The-Complete-Guide-to-Trading.pdf

The Corporate Finance Institute The Complete Guide to Trading The Complete Guide to Trading corporatefinanceinstitute.com 1 The Corporate Finance Institute The Complete Guide to Trading The Complete Guide to Trading (How to Trade the Markets and Win) A Publication of The Corporate Finance I...

The Corporate Finance Institute The Complete Guide to Trading The Complete Guide to Trading corporatefinanceinstitute.com 1 The Corporate Finance Institute The Complete Guide to Trading The Complete Guide to Trading (How to Trade the Markets and Win) A Publication of The Corporate Finance Institute corporatefinanceinstitute.com 2 The Corporate Finance Institute The Complete Guide to Trading “When you think the market can’t possibly go any higher (or lower), it almost invariably will, and whenever you think the market “must” go in one direction, nine times out of ten it will go in the opposite direction. Be forever skeptical of thinking that you know what the market is going to do.” – William Gallaher corporatefinanceinstitute.com 3 The Corporate Finance Institute The Complete Guide to Trading About Corporate Finance Institute® CFI is a world-leading provider of online financial analyst training programs. CFI’s courses, programs, and certifications have been delivered to tens of thousands of individuals around the world to help them become world-class financial analysts. The analyst certification program begins where business school ends to teach you job-based skills for corporate finance, investment banking, corporate development, treasury, financial planning and analysis (FP&A), and accounting. CFI courses have been designed to make the complex simple by distilling large amounts of information into an easy to follow format. Our training will give you the practical skills, templates, and tools necessary to advance your career and stand out from the competition. Our financial analyst training program is suitable for students of various professional backgrounds and is designed to teach you everything from the bottom up. By moving through the three levels of mastery, you can expect to be performing industry-leading corporate finance analysis upon successful completion of the courses. About CFI’s Complete Guide to Trading The following eBook’s purpose is to outline all the necessary fundament skills needed to understand the capital markets in a trading context. The three-part guide will walk you through the markets, trading concepts, and technical analysis and trading strategies. Produced after hours of research and planning by current and former professionals in the trading industry, you will become familiar with applicable knowledge that will allow you to be competitive in today’s markets. corporatefinanceinstitute.com 4 The Corporate Finance Institute The Complete Guide to Trading Copyright © 2018 CFI Education Inc. All rights reserved. No part of this work may be reproduced or used in any form whatsoever, including photocopying, without prior written permission of the publisher. This book is intended to provide accurate information with regard to the subject matter covered at the time of publication. However, the author and publisher accept no legal responsibility for errors or omissions in the subject matter contained in this book, or the consequences thereof. Corporate Finance Institute [email protected] 1-800-817-7539 www.corporatefinanceinstitute.com At various points in the manual a number of financial analysis issues are examined. The financial analysis implications for these issues, although relatively standard in treatment, remain an opinion of the authors of this manual. No responsibility is assumed for any action taken or inaction as a result of the financial analysis included in the manual. corporatefinanceinstitute.com 5 The Corporate Finance Institute The Complete Guide to Trading Table of contents 7 Part One – The Markets 8 Understanding Asset Classes 11 Types of Markets 14 The Fixed Income Market 17 The Money Market 21 The Stock Market 28 Exchange-Traded Funds 31 Commodity Futures 39 The Forex Market 44 Part Two – Trading Concepts 45 Random Walk Theory 48 Fundamental and Technical Analysis 51 How to Read Stock Charts 58 Stock Trading – Value Investing 65 Stock Trading - Growth Investing 69 Part Three – Technical and Trading Strategies 70 Technical Analysis – A Basic Guide 80 The ADX Indicator 84 Triangle Patterns 88 The Trin Indicator 92 The MACD Indicator 97 A Pin Bar Scalping Strategy 100 The Three Simplest Trend Following Strategies 104 The Psychology of Trading Winning Mindset 110 Six Essential Skills of Master Traders 114 Trading Inspiration: Quotes from the Masters corporatefinanceinstitute.com 6 The Corporate Finance Institute PART 01 corporatefinanceinstitute.com The Complete Guide to Trading The Market 7 The Corporate Finance Institute The Complete Guide to Trading The Market To learn more, please check out our online courses Understanding Asset Classes When you trade, you trade financial assets of one kind or another. There are different classes, or types, of assets – such as fixed income investments - that are grouped together based on their having a similar financial structure and because they are typically traded in the same financial markets and subject to the same rules and regulations. There’s some argument about exactly how many different classes of assets there are, but many analysts commonly divide assets into the following five categories: • Stocks, or equities - Equities are shares of ownership that are issued by publicly traded companies and traded on stock exchanges, such as the NYSE or Nasdaq. You can potentially profit from equities either through a rise in the share price or by receiving dividends. • Bonds, or other fixed income investments (such as certificates of deposit – CDs) – Fixed-income investments are investments in securities that pay a fixed rate of return in the form of interest. While not all fixed income investments offer a specific guaranteed return, such investments are generally considered to be less risk than investing in equities or other asset classes. • Cash or cash