen, with long family histories (and
emotional ties) to particular corporations. Over time, markets have become
more "institutionalized"; buyers and sellers are largely
institutions (e.g., pension funds, insurance companies, mutual funds,
hedge funds, investor groups, and banks). The rise of the institutional
investor has brought with it some improvements in market operations. Thus,
the government was responsible for "fixed" (and exorbitant) fees
being markedly reduced for the 'small' investor, but only after the large
institutions had managed to break the brokers' solid front on fees (they
then went to 'negotiated' fees, but only for large institutions).
However, corporate governance (at least in the West) has been greatly
affected by the rise of institutional 'owners.'
Braudel suggests that in Cairo in the 11th century Islamic and
Jewish merchants had already set up every form of trade association and
had knowledge of every method of credit and payment, disproving the belief
that these were invented later by Italians.
In 12th century France the courratiers de change were concerned
with managing and regulating the debts of agricultural communities on
behalf of the banks. Because these men also traded with debts, they could
be called the first brokers.
In late 13th century Bruges commodity traders gathered inside the house
of a man called Van der Beurse, and in 1309 they became the "Brugse
Beurse", institutionalizing what had been, until then, an
informal meeting. The idea quickly spread around Flanders and neighboring
counties and "Beurzen" soon opened in Ghent and
In the middle of the 13th century Venetian bankers began to trade in
government securities. In 1351 the Venetian government outlawed spreading
rumors intended to lower the price of government funds. Bankers in Pisa,
Verona, Genoa and Florence also began trading in government securities
during the 14th century. This was only possible because these were
independent city states not ruled by a duke but a council of influential
The Dutch later started joint stock companies, which let shareholders
invest in business ventures and get a share of their profits - or losses.
In 1602, the Dutch East India Company issued the first shares on the
Amsterdam Stock Exchange. It was the first company to issue stocks and
The Amsterdam Stock Exchange (or Amsterdam Beurs) is also said to have
been the first stock exchange to introduce continuous trade in the early
17th century. The Dutch "pioneered short selling, option trading,
debt-equity swaps, merchant banking, unit trusts and other speculative
instruments, much as we know them" (Murray Sayle, "Japan Goes
Dutch", London Review of Books XXIII.7, April 5, 2001).
There are now stock markets in virtually every developed and most
developing economies, with the world's biggest markets being in the United
States, China (Hong Kong), India, UK, Germany, France and Japan.
Function and purpose
The stock market is one of the most important sources for companies to
raise money. This allows businesses to go public, or raise additional
capital for expansion. The liquidity that an exchange provides affords
investors the ability to quickly and easily sell securities. This is an
attractive feature of investing in stocks, compared to other less liquid
investments such as real estate.
History has shown that the price of shares and other assets is an
important part of the dynamics of economic activity, and can influence or
be an indicator of social mood. Rising share prices, for instance, tend to
be associated with increased business investment and vice versa. Share
prices also affect the wealth of households and their consumption.
Therefore, central banks tend to keep an eye on the control and behavior
of the stock market and, in general, on the smooth operation of financial
system functions. Financial stability is the raison d'être of central
Exchanges also act as the clearinghouse for each transaction, meaning
that they collect and deliver the shares, and guarantee payment to the
seller of a security. This eliminates the risk to an individual buyer or
seller that the counterparty could default on the transaction.
The smooth functioning of all these activities facilitates economic
growth in that lower costs and enterprise risks promote the production of
goods and services as well as employment. In this way the financial system
contributes to increased prosperity.
Relation of the stock market to the modern financial system
The financial system in most western countries has undergone a
remarkable transformation. One feature of this development is
disintermediation. A portion of the funds involved in saving and financing
flows directly to the financial markets instead of being routed via banks'
traditional lending and deposit operations. The general public's
heightened interest in investing in the stock market, either directly or
through mutual funds, has been an important component of this process.
Statistics show that in recent decades shares have made up an increasingly
large proportion of households' financial assets in many countries. In the
1970s, in Sweden, deposit accounts and other very liquid assets with
little risk made up almost 60 per cent of households' financial wealth,
compared to less than 20 per cent in the 2000s.
The major part of this
adjustment in financial portfolios has gone directly to shares but a good
deal now takes the form of various kinds of institutional investment for
groups of individuals, e.g., pension funds, mutual funds, hedge funds,
insurance investment of premiums, etc. The trend towards forms of saving
with a higher risk has been accentuated by new rules for most funds and
insurance, permitting a higher proportion of shares to bonds. Similar
tendencies are to be found in other industrialized countries. In all
developed economic systems, such as the European Union, the United States,
Japan and other developed nations, the trend has been the same: saving has
moved away from traditional (government insured) bank deposits to more
risky securities of one sort or another.
The stock market, individual investors, and financial risk
Riskier long-term saving requires that an individual possess the
ability to manage the associated increased risks. Stock prices fluctuate
widely, in marked contrast to the stability of (government insured) bank
deposits or bonds. This is something that could affect not only the
individual investor or household, but also the economy on a large scale.
The following deals with some of the risks of the financial sector in
general and the stock market in particular. This is certainly more
important now that so many newcomers have entered the stock market, or
have acquired other 'risky' investments (such as 'investment' property,
i.e., real estate and collectables).
"...With each passing year, the noise level in the stock market
rises. Television commentators, financial writers, analysts, and market
strategists are all overtalking each other to get investors' attention. At
the same time, individual investors, immersed in chat rooms and message
boards, are exchanging questionable and often misleading tips. Yet,
despite all this available information, investors find it increasingly
difficult to profit. Stock prices skyrocket with little reason, then
plummet just as quickly, and people who have turned to investing for their
children's education and their own retirement become frightened. Sometimes
there appears to be no rhyme or reason to the market, only folly."
This is a quote from the preface to a published biography about the
well-known and long term value oriented stock investor Warren Buffett.
Buffett began his career with only 100 U.S. dollars and has over the years
built himself a multibillion-dollar fortune. The quote illustrates some of
what has been happening in the stock market during the end of the 20th
century and the beginning of the 21st.
From experience we know that investors may temporarily pull financial
prices away from their long term trend level. Over-reactions may occur—
so that excessive optimism (euphoria) may drive prices unduly high or
excessive pessimism may drive prices unduly low. New theoretical and
empirical arguments have been put forward against the notion that
financial markets are efficient.
According to the efficient market hypothesis (EMH), only changes in
fundamental factors, such as profits or dividends, ought to affect share
prices. (But this largely theoretic academic viewpoint also predicts that
little or no trading should take place— contrary to fact— since prices
are already at or near equilibrium, having priced in all public
knowledge.) But the efficient-market hypothesis is sorely tested by such
events as the stock market crash in 1987, when the Dow Jones index
plummeted 22.6 percent — the largest-ever one-day fall in the United
This event demonstrated that share prices can fall dramatically
even though, to this day, it is impossible to fix a definite cause: a
thorough search failed to detect any specific or unexpected development
that might account for the crash. It also seems to be the case more
generally that many price movements are not occasioned by new information;
a study of the fifty largest one-day share price movements in the United
States in the post-war period confirms this. Moreover, while the EMH
predicts that all price movement (in the absence of change in fundamental
information) is random (i.e., non-trending), many studies have shown a
marked tendency for the stock market to trend over time periods of weeks
Various explanations for large price movements have been promulgated.
For instance, some research has shown that changes in estimated risk, and
the use of certain strategies, such as stop-loss limits and Value at Risk
limits, theoretically could cause financial markets to overreact.
Other research has shown that psychological factors may result in
exaggerated stock price movements. Psychological research has demonstrated
that people are predisposed to 'seeing' patterns, and often will perceive
a pattern in what is, in fact, just noise. (Something like seeing familiar
shapes in clouds or ink blots.) In the present context this means that a
succession of good news items about a company may lead investors to
overreact positively (unjustifiably driving the price up). A period of
good returns also boosts the investor's self-confidence, reducing his
(psychological) risk threshold.
Another phenomenon— also from psychology— that works against an
objective assessment is group thinking. As social animals, it is not easy
to stick to an opinion that differs markedly from that of a majority of
the group. An example with which one may be familiar is the reluctance to
enter a restaurant that is empty; people generally prefer to have their
opinion validated by those of others in the group.
In one paper the authors draw an analogy with gambling. In normal times
the market behaves like a game of roulette; the probabilities are known
and largely independent of the investment decisions of the different
players. In times of market stress, however, the game becomes more like
poker (herding behavior takes over). The players now must give heavy
weight to the psychology of other investors and how they are likely to
The stock market, as any other business, is quite unforgiving of
amateurs. Inexperienced investors rarely get the assistance and support
they need. In the period running up to the recent Nasdaq crash, less than
1 per cent of the analyst's recommendations had been to sell (and even
during the 2000 - 2002 crash, the average did not rise above 5%). The
media amplified the general euphoria, with reports of rapidly rising share
prices and the notion that large sums of money could be quickly earned in
the so-called new economy stock market. (And later amplified the gloom
which descended during the 2000 - 2002 crash, so that by summer of 2002,
predictions of a DOW average below 5000 were quite common.)
Sometimes the market tends to react irrationally to economic news, even
if that news has no real effect on the technical value of securities
itself. Therefore, the stock market can be swayed tremendously in either
direction by press releases, rumors and mass panic.
Furthermore, the stock market comprises a large amount of speculative
analysts, or pencil pushers, who have no substantial money or financial
interest in the market, but make market predictions and suggestions
regardless. Over the short-term, stocks and other securities can be
battered or buoyed by any number of fast market-changing events, making
the stock market difficult to predict.
Stock market index
The movements of the prices in a market or section of a market are
captured in price indices called stock market indices, of which there are
many, e.g., the S&P, the FTSE and the Euronext indices. Such indices
are usually market capitalization (the total market value of floating
capital of the company) weighted, with the weights reflecting the
contribution of the stock to the index. The constituents of the index are
reviewed frequently to include/exclude stocks in order to reflect the
changing business environment.
Financial innovation has brought many new financial instruments whose
pay-offs or values depend on the prices of stocks. Some examples are
exchange traded funds (ETFs), stock index and stock options, equity swaps,
single-stock futures, and stock index futures. These last two may be
traded on futures exchanges (which are distinct from stock exchanges—their
history traces back to commodities futures exchanges), or traded
over-the-counter. As all of these products are only derived from stocks,
they are sometimes considered to be traded in a (hypothetical) derivatives
market, rather than the (hypothetical) stock market.
Stock that a trader does not actually own may be traded using short
selling; margin buying may be used to purchase stock with borrowed funds;
or, derivatives may be used to control large blocks of stocks for a much
smaller amount of money than would be required by outright purchase or
In short selling, the trader borrows stock (usually from his brokerage
which holds its clients' shares or its own shares on account to lend to
short sellers) then sells it on the market, hoping for the price to fall.
The trader eventually buys back the stock, making money if the price fell
in the meantime or losing money if it rose. Exiting a short position by
buying back the stock is called "covering a short position."
This strategy may also be used by unscrupulous traders to artificially
lower the price of a stock. Hence most markets either prevent short
selling or place restrictions on when and how a short sale can occur. The
practice of naked shorting is illegal in most (but not all) stock markets.
In margin buying, the trader borrows money (at interest) to buy a stock
and hopes for it to rise. Most industrialized countries have regulations
that require that if the borrowing is based on collateral from other
stocks the trader owns outright, it can be a maximum of a certain
percentage of those other stocks' value. In the United States, the margin
requirements have been 50% for many years (that is, if you want to make a
$1000 investment, you need to put up $500, and there is often a
maintenance margin below the $500). A margin call is made if the total
value of the investor's account cannot support the loss of the trade.
(Upon a decline in the value of the margined securities additional funds
may be required to maintain the account's equity, and with or without
notice the margined security or any others within the account may be sold
by the brokerage to protect its loan position.
The investor is responsible
for any shortfall following such forced sales.)
Regulation of margin
requirements (by the Federal Reserve) was implemented after the Crash of
1929. Before that, speculators typically only needed to put up as little
as 10 percent (or even less) of the total investment represented by the
stocks purchased. Other rules may include the prohibition of free-riding:
putting in an order to buy stocks without paying initially (there is
normally a three-day grace period for delivery of the stock), but then
selling them (before the three-days are up) and using part of the proceeds
to make the original payment (assuming that the value of the stocks has
not declined in the interim).
Global issuance of equity and equity-related instruments totaled $505
billion in 2004, a 29.8% increase over the $389 billion raised in 2003.
Initial public offerings (IPOs) by US issuers increased 221% with 233
offerings that raised $45 billion, and IPOs in Europe, Middle East and
Africa (EMEA) increased by 333%, from $ 9 billion to $39 billion.
One of the many things people always want to know about the stock
market is, "How do I make money investing?" There are many
different approaches; two basic methods are classified as either
fundamental analysis or technical analysis. Fundamental analysis refers to
analyzing companies by their financial statements found in SEC Filings,
business trends, general economic conditions, etc. Technical analysis
studies price actions in markets through the use of charts and
quantitative techniques to attempt to forecast price trends regardless of
the company's financial prospects. One example of a technical strategy is
the Trend following method, used by John W. Henry and Ed Seykota, which
uses price patterns, utilizes strict money management and is also rooted
in risk control and diversification.
Additionally, many choose to invest via the index method. In this
method, one holds a weighted or unweighted portfolio consisting of the
entire stock market or some segment of the stock market (such as the
S&P 500 or Wilshire 5000). The principal aim of this strategy is to
maximize diversification, minimize taxes from too frequent trading, and
ride the general trend of the stock market (which, in the U.S., has
averaged nearly 10%/year, compounded annually, since World War II).
Finally, one may trade based on inside information, which is known as insider
trading. However, this is illegal in most jurisdictions (i.e., in most
developed world stock markets).
The New York Stock
The New York Stock Exchange (NYSE), nicknamed the "Big
Board," is a New York City-based privately-owned stock exchange by
the NYSE Group (NYX). It is the largest stock exchange in the world by
dollar volume and the second largest by number of companies listed. Its
share volume was exceeded by that of NASDAQ during the 1990s, but the
total market capitalization of companies listed on the NYSE is five times
that of companies listed on NASDAQ. The New York Stock Exchange has a
global capitalization of $17.4 trillion, including $7.1 trillion in non-US
The NYSE is operated by NYSE Group, which was formed by merger with the
fully electronic stock exchange Archipelago Holdings. The New York Stock
Exchange trading floor is located at 11 Wall Street, and is composed of
five rooms used for the facilitation of trading. The main building is
listed on the National Register of Historic Places and is located at 18
Broad Street, between the corners of Wall Street and Exchange Place.
NYSE Group is acquiring Euronext, and many of its operations
(particularly IT and the trading platform) will be combined with that of
the New York Stock Exchange and NYSE Arca.
The NYSE trades in a continuous auction format. There is one specific
location on the trading floor where each listed stock trades. Exchange
members interested in buying and selling a particular stock on behalf of
investors gather around the appropriate post where a specialist broker,
who is employed by a NYSE member firm (that is, he/she is not an employee
of the New York Stock Exchange), acts as an auctioneer in an open outcry
auction market environment to bring buyers and sellers together and to
manage the actual auction. They do on occasion (approximately 10% of the
time) facilitate the trades by committing their own capital and as a
matter of course disseminate information to the crowd that helps to bring
buyers and sellers together. Most of the time natural buyers and sellers
meet in a market that provides efficient price discovery in an auction
environment that is designed to produce the fairest price for both
parties. The human interaction and expert judgment as to order execution
differentiates the NYSE from fully electronic markets. However, in excess
of 50% of all order flow is now delivered to the floor electronically.
Recent proposals have been made to adopt a Hybrid market structure
combining elements of open outcry and electronic markets. The frenzied
commotion of men and women in colored smocks has been captured in several
movies, including Wall Street.
In the mid-1960s, the NYSE Composite Index (NYSE: NYA) was created,
with a base value of 50 points equal to the 1965 yearly close, to reflect
the value of all stocks trading at the exchange instead of just the 30
stocks included in the Dow Jones Industrial Average. To raise the profile
of the composite index, in 2003 the NYSE set its new base value of 5,000
points equal to the 2002 yearly close. (Previously, the index had stood
just below 500 points, with lifetime highs and lows of 670 points and 33
points, respectively.) The lifetime high of the NYSE Composite in trading
stands at 9,188.17 points, reached on December 28, 2006, while its
lifetime low (as currently calculated) stands at 347.77 points, reached in
Since September 30, 1985 the NYSE trading hours have been 9:30 - 16:00
EST. The right to directly trade shares on the exchange is conferred upon
owners of the 1366 "seats". The term comes from the fact that up
until the 1870s NYSE members sat in chairs to trade; this system was
eliminated long ago. In 1868, the number of seats was fixed at 533, and
this number was increased several times over the years. In 1953, the
exchange stopped at 1366 seats. These seats are a sought-after commodity
as they confer the ability to directly trade stock on the NYSE. Seat
prices have varied widely over the years, generally falling during
recessions and rising during economic expansions. The most expensive seat,
adjusted for inflation, was sold in 1929 for $625,000, which is over six
million in today's dollars. In recent times, seats have sold for as high
as $4 million in the late 1990s and $1 million in 2001. In 2005, seat
prices shot up to $3.25 million as the exchange was set to merge with
Archipelago and become a for-profit, publicly traded company. Seat owners
received $500,000 cash per seat and 77,000 shares of the newly formed
corporation. The NYSE now sells one-year licenses to trade directly on the
The origin of the NYSE can be traced to May 17, 1792, when the
Buttonwood Agreement was signed by twenty-four stockbrokers outside of 68
Wall Street in New York under a buttonwood tree. On March 8, 1817, the
organization drafted a constitution and renamed itself the "New York
Stock & Exchange Board". This name was shortened to its current
form in 1863. Anthony Stockholm was elected the Exchange's first
The first central location of the NYSE was a room rented for $200 a
month in 1817 located at 40 Wall Street. But the volume of stocks traded
had increased sixfold in the years between 1896 and 1901 and a larger
space was required to conduct business in the expanding marketplace. Eight
New York City architects were invited to participate in a design
competition for a new building and the Exchange selected the neoclassic
design from architect George B. Post. Demolition of the existing building
at 10 Broad Street and the adjacent lots started on 10 May 1901.