equivalents, such as money market funds – The primary advantage of cash or cash equivalent investments is their liquidity. Money held in the form of cash or cash equivalents can be quickly and easily accessed at any time. • Real estate, or other tangible assets – Real estate or other tangible assets are considered as an asset class that offers protection against inflation. The tangible nature of such assets also leads to them being considered as more of a “real” asset, as compared to assets that exist only in the form of financial instruments. corporatefinanceinstitute.com 8 The Corporate Finance Institute • The Complete Guide to Trading Futures and other financial derivatives – This category includes futures contracts, the forex market, options, and an expanding array of financial derivatives. It’s difficult to classify some assets. For example, suppose you’re investing in stock market futures. Should those be classified with equities, since they’re essentially an investment in the stock market, or with futures, since they’re futures? Gold and silver are tangible assets, but are most frequently traded in the form of commodity futures or options, which are financial derivatives. If you invest in a real estate investment trust (REIT), should that be considered an investment in real estate or as an equity investment since REITs are exchange-traded securities? Things are further complicated by the expansion in available investments. Exchange-traded funds (ETFs), for example, are traded like stocks on equity exchanges, but ETFs may be composed of investments from one or more of the five basic asset classes. An ETF that offers exposure to the gold market may be partly composed of investments in gold bullion and partly composed of stock shares of gold mining companies. There are additional asset classes, such as artwork, various other collectibles, and peer to peer lending. Hedge funds and other sources of venture capital, along with markets that trade things such as Bitcoin and other alternative currencies, represent some other asset classes that are a bit more off the beaten path. Generally speaking, the more an investment falls into the category of “alternative investment”, the less liquid and the more risky it tends to be. Good news! – You don’t really have to know for certain which asset class a specific investment falls under. You just need to understand the basic concept that there are broad, general categories of investments. That fact is primarily important because of the concept of diversification. Diversification is the idea that you can reduce the overall risk of your investment portfolio by investing in different types of investments, such as investments in different asset classes. There is usually little correlation between the different asset classes. In other words, during periods of time when equities are performing well, bonds, real estate, and commodities may not be performing well for investors. However, during bear markets in stocks, other assets, such as real estate or bonds, may be showing investors above average returns. You can hedge your investments corporatefinanceinstitute.com 9 The Corporate Finance Institute The Complete Guide to Trading in one asset class, reducing your risk exposure by simultaneously holding investments in other asset classes. The practice of reducing investment portfolio risk by diversifying your investments across different asset classes is referred to as asset allocation. The other reason to have a basic understanding of asset classes is just to help your recognize the nature of various investments that you may choose to trade. For example, you might choose to devote all, or nearly all, of your investment capital to trading futures or other financial derivatives, such as foreign currency exchange (forex). But if you do, you ought to at least be aware that you have chosen to trade a class of assets that is usually considered to carry significantly more risk than bonds or equities. The extent to which you choose to employ asset allocation as a means of diversification is going to be an individual decision that is guided by your personal investment goals and your risk tolerance. If you’re very risk averse – have an extremely low risk tolerance – then you may just want to invest only in the relatively safe asset class of fixed-income investments. Alternately, you may aim to further diversify within an asset class – such as by holding a selection of large cap, mid cap, and small cap stocks, or by investing in various industry sectors of the stock market. On the other hand, if you’re blessed with a high risk tolerance and/or having money to burn, you may care very little about diversification, being more focused on trying to correctly identify the asset class that currently offers the highest potential profits. corporatefinanceinstitute.com 10 The Corporate Finance Institute The Complete Guide to Trading Types of Markets – Dealers, Brokers, and Exchanges For the buying and selling of assets, there are several different types of markets that facilitate trade. Each market operates under different trading mechanisms. The three main types of markets are: 1. Dealers (also known as the over-the-counter market) 2. Brokers 3. Exchanges Dealer Markets A dealer market operates with a dealer who acts as a counterparty for both buyers and sellers. The dealer sets bid and asks prices for the security in question, and will trade with any investor willing to accept those prices. Securities sold by dealers are sometimes referred to as being traded over-the-counter (OTC). By acting as a counterparty for both buyers and sellers, the dealer provides liquidity in the market at the cost of a small premium that exists in the form of bid and ask spreads. In other words, dealers set bid prices slightly lower than the going market price and ask prices slightly higher than the market. The spread between these prices is the profit the dealer makes in return for assuming the counterparty risk. Dealer markets are less common in stocks, more common in bonds and currency markets. Dealer markets are also appropriate for futures and options, or other standardized contracts and financial derivatives. Finally, the forex, or foreign exchange market is commonly operated through dealers, with banks and currency exchanges acting as the intermediary connecting dealers with buyers and sellers. Of the three types of markets, the dealer market is usually the most liquid, because of the fact that the dealer’s existence means that there will always be an available counterparty to traders wanting to buy or sell. Broker Markets A broker market operates by finding a counterparty for both buyers and sellers. When dealers act as the counterparty, the delay with corporatefinanceinstitute.com 11 The Corporate Finance Institute The Complete Guide to Trading brokers finding an appropriate counterparty results in less liquidity for brokered markets as compared to dealer markets. Traditionally, stock markets were brokered. Stockbrokers would try to find an appropriate counterparty for their client on the trading floor of a stock exchange. This is the stereotypical image that Wall Street used to be known for, with men and women in suits yelling at each other while holding pieces of paper representing their clients orders that they are seeking to fill. Broker markets are used for all manner of securities, especially those with initial issues. A stock initial public offering (IPO), for example, will usually be launched through an investment bank which brokers the issue trying to find buyers. There is a similar procedure for new bond issues. Finally, brokered markets are also appropriate for tailored or custom financial products. Exchanges Of the three types of markets, the exchange is the most highly automated. However, if no buyers and sellers are able to meet in terms of price, then no trades are executed. Because of the huge number of potential buyers and sellers trading through exchanges, such a situation is extremely unlikely and commonly only occurs in times of economic crisis. In practice, the large numbers of buyers and sellers makes a stock exchange virtually just as liquid as a dealer market. Although stockbrokers do still input orders for clients, the stock market is no longer truly a brokered market, having transitioned to operating as an automated exchange. Trades are executed based on order books that match buyers with sellers. The advantage of an exchange is the provision of a central location for buyers and sellers to find counterparties. Exchanges are used for all manner of securities, but are most appropriate for standardized securities such as stocks, bonds, futures contracts, and options. Exchanges typically specify the characteristics for securities that are traded on the exchange. Exchange-Specified Characteristics corporatefinanceinstitute.com • Contract or Lot Size • Contract Execution/Trading Months • Tick Size • Delivery Terms • Quality 12 The Corporate Finance Institute The Complete Guide to Trading Delivery terms and quality are not commonly specified in stock exchange trading or bond trading. In a stock exchange transaction, all that is stated is the contract and tick size, as well as the execution, which is typically immediate. Contract sizes for securities or financial instruments are typically set to a minimum amount. For example, a stock might only be available for purchase in lots of 100 on a certain exchange. Tick size is commonly the lowest denomination of a currency. On US stock exchanges, the lowest tick price is one cent. A minimum 100-lot contract size under such conditions might then have a minimum tick value of $1 ($0.01 x 100 shares per lot). Delivery terms and quality are more appropriately used in reference to commodity trading and to derivatives involving commodity-like assets. Gold and diamonds, for example, have qualities and ratings. Additionally, there must be provisions for potential delivery of the physical asset to the buyer or contract holder. Such characteristics are specified by the exchange an asset or financial instrument is traded on. corporatefinanceinstitute.com 13 The Corporate Finance Institute The Complete Guide to Trading The Fixed Income Market Fixed income securities such as Treasury bonds are a type of debt instrument that provides returns in the form of regular, or fixed, payments and repayments of the principal when maturity is reached. These instruments are issued by governments, corporations and other entities to finance their operations. They differ from equity, as they do not entail ownership in a company, but bonds usually have seniority of claim in cases of bankruptcy or default. Fixed income securities are generally considered a safer investment than equities or other market investments, but do not usually offer investment returns as high as those that can be obtained through other investments. The term fixed income refers to interest payments that an investor receives, which are based on the creditworthiness of the borrower and current market rates. Generally speaking, fixed income securities such as bonds pay a higher rate of interest - known as the coupon - the longer their maturities are. At the end of the term or maturity, the borrower returns the borrowed money, known as the principal, or par value, amount. The primary risks associated with fixed income securities concern the borrower’s vulnerability to defaulting on its debt. In turn, this risk is incorporated in the interest or coupon that the security pays the investor. Additional risks involving the exchange rate for international bonds can be of concern, as well as the risk that changes in interest rates may increase (or decrease) the market value of a bond currently held. This is known as interest rate risk. Credit/default risk arises if the issuer of a security is unable to pay interest and/or principal in a timely fashion. The probability of credit/default risk occurring depends on the issuer’s ability to meet their financial obligations and on their credit worthiness. There is a negative correlation between credit rating and yield – the lower a bond issuer’s credit rating, the higher the yield that will be offered to compensate for higher risk. A change in the issuer’s credit rating affects the value