The New York Stock Exchange building opened at 18 Broad Street on April
22, 1903 at a cost of $4 million. The trading floor was one of the largest
volumes of space in the city at the time at 109 x 140 feet wide (33 x 42.5
meters) with a skylight set into a 72 foot high ceiling (22 m.) The main
facade of the building features marble sculpture by John Quincy Adams Ward
in the pediment, above six tall Corinthian capitals, called
"Integrity Protecting the Works of Man". The building was listed
as a National Historic Landmark and added to the National Register of
Historic Places on June 2, 1978.
In 1922, a building designed by Trowbridge & Livingston was added
at 11 Broad Street for offices, and a new trading floor called "the
garage". Additional trading floor space was added in 1969 and 1988
(the "blue room") with the latest technology for information
display and communication. Another trading floor was opened at 30 Broad
Street in 2000. With the arrival of the Hybrid Market, a greater
proportion of trading was executed electronically and the NYSE decided to
close the 30 Broad Street trading room in early 2006.
The Exchange was closed shortly after the beginning of World War I
(July 1914), but it was re-opened on November 28 of that year in order to
help the war effort by trading bonds.
On September 16, 1920, a bomb exploded on Wall Street outside the NYSE
building, killing 33 people and injuring more than 400. The perpetrators
were never found. The NYSE building and some buildings nearby, such as the
JP Morgan building, still have marks on their facades caused by the
The Black Thursday crash of the Exchange on October 24, 1929, and the
sell-off panic which started on Black Tuesday, October 29, are often
blamed for precipitating the Great Depression. In an effort to try to
restore investor confidence, the Exchange unveiled a fifteen-point program
aimed to upgrade protection for the investing public on October 31, 1938.
On October 1, 1934, the exchange was registered as a national
securities exchange with the U.S. Securities and Exchange Commission, with
a president and a thirty-three member board. On February 18, 1971 the
not-for-profit corporation was formed, and the number of board members was
reduced to twenty-five.
On August 24, 1967, Abbie Hoffman led a group opposed to capitalism
(and other things, including the Vietnam War) in the gallery of the New
York Stock Exchange. The protestors threw fistfuls of (mostly fake) dollar
bills down to the traders below, who began to scramble frantically to grab
the money, as fast as they could. Hoffman claimed to be pointing out that,
metaphorically, that's what NYSE traders "were already doing".
The NYSE then installed barriers in the gallery, to prevent this kind of
protest from interfering with trading again.
Following a 554.26 point drop in the Dow Jones Industrial Average
(DJIA) on October 27, 1997, officials at the Exchange for the first time
invoked the "circuit breaker" rule to stop trading. This was a
very controversial move and prompted a quick change in the rule; trading
now halts for an hour, two hours, or the rest of the day when the DJIA
drops 10, 20, or 30 percent, respectively. In the afternoon, the 10 and
20% drops will halt trading for a shorter period of time, but a 30% drop
will always close the exchange for the day. The rationale behind the
trading halt was to give investors a chance to cool off and reevaluate
The NYSE was closed from September 11 until September 17, 2001 as a
result of the September 11, 2001 attacks.
On September 17, 2003, NYSE chairman and chief executive Richard Grasso
stepped down as a result of controversy concerning the size of his
deferred compensation package. He was replaced as CEO by John Thain, the
former President of Goldman Sachs Group Inc.
On April 21, 2005, the NYSE announced its plans to acquire Archipelago,
in a deal that is intended to bring the NYSE public.
On December 6, 2005, the NYSE's governing board voted to acquire rival
Archipelago and become a for-profit, public company. It began trading
under the name NYSE Group on March 8, 2006.
The Dow Jones Industrial Average, which started on October 1,
1928, hit a record high on January 03 2006 of 12.580,35. Marsh Carter is
the Chairman of the New York Stock Exchange, succeeding John S. Reed. John
Thain is the CEO of the NYSE. Gerald Putnam and Catherine Kinney are the
co-Presidents of the NYSE.
New York Stock Exchange Milestones
||The first traded company on the NYSE
||Rules and a Constitution - The New York Stock and Exchange Board
||The First Stock Ticker
||NYSE closes for 10 Days
||DJIA published by The Wall Street Journal
||NYSE moves into its new quarters at 18 Broad Street
||Panic of 1907
||World War I causes longest exchange shutdown
||Market price in Dollars
||Central Quote System
||Black Thursday (October 24) and Black Tuesday (October 29)
||Women Work on Trading Floor
||Longest Bull Run begins
||Dow surpasses 1929 peak
||NYSE creates Common Stock Index
||Floor data fully automated
||Securities Investor Protection Corporation established
||DJIA Closes Over 1,000
||Foreign Brokers/Dealers are admitted
||New York Futures Exchange established
||Ronald Reagan visits NYSE
||Largest One-Day Percentage Drop of DJIA (Black Monday, 19
||Dow exceeds 3,000
||NYSE celebrates its Bicentennial
||Real-time Ticker introduced
||DJIA tops 10,000
||DJIA at record high (until 2006)
||First Global Index Launches
||Trading in Fractions (n/16) ends, replaced by decimals (decimalization)
||Terrorist Attacks on World Trade Center (September 11): NYSE
closed for 4 session days
||NYSE Composite Index relaunched
||NYSE and ArcaEx agree to merge
||NYSE and ArcaEx merge - NYSE Group, Inc. For-profit, publicly
||NYSE Group buys Euronext, creating the first trans-Atlantic
stock exchange group
||DJIA tops 12,000 on October 19th; NYSE Composite tops 9,000 on
||President George W. Bush visits the NYSE. He showed up
unannounced to the Floor about an hour and a half before an FOMC
interest rate decision. The market nearly came to a complete
stand-still for approximately 30 minutes. During the trading day
he spent a few minutes talking with specialists.
The Dow Jones
The Dow Jones Industrial Average (NYSE: DJI, also called DJIA,
Dow 30, or informally the Dow Jones index or the Dow) is one of several
stock market indices created by Wall Street Journal editor and Dow Jones
& Company founder Charles Dow. Dow compiled the index as a way to
gauge the performance of the industrial component of America's stock
markets. It is the oldest continuing U.S. market index.
Today, the average consists of 30 of the largest and most widely held
public companies in the United States. The "industrial" portion
of the name is largely historical — many of the 30 modern components
have little to do with heavy industry. To compensate for the effects of
stock splits and other adjustments, it is currently a scaled average, not
the actual average of the prices of its component stocks — the actual
average of prices is multiplied by a scale factor, which changes over
time, to generate the value of the index.
First published on May 26, 1896, the DJIA represented the average of
twelve stocks from various important American industries. Of those
original twelve, only General Electric remains part of the average. The
other eleven were:
American Cotton Oil Company, a predecessor of Bestfoods, now part
||American Sugar Company,
now Amstar Holdings
||American Tobacco Company,
broken up in 1911
||Chicago Gas Company,
bought by Peoples Gas Light & Coke Co. in 1897 (now Peoples
||Distilling & Cattle
Feeding Company, now Millennium Chemicals, a division of
Lyondell Chemical Company
||Laclede Gas Light Company,
still in operation as The Laclede Group
||National Lead Company,
now NL Industries
||North American Company,
(Edison) electric company broken up in the 1950s
||Tennessee Coal, Iron and
Railroad Company, bought by U.S. Steel in 1907
||U.S. Leather Company,
||United States Rubber Company,
changed its name to Uniroyal in 1967, bought by Michelin in 1990
When it was first published, the index stood at 40.94. It was computed
as a direct average, by first adding up stock prices of its components and
dividing by the number of stocks. Many of the biggest percentage price
moves in the Dow occurred early in its history, as the nascent industrial
||The index hit its all-time low
of 28.48 during the summer of 1896.
||The largest one-day percentage
drop in the history of the Dow occurred on December 12, 1914,
24.39%, after a multi-month NYSE hiatus brought on by World War I.
In 1916, the number of stocks in the DJIA was increased to twenty, and
finally to thirty in 1928, near the height of the "roaring
1920s" bull market. The crash of 1929 and the ensuing Great
Depression returned the average to its starting point, almost 90% below
its peak, by July 8, 1932. The highs of September 3, 1929 would not be
surpassed until 1954.
||The largest one-day percentage
gain in the index, 14.87%, happened on October 6, 1931, in the
depths of the 1930s bear market.
||The post-World War II bull
market, which brought the market well above its 1920s highs,
lasted until 1966.
||On November 14, 1972 the
average closed above 1,000 (1,003.16) for the first time, in the
midst of a lengthy bear market.
The 1980s and especially the 1990s saw a very rapid increase in the
average, though severe corrections did occur along the way.
||The largest one-day percentage
drop since 1914 occurred on "Black Monday", October 19,
1987, when the average fell 22.6%.
||The largest one-day percentage
gain since 1932, 10.15%, occurred two days later on Wednesday,
October 21, bringing the Dow back above 2,000 and in line for a
||On November 21, 1995 the DJIA
closed above 5,000 (5,023.55) for the first time.
||On March 29,
1999, the average
closed at 10,006.78, its first close above the 10,000 mark.
||On May 3,
1999, the Dow closed
at 11,014.70, its first close above 11,000.
The uncertainty of the early 2000s brought a significant bear market,
and whether it has ended or simply gone into hibernation has been an
ongoing subject of debate.
||On January 14, 2000, the DJIA
reached a record high of 11,750.28 in trading before settling at a
record closing price of 11,722.98; these two records would not be
broken until October 3, 2006.
||The largest one-day point gain
in the Dow, an advance of 499.19, or 4.93%, occurred on March 16,
2000, as the broader market approached its top.
||The largest one-day point drop
in DJIA history occurred on September 17, 2001, the first day of
trading after the September 11, 2001 attacks, when the Dow fell
684.81 points, or 7.1%. By the end of that week, the Dow had
fallen 1,369.70 points, or 14.3%. A recovery attempt allowed the
average to close the year above 10,000.
||By mid-2002, the average had
returned to its 1998 level of 8,000.
||On October 9, 2002, the DJIA
bottomed out at 7,286.27 (intra-day low 7,197.49), its lowest
close since October 1997.
||By the end of 2003, the Dow
returned to the 10,000 level.
||On January 9, 2006 the average
broke the 11,000 barrier for the first time since June 2001,
closing at 11,011.90.
||In October 2006, four years
after its bear market low, the DJIA set fresh record theoretical,
intra-day, daily close, weekly, and monthly highs for the first
time in almost seven years, closing above 12,000 for the first
time on the 19th anniversary of Black Monday.
The DJIA is criticized for being a price-weighted average, which gives
relatively higher-priced stocks more influence over the average than their
lower-priced counterparts. This can produce misleading results, as a $1
increase in a lower-priced stock can be negated by a $1 decrease in a much
higher-priced stock, even though the first stock experienced a larger
percentage change. Additionally, the inclusion of only 30 stocks in the
average has brought on additional criticism of the average, as the DJIA is
widely used as an indicator of overall market performance.
Many critics of the DJIA recommend the float-adjusted market-value
weighted S&P 500 index as a better indicator of the wider economy.
Another issue with the Dow is that not all 30 components open at the
same time in the morning. Only a few components open at the start and the
posted opening price of the Dow is determined by the price of those few
components that open first and the previous day's closing price of the
remaining components that haven't opened yet; therefore, the posted
opening price on the Dow will always be close to the previous day's
closing price (which can be observed by looking at Dow price history) and
will never accurately reflect the true opening prices of all its
components. Thus, in terms of candlestick charting theory, the Dow's
posted opening price cannot be used in determining the condition of the
The individual components of the DJIA are occasionally changed as
market conditions warrant. They are selected by the editors of The Wall
Street Journal. When companies are replaced, the scale factor used to
calculate the index is also adjusted so that the value of the average is
not directly affected by the change.
On November 1, 1999, Chevron, Goodyear Tire and Rubber Company, Sears
Roebuck, and Union Carbide were removed from the DJIA and replaced by
Intel, Microsoft, Home Depot, and SBC Communications. Intel and Microsoft
became the first two companies traded on the NASDAQ exchange to be listed
in the DJIA. On April 8, 2004, another change occurred as International
Paper, AT&T, and Eastman Kodak were replaced with Pfizer, Verizon, and
AIG. On December 1, 2005 AT&T's original T symbol returned to the DJIA
as a result of the SBC Communications and AT&T merger.
The Dow Jones Industrial Average consists of the following 30
||3M Co. (NYSE: MMM)
||ALCOA Inc. (NYSE: AA)
||Altria Group Inc. (NYSE: MO)
||American Express Co. (NYSE: AXP)
||American International Group
Inc. (NYSE: AIG) (property & casualty insurance)
||AT&T Inc. (NYSE: T) (telecoms)
||Boeing Co. (NYSE: BA)
||Caterpillar Inc. (NYSE: CAT)
(farm & construction equipment)
||Citigroup Inc. (NYSE: C) (money
||Coca-Cola Co. (NYSE: KO)
||E.I. du Pont de Nemours &
Co. (NYSE: DD) (chemicals)
||Exxon Mobil Corp. (NYSE: XOM)
(major integrated oil & gas)
||General Electric Co. (NYSE: GE)
||General Motors Corp. (NYSE: GM)
||Hewlett-Packard Co. (NYSE: HPQ)
(diversified computer systems)
||Home Depot Inc. (NYSE: HD)
(home improvement stores)
||Honeywell International Inc.
(NYSE: HON) (conglomerates)
||Intel Corp. (NASDAQ: INTC)
||International Business Machines
Corp. (NYSE: IBM) (diversified computer systems)
||Johnson & Johnson (NYSE:
JNJ) (consumer and health care products conglomerate)
||JPMorgan Chase & Co. (NYSE:
JPM) (money center banks)
||McDonald's Corp. (NYSE: MCD)
||Merck & Co. Inc. (NYSE: MRK)
||Microsoft Corp. (NASDAQ: MSFT)
||Pfizer Inc. (NYSE: PFE) (drug
||Procter & Gamble Co. (NYSE:
PG) (consumer goods)
||United Technologies Corp.
(NYSE: UTX) (conglomerates)
||Verizon Communications Inc.
(NYSE: VZ) (telecoms)
||Wal-Mart Stores Inc. (NYSE: WMT)
(discount, variety stores)
||Walt Disney Co. (NYSE: DIS)
To calculate the DJIA, the sum of the prices of all 30 stocks is
divided by a "divisor", which is published on the Chicago Board
of Trade's website. The divisor is adjusted in case of splits,
spinoffs or similar structural changes, to ensure that such events do not
in themselves alter the numerical value of the DJIA. The initial divisor
was the number of component companies, so that the DJIA was at first a
simple arithmetic average; the present divisor, after many adjustments, is
less than one (meaning the index is actually larger than the sum of the
prices of the component prices). That is:
where p are the prices of the component stocks and d is the Dow
Events like stock splits or changes in the list of the companies
composing the index alter the sum of the prices of the component prices.
In these cases, in order to avoid discontinuity in the index, the Dow
divisor is updated so that the quotations right before and after the event
Because the DJIA is an average of stock prices, it is more strongly
affected by relative changes in performance of high-priced stocks than by
lower-priced ones. For example, a 100% price increase of a $1 stock would
have the same effect on the index as a 1% price increase of a $100 stock,
even if both companies had the same market capitalization. In this sense
higher-priced stocks have a greater "weight" in the index. A
list of the effective weight of each component is published daily by Dow
Jones, (although the weights change whenever the prices of the component
stocks change). The weights are simply proportional to the stock prices,
and are not used in calculating the DJIA.
Apart from investing in the individual stocks in the Dow Jones, there
also is the option to invest in an exchange-traded fund (ETF) which
represents ownership in a portfolio of the equity securities that comprise
the DJIA. This ETF is called the Diamonds, and the ticker symbol is AMEX:
DIA. The units of this ETF, therefore, represent an opportunity for the
investor to achieve the same performance of the DJIA (minus fund expenses)
and trade like any other stock on the Amex Exchange, so they can be bought
on margin, sold short or held for the long term.
Dow futures and option contracts trade actively on the Chicago Board of
Closing milestones of the Dow Jones Industrial Average
Like most other stock market indices, the Dow undergoes periods of
general increase and general declines or stagnation. A bull market is a
term denoting a period of price increases, while a bear market denotes a
period of declines. Wall Street generally considers a bear market in
session when the main stock market index is more than 20 percent below its
all-time high. By this definition, as of the close of 2006, the Dow will
enter a bear market if it sustains a fall below the 10,000 point
milestone, which it last touched in April 2005.
There are two types of bull markets. A secular bull market is a period
in which the stock market index is continually reaching all-time highs
with only brief periods of correction, as during the 1990s, and can last
upwards of 15 years. A cyclical bull market is a period in which the stock
market index is reaching 52-week or multi-year highs and may briefly peak
at all-time highs before a rapid decline, as in the early 1970s. It
usually occurs within relatively longer bear markets and lasts about three
The following are the secular bull and bear markets experienced by
the Dow since its inception:
– 1929: Bull market. In the summer of 1896 the Dow
sheds 30% to set an all-time low of 28.48, but quickly erases its
losses, and eventually grows to a closing high of 381.17
(theoretical intra-day high of 386.1) on September 3, 1929.
– 1948: Bear market. The stock market crash of 1929
precedes the Great Depression. The Dow plunges to 41.22
(theoretical intra-day low of 40.56) on July 8, 1932, thus erasing
36 years of gains. From here, the index would take 22 years to
surpass its previous highs.
– 1966: Bull market. The Dow posts impressive growth
in the booming economy following the Second World War . Starting
from about 150 in June 1949, when P/E ratios reach multi-decade
lows, the index ends just five points below 1,000 on February 9,
– 1982: Bear market. Traders deal with a stagnant
economy in an inflationary monetary environment. The Dow enters
two long downturns in 1970 and 1974; during the latter, it falls
nearly 45% to the bottom of a 20-year range. The index approaches
the 1,000 milestone at the top of its range three times in 1972,
1976 and 1981, but fails to break the mark decisively.