of their outstanding fixed income securities. There is a purchasing power risk associated with fixed income securities because the real rate of return on fixed income investments equals the rate of return minus the rate of inflation. During periods of high inflation, the real rate of return on fixed income investments may become negative. corporatefinanceinstitute.com 14 The Corporate Finance Institute The Complete Guide to Trading Bond Pricing The price of a bond depends on several characteristics that apply to every bond issued. These characteristics are as follows: • Coupon, or lack thereof - A bond may or may not come with attached coupons. A coupon is stated as a nominal percentage on the par value of the bond. Each coupon is redeemable per period for that percentage. A bond may also come with no coupon. In this case, the bond is known as a zero-coupon bond. Zero-coupon bonds are typically priced lower than bonds with coupons. • Principal/par value - Every bond comes with a par value – the principal amount that is repaid at maturity. Without the principal value, a bond would have no use. The principal value is to be repaid to the lender (the bond purchaser) by the borrower (the bond issuer). A zero-coupon bond pays no coupons but guarantees the principal amount at maturity. The interest paid on a zero-coupon bond is delivered in the form of the bond price being less than the principal amount that will be paid at maturity. For example, a zero-coupon bond with a par value of $1,000 might be available for purchase for $900. When the purchaser of the bond receives the $1,000 par value on the bond’s maturity date, they have, in effect, received approximately 10% interest on the bond. • Yield to maturity - Bonds are priced to yield a certain return to investors. A bond that sells at a premium (where price is above par value) will have a yield to maturity that is lower than the coupon rate. Alternatively, the causality of the relationship between yield to maturity and price may be reversed. A bond could be sold at a higher price if the intended yield (market interest rate) is lower than the coupon rate. This is because the bondholder will receive coupon payments that are higher than the market interest rate, and will therefore pay a premium for the difference. • Coupon Periods to Maturity – Bonds vary in the number of coupon payments that occur until the bond matures. More frequent coupon (interest) payments are considered more desirable and typically increase the price of a bond. All else being equal, the following statements about bond pricing are true: corporatefinanceinstitute.com 15 The Corporate Finance Institute The Complete Guide to Trading A bond with a higher coupon rate will be priced higher. A bond with a higher par value will be priced higher. A bond with a higher number of periods to maturity will be priced higher. A bond with a higher yield to maturity or market rates will be priced lower. An easier way to remember this is that bonds are priced higher for all characteristics except for yield to maturity. A higher yield to maturity results in lower bond pricing. corporatefinanceinstitute.com 16 The Corporate Finance Institute The Complete Guide to Trading The Money Market The money market is an organized exchange market where participants can lend and borrow short-term, high-quality debt securities for one year or less. The market allows governments, companies, or banks and other financial institutions to obtain short-term securities to fund their short-term cash flow needs. It also allows individual investors to invest small amounts of money in a low-risk market. Some of the instruments traded in this market include Treasury bills, certificates of deposit, commercial paper, bills of exchange, and short-term mortgage-backed or asset-backed securities. Large corporations with short-term cash flow needs can borrow from the money market directly through a dealer while small companies with excess cash can lend money through money market mutual funds. Individual traders who want to profit from the money market can invest through a money market bank account or money market mutual fund. A money market mutual fund is a professionally managed fund that buys money market securities on behalf of individual investors. Functions of the Money Market The money market contributes to a smooth-running economy of a country by providing short-term liquidity to governments, banks, and other large organizations. Investors with excess money that they do not immediately need can invest it in the money market and earn interest. Here are the main functions of the money market: #1 Financing Trade The money market provides financing to local and international traders who are in an urgent need of short-term funds. It provides a facility to discount bills of exchange, and this provides buyers of goods with immediate financing to pay for such goods. The money market also makes funds available for other units of the economy, such as agriculture and small-scale industries. #2 Central Bank Policies The central bank is responsible for guiding the monetary policy of a country and taking measures to ensure a healthy financial system. Through the money market, the central bank can perform part of its policy-making function efficiently. For example, the short-term interest rates in the money market represent the prevailing corporatefinanceinstitute.com 17 The Corporate Finance Institute The Complete Guide to Trading conditions in the banking industry and can guide the central bank in developing an appropriate future interest rate policy. Also, by adjusting the interest rates at which government-issued debt, such as Treasury bills and bonds, are offered, the central bank can influence interest rates for all types of fixed-income financial instruments. #3 Growth of Industries The money market provides an easy avenue for companies to obtain short-term loans to finance their working capital or other cash flow needs. Due to the large volumes of transactions, companies may experience cash shortages in regard to buying raw materials, paying employees, or meeting other short-term expenses. Through