– 2000: Bull market. The Dow experiences its most
spectacular rise in history. From a meager 777 on August 12, 1982,
the index grows more than 1,500% to 11,722.98 (actual and
theoretical intra-day highs of 11,750.28 and 11,908.50) by January
undetermined: Bear market. The Dow struggles with the
10,000 - 11,000 range for a year and then deteriorates into a
panic atmosphere of severe declines punctuated by brief and
violent rallies. The index hits a closing low of 7,286.27 (actual
and theoretical intra-day lows of 7,197.49 and 7,181.47 the
following day), 38% below its highs, on October 9, 2002. The
records of early 2000 stood until the fourth quarter of 2006.
On October 3, 2006, the Dow achieved new record closing and intra-day
highs for the first time in nearly seven years. Later that month, the
index closed above 12,000 for the first time (October 19), and stayed
above the milestone to set record weekly (October 27) and monthly (October
31) closing levels. While some experts might consider the concurrent
record highs on the DJIA, the Dow Jones Transportation Average, and the
Dow Jones Utilities taking place on February 14, 2007 (the first time that
all three finished at record highs on the same day since March 17, 1998)
as Dow Theory confirmation that the bear market ended in 2002, the
depressed state of the technology market compared with 2000 leaves that a
matter of dispute. It is notable, however, that both the tech-laden NASDAQ
Composite and the broader S&P 500, while not yet at all-time highs,
both achieved six-year monthly closing highs concurrently with the DJIA on
November 30, 2006.
Note: For current record highs, please see Wikipedia's
Closing Milestones of the
Dow Jones Industrial Average.
Dow Theory is a theory on stock price movements that provides a basis
for technical analysis. The theory was derived from 255 Wall Street
Journal editorials written by Charles H. Dow (1851–1902), journalist,
first editor of the Wall Street Journal and co-founder of Dow Jones and
Company. Following Dow's death, William P. Hamilton, Robert Rhea and E.
George Schaefer organized and collectively represented "Dow
Theory," based on Dow's editorials. Dow himself never used the term
"Dow Theory," though.
The six basic tenets of Dow Theory as summarized by Hamilton, Rhea,
and Schaefer are described below.
As with many investment theories, there is conflicting evidence in
support and opposition of Dow Theory. Alfred Cowles in a study in
Econometrica in 1934 showed that trading based upon the editorial advice
would have resulted in earning less than a buy-and-hold strategy using a
well diversified portfoilio. Cowles concluded that a buy-and-hold strategy
produced 15.5% annualized returns from 1902-1929 while the Dow Theory
strategy produced annualized returns of 12%. After numerous studies
supported Cowles over the following years, many academics stopped studying
Dow Theory believing Cowles's results were conclusive.
In recent years however, some in the academic community have revisited
Dow Theory and question Cowles' conclusions. William Goetzmann, Stephen
Brown, and Alok Kumar believe that Cowles' study was incomplete and
that Dow Theory produces excess risk-adjusted returns. Specifically, the
absolute return of a buy-and-hold strategy was higher than that of a Dow
Theory portfolio by 2%, but the riskiness and volatility of the Dow Theory
portfolio was so much lower that the Dow Theory portfolio produced higher
risk-adjusted returns according to their study. The Chicago Board of Trade
also notes that there is growing interest in market timing strategies such
as Dow Theory.
One key problem with any analysis of Dow Theory is that the editorials
of Charles Dow did not contain explicitly defined investing
"rules" so some assumptions and interpretations are necessary.
And as with many academic studies of investing strategies, practitioners
often disagree with academics.
Many technical analysts consider Dow Theory's definition of a trend and
its insistence on studying price action as the main premises of modern
1. Markets have three trends
Price is all vibrant. It is never stagnant and can't be. It should and
must have its own direction to move, which may or may not be known to us.
This direction is called as the trends of that particular stock or the
average. To start with, Dow defined an uptrend (trend 1) as a time
when successive rallies in a security price close at levels higher than
those achieved in previous rallies and when lows occur at levels higher
than previous lows. Downtrends (trend 2) occur when markets make
lower lows and lower highs. It is this concept of Dow Theory that provides
the basis of technical analysis' definition of a price trend. Dow
described what he saw as a recurring theme in the market: that prices
would move sharply in one direction, recede briefly in the opposite
direction, and then continue in their original direction (trend 3).
But we can still find out a direction to the stock trend and that's called
"choppy trend". Simply the sideways movements of any
scrip is defined as "choppy" trend.
2. Trends have three phases
Dow Theory asserts that major market trends are composed of three
phases: an accumulation phase, a public participation phase, and a
distribution phase. The accumulation phase (phase 1) is when
investors "in the know" are actively buying (selling) stock
against the general opinion of the market. During this phase, the stock
price does not change much because these investors are in the minority
absorbing (releasing) stock that the market at large is supplying
(demanding). Eventually, the market catches on to these astute investors
and a rapid price change occurs (phase 2). This is when trend
followers and other technically oriented investors participate. This phase
continues until rampant speculation occurs. At this point, the astute
investors begin to distribute their holdings to the market (phase 3).!!!
3. The stock market discounts all news
Stock prices quickly incorporate new information as soon as it becomes
available. Once news is released, stock prices will change to reflect this
new information. On this point, Dow Theory agrees with one of the premises
of the efficient market hypothesis.
4. Stock market averages must confirm each other
In Dow's time, the US was a growing industrial power. The US had
population centers but factories were scattered throughout the country.
Factories had to ship their goods to market, usually by rail. Dow's first
stock averages were an index of industrial (manufacturing) companies and
rail companies. To Dow, a bull market in industrials could not occur
unless the railway average rallied as well, usually first. The logic is
simple to follow. If manufacturers' profits are rising, it follows that
they are producing more. If they produce more, then they have to ship more
goods to consumers. Hence, if an investor is looking for signs of health
in manufacturers, he or she should look at the performance of the
companies that ship the output of them to market, the railroads. The two
averages should be moving in the same direction. When the performance of
the averages diverge, it is a warning that change is in the air.
Even today, both Barron's Magazine and the Wall Street Journal publish
the daily performance of the Dow Jones Transportation Index in chart form.
The index contains major railroads, shipping companies, and air freight
carriers in the US.
5. Trends are confirmed by volume
Dow believed that volume confirmed price trends. When prices move on
low volume, there could be many different explanations why. An overly
aggressive seller could be present for example. But when price movements
are accompanied by high volume, Dow believed this represented the
"true" market view. If many participants are active in a
particular security, and the price moves significantly in one direction,
Dow maintained that this was the direction in which the market anticipated
continued movement. To him, it was a signal that a trend is developing.
6. Trends exist until definitive signals prove that they have ended
Dow believed that trends existed despite "market noise".
Markets might temporarily move in the direction opposite the trend, but
they will soon resume the prior move. The trend should be given the
benefit of the doubt during these reversals. Determining whether a
reversal is the start of a new trend or a temporary movement in the
current trend is not easy. Dow Theorists often disagree in this
determination. Technical analysis tools attempt to clarify this but they
can be interpreted differently by different investors.
The S&P 500 is an index containing the stocks of 500 Large-Cap
corporations, most of which are American. The index is the most notable of
the many indices owned and maintained by Standard & Poor's, a division
of McGraw-Hill. S&P 500 is used in reference not only to the index but
also to the 500 actual companies whose stocks are included in the index.
The S&P 500 index forms part of the broader S&P 1500 and
S&P Global 1200 stock market indices.
All of the stocks in the index are those of large publicly held
companies and trade on major US stock exchanges such as the New York Stock
Exchange and Nasdaq. After the Dow Jones Industrial Average, the S&P
500 is the most widely watched index of large-cap US stocks. It is
considered to be a bellwether for the US economy and is a component of the
Index of Leading Indicators. It is often quoted using the symbol SPX, and
may be prefixed with a caret (^) or with a dollar sign ($).
Many index funds and exchange-traded funds track the performance of the
S&P 500 by holding the same stocks as the index, in the same
proportions, and thus attempting to match its performance (before fees and
expenses). Partly because of this, a company which has its stock added to
the list may see a boost in its stock price as the managers of the mutual
funds must purchase that company's stock in order to match the funds'
composition to that of the S&P 500 index.
In stock and mutual fund performance charts, the S&P 500 index is
often used as a baseline for comparison. The chart will show the S&P
500 index, with the performance of the target stock or fund overlaid.
Prior to 1957, the primary S&P stock market index consisted of 90
companies, known as the S&P 90, and was published on a daily basis. A
broader index of 423 companies was also published weekly. On March 4,
1957, a broad, real-time stock market index, the S&P 500 was
introduced. This introduction was made possible by advancements in the
computer industry which allowed the index to be calculated and
disseminated in real time.
The S&P 500 is used widely as an indicator of the broader market,
as it includes both "growth" stocks (which inflated and then
deflated in the dot-com bubble and bust) and generally less volatile
"value" stocks; it also includes stocks from both the NASDAQ
stock market and the NYSE. The index, near the height of the bubble,
reached an all-time closing high of 1,527.46, and intra-day high of
1,553.11, on March 24, 2000. After that, the index eventually lost
approximately 50% of its value, spiking below 800 in July 2002 and
reaching a bear market low of 768.63 intra-day on October 10, 2002. Since
then, the US stock markets have gradually recovered. However, during the
week of October 2, 2006, when the DJIA set new record highs for the first
time in nearly seven years, the S&P 500 remained below its all-time
closing high. As of late 2006, the S&P 500 remains below its all-time
high, although it established a monthly close above 1400 points for the
first time in over six years on November 30, 2006.
The components of the S&P 500 are selected by committee. This is
similar to the Dow 30, but different from others such as the Russell 1000,
which are strictly rules-based.
Although the index includes many large companies in the US, it is not
simply a list of the 500 biggest companies, and includes a handful (11 as
of September 19, 2006) that are incorporated outside of the US and are
therefore technically not US companies. The companies are carefully
selected to ensure that they are representative of various industries in
the US economy. In addition, companies that do not trade publicly (such as
those that are privately or mutually held) and stocks that do not have
sufficient liquidity are not in the index. By contrast, the Fortune 500
attempts to list the 500 largest companies in the United States by gross
revenue, regardless of whether their stocks trade or their liquidity,
without adjustment for industry representation, and excluding companies
incorporated outside the US.
The index was previously market-value weighted; that is, movements in
price of companies whose total market valuation (share price times the
number of outstanding shares) is larger will have a greater effect on the
index than companies whose market valuation is smaller.
The index has since been converted to float weighted; that is, only
shares which Standard & Poor's determines are available for public
trading ("float") are counted. The transition was made in two
tranches, the first on March 18, 2005 and the second on September 16,
2005. (For example, only the Class A shares of Google ("GOOG")
are publicly traded; thus, of the 207,096,000 Class A shares outstanding
as of March 2006, only 199,570,000 shares were considered float, so only
the value of the latter number of shares was used to incorporate Google
into the S&P 500 on March 31, 2006.) Only a minority of companies in
the index have this sort of public float lower than their total
capitalization; for most companies in the index S&P considers all
shares to be part of the public float and thus the capitalization used in
the index calculation equals the market capitalization for those
Apart from purchasing the individual stocks in the S&P 500,
investors may also purchase shares of an exchange-traded fund (ETF) which
represents ownership in a portfolio of the equity securities that comprise
the Standard & Poor's 500 Index. One of these ETF's is called the
Standard & Poor's Depositary Receipts (SPDRs, pronounced
"spiders"), and the ticker symbol is SPY. Typical volume for the
SPDR is over 42 million shares per day, second only to QQQQ. There is also
the smaller, newer iShares S&P 500 (Symbol:IVV), which has a slightly
lower expense ratio, but is otherwise identical to the SPDRs. Rydex also
offers an ETF, Rydex S&P Equal Weight (Symbol:RSP), which provides
equal exposure to all the companies in the S&P 500.
The relatively compact units of these ETFs represent an opportunity for
the smaller investor to achieve a performance close to the S&P 500
Index (minus fees and expenses). They trade like any other stock on the
American Stock Exchange, so they can be bought on margin, sold short, or
held for the long term.
Several mutual fund managers also provide index funds that track the
S&P 500. Notable among them is The Vanguard Group's (fund: VFINX).
Additionally, the Chicago Mercantile Exchange (CME) offers futures and
options on the S&P 500 index. S&P futures can be traded on the
exchange floor in an open outcry auction, or on CME's Globex platform,
though only E-mini contracts are traded during regular trading hours.
These are the closing milestones
of the S&P 500 in 100-point increments.
||June 4, 1968
||November 21, 1985
||March 23, 1987
||December 26, 1991
||March 24, 1995
||November 17, 1995
||October 11, 1996
||February 12, 1997
||July 2, 1997
||February 2, 1998
||March 24, 1998
||December 21, 1998
||March 15, 1999
||July 9, 1999
||March 22, 2000
NASDAQ (originally an acronym for National
Association of Securities Dealers Automated Quotations system) is an
American electronic stock exchange. It was founded in 1971 by the National
Association of Securities Dealers (NASD), who divested it in a series of
sales in 2000 and 2001. It is owned and operated by The Nasdaq Stock
Market, Inc. (NASDAQ: NDAQ) the stock of which was listed on its own stock
exchange in 2002. NASDAQ is the largest electronic screen-based equity
securities market in the United States. With approximately 3,200
companies, it lists more companies and, on average, trades more shares per
day than any other U.S. market. The current chief executive officer is
When it began trading on February 8, 1971, it was the
world's first electronic stock market. At first, it was merely a computer
bulletin board system and did not actually connect buyers and sellers. The
NASDAQ helped lower the spread (the difference between the bid price and
the ask price of the stock) but somewhat paradoxically was unpopular among
brokerages because they made much of their money on the spread. Over the
years, NASDAQ became more of a stock market by adding trade and volume
reporting and automated trading systems. NASDAQ was also the first stock
market to advertise to the general public, highlighting NASDAQ-traded
companies (usually in technology) and closing with the declaration that
NASDAQ is "the stock market for the next hundred years."
Until 1987, most trading occurred via the telephone, but
during the October 1987 stock market crash, market makers often didn't
answer their phones. To counteract this, the Small Order Execution System
(SOES) was established, which provides an electronic method for dealers to
enter their trades. NASDAQ requires market makers to honor trades over
On July 17, 1995, the NASDAQ Composite index closed above
the 1,000 mark for the first time. The index peaked at an intra-day high
of 5,132.52 on March 10, 2000, which signaled the beginning of the end of
the dot-com stock market bubble. The index declined to half its value
within a year, and finally found a bear market bottom at its intra-day low
of 1,108.49 on October 10, 2002. While the index has gradually recovered
since then, reaching a six-year monthly closing high above the 2,400 level
on November 30, 2006, it is still (as of early 2007) trading for less than
half of its peak value.
Merger attempt with London Stock Exchange
In December of 2005, the London Stock Exchange (LSE)
rejected a £1.6 billion takeover offer from Macquarie Bank. The LSE
described the offer as "derisory." It then received a bid in
March of 2006 for £2.4 billion from NASDAQ, which was also rejected by
the LSE. NASDAQ later pulled its bid, and less than two weeks later on
April 11, 2006, struck a deal with LSE's largest shareholder, Ameriprise
Financial's Threadneedle Asset Management unit, to acquire all of that
firm's stake, consisting of 35.4 million shares, at £11.75 per share.
NASDAQ also purchased 2.69 million additional shares, resulting in a total
stake of 15%. While the seller of those shares was undisclosed, it
occurred simultaneously with a sale by Scottish Widows of 2.69 million
shares. The move was seen as an effort to force LSE to negotiate either a
partnership or eventual merger, as well as to block other suitors such as
NYSE Group, owner of the New York Stock Exchange.
Subsequent purchases increased NASDAQ's stake to 29%,
holding off competing bids for several months. However only a further 0.4%
of shareholders accepted the offer by the deadline and therefore the offer
was rejected on February 10, 2007.
NASDAQ allows multiple market participants to trade
through its Electronic Communication Networks (ECNs) structure, increasing
competition. The Small Order Execution System (SOES) is another NASDAQ
feature, introduced in 1987, to ensure that in 'turbulent' market
conditions small market orders are not forgotten but are automatically
processed. With approximately 3,200 companies, it lists more companies
and, on average, trades more shares per day than any other stock exchange
in the world. It is home to companies that are leaders across all areas of
business including technology, retail, communications, financial services,
digging, transportation, media and biotechnology. NASDAQ is the primary
market for trading NASDAQ-listed stocks.
NASDAQ quotes are available at three levels. Level I shows
the highest bid and lowest offer — the inside quote. Level II shows all
public quotes of market makers together with information of market makers
wishing to sell or buy stock and recently executed orders. Level III is
used by the market makers and allows them to enter their quotes and
||NASDAQ Biotechnology Index
||NASDAQ Global Select Market
||NASDAQ Global Market
||NASDAQ Capital Market
NASD, Inc. (formerly known as the National Association of
Securities Dealers) is the primary Self Regulatory Organization (SRO)
responsible for the regulation of persons and companies involved in the
securities industry in the United States, with delegated authority from
the Securities and Exchange Commission. It was founded in 1936.
The NASD Board of Governors consists of two staff members
(the CEO and the President of one of NASD's divisions), seven individuals
representing the industry, seven individuals representing the public, and
two individuals categorized as "non-public".
Functions: Regulation and licensure
NASD regulates trading in equities, corporate bonds,
securities futures and options, with authority over the activities of more
than 5,025 brokerage firms, approximately 169,470 branch offices, and more
than 658,170 registered securities representatives. All firms dealing in
securities that are not regulated by another SRO, such as by the Municipal
Securities Rulemaking Board ("MSRB"), are required to be member
firms of the NASD.
NASD licenses individuals and admits firms to the
industry, writes rules to govern their behavior, examines them for
regulatory compliance, and is sanctioned by the U.S. Securities and
Exchange Commission ("SEC") to discipline registered
representatives and member firms that fail to comply with federal
securities laws and NASD's rules and regulations. It provides education
and qualification examinations to industry professionals. It also sells
outsourced regulatory products and services to a number of stock markets
and exchanges (e.g. American Stock Exchange ("AMEX") and the
International Securities Exchange ("ISE").
NASD founded the NASDAQ ("National Association of
Securities Dealers Automated Quotations") stock market in 1971. In
2006, NASD demutualized from NASDAQ by selling its ownership interest.