commercial paper or similar financing, they can borrow and obtain funds almost immediately for a relatively short loan duration. Although the money market does not provide longterm loans, it influences the overall capital market and can help companies obtain long-term financing. The capital market benchmarks its interest rates based on the prevailing interest rate in the money market. #4 Commercial Banks Self-Sufficiency The money market provides commercial banks with a ready market where they can invest their excess reserves and earn interest while maintaining liquidity. The short-term investments such as bills of exchange can easily be converted to cash to support customer withdrawals. Also, when faced with liquidity problems, they can borrow from the money market on a short-term basis as an alternative to borrowing from the central bank. Instruments Traded in the Money Market Several financial instruments are created for short-term lending and borrowing in the money market, such as the following: #1 Treasury Bills Treasury bills are considered the safest money market instruments because they are issued with a full guarantee by the United States government. They are regularly issued by the U.S. Treasury to refinance Treasury bills reaching maturity and to finance government deficits. T-bills have a maturity of one, three, six, or twelve months. They are sold at a discount to their face value, and the difference between the discounted purchases price and face value represents the interest rate paid to investors. They are commonly purchased by banks, broker-dealers, individual corporatefinanceinstitute.com 18 The Corporate Finance Institute The Complete Guide to Trading investors, pension funds, insurance companies, and other large institutions. #2 Certificates of Deposit A certificate of deposit (CD) is issued directly by a commercial bank, but it can also be purchased through brokerage firms. It has a maturity date ranging from three months to five years and can be issued in any denomination. Most CDs have a fixed maturity date and interest rate, and they extract a penalty for cashing in the CD prior to the time of maturity. Any time after the expiry of the CD’s maturity date, the principal amount and interest earned is available for withdrawal. CDs are insured by the Federal Deposit Insurance Corporation (FDIC). #3 Commercial Paper Commercial paper is an unsecured loan issued by large institutional buyers to finance short-term financial needs such as inventory and accounts receivables. It is issued at a discount, with the difference between the price and face value of the commercial paper being the profit in interest paid to the investor. Typically, only large institutions with a high credit rating can issue commercial paper, and it is, therefore, considered a very safe investment. Commercial paper is issued in denominations of $100,000 and above. Individual investors can invest in commercial paper indirectly through money market funds. Commercial paper usually has a maturity date of less than one year from the date of issue. #4 Banker’s Acceptance Notes A banker’s acceptance note is a short-term debt instrument issued by a non-financial institution but guaranteed by a commercial bank. It is created by a drawer, providing the bearer the right to the monetary amount indicated on its face at a specified date. It is often used in international trade because of the benefits to both the drawer (issuer) and bearer (holder). The holder of the acceptance note may decide to sell it on a secondary market. The date of maturity for banker’s acceptance notes usually ranges between one month and six months from the date of issue. #5 Repurchase Agreements A repurchase agreement, commonly known as a “repo”, is a shortterm form of borrowing that involves selling a security with an agreement to repurchase it at a higher price at a later date. It is commonly used by dealers in government securities who sell Treasury bills to a lender and agree to repurchase them at an corporatefinanceinstitute.com 19 The Corporate Finance Institute The Complete Guide to Trading agreed upon price at a later date. The Federal Reserve buys repurchase agreements as a way of regulating the money supply and bank reserves. Repo dates of maturity range from overnight to 30 days or more. Conclusion The money market exists to facilitate short-term cash flow needs. Because of the fact that most money market instruments are issued by either government entities or large financial institutions, and also because most money market instruments mature within a short period of time, money market instruments are considered among the safest of fixed income investments. However, shortterm maturities and low risk translate to lower profit potential for investors. For example, while a 10-year bond issued by a private corporation might offer investors a 5% interest rate, a three-month Treasury bill might only offer an interest rate return of just 1%. corporatefinanceinstitute.com 20 The Corporate Finance Institute The Complete Guide to Trading The Stock Market The stock market refers to public markets that exist for issuing, buying, and selling of stocks that trade on a stock exchange or over-the-counter. Stocks, also known as equities, represent fractional ownership in a company, asset, or security, and so the stock market is a place where investors can buy and sell ownership of such investable assets. An efficiently functioning stock market is critical to economic development, as it gives companies the ability to quickly access capital from the public. Purposes of the Stock Market – Capital and Investment Income The stock market serves two very important purposes. The first is to provide capital to companies that they can use to fund and expand their businesses. If a company issues one million shares of stock that initially sell for $10 a share, then that provides the company with $10 million of capital that it can use to grow its business (minus whatever fees the company pays for an investment bank to manage the stock offering). By offering stock shares instead of borrowing the capital needed for expansion, the company avoids incurring debt and paying interest charges on that debt. The secondary purpose that the stock market serves is to give investors – those who purchase stocks – the opportunity to share in the profits of publicly-traded companies. Investors can profit from stock buying in one of two ways. Some stocks pay regular dividends (a given amount of money per share of stock someone owns). The other way investors can profit from buying stocks is by selling their stock for a profit if the stock price increases from their purchase price. For example, if an investor buys shares of a company’s stock at $10 a share and the price of the stock subsequently rises to $15 a share, the investor can then realize a 50% profit on their investment by selling their shares. History of Stock Trading Although stock trading dates back as far as the mid-1500s in Antwerp, modern stock trading is generally recognized as starting with the trading of shares in the East India Company in London. Throughout the 1600s, British, French, and Dutch governments provided charters to a number of companies that included East India in the name. All goods brought back from the east were transported by sea, involving risky trips often threatened by severe storms and pirates. To mitigate these risks, ship owners regularly corporatefinanceinstitute.com 21 The Corporate Finance Institute The Complete Guide to Trading sought out investors to proffer financing collateral for a voyage. In return, investors received a portion of the monetary returns realized if the ship made it back successfully, loaded with goods for sale. These are the earliest examples of limited liability companies (LLCs), and many held together only long enough for one voyage. The formation of the East India Company in London eventually led to a new investment model, with importing companies offering stocks that essentially represented a fractional ownership interest in these companies, and that offered investors dividends on all proceeds from all the voyages a company funded, instead of just a single trip. The new business model made it possible for the companies to ask for larger investments per share, enabling them to easily increase the size of their shipping fleets. Investing in such companies, they are often protected from competition by royallyissued charters, which became very popular due to the fact that investors could potentially realize massive profits on their investments. The First Shares and the First Exchange Company shares were issued on paper, enabling investors to trade shares back and forth with other investors, but regulated exchanges did not exist until the formation of the London Stock Exchange (LSE) in 1773. Although a significant amount of financial turmoil followed the immediate establishment of the LSE, exchange trading overall managed to survive and grow throughout the 1800s. The Beginnings of the New York Stock Exchange Enter the New York Stock Exchange (NYSE), established in 1792. Though not the first on U.S. soil – that honor goes to the Philadelphia Stock Exchange (PSE) – the NYSE rapidly grew to become the dominant stock market in the United States and eventually in the world. The NYSE occupied a physically strategic position, located among some of the country’s largest banks and companies, not to mention being situated in a major shipping port. The exchange established listing requirements for shares, and rather hefty fees initially, enabling it to quickly become a wealthy institution itself. Modern Stock Trading – The Changing Face of Global Exchanges Domestically, the NYSE saw meager competition for more than two centuries, and its growth was primarily fueled by an ever-growing American economy. The LSE continued to dominate the European market for stock trading, but the NYSE became home to a continually expanding number of large companies. Other major corporatefinanceinstitute.com 22 The Corporate Finance Institute The Complete Guide to Trading countries, such as France and Germany, eventually developed their own stock exchanges, though these were often viewed primarily as stepping stones for companies on their way to listing with the LSE or NYSE. The late 20th century saw the expansion of stock trading into many other exchanges, including the NASDAQ, which became a favorite home of burgeoning technology companies, which gained increased importance during the technology sector boom of the 1980s and 1990s. The NASDAQ emerged as the first exchange operating between a web of computers that electronically executed trades. Electronic trading made the entire process of trading more time and cost-efficient. In addition to the rise of the NASDAQ, the NYSE faced increasing competition from stock exchanges in Australia and Hong Kong, the financial center of Asia. The NYSE eventually merged with Euronext, which formed in 2000 through the merger of the Brussels, Amsterdam, and Paris exchanges. The NYSE/Euronext merger in 2007 established the first trans-Atlantic exchange. How Stocks are Traded – Exchanges and OTC Most stocks are traded on exchanges such as the New York Stock Exchange (NYSE) or the NASDAQ. Stock exchanges essentially provide the marketplace to facilitate the buying and selling of stocks among investors. Stock exchanges are regulated by government agencies, such as the Securities and Exchange Commission (SEC) in the United States, that oversee the market in order to protect investors from financial fraud and to keep the exchange market functioning smoothly. Although the vast majority of stocks are traded on exchanges, some stocks are traded over the counter (OTC), where buyers and sellers of stocks commonly trade through a dealer, or “market maker”, who specifically deals with the stock. OTC stocks are stocks that do not meet the minimum price or other requirements for being listed on exchanges. OTC stocks are not subject to the same public reporting regulations as stocks listed on exchanges, so it is not as easy for investors to obtain reliable information on the companies issuing such stocks. Stocks in the OTC market are typically much more thinly traded than exchange-traded stocks, which