NASD has a staff of nearly 2,000 and an annual budget of
more than $500 million. The NASD is funded primarily by assessments of
member firms' registered representatives and applicants, annual fees paid
by members, and by fines that it levies. The annual fee that each member
pays includes a basic membership fee, an assessment based on gross income,
a fee for each principal and registered representative, and charge for
each branch office.
The securities market has become increasingly
"retail"; with a majority of American's owning stock through
work and personal investing. Some members of the securities industry have
criticized the NASD for purportedly pursuing minor rule violations. In the
past, some claimed that the NASD turned a blind eye to alleged abuses on
the NASDAQ market of the late 1990's. Some investors lost money from their
investments during the volatility experienced during this period, bringing
into question whether the NASD carried out is duty to protect the
individual investor. Today, NASD, in conjunction with the SEC, and various
state attorney general offices' have vigorously worked to ensure the
integrity of the market place for the investing public.
The NASD operates the nation's largest arbitration forum
for the resolution of disputes between customers and member firms, as well
as between brokerage firm employees and their firms. As of June 2005, the
pool of arbitrators consisted of 3,700 individuals classified as
representing the public and 2,700 individuals considered industry
In 1987, in Shearson/American Express v. McMahon, the
Supreme Court ruled that account forms signed by customers requiring
arbitration for disputes were enforceable contracts. Brokerage firms now
require all customers to sign such documents, requiring binding
For disputes between customers and member firms, the panel
that decides the case consists of three arbitrators, one representing the
securities industry and two designated as public investor representatives.
For a given case, the two sides are provided separate lists by NASD of
local, available arbitrators, from which they chose. If one side rejects
all listed arbitrators, NASD names the arbitrators who will serve; these
can be rejected only for biases, misclassification, conflicts, or
undisclosed material information, and biases or conflicts must be
identified prior to the beginning of hearings. For an overview of the
Securities Arbitration process, see Introduction to Securities
According to NASD, there were 6,074 cases for arbitration
filed in 2005, a decrease from the peak of 8,945 cases filed in 2003. The
average time to complete a case has risen from 10.5 months in 1995 to 14.3
months in 2005, a decrease from 2004 when it was 15.4 months. The
percentage of cases where customers are awarded damages has fallen from
slightly above 50% in the 2000-2002 period to slightly above 40% in 2005.
NASD rules do not require parties to be represented by
attorneys. A party may appear pro se, or be represented by a non-attorney
in arbitration. However, representation by a non-attorney is not advised
since this may be the unauthorized practice of law. Brokerage firms
routinely hire attorneys, so a customer who does not can be at a serious
disadvantage. One organization whose members specialize in representing
customers against brokerage firms in NASD and NYSE arbitration is the
Public Investors Arbitration Bar Association ("PIABA").
In June 2006, Lewis D. Lowenfels, an expert in securities
law at a New York law firm, said of the NASD arbitration process:
"What started out as a relatively swift and economical process for a
public customer claimant to seek justice has evolved into a costly
extended adversarial proceeding dominated by trial lawyers and the usual
Value investing is a style of investment strategy from the so-called
"Graham & Dodd" School. Followers of this style, known as
value investors, generally buy companies whose shares appear underpriced
by some forms of fundamental analysis; these may include shares that are
trading at, for example, high dividend yields or low price-to-earning or
The main proponents of value investing, such as Benjamin Graham and
Warren Buffett have argued that the essence of value investing is buying
stocks at less than their intrinsic value. The discount of the market
price to the intrinsic value is what Benjamin Graham called the
"margin of safety". The intrinsic value is the discounted value
of all future distributions.
However, the future distributions and the appropriate discount rate can
only be assumptions. Warren Buffett has taken the value investing concept
even further as his thinking has evolved to where for the last 25 years or
so his focus has been on "finding an outstanding company at a
sensible price" rather than generic companies at a bargain price.
Value investing was established by Benjamin Graham and David Dodd, both
professors at Columbia University and teachers of many famous investors.
In Graham's book The Intelligent Investor, he advocated the important
concept of margin of safety — first introduced in Security Analysis, a
1934 book he coauthored with David Dodd — which calls for a cautionary
approach to investing. In terms of picking stocks, he recommended
defensive investment in stocks trading not far from their tangible book
value as a safeguard to adverse future developments often encountered in
the stock market.
However, the concept of value (as well as "book value") has
evolved significantly since the 1970s. Book value is meaningful only in
some traditional stable industries where the value of an asset is well
defined. When an industry is going through fast technological
advancements, the value of its assets is not easily estimated. Sometimes,
the production power of an asset can be significantly reduced due to
competitive disruptive innovation and therefore its value can suffer
permanent impairment. One good example of decreasing asset value is a
personal computer. An example of where book value does not mean much is
the service and retail sectors. One modern model of calculating value is
the discounted cash flow model (DCF). The value of an asset is the sum of
its future cash flows, discounted back to the present.
Performance, value strategies
Value investing has proved to be a successful investment strategy.
There are several ways to evaluate its success. One way is to examine the
performance of simple value strategies, such as buying low PE ratio
stocks, low price-to-cash-flow ratio stocks, or low price-to-book ratio
stocks. Numerous academics have published studies investigating the
effects of buying value stocks. These studies have consistently found that
value stocks outperform growth stocks and the market as a whole.
Performance, value investors
Another way to examine the performance of value investing strategies is
to examine the investing performance of well-known value investors. Simply
examining the performance of the best known value investors would not be
instructive, because investors do not become well known unless they are
successful. This introduces a selection bias. A better way to investigate
the performance of a group of value investors was suggested by Warren
Buffett, in his May 17, 1984 speech that was published as The
SuperInvestors of Graham and Doddsville. In this speech, Buffett examined
the performance of those investors who worked at Graham-Newman Corporation
and were thus most influenced by Benjamin Graham. Buffett's conclusion is
identical to that of the academic research on simple value investing
strategies--value investing is, on average, successful in the long run.
Well Known Value Investors
Benjamin Graham is regarded by many to be the father of value
investing. Along with David Dodd, he wrote Security Analysis, first
published in 1934. The most lasting contribution of this book to the field
of security analysis was to emphasize the quantifiable aspects of security
analysis (such as the evaluations of earnings and book value) while
minimizing the importance of more qualitative factors such as the quality
of a company's management. Graham later wrote The Intelligent Investor, a
book that brought value investing to individual investors. Many of
Graham's students, such as William J. Ruane, Irving Kahn, Walter Schloss,
and Charles Brandes went on to become successful investors in their own
Graham's most famous student, however, was Warren Buffett, who ran
successful investing partnerships before closing them in 1969 to focus on
running Berkshire Hathaway. Charlie Munger joined Buffett at Berkshire
Hathaway in the 1970s and has since worked as Vice Chairman of the
company. Buffett has credited Munger with encouraging him to focus on
long-term sustainable growth rather than on simply the valuation of
current cash flows or assets.
Another famous value investor is John Templeton. He first achieved
investing success by buying shares of a number of companies in the
aftermath of the stock market crash of 1929. He went on to become famous
for investing in global equity markets.
Many successful value investors have gained fame recently. Joel
Greenblatt is widely renowned for achieving annual returns at the hedge
fund Gotham Capital of over 50% per year for 10 years from 1985 to 1995
before closing the fund and returning his investors' money. He is known
for investing in special situations such as spin-offs, mergers, and
divestitures. Edward Lampert is the chief of ESL Investments. He is best
known for buying large stakes in Sears and Kmart and then merging the two
Fundamental analysis of a business involves analyzing its financial
statements and health, its management and competitive advantages, and its
competitors and markets.
The objectives of the analysis may be to calculate credit risk, to
evaluate management and make internal business decisions, or to determine
the value of a company's stock and its probable future. The analysis is
performed on historical and present data, but the objective is to predict
future stock or business performance.
Two analytical models
When the objective of the analysis is to determine what stock to buy
and at what price, there are two basic methodologies.
|| Fundamental analysis maintains that markets may misprice a security
in the short run but that the "correct" price will eventually be
reached. Profits can be made by trading the mispriced security and then
waiting for the market to recognize its "mistake" and reprice
the security. Even if the investor believes he cannot beat the market
index, he may still pick stock for the challenge, for the fun of trying,
and for the ego rush when he does beat the market.
|| Technical analysis maintains that all information is reflected
already in the stock price, so fundamental analysis is a waste of time.
Trends 'are your friend' and sentiment changes predate and predict trend
changes. Investors' emotional responses to price movements lead to
recognizable price chart patterns. Technical analysis does not care what
the 'value' of a stock is. Their price predictions are only extrapolations
from historical price patterns.
Investors can use both these different but somewhat complementary
methods for stock picking. Many fundamental investors use technicals for
deciding entry and exit points. Many technical investors use fundamentals
to limit their universe of possible stock to 'good' companies.
The choice of stock analysis is determined by the investor's belief in
the different paradigms for "how the stock market works". See
the discussions at efficient market hypothesis , random walk hypothesis,
Capital Asset Pricing Model, Fed model Theory of Equity Valuation, and
Use by different portfolio styles
Investors may use fundamental analysis within different portfolio
|| Buy and hold investors believe that latching onto good businesses
allows the investor's asset to grow with the business. Fundamental
analysis lets them find 'good' companies, so they lower their risk and
probability of wipe-out.
|| Managers may use fundamental analysis to correctly value 'good' and
'bad' companies. Even 'bad' company's stock goes up and down, creating
opportunities for profits.
|| Contrarian investors distinguish "in the short run, the market
is a voting machine, not a weighing machine". Fundamental analysis
allows you to make your own decision on value, and ignore the market.
|| Value investors restrict their attention to lower valued companies,
believing that 'it's hard to fall out of a ditch'. The value comes from
|| Managers may use fundamental analysis to determine future growth
rates for buying high priced growth stocks.
|| Managers may also include fundamental factors along with technical
factors into computer models (quantitative analysis).
Top-down and Bottom-up
Investors can use either a top-down or bottom-up approach.
|| The top-down investor starts his analysis with global economics,
including both international and national economic indicators, such as GDP
growth rates, inflation, interest rates, exchange rates, productivity, and
energy prices. He narrows his search down to regional/industry analysis of
total sales, price levels, the effects of competing products, foreign
competition, and entry or exit from the industry. Only then does he narrow
his search to the best business in that area.
|| The bottom-up investor starts with specific businesses, regardless of
The analysis of a business' health starts with financial statement
analysis that includes ratios. It looks at dividends paid, operating cash
flow, new equity issues and capital financing. The earnings estimates and
growth rate projections published widely by Thomson Financial and others
can be considered either 'fundamental' (they are facts) or 'technical'
(they are investor sentiment) based on your perception of their validity.
The determined growth rates (of income and cash) and risk levels (to
determine the discount rate) are used in various valuation models. The
foremost is the discounted cash flow model, which calculates the present
value of the future
|| dividends received by the
investor, along with the eventual sale
price. (Gordon model)
|| earnings of the
|| cash flows of the
The simple model commonly used is the Price/Earnings ratio. Implicit in
this model of a perpetual annuity (Time value of money) is that the 'flip'
of the P/E is the discount rate appropriate to the risk of the business.
The multiple accepted is adjusted for expected growth (that is not built
into the model).
Growth estimates are incorporated into the PEG ratio but the math does
not hold up to analysis. Its validity depends on the length of time you
think the growth will continue.
Computer modeling of stock prices has now replaced much of the
subjective interpretation of fundamental data (along with technical data)
in the industry. Since about year 2000, with the power of computers to
crunch vast quantities of data, a new career has been invented. At some
funds the manager's decisions have been replaced by proprietary
What is a Shareholder?
A shareholder or stockholder is an individual or company (including a
corporation) that legally owns one or more shares of stock in a joint stock
company. Companies listed at the stock market strive to enhance shareholder
Stockholders are granted special privileges depending on the class of
stock, including the right to vote (usually one vote per share owned) on
matters such as elections to the board of directors, the right to share in
distributions of the company's income, the right to purchase new shares issued
by the company, and the right to a company's assets during a liquidation of
the company. However, stockholder's rights to a company's assets are
subordinate to the rights of the company's creditors. This means that
stockholders typically receive nothing if a company is liquidated after
bankruptcy (if the company had had enough to pay its creditors, it would not
have entered bankruptcy), although a stock may have value after a bankruptcy
if there is the possibility that the debts of the company will be
Stockholders or shareholders are considered by some to be a partial subset
of stakeholders, which may include anyone who has a direct or indirect equity
interest in the business entity or someone with even a non-pecuniary interest
in a non-profit organization. Thus it might be common to call volunteer
contributors to an association stakeholders, even though they are not
Although directors and officers of a company are bound by fiduciary duties
to act in the best interest of the shareholders, the shareholders themselves
normally do not have such duties towards each other.
However, in a few unusual cases, some courts have been willing to imply
such a duty between shareholders. For example, in California, majority
shareholders of closely held corporations have a duty to not destroy the value
of the shares held by minority shareholders.
The largest shareholders (in terms of percentages of companies owned) are
often mutual funds, and especially passively managed exchange-traded funds.
List of Economic Reports by U.S. Government Agencies
The following reports on economic indicators are reported by United
States government agencies:
Industrial Production (Federal Reserve)
Regional Manufacturing Surveys (Purchasing
managers' organizations and Federal Reserve banks)
Philadelphia Fed Index (Federal Reserve Bank of Philadelphia)
Construction Spending (U.S. Census Bureau)
Business Inventories (U.S. Census Bureau)
International trade (U.S. Census Bureau and
the Bureau of Economic Analysis)
International Capital Flows (U.S.
Treasury International Capital (TICs)
Auto and Truck Sales (U.S.
Department of Commerce)
Retail Sales (U.S.
Durable Goods Orders (U.S.
Factory Orders (U.S. Census Bureau)
Housing Starts and Building Permits (U.S.
New Home Sales (U.S. Census Bureau)
GDP (Gross Domestic Product) (Bureau of
Productivity and Costs (Bureau
of Labor Statistics)
Consumer Credit (Federal Reserve)
Employment Cost Index (U.S. Department of
Personal Income and Consumption (Bureau
of Economic Analysis)
The Employment Report (Bureau
of Labor Statistics)
Price increase ("inflation")
Price Index) (Bureau of Labor Statistics)
PPI (Producer Price Index) (Bureau of Labor
Treasury Budget (U.S.
M2 (Federal Reserve Board)
Initial Public Offering
An initial public offering (IPO) is the first sale of a corporation's
common shares to investors on a public stock exchange. The main purpose
of an IPO is to raise capital for the corporation. While IPOs are
effective at raising capital, they also impose heavy regulatory
compliance and reporting requirements. The term only refers to the first
public issuance of a company's shares; any later public issuance of
shares is referred to as a secondary market offering or a rights issue.
A shareholder selling his existing shares (rather than shares newly
issued to raise capital) on the Primary Market is an offer for sale, but
if the company is being newly listed this is still considered to fall
under the "IPO" umbrella.
Reasons for listing
When a company lists its shares on a public exchange it will almost
invariably look to issue additional new shares in order to raise extra
capital at the same time. The money paid by investors for the
newly-issued shares goes directly to the company (in contrast to a later
trade of shares on the exchange, where the money passes between
investors). An IPO therefore allows a company to tap a wide pool of
stock market investors to provide it with large volumes of capital for
future growth. The company is never required to repay the capital, but
instead the new shareholders have a right to future profits distributed
by the company.
The existing shareholders will see their shareholdings diluted as a
proportion of the company's shares. However, they hope that the capital
investment will make their shareholdings more valuable in absolute
In addition, once a company is listed it will be able to issue
further shares via a rights issue, thereby again providing itself with
capital for expansion without incurring any debt. This regular ability
to raise large amounts of capital from the general market, rather than
having to seek and negotiate with individual investors, is a key
incentive for many companies seeking to list.
IPOs generally involve one or more investment banks as
"underwriters." The company offering its shares, called the
"issuer," enters a contract with a lead underwriter to sell
its shares to the public. The underwriter then approaches investors with
offers to sell these shares.
The sale (that is, the allocation and pricing) of shares in an IPO
may take several forms. Common methods include:
||Self Distribution of Stock
A large IPO is usually underwritten by a "syndicate" of
investment banks led by one or more major investment banks (lead
underwriter). Upon selling the shares, the underwriters keep a
commission based on a percentage of the value of the shares sold.
Usually, the lead underwriters, i.e. the underwriters selling the
largest proportions of the IPO, take the highest commissions—up to 8%
in some cases. Multinational IPOs may have as many as three syndicates
to deal with differing legal requirements in both the issuer's domestic
market and other regions. (e.g., an issuer based in the E.U. may be
represented by the main selling syndicate in its domestic market,
Europe, in addition to separate syndicates or selling groups for
US/Canada and for Asia. Usually the lead underwriter in the main selling
group is also the lead bank in the other selling groups.)
Because of the wide array of legal requirements, IPOs typically
involve one or more law firms with major practices in securities law,
such as the Magic Circle firms of London and the white shoe firms of New
Usually the offering will include the issuance of new shares,
intended to raise new capital, as well the secondary sale of existing
shares. However, certain regulatory restrictions and restrictions
imposed by the lead underwriter are often placed on the sale of existing
Public offerings are primarily sold to institutional investors, but
some shares are also allocated to the underwriters' retail investors. A
broker selling shares of a public offering to his clients is paid
through a sales credit instead of a commission. The client pays no
commission to purchase the shares of a public offering, the purchase
price simply includes the built in sales credit.
The issuer usually allows the underwriters an option to increase the
size of the offering by up to 15% under certain circumstance known as
the greenshoe or over-allotment option.
In the United States, during the dot-com bubble of the late 1990s,
many venture capital driven companies were started, and seeking to cash
in on the bull market, quickly offered IPOs. Usually, stock price
spiraled upwards as soon as a company went public, as investors sought
to get in at the ground-level of the next potential Microsoft and
Initial founders could often become overnight millionaires, and due
to generous stock options, employees could make a great deal of money as
well. The majority of IPOs could be found on the Nasdaq stock exchange,
which is laden with companies related to computer and information
This phenomenon was not limited to the United States. In Japan, for
example, a similar situation occurred. Some companies were operated in a
similar way in that their only goal was to have an IPO. Some stock
exchanges were set up for those companies, such as Nasdaq Japan.
Perhaps the clearest bubbles in the history of hot IPO markets were
in 1929, when closed-end fund IPOs sold at enormous premiums to net
asset value, and in 1989, when closed-end country fund IPOs sold at
enormous premiums to net asset value. What makes these bubbles so clear
is the ability to compare market prices for shares in the closed-end
funds to the value of the shares in the funds' portfolios. When market
prices are multiples of the underlying value, bubbles are clearly
A venture capitalist named Bill Hambrecht has attempted to devise a
method that can reduce the inefficient process. He devised a way to
issue shares through a Dutch auction as an attempt to minimize the
extreme underpricing that underwriters were nurturing. Underwriters,
however, have not taken to this strategy very well. Though not the first
company to use Dutch auction, Google is one established company that
went public through the use of auction. Google's share price rose 17% in
its first day of trading despite the auction method. Perception of IPOs
can be controversial. For those who view a successful IPO to be one that
raises as much money as possible, the IPO was a total failure. For those
who view a successful IPO from the kind of investors that eventually
gained from the underpricing, the IPO was a complete success. It's
important to note that different sets of investors bid in auctions
versus the open market - more institutions bid, fewer private
individuals bid. Google may be a special case, however, as many
individual investors bought the stock based on long-term valuation
shortly after it launched its IPO, driving it beyond institutional
Historically, IPOs both globally and in the US have been underpriced.
The effect of underpricing an IPO is to generate additional interest in
the stock when it first becomes publicly traded. This can lead to
significant gains for investors who have been allocated shares of the
IPO at the offering price. However, underpricing an IPO results in
"money left on the table," lost capital that could have been
raised for the company had the stock been offered at a higher price.
The danger of overpricing is also an important consideration. If a
stock is offered to the public at a higher price than what the market
will pay, the underwriters may have trouble meeting their commitments to
sell shares. Even if they sell all of the issued shares, if the stock
falls in value on the first day of trading, it may lose its
marketability and hence even more of its value.
Investment banks therefore take many factors into consideration when
pricing an IPO, and attempt to reach an offering price that is low
enough to stimulate interest in the stock, but high enough to raise an
adequate amount of capital for the company. The process of determining
an optimal price usually involves the underwriters
("syndicate") arranging share purchase commitments from lead
Note: Not all IPOs are eligible for delivery settlement through the
DTC system, which would then either require the physical delivery of the
stock certificates to the clearing agent bank's custodian, or a delivery
versus payment ("DVP") arrangement with the selling group
After the newly public company has its IPO, it enters a "quiet
period." During this time, the insiders, and any underwriters
involved in the IPO, are restricted from issuing any earnings forecasts
or research reports for the company. The quiet period is in effect for
40 calendar days following the first trading day. Regulatory changes by
the United States Securities and Exchange Commission, changed the quiet
period of 25 days, to 40 days on July 9, 2002. When the quiet period is
over, generally the lead underwriters will initiate research coverage on
What is a Commodity?
Commodity is a term with distinct meanings in both business and in
Marxian political economy. For the former, it is a largely homogeneous
product, traded solely on the basis of price, whereas for the latter, it
refers to wares offered for exchange.
Linguistically, the word commodity came into use in English in the
15th century, being derived from the French word "commodité",
meaning today's (2000) "convenience" in term of quality of
services. The Latin root meaning is commoditas, referring variously to
the appropriate measure of something; a fitting state, time or
condition; a good quality; efficaciousness or propriety; and advantage,
or benefit. The German equivalent is die Ware, i.e. wares or goods
offered for sale. The French equivalent is "produit de base"
like energy, goods, industrial raw materials.
In the world of business, a commodity is an undifferentiated product,
good or service that is traded based solely on its price, rather than
quality and features. Examples include: electricity (most users of
electric power are only concerned with energy consumption; only a
minority of users are concerned with the quality and technical details
of voltage and frequency deviations, phase imbalance,
"stability" as guaranteed by backup equipment, etc.), wheat,
bulk chemicals such as sulfuric acid, base and other metals, and even
pork-bellies and orange juice. More modern commodities include
bandwidth, RAM chips and (experimentally) computer processor cycles, and
negative commodity units like emissions credits.
In the original and simplified sense, commodities were things of
value, of uniform quality, that were produced in large quantities by
many different producers; the items from each different producer are
considered equivalent. It is the contract and this underlying standard
that define the commodity, not any quality inherent in the product. One
can reasonably say that food commodities, for example, are defined by
the fact that they substitute for each other in recipes, and that one
can use the food without having to look at it too closely.
Commodities exchanges include:
Chicago Board of Trade
||London Metal Exchange
||New York Mercantile Exchange
Microeconomists also include labor, and currency as commodities that
can be bought and sold.
Wheat is an example of a soft commodity. Wheat from many different
farms is pooled. Generally, it is all traded at the same price; wheat
from farm A is not differentiated from wheat from farm B. Some uniform
standard of quality must necessarily be assumed. There may be various
standards leading to different pools: one say for genetically modified
wheat, and one for unmodified wheat. Failures to match the consumer's
assessment of risk and usefulness for some purpose, can lead to lower
prices or the necessity of dividing the market into different pools - a
very major issue in agricultural policy.
Markets for trading commodities can be very efficient, particularly
if the division into pools matches demand segments. These markets will
quickly respond to changes in supply and demand to find an equilibrium
price and quantity.
Commodities and Marxism
In classical political economy and especially Karl Marx's critique of
political economy, a commodity is simply any good or service offered as
a product for sale on the market. Some items are also seen as being
treated as if they were commodities, e.g. human labor or labor power,
works of art and natural resources, even though they may not be produced
specifically for the market, or be non-reproducible goods.
Marx's analysis of the commodity is intended to help solve the
problem of what establishes the economic value of goods, using the labor
theory of value. This problem was extensively debated by Adam Smith,
David Ricardo and Karl Rodbertus-Jagetzow among others. Value and price
are not equivalent terms in economics, and theorizing the specific
relationship of value to market price has been a challenge for both
liberal and Marxist economists.
Characteristics of commodity
In Marx's theory, a commodity has value, which represents a quantity
of human labor. The fact that it has value implies straightaway that
people try to economize its use. A commodity also has a use value, an
exchange value and a price.
||It has a use value because,
by its intrinsic characteristics, it can satisfy some human need
or want, physical or ideal. By nature this is a social use
value, i.e. the object is useful not just to the producer but
has a use for others generally.
||It has an exchange value,
meaning that a commodity can be traded for other commodities,
and thus give its owner the benefit of others' labor (the labor
done to produce the purchased commodity).
||Price is then the monetary
expression of exchange-value (but exchange value could also be
expressed as a direct trading ratio between two commodities
without using money).
According to the labor theory of value, product-values in an open
market are regulated by the average socially necessary labor time
required to produce them, and price relativities are ultimately governed
by the law of value.
To understand the concept of a commodity, consider a chair. It is a
commodity if the chair is a tradeable product of human work possessing a
social use-value. By contrast, a fallen log of deadwood sat upon in the
forest is not a commodity, as it was not produced by human work for the
purpose of trade. A chair created by a hobbyist as a gift to someone is
not a commodity. Nor is a chair a commodity (as a chair) if its only use
would be as scrap firewood (unless one purchases a chair specifically to
chop it up for fire wood). A chair that nobody could sit on has no
use-value, and cannot be a commodity (unless it has an ornamental value,
e.g. in a doll's house).
Click here for a List
of Traded Commodities, from Wikipedia
Commodity markets are markets where raw or primary products are
exchanged. These raw commodities are traded on regulated commodities
exchanges, in which they are bought and sold in standardized Contracts.
This article focuses on the history and current debates regarding
global commodity markets. It covers physical product (food, metals,
electricity) markets but not the ways that services, including those of
governments, nor investment, nor debt, can be seen as a commodity.
Articles on reinsurance markets, stock markets, bond markets and
currency markets cover those concerns separately and in more depth. One
focus of this article is the relationship between simple commodity money
and the more complex instruments offered in the commodity markets.
The modern commodity markets have their roots in the trading of
agricultural products. While wheat and corn, cattle and pigs, were
widely traded using standard instruments in the 19th century in the
United States, other basic foodstuffs such as soybeans were only added
quite recently in most markets. For a commodity market to be
established, there must be very broad consensus on the variations in the
product that make it acceptable for one purpose or another.
The economic impact of the development of commodity markets is hard
to over-estimate. Through the 19th century "the exchanges became
effective spokesmen for, and innovators of, improvements in
transportation, warehousing, and financing, which paved the way to
expanded interstate and international trade."
Early history of commodity markets
Historically, dating from ancient Sumerian use of sheep or goats, or
other peoples using pigs, rare seashells, or other items as commodity
money, people have sought ways to standardize and trade contracts in the
delivery of such items, to render trade itself more smooth and
Commodity money and commodity markets in a crude early form are
believed to have originated in Sumer where small baked clay tokens in
the shape of sheep or goats were used in trade. Sealed in clay vessels
with a certain number of such tokens, with that number written on the
outside, they represented a promise to deliver that number. This made
them a form of commodity money - more than an "I.O.U." but
less than a guarantee by a nation-state or bank. However, they were also
known to contain promises of time and date of delivery - this made them
like a modern futures contract. Regardless of the details, it was only
possible to verify the number of tokens inside by shaking the vessel or
by breaking it, at which point the number or terms written on the
outside became subject to doubt. Eventually the tokens disappeared, but
the contracts remained on flat tablets. This represented the first
system of commodity accounting.
However, the Commodity status of living things is always subject to
doubt - it was hard to validate the health or existence of sheep or
goats. Excuses for non-delivery were not unknown, and there are
recovered Sumerian letters that complain of sickly goats, sheep that had
already been fleeced, etc.
If a seller's reputation was good, individual "backers" or
"bankers" could decide to take the risk of
"clearing" a trade. The observation that trust is always
required between market participants later led to credit money. But
until relatively modern times, communication and credit were primitive.
Classical civilizations built complex global markets trading gold or
silver for spices, cloth, wood and weapons, most of which had standards
of quality and timeliness. Considering the many hazards of climate,
piracy, theft and abuse of military fiat by rulers of kingdoms along the
trade routes, it was a major focus of these civilizations to keep
markets open and trading in these scarce commodities. Reputation and
clearing became central concerns, and the states which could handle them
most effectively became very powerful empires, trusted by many peoples
to manage and mediate trade and commerce.
Commodity and Futures contracts are based on what’s termed
"Forward" Contracts. Early on these "forward"
contracts (agreements to buy now, pay and deliver later) were used as a
way of getting products from producer to the consumer. These typically
were only for food and agricultural products. Forward contracts have
evolved and have been standardized into what we know today as futures
contracts. Although more complex today, early "Forward"
contracts for example, were used for rice in seventeenth century Japan.
Modern "forward", or futures agreements, began in Chicago in
the 1840s, with the appearance of the railroads. Chicago, being
centrally located, emerged as the hub between Midwestern farmers and
producers and the east coast consumer population centers.
"Hedging", a common (and sometimes mandatory) practice of
farming cooperatives, insures against a poor harvest by purchasing
futures contracts in the same commodity. If the cooperative has
significantly less of its product to sell due to weather or insects, it
makes up for that loss with a profit on the markets, since the overall
supply of the crop is short everywhere that suffered the same
Whole developing nations may be especially vulnerable, and even their
currency tends to be tied to the price of those particular commodity
items until it manages to be a fully developed nation. For example, one
could see the nominally fiat money of Cuba as being tied to sugar
prices, since a lack of hard currency paying for sugar means less
foreign goods per peso in Cuba itself. In effect, Cuba needs a hedge
against a drop in sugar prices, if it wishes to maintain a stable
quality of life for its citizens.
Delivery and condition guarantees
In addition, delivery day, method of settlement and delivery point
must all be specified. Typically, trading must end two (or more)
business days prior to the delivery day, so that the routing of the
shipment (which for soybeans is 30,000 kilograms or 1,102 bushels) can
be finalized via ship or rail, and payment can be settled when the
contract arrives at any delivery point.
U.S. soybean futures, for example, are of standard grade if they are
"GMO or a mixture of GMO and Non-GMO No. 2 yellow soybeans of
Indiana, Ohio and Michigan origin produced in the U.S.A. (Non-screened,
stored in silo)," and of deliverable grade if they are "GMO or
a mixture of GMO and Non-GMO No. 2 yellow soybeans of Iowa, Illinois and
Wisconsin origin produced in the U.S.A. (Non-screened, stored in
silo)." Note the distinction between states, and the need to
clearly mention their status as "GMO" ("Genetically
Modified Organism") which makes them unacceptable to most
"organic" food buyers.
Similar specifications apply for orange juice, cocoa, sugar, wheat,
corn, barley, pork bellies, milk, feedstuffs, fruits, vegetables, other
grains, other beans, hay, other livestock, meats, poultry, eggs, or any
other commodity which is so traded.
The concept of an interchangeable deliverable or guaranteed delivery
is always to some degree a fiction. Trade in commodities is like trade
in any other physical product or service. No magic of the commodity
contract itself makes "units" of the product totally uniform
nor gets it to the delivery point safely and on time.
Regulation of commodity markets
Cotton, kilowatt-hours of electricity, board feet of wood, long
distance minutes, royalty payments due on artists' works, and other
products and services have been traded on markets of varying scale, with
varying degrees of success. One issue that presents major difficulty for
creators of such instruments is the liability accruing to the purchaser:
Unless the product or service can be guaranteed or insured to be free
of liability based on where it came from and how it got to market, e.g.
kilowatts must come to market free from legitimate claims for smog death
from coal burning plants, wood must be free from claims that it comes
from protected forests, royalty payments must be free of claims of
plagiarism or piracy, it becomes impossible for sellers to guarantee a
Generally, governments must provide a common regulatory or insurance
standard and some release of liability, or at least a backing of the
insurers, before a commodity market can begin trading. This is a major
source of controversy in for instance the energy market, where
desirability of different kinds of power generation varies drastically.
In some markets, e.g. Toronto, Canada, surveys established that
customers would pay 10-15% more for energy that was not from coal or
nuclear, but strictly from renewable sources such as wind.
Proliferation of contracts, terms, and derivatives
However, if there are two or more standards of risk or quality, as
there seem to be for electricity or soybeans, it is relatively easy to
establish two different contracts to trade in the more and less
desirable deliverable separately. If the consumer acceptance and
liability problems can be solved, the product can be made
interchangeable, and trading in such units can begin.
Since the detailed concerns of industrial and consumer markets vary
widely, so do the contracts, and "grades" tend to vary
significantly from country to country. A proliferation of contract
units, terms, and futures contracts have evolved, combined into an
extremely sophisticated range of financial instruments.
These are more than one-to-one representations of units of a given
type of commodity, and represent more than simple futures contracts for
future deliveries. These serve a variety of purposes from simple
gambling to price insurance.
The underlying of futures contracts are no longer restricted to
Oil and fiat
Building on the infrastructure and credit and settlement networks
established for food and precious metals, many such markets have
proliferated drastically in the late 20th century. Oil was the first
form of energy so widely traded, and the fluctuations in the oil markets
are of particular political interest.
Some commodity market speculation is directly related to the
stability of certain states, e.g. during the Gulf War, speculation on
the survival of the regime of Saddam Hussein in Iraq. Similar political
stability concerns have from time to time driven the price of oil. Some
argue that this is not so much a commodity market but more of an
assassination market speculating on the survival (or not) of Saddam or
other leaders whose personal decisions may cause oil supply to fluctuate
by military action.
The oil market is, however, an exception. Most markets are not so
tied to the politics of volatile regions - even natural gas tends to be
more stable, as it is not traded across oceans by tanker as extensively.
Commodity markets and protectionism
Developing countries (Democratic or not) have been moved to harden
their currencies, accept IMF rules, join the WTO, and submit to a broad
regime of reforms that amount to a "hedge" against being
isolated. China's entry into the WTO signaled the end of truly isolated
nations entirely managing their own currency and affairs. The need for
stable currency and predictable clearing and rules-based handling of
trade disputes, has led to a global trade hegemony - many nations
"hedging" on a global scale against each other's anticipated
"protectionism", were they to fail to join the WTO.
There are signs, however, that this regime is far from perfect. U.S.
trade sanctions against Canadian softwood lumber (within NAFTA) and
foreign steel (except for NAFTA partners Canada and Mexico) in 2002 signaled
a shift in policy towards a tougher regime perhaps more driven by
political concerns - jobs, industrial policy, even sustainable forestry
and logging practices.
Commodity thinking is undergoing a more direct revival thanks to the
theorists of "natural capital" whose products, some economists
argue, are the only genuine commodities - air, water, and calories we
consume being mostly interchangeable when they are free of pollution or
disease. Whether we wish to think of these things as tradeable
commodities rather than birthrights has been a major source of
controversy in many nations.
Most types of environmental economics consider the shift to measuring
them inevitable, arguing that reframing political economy to consider
the flow of these basic commodities first and foremost, helps avoids use
of any military fiat except to protect "natural capital"
itself, and basing credit-worthiness more strictly on commitment to
preserving biodiversity aligns the long-term interests of ecoregions,
societies, and individuals. They seek relatively conservative
sustainable development schemes that would be amenable to measuring
well-being over long periods of time, typically "seven
generations", in line with Native American thought.
However, this is not the only way in which commodity thinking
interacts with ecologists' thinking. Hedging began as a way to escape
the consequences of damage done by natural conditions. It has matured
not only into a system of interlocking guarantees, but also into a
system of indirectly trading on the actual damage done by weather, using
"weather derivatives". For a price, this relieves the
purchaser of the following types of concerns:
"Will a freeze hurt the Brazilian coffee crop? Will there be a
drought in the U.S. Corn Belt? What are the chances that we will have a
cold winter, driving natural gas prices higher and creating havoc in
Florida orange areas? What is the status of El Niño?"
Weather trading is just one example of "negative
commodities", units of which represent harm rather than good.
"Economy is three fifths of ecology" argues Mike Nickerson,
one of many economic theorists who holds that nature's productive
services and waste disposal services are poorly accounted for. One way
to fairly allocate the waste disposal capacity of nature is "cap
and trade" market structure that is used to trade toxic emissions
rights in the United States, e.g. SO2. This is in effect a
"negative commodity", a right to throw something away.