means that investors often must deal with large spreads between bid and ask prices for an OTC stock. In contrast, exchange-traded stocks are much more liquid, with relatively small bid-ask spreads. corporatefinanceinstitute.com 23 The Corporate Finance Institute The Complete Guide to Trading Stock Market Players – Investment Banks, Stockbrokers, and Investors There are a number of regular participants in stock market trading. Investment banks handle the initial public offering – IPO - of stock that occurs when a company first decides to become a publiclytraded company by offering stock shares. Here’s an example of how an IPO works. A company that wishes to go public and offer stock shares approaches an investment bank to act as the “underwriter” of the company’s initial stock offering. The investment bank, after researching the company’s total value and taking into consideration what percentage of ownership the company wishes to relinquish in the form of stock shares, handles the initial issuing of shares in the market in return for a fee, while guaranteeing the company a determined minimum price per share. It is therefore in the best interests of the investment bank to see that all the shares offered are sold, and at the highest possible price. Shares offered in IPOs are most commonly purchased by large institutional investors such as pension funds or mutual fund companies. The IPO market is known as the primary, or initial, market. Once a stock has been issued in the primary market, all trading in the stock thereafter occurs through the stock exchanges in what is known as the secondary market. The term “secondary market” is a bit misleading, since this is the market where the overwhelming majority of stock trading occurs day to day. Stockbrokers, who may or may not also be acting as financial advisors, buy and sell stocks for their clients, who may be either institutional investors or individual retail investors. Equity research analysts may be employed by stock brokerage firms, mutual fund companies, hedge funds, or investment banks. These are individuals who research publicly-traded companies and attempt to forecast whether a company’s stock is likely to rise or fall in price. Fund managers or portfolio managers, which include hedge fund managers, mutual fund managers, and exchange-traded fund managers, are important stock market participants because they buy and sell large quantities of stocks. If a popular mutual fund decides to invest heavily in a particular stock, that demand for corporatefinanceinstitute.com 24 The Corporate Finance Institute The Complete Guide to Trading the stock alone is often significant enough to drive the stock’s price noticeably higher. Stock Market Indexes The overall performance of the stock markets is usually tracked and reflected in the performance of various stock market indexes. Stock indexes are composed of a selection of stocks that is designed to reflect how stocks are performing overall. Stock market indexes themselves are traded in the form of options and futures contracts which are also traded on regulated exchanges. Among the key stock market indexes are the Dow Jones Industrial Average (DJIA), Standard & Poor’s 500 Index (S&P 500), the Financial Times Stock Exchange 100 Index (FTSE 100), the Nikkei 225 Index, the NASDAQ Composite Index, and the Hang Seng Index. Bull and Bear Markets, and Short Selling Two of the basic concepts of stock market trading are “bull” and “bear” markets. The term bull market is used to refer to a stock market in which the price of stocks is generally rising. This is the type of market most investors prosper in, as the majority of stock investors are buyers, rather than sellers, of stocks. A bear market exists when stock prices are overall declining in price. Investors can still profit even in bear markets through short selling. Short selling is the practice of borrowing stock that the investor does not hold from a brokerage firm which does own shares of the stock. The investor then sells the borrowed stock shares in the secondary market and receives the money from that sale of stock. If the stock price declines as the investor hopes, then the investor can realize a profit by purchasing a sufficient number of shares to return to the broker the number of shares they borrowed. For example, if an investor believes that the stock of company “A” is likely to decline from its current price of $20 a share, the investor can put down what is known as a margin deposit in order to borrow 100 shares from his broker. He then sells those shares for $20 each, the current price, which gives him $2,000. If the stock then falls to $10 a share, the investor can then buy 100 shares to return to his broker for only $1,000, leaving him with a $1,000 profit. Analyzing Stocks – Market Cap, EPS, and Financial Ratios Stock market analysts and investors may look at a variety of factors to indicate a stock’s probable future direction, up or down in price. corporatefinanceinstitute.com 25 The Corporate Finance Institute The Complete Guide to Trading Here’s a rundown on some of the most commonly viewed variables for stock analysis. A stock’s market capitalization, or market cap, is the total value of all the outstanding shares of the stock. A higher market capitalization usually indicates a company that is more wellestablished and financially sound. Publicly traded companies are required by exchange regulatory bodies to regularly provide earnings reports. These reports, issued quarterly and annually, are carefully watched by market analysts as a good indicator of how well a company’s business is doing. Among the key factors analyzed from earnings reports are the company’s earnings per share (EPS), which reflects the company’s profits as divided among all of its outstanding shares of stock. Analysts and investors also frequently examine any of a number of financial ratios that are intended to indicate the financial stability, profitability, and growth potential of a publicly traded company. Following are a few of the key financial ratios that investors and analysts consider: Price to Earnings (P/E) Ratio: The ratio