In this market, the atmosphere's capacity to absorb certain amounts
of pollutants is measured, divided into units, and traded amongst
various market players. Those who emit more SO2 must pay those who emit
less. Critics of such schemes argue that unauthorized or unregulated
emissions still happen, and that "grandfathering" schemes
often permit major polluters, such as the state governments' own
agencies, or poorer countries, to expand emissions and take jobs, while
the SO2 output still floats over the border and causes death.
In practice, political pressure has overcome most such concerns and
it is questionable whether this is a capacity that depends on U.S.
clout: The Kyoto Protocol established a similar market in global
greenhouse gas emissions without U.S. support.
Community as commodity?
This highlights one of the major issues with global commodity markets
of either the positive or negative kind. A community must somehow
believe that the commodity instrument is real, enforceable, and well
worth paying for.
A very substantial part of the anti-globalization movement opposes
the commodification of currency, national sovereignty, and traditional
cultures. The capacity to repay debt, as in the current global credit
money regime anchored by the Bank for International Settlements, does
not in their view correspond to measurable benefits to human well-being
worldwide. They seek a fairer way for societies to compete in the global
markets that will not require conversion of natural capital to natural
resources, nor human capital to move to developed nations in order to
Some economic systems by green economists would replace the
"gold standard" with a "biodiversity standard". It
remains to be seen if such plans have any merit other than as political
ways to draw attention to the way capitalism itself interacts with life.
Is human life a commodity?
While classical, neoclassical, and Marxist approaches to economics
tend to treat labor differently, they are united in treating nature as a
The green economists and the more conservative environmental
economics argue that not only natural ecologies, but also the life of
the individual human being is treated as a commodity by the global
markets. A good example is the IPCC calculations cited by the Global
Commons Institute as placing a value on a human life in the developed
world "15x higher" than in the developing world, based solely
on the ability to pay to prevent climate change.
Is free time a commodity?
Accepting this result, some argue that to put a price on both is the
most reasonable way to proceed to optimize and increase that value
relative to other goods or services. This has led to efforts in
measuring well-being, to assign a commercial "value of life",
and to the theory of Natural Capitalism - fusions of green and
neoclassical approaches - which focus predictably on energy and material
efficiency, i.e. using far less of any given commodity input to achieve
the same service outputs as a result.
Indian economist Amartya Sen, applying this thinking to human freedom
itself, argued in his 1999 book "Development as Freedom" that
human free time was the only real service, and that sustainable
development was best defined as freeing human time. Sen won The Bank of
Sweden Prize in Economic Sciences in Memory of Alfred Nobel in 1999
(sometimes incorrectly called the "Nobel Prize in Economics")
and based his book on invited lectures he gave at the World Bank.
Commodity money is money whose value comes from a commodity out of
which it is made. Examples of commodities that have been used as mediums
of exchange include gold, silver, copper, salt, peppercorns, large
stones, decorated belts, shells, cigarettes, and candy.
Commodity money is to be distinguished from representative money
which is a certificate or token which can be exchanged for the
underlying commodity. A key feature of commodity money is that the value
is directly perceived by the users of this money, who recognize the
utility or beauty of the tokens as they would recognize the goods
themselves. That is, the effect of holding a token for a barrel of oil
must be the same economically as actually having the barrel at hand.
This thinking guides the modern commodity markets, although they use a
sophisticated range of financial instruments that are more than
one-to-one representations of units of a given type of commodity.
In situations where the commodity is metal, typically gold or silver,
a government mint will often coin money by placing a mark on the metal
that serves as a guarantee of the weight and purity of the metal. In
doing so, the government will often impose a fee which is known as
seigniorage. The role of a mint and of coin is different between
commodity money and fiat money. In situations where there is commodity
money, the coin retains its value if it is melted and physically
altered, while in fiat money it does not.
Commodity money often comes into being in situations where other
forms of money are not available or not trusted. Various commodities
were used in pre-Revolutionary America including wampum, maize, iron
nails, beaver pelts, and tobacco. In post-war Germany, cigarettes became
used as a form of commodity money in some areas. Cigarettes are still
used as a form of commodity money in prisons.
Although commodity money is more convenient than barter, it can be
inconvenient to use as a medium of exchange or a standard of deferred
payment due to the transport and storage concerns. The cost of such
storage is often referred to as Demurrage (currency) and is in some
instances regarded as a positive influence on the overlying financial
system. Accordingly, notes began to circulate that a government or other
trusted entity (e.g. the Knights Templar in Europe in the 13th century)
would guarantee as representing a certain stored value on account. This
creates a form of money known as representative money - the beginning of
a long slow shift to credit money.
Historically gold was by far the most widely recognized commodity out
of which to make money: gold was compact, easy to work into more
beautiful jewelry, had decorative and functional utility as a finely
strung wire or thin foil leaf, and most importantly, could always be
traded for other metals to make weapons with. A state could be described
as a political enterprise with sufficient land, gold and reputation for
protecting both, e.g. the Fort Knox gold repository long maintained by
the United States, could reliably issue certificates to substitute for
the gold and be trusted to actually have it. Between 1933 and 1970, one
U.S. dollar was technically worth exactly 1/35 of a troy ounce (889 mg)
of gold. However, actual trade in gold as a precious metal within the
United States was banned - presumably to prevent anyone from actually
going up to Fort Knox and asking for their gold. This was a fairly
typical transition from commodity to representative to fiat money, with
people trading in other goods being forced to trade in gold, then to
receive paper money that purported to be as good as gold, and then
ultimately see this currency "float" on commodity markets.
However, commodity money remained active in the background in some
form or another, and seems to have been revived thanks to global
capitalism, wherein a currency is widely traded as a commodity. One way
to view such trade is that currency of resource-rich nations tends to be
tied to the price of those particular commodity items until it becomes a
"developed nation". Thus, one could see the nominally fiat
money of say Cuba as being tied to the commodity "sugar"
globally, rather than to the military power of Cuba that holds within
its own borders.
Also, commodity supplies and protections of supplies by states'
military fiat remain critical to trade, and there are active commodity
market speculations on the stability of certain states, e.g. speculation
on the survival of the regime of Saddam Hussein in Iraq has from time to
time driven the price of oil. Some argue that this is not so much a
commodity market but more of an assassination market speculating on the
survival (or not) of Saddam himself.
Finally, commodity money is undergoing a more direct revival thanks
to theorists of green economics and natural capitalism, some of whom
suggest a form of money based on ecological yield. They argue that the
outputs of "natural capital" are the only genuine commodities
- air, water, and renewable energy we consume being mostly
interchangeable when they are free of pollution or disease. However,
such goods cannot be held directly, and so it is common to suggest that
representative money be issued based on enhancing and extending nature's
services, giving one the right to receive the yield as benefit. They
argue that reframing political economy to consider the flow of these
basic commodities first and foremost, avoiding use of military fiat
except to protect "natural capital" itself, and basing
credit-worthiness more strictly on commitment to preserving biodiversity
rather than repayment of debt, as in the current global credit money
regime anchored by the Bank for International Settlements, would provide
measurable benefits to human well-being worldwide.
Critics of this type of proposal often note that, as with other
transitions from commodity to representative money, inadequate
substitutes will be made on a "just trust me" basis - as per
Gresham's Law which states that bad money drives out good. Other
proposals, such as time-based money, rely on the availability of human
labor as a commodity, especially within a community, which is presumably
harder to guarantee access to, but also harder to steal. Still others
deny the utility of commodifying labor as such, and suggest making free
time the standard, since physical capital used for leisure, sport, art,
theatre, and other forms of play is commodifiable and possible to
Some, in environmental economics, argue that the life of the
individual human being and the natural ecologies are already both
treated as commodities in global markets. They argue that to put a price
on both is the most reasonable way to proceed to optimize and increase
that value relative to other goods or services. This has led to efforts
in measuring well-being, to assign a commercial "value of
life", and to the theory of Natural Capitalism - which focuses
predictably on energy and material efficiency, i.e. using far less of
any given commodity input to achieve the same service outputs as a
result. An extreme example of this view is held by Indian economist
Amartya Sen, who discussed the relationship between access to
commodities, labor, and "the right to live as we would like"
in his 1999 book "Development as Freedom", arguing that human
free time was the only real service, and that sustainable development
was best defined as freeing human time.
Sen's views are relatively mainstream - he won the 1999 Bank of
Sweden Prize in Economic Sciences in Memory of Alfred Nobel (sometimes
incorrectly called the "Nobel Prize in Economics").
In 1996, digital gold currency was launched by e-gold as a form of
commodity money, which uses a long established medium of exchange,
What is a Futures
In finance, a futures contract is a standardized contract, traded on
a futures exchange, to buy or sell a certain underlying instrument at a
certain date in the future, at a specified price. The future date is
called the delivery date or final settlement date. The pre-set price is
called the futures price. The price of the underlying asset on the
delivery date is called the settlement price. The settlement price,
normally, converges towards the futures price on the delivery date.
A futures contract gives the holder the obligation to buy or sell,
which differs from an options contract, which gives the holder the
right, but not the obligation. In other words, the owner of an options
contract may exercise the contract. If it is an American-style option,
it can be exercised on or before the expiration date; a European option
can only be exercised at expiration. Thus, a Futures contract is more
like a European option. Both parties of a "futures contract"
must fulfill the contract on the settlement date. The seller delivers
the commodity to the buyer, or, if it is a cash-settled future, then
cash is transferred from the futures trader who sustained a loss to the
one who made a profit. To exit the commitment prior to the settlement
date, the holder of a futures position has to offset his position by
either selling a long position or buying back a short position,
effectively closing out the futures position and its contract
Futures contracts, or simply futures, are exchange traded
derivatives. The exchange's clearinghouse acts as counterparty on all
contracts, sets margin requirements, etc.
Futures vs. Forwards
While futures and forward contracts are both a contract to deliver a
commodity on a future date, key differences include:
Futures are always traded on an exchange, whereas forwards always trade
over-the-counter, or can simply be a signed contract between two
||Futures are highly
standardized, whereas each forward is unique.
||The price at which the
contract is finally settled is different:
||Futures are settled at the
settlement price fixed on the last trading date of the contract
(i.e. at the end).
||Forwards are settled by the
delivery of the commodity at the specified contract price.
||The credit risk of futures is
much lower than that of forwards:
||Traders are not subject to
credit risk because the clearinghouse always takes the other
side of the trade. The day's profit or loss on a futures
position is marked-to-market in the trader's account. If the
mark to market results in a balance that is less than the margin
requirement, then the trader is issued a margin call.
||The risk of a forward
contract is that the supplier will be unable to deliver the
grade and quantity of the commodity, or the buyer may be unable
to pay for it on the delivery day.
||In case of physical delivery,
the forward contract specifies to whom to make the delivery. The
counterparty on a futures contract is chosen randomly by the
||In a forward there are no
cash flows until delivery, whereas in futures there are margin
requirements and a daily mark to market of the traders'
Futures contracts ensure their liquidity by being highly
standardized, usually by specifying:
||The underlying asset or
instrument. This could be anything from a barrel of crude oil to
a short term interest rate.
||The type of settlement,
either cash settlement or physical settlement.
||The amount and units of the
underlying asset per contract. This can be the notional amount
of bonds, a fixed number of barrels of oil, units of foreign
currency, the notional amount of the deposit over which the
short term interest rate is traded, etc.
||The currency in which the
futures contract is quoted.
||The grade of the deliverable.
In the case of bonds, this specifies which bonds can be
delivered. In the case of physical commodities, this specifies
not only the quality of the underlying goods but also the manner
and location of delivery. For example, the NYMEX Light Sweet
Crude Oil contract specifies the acceptable sulfur content and
API specific gravity, as well as the location where delivery
must be made.
||The delivery month.
||The last trading date.
||Other details such as the
commodity tick, the minimum permissible price fluctuation.
To minimize credit risk to the exchange, traders must post margin or
a performance bond, typically 5%-15% of the contract's value.
Margin requirements are waived or reduced in some cases for hedgers who
have physical ownership of the covered commodity or spread traders who
have offsetting contracts balancing the position.
Initial margin is paid by both buyer and seller. It represents the loss
on that contract, as determined by historical price changes, that is not
likely to be exceeded on a usual day's trading.
A futures account is marked to market daily. If the margin drops
below the margin maintenance requirement established by the exchange
listing the futures, a margin call will be issued to bring the account
back up to the required level.
Margin-equity ratio is a term used by speculators, representing the
amount of their trading capital that is being held as margin at any
particular time. The low margin requirements of futures results in
substantial leverage of the investment. However, the exchanges require a
minimum amount that varies depending on the contract and the trader. The
broker may set the requirement higher, but may not set it lower. A
trader, of course, can set it above that, if he doesn't want to be
subject to margin calls.
Return on margin (ROM) is often used to judge performance because it
represents the gain or loss compared to the exchange’s perceived risk
as reflected in required margin. ROM may be calculated (realized return)
/ (initial margin). The Annualized ROM is equal to (ROM+1)(year/trade
For example if a trader earns 10% on margin in two months, that would be
about 77% annualized.
Settlement is the act of consummating the contract, and can be done
in one of two ways, as specified per type of futures contract:
||Physical delivery -
the amount specified of the underlying asset of the contract is
delivered by the seller of the contract to the exchange, and by
the exchange to the buyers of the contract. Physical delivery is
common with commodities and bonds. In practice, it occurs only
on a minority of contracts. Most are cancelled out by purchasing
a covering position - that is, buying a contract to cancel out
an earlier sale (covering a short), or selling a contract to
liquidate an earlier purchase (covering a long). The Nymex crude
futures contract uses this method of settlement upon expiration.
||Cash settlement - a
cash payment is made based on the underlying reference rate,
such as a short term interest rate index such as Euribor, or the
closing value of a stock market index. A futures contract might
also opt to settle against an index based on trade in a related
spot market. Ice Brent futures use this method.
||Expiry is the time
when the final prices of the future is determined. For many
equity index and interest rate futures contracts (as well as for
most equity options), this happens on the third Friday of
certain trading month. On this day the t+1 futures contract
becomes the t forward contract. For example, for most CME and
CBOT contracts, at the expiry on December, the March futures
become the nearest contract. This is an exciting time for
arbitrage desks, as they will try to make rapid gains during the
short period (normally 30 minutes) where the final prices are
averaged from. At this moment the futures and the underlying
assets are extremely liquid and any mispricing between an index
and an underlying asset is quickly traded by arbitrageurs. At
this moment also, the increase in volume is caused by traders
rolling over positions to the next contract or, in the case of
equity index futures, purchasing underlying components of those
indexes to hedge against current index positions. On the expiry
date, a European equity arbitrage trading desk in London or
Frankfurt will see positions expire in as many as eight major
markets almost every half an hour.
The situation where the price of a commodity for future delivery is
higher than the spot price, or where a far future delivery price is
higher than a nearer future delivery, is known as contango. The reverse,
where the price of a commodity for future delivery is lower than the
spot price, or where a far future delivery price is lower than a nearer
future delivery, is known as backwardation.
When the deliverable asset exists in plentiful supply, or may be
freely created, then the price of a future is determined via arbitrage
arguments. The forward price represents the expected future value of the
underlying discounted at the risk free rate—as any deviation from the
theoretical price will afford investors a riskless profit opportunity
and should be arbitraged away; see rational pricing of futures.
Thus, for a simple, non-dividend paying asset, the value of the
future/forward, F(t), will be found by compounding the present
value S(t) at time t to maturity T by the rate of
risk-free return r.
or, with continuous compounding
This relationship may be modified for storage costs, dividends,
dividend yields, and convenience yields.
In a perfect market the relationship between futures and spot prices
depends only on the above variables; in practice there are various
market imperfections (transaction costs, differential borrowing and
lending rates, restrictions on short selling) that prevent complete
arbitrage. Thus, the futures price in fact varies within arbitrage
boundaries around the theoretical price.
The above relationship, therefore, is typical for stock index
futures, treasury bond futures, and futures on physical commodities when
they are in supply (e.g. on corn after the harvest). However, when the
deliverable commodity is not in plentiful supply or when it does not yet
exist, for example on wheat before the harvest or on Eurodollar Futures
or Federal Funds Rate futures (in which the supposed underlying
instrument is to be created upon the delivery date), the futures price
cannot be fixed by arbitrage. In this scenario there is only one force
setting the price, which is simple supply and demand for the future
asset, as expressed by supply and demand for the futures contract.
In a deep and liquid market, this supply and demand would be expected
to balance out at a price which represents an unbiased expectation of
the future price of the actual asset and so be given by the simple
With this pricing rule, a speculator is expected to break even when
the futures market fairly prices the deliverable commodity.
In a shallow and illiquid market, or in a market in which large
quantities of the deliverable asset have been deliberately withheld from
market participants (an illegal action known as cornering the market),
the market clearing price for the future may still represent the balance
between supply and demand but the relationship between this price and
the expected future price of the asset can break down.
Futures contracts and exchanges
There are many different kinds of futures contract, reflecting the
many different kinds of tradable assets of which they are derivatives:
||Foreign exchange market
||Equity index market
||Soft Commodities market
Trading on commodities began in Japan in the 18th century with the
trading of rice and silk, and similarly in Holland with tulip bulbs.
Trading in the US began in the mid 19th century, when central grain
markets were established and a marketplace was created for farmers to
bring their commodities and sell them either for immediate delivery
(also called spot or cash market) or for forward delivery. These forward
contracts were private contracts between buyers and sellers and became
the forerunner to today's exchange-traded futures contracts. Although
contract trading began with traditional commodities such grains, meat
and livestock, exchange trading has expanded to include metals, energy,
currency and currency indexes, equities and equity indexes, government
interest rates and private interest rates.
Contracts on financial instruments was introduced in the 1970s by the
Chicago Mercantile Exchange (CME) and these instruments became hugely
successful and quickly overtook commodities futures in terms of trading
volume and global accessibility to the markets. This innovation led to
the introduction of many new futures exchanges worldwide, such as the
London International Financial Futures Exchange in 1982 (now
Euronext.liffe), Deutsche Terminbörse (now Eurex) and the Tokyo
Commodity Exchange (TOCOM). Today, there are more than 75 futures and
futures options exchanges worldwide trading to include:
||Chicago Board of Trade (CBOT)
-- Interest Rate derivatives (US Bonds); Agricultural (Corn,
Soybeans, Soy Products, Wheat); Index (Dow Jones Industrial
Average); Metals (Gold, Silver)
||Chicago Mercantile Exchange
-- Currencies, Agricultural (Pork, Cattle, Butter, Milk); Index
(NASDAQ, S&P, etc); Various Interest Rate Products
||ICE Futures - the
International Petroleum Exchange trades energy including crude
oil, heating oil, natural gas and unleaded gas and merged with
IntercontinentalExchange (ICE) to form ICE Futures.
||Sydney Futures Exchange
||London Commodity Exchange -
softs: grains and meats. Inactive market in Baltic Exchange
||Tokyo Commodity Exchange
||London Metal Exchange -
metals: copper, aluminum, lead, zinc, nickel and tin.
||New York Board of Trade -
softs: cocoa, coffee, cotton, orange juice, sugar
||New York Mercantile Exchange
- energy and metals: crude oil, gasoline, heating oil, natural
gas, coal, propane, gold, silver, platinum, copper, aluminum and
Who trades futures?
Futures traders are traditionally placed in one of two groups:
hedgers, who have an interest in the underlying commodity and are
seeking to hedge out the risk of price changes; and speculators, who
seek to make a profit by predicting market moves and buying a commodity
"on paper" for which they have no practical use.
Hedgers typically include producers and consumers of a commodity.
For example, in traditional commodities markets farmers often sell
futures contracts for the crops and livestock they produce to guarantee
a certain price, making it easier for them to plan. Similarly, livestock
producers often purchase futures to cover their feed costs, so that they
can plan on a fixed cost for feed. In modern (financial) markets,
"producers" of interest rate swaps or equity derivative
products will use financial futures or equity index futures to reduce or
remove the risk on the swap.
The social utility of futures markets is considered to be mainly in
the transfer of risk, and increase liquidity between traders with
different risk and time preferences, from a hedger to a speculator for
Options on futures
In many cases, options are traded on futures. A put is the option to
sell a futures contract, and a call is the option to buy a futures
contract. For both, the option strike price is the specified futures
price at which the future is traded if the option is exercised. See the
Black model, which is the most popular method for pricing these option
Futures Contract Regulations
All futures transactions in the United States are regulated by the
Commodity Futures Trading Commission (CFTC), an independent agency of
the United States Government. The Commission has the right to hand out
fines and other punishments for an individual or company who breaks any
rule. Although by law the commission regulates all transactions, each
exchange can have its own rule, and under contract can fine companies
for different things or extend the fine that the CFTC hands out.
The CFTC publishes weekly reports containing details of the open
interest of market participants for each market-segment, which has more
than 20 participants. These reports are released every Friday (including
data from the previous Tuesday) and contain data on open interest split
by reportable and non-reportable open interest as well as commercial and
non-commercial open interest. This type of report is referred to as
'Commitments-Of-Traders'-Report, COT-Report or simply COTR.
What is a Hedge?
In finance, a hedge is an investment that is taken out specifically
to reduce or cancel out the risk in another investment. Hedging is a
strategy designed to minimize exposure to an unwanted business risk,
while still allowing the business to profit from an investment activity.
Typically, a hedger might invest in a security that he believes is
under-priced relative to its "fair value" (for example a
mortgage loan that he is then making), and combine this with a short
sale of a related security or securities. Thus the hedger doesn't care
whether the market as a whole goes up or down in value, only whether the
under-priced security appreciates relative to the hedge. Holbrook
Working, a pioneer in hedging theory, called this strategy
"speculation in the basis," where the basis is the difference
between the 's theoretical value and its actual value (or between spot
and futures prices in Working's time).
Some form of risk taking is inherent to any business activity. Some
risks are considered to be "natural" to specific businesses,
such as the risk of oil prices increasing or decreasing is natural to
oil drilling and refining firms. Other forms of risk are not wanted, but
cannot be avoided without hedging. Someone who has a shop, for example,
can take care of natural risks such as the risk of competition, of poor
or unpopular products, and so on. The risk of the shopkeeper's inventory
being destroyed by fire is unwanted, however, and can be hedged via a
fire insurance contract. Not all hedges are financial instruments: a
producer that exports to another country, for example, may hedge its
currency risk when selling by linking its expenses to the desired
A stock trader believes that the stock price of FOO, Inc., will rise
over the next month, due to this company's new and efficient method of
producing widgets. He wants to buy FOO shares to profit from their
expected price increase. But FOO is part of the highly volatile widget
industry. If the trader simply bought the shares based on his belief
that the FOO shares were underpriced, the trade would be a speculation.
Since the trader is interested in the company, rather than the
industry, he wants to hedge out the industry risk by short selling an
equal value (number of shares x price) of the shares of FOO's direct
competitor, BAR. If the trader were able to short sell an asset whose
price had a mathematically defined relation with FOO's stock price (for
example a call option on FOO shares) the trade might be essentially
riskless and be called an arbitrage. But since some risk remains in the
trade, it is said to be "hedged."
The first day the trader's portfolio is:
Long 1000 shares of FOO at $1 each
||Short 500 shares of BAR at $2
(Notice that the trader has sold short the same value of shares).
On the second day, a favorable news story about the widgets industry
is published and the value of all widgets stock goes up. FOO, however,
because it is a stronger company, goes up by 10%, while BAR goes up by
||Long 1000 shares of FOO at
$1.10 each — $100 profit
||Short 500 shares of BAR at
$2.10 each — $50 loss
(In a short position, the investor loses money when the price goes
The trader might regret the hedge on day two, since it reduced the
profits on the FOO position. But on the third day, an unfavorable news
story is published about the health effects of widgets, and all widgets
stocks crash -- 50% is wiped off the value of the widgets industry in
the course of a few hours. Nevertheless, since FOO is the better
company, it suffers less than BAR:
Value of long position:
||Day 1 — $1000
||Day 2 — $1100
||Day 3 — $550 => $450
Value of short position:
||Day 1 — $1000
||Day 2 — $1050
||Day 3 — $525 => $475
Without the hedge, the trader would have lost $450. But the hedge -
the short sale of BAR - gives a profit of $475, for a net profit of $25
during a dramatic market collapse.
Types of hedging
The example above is a "classic" sort of hedge, known in
the industry as a "pairs trade" due to the trading on a
pair of related securities. As investors became more sophisticated,
along with the mathematical tools used to calculate values, known as
models, the types of hedges have increased greatly. In general, however,
all hedge strategies look for a "spread" between market value
and theoretical or "true" value, and attempt to extract
profits when the values diverge.
Many hedges do not involve exotic financial instruments or
derivatives. A natural hedge is an investment that reduces the undesired
risk by matching cash flows, (for example) revenues and expenses. For
example, an exporter to the United States faces a risk of changes in the
value of the U.S. dollar, and could choose to open a production facility
in that market to match its expected sales revenue to its cost
structure. Another example is a company that opens a subsidiary in
another country and borrows in the local currency to finance its
operations, even though the local interest rate may be more expensive
than in its home country: by matching the debt payments to expected
revenues in the local currency, the parent company has reduced its
foreign currency exposure.
Similarly, an oil producer may expect to receive its revenues in U.S.
dollars, but face costs in a different currency; it would be applying a
natural hedge if it agreed to, for example, pay bonuses to employees in
One of the oldest means of hedging against risk is the purchase of
protection against accidental property damage or loss, personal injury,
or loss of life. See Insurance.
Contract for differences
A Contract for Differences (CfD) is a two way hedge or swap contract
that allows the seller and purchaser to fix the price of a volatile
commodity. For instance, consider a deal between an electricity producer
and an electricity retailer who both trade through an electricity market
pool. If the producer and the retailer agree to a strike price of $50
per MWh, for 1 MWh in a trading period, and if the actual pool price is
$70, then the producer gets $70 from the pool but has to rebate $20 (the
"difference" between the strike price and the pool price) to
the retailer. Conversely, the retailer pays the difference to the
producer if the pool price is lower than the agreed upon contractual
In effect, the pool volatility is nullified and the parties pay and
receive $50 per MWh. However, the party who pays the difference is
"out of the money" because without the hedge they would have
received the benefit of the pool price.
Categories of hedgeable risk
For the following categories of the risk, for exporters, that the
value of their accounting currency will fall against the value of the
importers, also known as volatility risk.
||Interest rate – the
risk, for those who borrow, that interest rates will rise, (or
for those who lend, that they fall)
||Equity – the risk,
for those whose assets are equity holdings, that the value of
the equity falls
Futures contracts and forward contracts are a means of hedging
against the risk of adverse market movements. These originally developed
out of commodity markets in the nineteenth century, but over the last
fifty years there has developed a huge global market in products to
hedge financial market risk.
One of the oldest means of hedging against risk is the purchase of
protection against accidental property damage or loss, personal injury,
or loss of life.
Hedging credit risk
Credit risk is the risk that money owing will not be paid by an
obligor. Since credit risk is the natural business of banks, but an
unwanted risk for commercial traders, naturally an early market
developed between banks and traders: that involving selling obligations
at a discounted rate. See for example forfeiting, bill of lading, or
More recent forms of hedging have become available in the credit
Hedging currency risk (a.k.a. Foreign Exchange Risk, or FX Risk)
Currency hedging is used both by financial investors to parse out the
risks they encounter when investing overseas, as well as by
non-financial actors in the global economy for whom multi-currency
activities is a necessary evil rather than a desired state of exposure.
For example, cost of labor variables dictate that much of the simple
commoditized manufacturing in the global economy today goes on in China
and south-east Asia (Taiwan, Philippines, Vietnam, Indonesia, etc.). The
cost benefit of moving manufacturing to outsource providers outweighs
the uncertainties of never having done business in foreign countries, so
many businesses are jumping into the fray and becoming part of the
globalization trend of moving manufacturing operations overseas. The
benefits of doing this however, come with numerous risks that were never
a problem when manufacturing was done at home--among them currency risk.
If your cost of manufacturing goods in another country is denominated
in a currency other than the one that you sell the finished goods in,
there is the risk that the currency "volatility" alone may
destroy the margin between what you pay to produce your product, and
what you collect when you sell it (note you may be selling your product
in a foreign country too, so you can hedge against the currency risk on
this side as well!). So when you convert all costs on the production
side, and all sales receipts from the retail side, back into your home
currency, you may be alarmed to find that your profits have diminished
significantly, or disappeared altogether. That's currency risk-- it is
germane to doing business globally, but entirely independent of your
specific business or products. Currency hedging then, is the insurance
you can purchase to limit the impact this unpredictable risk has on your
business, the same way Fire or Hurricane insurance protects your
physical premises from unexpected events beyond your control.
Currency hedging is not always available, but is readily found at
least in the major currencies of the world economy, the growing list of
which qualify as major liquid markets beginning with the "Major
Eight" (USD, GBP, EUR, JPY, CHF, HKD, AUD, CAD), which are also
called the "Benchmark Currencies", and expands to include
several others by virtue of liquidity. The currencies beyond the Major 8
can most reliably be identified by checking to see which are included
within the "Continuous-Linked Settlement Bank" "(CLS
Bank)", which handles a growing percentage of the globe's daily
settlement volume between currencies.
Currency hedging, like many other forms of financial hedging, can be
done in two primary ways, with standardized contracts, or with
customized contracts (also known as over-the-counter or OTC).
The financial investor may be a hedge fund that decides to invest in
a company in, for example, Brazil, but does not want to necessarily
invest in the Brazilian currency. The hedge fund can separate out the
credit risk (i.e. the risk of the Company defaulting), from the currency
risk of the Brazilian Real by "hedging" out the currency risk.
In effect, this means that the investment is effectively a USD
investment, in Brazil. Hedging allows the investor to transfer the
currency risk to someone else who does want a position in the currency.
The hedge fund has to pay this other investor to take on the currency
exposure, similar to insuring against other types of events.
As with other types of financial products, hedging may allow economic
activity to take place that would otherwise not have been possible (as a
loan, for example, may allow an individual to purchase a home that would
be "too expensive". The increased investment is assumed in
this way to raise economic efficiency.
A contracted agreement specifying an amount of currency to be
delivered, at an exchange rate decided on the date of contract.
Forward Rate Agreement
A contract agreement specifying an interest rate amount to be
settled, at a pre-determined interest rate on the date of the contract.
This is also known as FRAs.
A contract that gives the owner the right but not the obligation to
take (call option) or deliver (put option) a specified amount of
currency, at an exchange rate decided at the date of purchase.
Non-Deliverable Forwards (NDF)
A strictly risk-transfer financial product similar to a Forward Rate
Agreement, but only used where monetary policy restrictions on the
currency in question limit the free flow and conversion of capital. NDFs
are, as the name suggests, not delivered, but rather, these are settled
in a reference currency, usually USD or EUR, where the parties exchange
the gain or loss that the NDF instrument yields, and if the buyer of the
controlled currency truly needs that hard currency, he can take the
reference payout and go to the government in question and convert the
USD or EUR payout. The insurance effect is the same, it's just that the
supply of insured currency is restricted and controlled by government.
See Capital Control.
The simple concept that two similar investments in two different
currencies, ought to yield the same return. If the two similar
investments are not at face value offering the same interest rate
return, the difference should conceptually be made up by changes in the
exchange rate over the life of the investment. IRP basically gives you
the math to calculate a projected or implied forward rate of exchange.
This calculated rate is not and cannot be considered a prediction or
forecast, but rather is the arbitrage-free calculation for what the
exchange rate is implied to be in order for it to be impossible to make
a free profit by converting money to one currency, investing it for a
period, then converting back and making more money than if you had
invested in the same opportunity in the original currency.
Hedging equity & equity futures
Equity in a portfolio can be hedged by taking an opposite position in
futures. To protect your stock picking against systematic market risk,
you short futures when you buy equity. Or long futures when you short
There are many ways to hedge, and one is the market neutral approach.
In this approach, an equivalent dollar amount in the stock trade is
taken in futures. Buy 10000 GBP worth of Vodafone and short 10000 worth
of FTSE futures.
Another method to hedge is the beta neutral. Beta is the historical
correlation between a stock and an index. If the beta of a Vodafone is
2, then for a 10000 GBP long position in Vodafone you will hedge with a
20000 GBP equivalent short position in the FTSE futures.
If you primarily trade in futures, you hedge your futures against
synthetic futures. A synthetic in this case is a synthetic future
comprising a call and a put position. Long synthetic futures means long
call and short put at the same expiry price. So if you are long futures
in your trade you can hedge by shorting synthetics, and vice versa.
Gold as an Investment
Gold was in use as a form of money, in one form or another, at least
from 560 BC until the end of the Bretton Woods system in 1971. It was
used as a store of value both by individuals and countries for much of
Since the end of the Bretton Woods system in 1971, gold has largely
lost its role as a form of currency. It is still considered by many as a
store of value and a safe haven in times of crisis.
as a financial asset
Gold and other precious metals are assets that are both tangible and
liquid (i.e. easily traded), unlike real estate which is tangible but
not liquid, or company shares and bonds which are liquid but not
Considering its high density and high value per unit mass, storing
and transporting gold is very easy. Gold also does not corrode.
Historically, it was also very easy to verify that an offered coin had
the density of gold through the use of Archimedes' principle. Today,
however, some metals are denser than gold yet cheaper. While some think
gold deserves special treatment based on its cultural value and use as
money, others consider gold a commodity, like copper or lead.
Buying physical gold
Some people, sometimes referred to as gold bugs, buy gold which they
retain in their physical possession in the belief that should the
monetary and financial system collapse, gold would still be considered
valuable. Other reasons for doing so include the ease of hiding the gold
from others, such as family members or tax authorities.
Buying gold for the gold price
Some people buy gold not in their physical possession, but stored for
them by a bank, through a gold exchange-traded fund, or in the form of a
gold certificate; their motivations also apply to those who hold gold
Some asset allocation strategies use exposure to gold as a form of
diversification, though the inclusion of gold in model portfolios
created by major financial advisory companies is no longer common. Gold
may be included in portfolios as an insurance against unforeseen
calamities which may affect the price of other investments negatively.
From the perspective of a currency trader, one can view gold as
simply another form of currency and that buying gold is a process
analogous to currency speculation. For example, when it is expected that
the dollar will soon decline against other currencies, for an investor
who normally covers his expenses in dollars, buying gold or other
currency before the decline and selling it afterwards could realize a
profit. Additionally speculators attempt to make a profit by predicting
the gold price, and detecting market trends they believe will show them
the future price direction.
For centuries gold has been used as a store of value. When viewed
from the historical perspective of a multicentury time frame, no other
investment has the wealth preserving power of gold. Other assets are
dependent upon a certain government or political climate to retain
value, appreciate, and not be excessively taxed, but gold is largely
independent of political climate (with the exception of laws
specifically confiscating gold as Franklin Roosevelt did). Gold
investors believe that political and economic turmoil may have a
negative influence on the value of their other investments, but the
opposite effect on the value of gold.
Types of gold investor
Investors may buy gold as an investment because they are either one
of, or a combination of, the following:
Gold, a popular investment and part of many asset allocation models
in the 1970s, has largely been abandoned since the 1980s. However,
some asset allocators and investment advisors are again advocating it.
Cacheurs (people hiding wealth)
gold can be anonymous. Gold is a very soft metal, meaning that (assuming
the gold is in the physical possession of the owner) the bar's serial
number can be altered or obliterated with a hammer and chisel. If the
bullion's ownership is not recorded anywhere the gold can become
untraceable. Cacheurs seek to hide part of their wealth from their
spouse, family, tax authorities, creditors, thieves, invaders or others.
The density of gold allows them to store a large value in a very small
space, without fear of depreciation or erosion over a long period of
Although central banks as a whole have been net sellers of gold over
the last few years, some have been buyers. A central bank may invest in
gold in order to ensure that part of its reserves are held in a liquid
and tangible form which could be used quickly in times of crisis. Most
central banks keep the majority of their reserves in USD, but like any
other investor diversification makes sense. The dollar is a liability of
the United States of America. Its value thus depends on the USA honoring
it in exchange for goods or services. Central banks may fear that in a
time of crisis, or if there were a USD crisis, dollars may not prove to
be useful. This might happen if sanctions or exchange controls exist.
The banking system may make it hard to move USD if restrictions were
Since the main gold market is priced in US dollars, speculators who
believe the dollar will decline may buy gold. They think that if the
dollar declines, the gold price will remain constant in other
currencies, thus rising in terms of the U.S. dollar. Gold may also be
bought if they feel that a different currency will decline, since they
expect the dollar price to be stable, but the foreign currency price to
Banks and funds may invest in gold to protect themselves against
potential loss on gold linked products that they have issued. These may
include gold certificates, options, forward contracts, gold linked notes
and other products containing a derivative feature linked to the gold
Gold bugs, in the traditional sense, believe in, fear, or even hope
for another Great Depression or Armageddon, and believe that by holding
gold they will survive and prosper.
Some investors consider gold as a long-term store of value and
invest in it to maintain their purchasing power. By buying gold and
hanging on for the long term, they believe they can keep their wealth
Libertarians may use privately issued digital gold currency, in
preference to fiat currency, for reasons such as lack of trust in
fractional-reserve banking or monetary policy.
Some have speculated that there is a correlation between the price
of oil and the price of gold. The general rule is that the price of an
ounce of gold is 10 times the price of a barrel of oil. This is in part
because mining gold is an energy intensive process, the cost to mine an
ounce of gold will increase as the price of oil increases and in part
because they are both commodities and often affected by the same
economic stimuli. Buying gold is one way for a speculator to bet on the
price of oil going up.
Similar to asset allocators, except the purpose of the investment is
to hedge against rapid inflation or unforeseen calamities which may
affect other investments negatively. These individuals believe that
certain events, if they occur (e.g. war or economic crisis), may have a
negative influence on the value of their other investments, but the
opposite effect on the value of their gold.
Speculators attempt to make a profit by predicting the gold price.
They may think that macroeconomics are affecting the demand for gold, or
believe they have detected a market trend showing them the future price
The survival kit issued to US and British Fighter Pilots includes
gold soverigns to help bribe local officials independent of local
currencies. In the James Bond books by Ian Fleming, James regularly
traveled wearing a belt containing 20 gold sovereigns.
The usual benchmark for the price of gold is known as the London Gold
Fixing, a twice-daily (telephone) meeting of representatives from five
bullion-trading firms. Furthermore, there is active gold trading based
on the intra-day spot price, derived from gold-trading markets around
the world as they open and close throughout the day.
Factors influencing the gold price
Today, like all investments and commodities, the price of gold is
ultimately driven by supply and demand, including hoarding and dis-hoarding.
Unlike most other commodities, the hoarding and dis-hoarding plays a
much bigger role in affecting the price, since almost all the gold ever
mined still exists and is potentially able to come on to the market at
the right price. Given the huge quantity of above ground hoarded gold,
compared to the annual production, the price of gold is mainly affected
by changes in sentiment, rather than changes in annual production or
gold jewelry demand.
Central banks and the International Monetary Fund play an important
role in the gold price. At the end of 2004 central banks and official
organizations held 19 percent of all above ground gold as official gold
reserves . The Washington Agreement on Gold (WAG) which dates from
September 1999, limits gold sales by its members (Europe, United States,
Japan, Australia, Bank for International Settlements and the
International Monetary Fund) to less than 400 tons a year. European
central banks, such as the Bank of England and Swiss National Bank, have
been key sellers of gold over this period.
In November 2005, Russia, Argentina and South Africa expressed
interest in increasing their gold holdings. Other than Russia, these are
not viewed as significant central banks, but any move by Japan, China or
South Korea to do the same would be seen as significant. Currently the
United States Federal Reserve has 16% of its assets in gold, whereas
China holds approximately 1% in gold.
Although central banks do not generally announce gold purchases in
advance, some such as Russia have expressed interest in growing their
gold reserves again as of late 2005. In early 2006, China, who only
holds 1.3% of its reserves in gold, announced that it was looking for
ways to improve the returns on its official reserves. Many bulls took
this as a thinly veiled signal that gold would play a larger role in
China's reserves, which they hope will push up the price of gold.
Inflation fears have also been influential in the past. The October
2005 consumer price index level of 199.2 (1982-84=100) was 4.3 percent
higher than in October 2004. During the first ten months of 2005, the
CPI-U rose at a 4.9 percent seasonally adjusted annual rate (SAAR). This
compares with an increase of 3.3 percent for all of 2004.
When dollars were fully convertible into gold, both were regarded as
money. However, most people preferred to carry around paper banknotes
rather than the somewhat heavier and less divisible gold coins. If
people feared their bank would fail, a bank run might have been the
result. This is what happened in the USA during the Great Depression of
the 1930s, leading President Roosevelt to impose a national emergency
and to outlaw the holding of gold by US citizens.
Paper currencies pose a risk of being inflated, possibly to the point
of hyperinflation. Historically, currencies have lost their value in
this way over time. In times of inflation, people seek to protect their
savings by purchasing liquid, tangible assets that are valued for some
other purpose. Gold is in this respect a good candidate, since producing
more is far more difficult than issuing new fiat currency, and its value
does not rely on any particular government's health.
Low or negative real interest rates
Gold has a long history of being an inflation proof investment.
During times of low or negative real interest rates when significant
inflation is present and interest rates are relatively low investors
seek the safe haven of gold to protect their capital. A prime example of
this is the period of Stagflation that occurred during the 1970s and
which led to an economic bubble forming in precious metals.
In times of national crisis, people fear that their assets may be
seized, and the currency may become worthless. They see gold as a solid
asset which will always buy food or transportation. Thus in times of
great uncertainty, particularly when war is feared, the demand for gold
According to the World Gold Council, annual gold production over the
last few years has been close to 2,500 tons. However, the effects of
official gold sales (500 tons), scrap sales (850 tons), and producer
hedging activities take the annual gold supply to around 3,500 tons.
About 3,000 tons goes into jewelry or industrial/dental production,
and around 500 tons goes to retail investors and exchange traded gold
Some investors consider that supply and demand factors are less
relevant than with other commodities since most of the gold ever mined
is still above ground and available for sale at a price. However, supply
and demand do play a role. According to the World Gold Council, gold
demand rose 29% in the first half of 2005. The increase came mainly from
the launch of a gold exchange-traded fund, but also from jewelry. Gold
demand was at an all time record. Demand from the electronics industry
is rising by 11% a year, jewelry by 19%, and industrial and dental by
Methods of investing in gold
Investment in gold can be done directly through ownership, or
indirectly through certificates, accounts, shares, futures etc.
Other than storing gold in one's own safe deposit box at a bank, gold
can also be placed in allocated (also known as non-fungible), or
unallocated (fungible or pooled) storage with a bank or dealer. In the
case of the latter going bankrupt, the client will be unable to claim
the gold and would become a general creditor, whereas gold held in
allocated storage should be returned to the client in full. However even with gold held in allocated storage, many gold
bugs would still choose their storage provider carefully, making sure of
high net worth, with some preferring an offshore bank or storage
traditional way of investing in gold is by buying bullion gold bars. In
some countries, like Austria, Liechtenstein and Switzerland, these can
easily be bought or sold "over the counter" of the major
banks. Alternatively, there are bullion dealers which provide the same
service. Bars are available in various sizes, for example in Europe
these would typically be in 12.5kg or 1kg bars (1kg = 32.15072 Troy
ounces), although many other weights exist, such as the Tael, the 10oz
or 1oz bar.
Buying gold coins is a popular way of holding gold. Typically bullion
coins are priced according to their weight, with little or no premium
above the gold price. Amongst the most popular bullion gold coins are
the South African Krugerrand, the Canadian Gold Maple Leaf, the American
Gold Eagle, the American Gold Buffalo, and the Australian Gold Nugget,
all of which contain exactly one troy ounce of gold each. Other popular
one ounce bullion coins include the Chinese Panda, and the Austrian
Philharmonic. Gold coins which are used as bullion coins include the
British gold sovereign and the Swiss Vreneli, but these are much lighter
than one ounce. Again the large Swiss and Liechtenstein banks will buy
and sell these coins over the counter. Also available is the gold dinar
which has Islamic significance.
A certificate of ownership can be held by gold investors, instead of
storing the actual gold bullion. Gold certificates allow investors to
buy and sell the security without the hassles associated with the
transfer of actual physical gold. The Perth Mint Certificate Program (PMCP)
is the only government guaranteed gold certificate program in the world.
Some argue that it is not the same as owning the real thing, as a
certificate is just a piece of paper, especially in a war, crisis, or
Most Swiss banks offer gold accounts where gold can be instantly
bought or sold just like any foreign currency. Digital gold currency
accounts and the BullionVault gold exchange work on a similar principle.
Gold accounts are typically backed through unallocated or allocated gold
storage. Different accounts impose varying levels of intermediation
between the client and their gold, for example through bailment or
within a trust. Bailment is the legal action of a client entrusting
their physical property to another party for safekeeping, and paying for
Gold exchange-traded fund
Gold exchange-traded funds (or GETFs) are traded like shares on the
major stock exchanges including London, New York and Sydney. The first
gold ETF, Gold Bullion Securities (ticker symbol "GOLD"), was
launched in March 2003 on the Australian Stock Exchange, and originally
represented exactly one-tenth of an ounce of gold. Due to costs, the
amount of gold in each certificate is now slightly less. They are fully
backed by gold which is both deposited and insured. The inventory of
gold is managed by buying and selling gold on the open market.
Gold ETFs represent an easy way to gain exposure to the gold price,
without the hassle of buying gold directly. Typically a small commission
is charged for trading in gold ETFs and a small annual storage fee is
charged. The annual expenses of the fund such as storage, insurance, and
management fees are charged by selling a small amount of gold
represented by each certificate, so the amount of gold in each
certificate will gradually decline over time. In some countries, gold
ETFs represent a way to avoid the sales tax or the VAT which would apply
to physical gold coins and bars. Economies of scale, liquidity, and ease
of purchase and sale make ETFs an increasingly popular method of
investing in gold.
Gold mining companies
These do not represent gold at all, but rather are shares in gold
mining companies. If the gold price rises, the profits of the gold
mining company could be expected to rise and as a result the share price
may rise. However, there are many factors to take into account and it is
not always the case that a share price will rise when the gold price
increases. Some of the following questions might be relevant before
investing in the shares of a gold mining company: Has the company hedged
the gold price i.e. already sold part of its future gold production
through forward sales? Is the company already producing gold, or is it
mainly exploring for gold? Does the company make a profit? How many
years of ore reserves are left in the mines before they have to be
closed down? What P/E ratio and dividend yield does the company have now
and in the following years? Are the mines subject to political or
Unlike gold bullion, which is regarded as a safe haven asset, gold
shares or funds are regarded as high risk and extremely volatile. This
volatility is due to the inherent leverage in the mining sector. For
example, if you own a share in a gold mine where the costs of production
are $300 per ounce and the price of gold is $600, the mine's profit
margin will be $300. A 10% increase in the gold price to $660 per ounce
will push that margin up to $360, which actually represents a 20%
increase in the mine's profitability, and potentially a 20% increase in
the share price. Conversely, a 10% fall in the gold price to $540 will
decrease that margin to $240, which actually represents a 20% fall in
the mine's profitability, and potentially a 20% decrease in the share
price. The amplification of gold mining profits during periods of rising
prices can cause a gold rush.
In order to reduce this volatility many gold mining companies hedge
the gold price up to 18 months in advance. This provides the mining
company and investor with less exposure to short term gold price
fluctuations, but reduces potential returns when the gold price is
rising. The AMEX Gold BUGS Index is comprised of the largest unhedged
gold stocks listed on AMEX (BUGS - Basket of Unhedged Gold Stocks). As
of January 2007, the two largest stocks listed in the index were
Goldcorp and Newmont Mining. The AMEX Gold BUGS Index (ticker symbol
"HUI") has outperformed general gold mining stocks,
represented by the Philadelphia Gold and Silver Index ("XAU"),
over recent years.
Instead of personally selecting individual companies, some investors
prefer spreading their risk by investing in gold mining mutual funds
such as the Gold & General Fund by Merrill Lynch, or exchange-traded
funds such as the Market Vectors Gold Miners ETF (NYSE: GDX) by Van Eck
Global which tracks the Amex Gold Miners Index ("GDM").
Firms such as Cantor Index and IG Index, both from the UK, offer the
ability to take a bet on the price of gold through what is known as a
spread bet. Say the price of December gold was quoted at $475.10 to
$476.10 per troy ounce. An investor who thought the price would go down
would "sell" at $475.10. The minimum bet is $2 per point,
(i.e. equivalent to 200 ounces). If the price of gold finished at
$480.10 when the seller closed their bet, the loss would be 500 points
multiplied by the bet of $2 making a loss of $1000 in total. No
commissions or taxes are levied in the UK on spread betting.
Derivatives, such as gold forwards, futures and options, currently
trade on various exchanges around the world and over-the-counter (OTC)
directly in the private market. In the U.S., gold futures are primarily
traded on the New York Commodities Exchange (COMEX), a division of the
New York Mercantile Exchange (NYMEX), and Chicago Board of Trade (CBOT).
In November 2006, the National Commodity and Derivatives Exchange (NCDEX)
in India introduced 100 gram gold futures.
Investors may base their investment decisions on fundamental
analysis. These investors analyze the macroeconomic situation, which
includes international economic indicators, such as GDP growth rates,
inflation, interest rates, productivity, and energy prices. They would
also analyze the total global gold supply versus demand. Over 2005 the
World Gold Council estimated total global gold supply to be 3,859 tons
and demand to be 3,754 tons, giving a surplus of 105 tons. Others
point out that total mine production is only about 2500 tons each
year, leaving a 1300 ton deficit that must be made up by central bank
or private sales. While gold production is unlikely to change in the
near future, supply and demand due to private ownership is highly liquid
and subject to rapid changes. This makes gold very different from almost
every other commodity.
Investors may base their investment decisions solely on, or partly
on, technical analysis. Typically this involves analyzing past price
patterns and market trends, in order to speculate on the future price.
Some investors try to predict the future gold price by tracking the
ratio between the Dow Jones 30 and the gold price. The Dow/gold ratio
has fluctuated from a low of 1.0 in 1980 (i.e. the Dow and gold price
were the same) to a high of 43.7 in 1999 (i.e. the Dow was 43.7 times
the gold price).
Bullish investors may choose to leverage their position by borrowing
money against their existing gold assets and then purchasing more gold
on account with the loaned funds. In order to keep the cost of debt to a
minimum, these individuals would normally seek a loan in the currency
with the lowest LIBOR, which as of April 2006 was the Japanese yen. This
technique is referred to as a "yen-gold carry trade". Leverage
is also an integral part of buying gold derivatives. Leverage may
increase investment gains but also increases risk, as if the gold price
decreases the investor may be subject to a margin call.
Historically increases in the supply of paper money or fiat currency
through increased money supply would cause the demand for gold to
increase. There was a time when gold was money and vice versa. If
citizens felt that there may be insufficient gold to cover the paper
money in circulation, they would queue up at the bank to change their
paper currency back into gold.
However, since the gold standard was ended on August 15, 1971,
governments have been free to print as much money as they choose,
without fear that their populations will come knocking on the central
bank's door demanding to change their paper money back into gold.
In January 1959 US M3 money supply was $288.8 billion, and the
official gold reserves of the United States was then 17,335.1 tons, or
557,336,000 ounces (there are 32,150.7 troy ounces in a ton). That
means that in 1959, there were $518 in circulation for every ounce of
gold reserves held by the USA. Although the theoretical price should
then have been $518 per ounce, the actual price, as fixed under the gold
standard was only $35 an ounce.
By August 2005, the US M3 money supply had risen to $9,873.9 billion,
whilst at the same time the Official Gold Holdings of the United States
had fallen to just 8,133.5 tons, or 261.50 million Troy Ounces. This
means that today, in 2005, there are $37,831 in circulation for every
troy ounce of gold held by the United States.
However, this increase of 75 times in the ratio of central bank gold
holdings to debt does not allow for the fact that the gold standard was
abandoned in 1971 and gold holdings have been deliberately and
considerably reduced. Another far less dramatic way of looking at the
same figures is this: In 1959 US government debt valued in gold was 8
billion Troy ounces, in 2005 US government debt was 20 billion oz gold -
an increase of only 2.5 times.
The above numbers show the falling influence of gold in today's
monetary system. Gold bugs believe, or hope, that one day gold's
importance will return as the printing of paper money gets out of
control and we end in a hyper-inflationary fiat money collapse.
The US Federal Reserve ceased publishing M3 data on 23 March 2006,
with the last published data indicating a year-on-year growth rate of
8.23%. Central banks may see this as a reason to limit further increases
in their reserves of dollars, and thus alternatives such as gold or the
euro might be considered. Jon Nadler, an analyst at Kitco Bullion
Dealers, said gold was still benefiting from August 30, 2006 release of
the minutes to the last rate-setting meeting of the US Federal Reserve.
The minutes to the August 8, 2006 meeting, at which the Federal Open
Market Committee kept short-term interest rates unchanged for the first
time since 2004, supported the view that US borrowing costs have peaked.
In 2001, it was estimated that all the gold ever mined totaled
145,000 tons, which would form a rectangular pyramid slightly less
than 29m on a side. Global gold mine production is between 2,500 to
3,000 tons per year, which would mean that about 155,000 tons of
gold would have been mined as of 2006, with a total value of $3.2
trillion at June 2006 prices.
Many argue that gold's role in the world's monetary system has ended,
and that it will never again represent the store of value that it once
was. The gold price peaked at around $850/oz t ($27,300,000 per ton) in
1980, and in real terms is still well below that. However, since April
2001 the gold price has more than doubled in value against the US
dollar, speculation circulates that this long secular bear market (or
the Great Commodities Depression) has ended and a bull market has
Gold maintains a special position in the market with many tax
regimes. For example, in the European Union the trading of recognized
gold coins and bullion products is free of VAT. Silver, and other
precious metals or commodities, do not have the same allowance. Other
taxes such as capital gains tax may still apply for individuals,
according to their jurisdiction. There is no capital gains tax in
Scams and frauds
Gold attracts its fair share of fraudulent activity. Some of the most
common to be aware of are:
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