of a company’s stock price in relation to its EPS. A higher P/E ratio indicates that investors are willing to pay higher prices per share for the company’s stock because they expect the company to grow and the stock price to rise. Debt to Equity Ratio: This is a fundamental metric of a company’s financial stability, as it shows what percentage of company’s operations are being funded by debt as compared to what percentage are being funded by equity investors. A lower debt to equity ratio, indicating primary funding from investors, is preferable. Return on Equity (ROE) Ratio: The return on equity (ROE) ratio is considered a good indicator of a company’s growth potential, as it shows the company’s net income relative to the total equity investment in the company. Profit Margin: There are several profit margin ratios that investors may consider, including operating profit margin and net profit margin. The advantage of looking at profit margin over just an absolute dollar profit figure is that it shows what a company’s percentage profitability is. For example, a company may show a profit of $2 million, but if that only translates to a 5% profit margin, then any corporatefinanceinstitute.com 26 The Corporate Finance Institute The Complete Guide to Trading significant decline in revenues may threaten the company’s profitability. Other commonly used financial ratios include return on assets (ROA), dividend yield, price to book (P/B) ratio, current ratio and the inventory turnover ratio. Two Basic Approaches to Stock Market Investing – Value Investing and Growth Investing There are countless methods of stock picking that analysts and investors employ, but virtually all of them are one form or another of the two basic stock buying strategies of value investing or growth investing. Value investors typically invest in well-established companies that have shown steady profitability over a long period of time, and that may offer regular dividend income. Value investing is more focused on avoiding risk than growth investing is. Growth investors seek out companies with exceptionally high growth potential, hoping to realize maximum appreciation in share price. They are usually less concerned with dividend income and are more willing to risk investing in relatively young companies. Technology stocks, because of their high growth potential, are often favored by growth investors. corporatefinanceinstitute.com 27 The Corporate Finance Institute The Complete Guide to Trading Exchange-Traded Funds An exchange-traded fund (ETF) is an investment fund that holds assets such as stocks, commodities, bonds, and foreign currency. An ETF is traded like a stock, throughout the trading day, at fluctuating prices. They often track indexes such as the NASDAQ, S&P 500, Dow Jones, and Russell 2000. Investors in ETFs do not directly own the underlying investments, but instead have an indirect claim and are entitled to a portion of the profits and residual value in case of fund liquidation. Their ownership shares or interest can be readily bought and sold in the secondary market. ETFs have begun to eclipse mutual funds as a favored investment vehicle because they offer investments beyond just stocks, and because of the fact that ETFs often have lower transaction costs than the average mutual fund. Different Types of ETFs There are many types of ETFS, including the following: Stock ETFs – These hold a particular set of equities or stocks and are similar to an index. Stock ETFs commonly hold a selection of stocks in a given market sector. Index ETFs – These ETFs have portfolios that are designed to mimic the performance of a specific stock index, such as the S&P 500 Index. They only make portfolio changes when changes happen in the underlying index. Bond ETFs – These are specifically invested in bonds or other fixed-income securities. Commodity ETFs – These ETFs hold physical commodities, such as agricultural goods, natural resources, and precious metals. Currency ETFs – These are invested in a single currency or a basket of various currencies, and are widely used by investors who wish to gain exposure to the foreign exchange market without using futures or trading the forex market directly. They usually track the most popular international currencies, such as the U.S. dollar, the euro, the British pound, or the Japanese yen. Inverse ETFs – These are funds built by using various derivatives to gain profits through short selling when there is a decline in the value of broad market indexes. corporatefinanceinstitute.com 28 The Corporate Finance Institute The Complete Guide to Trading Leveraged ETFs – These funds mostly consist of financial derivatives that are used to amplify percentage returns. It’s important to note that while leveraged ETFs increase profit potential, they also likewise increase risk. Real Estate ETFs – These funds invest in real estate investment trusts (REITs), real estate service firms, and real estate development companies. Advantages of Investing in ETFs There are many advantages to investing in an exchange-traded fund, including: Cost benefits: ETFs usually offer a significantly lower expense ratio than the average mutual fund. This is in part because of their exchange-traded nature, which places typical costs on the brokers or the exchange, in comparison with a mutual fund which must bear the cost in aggregate. Accessibility to markets: ETFs offer exposure to asset classes that were previously hard for individual investors to access, and provide investors with the possibility to own assets such as emerging markets bonds, gold bullion, or crypto-currencies. Because ETFs can be sold short and used to apply other more sophisticated investment strategies, they represent a broader range of opportunities for investors. Transparency: Hedge funds and even mutual funds operate in a not-so-transparent manner as compared to ETFs. Hedge funds and mutual funds usually report their holdings only on a quarterly basis. In contrast, ETFs clearly disclose their daily portfolio holdings. Liquidity: Because they can be bought or sold in secondary markets throughout the day, ETFs are extremely liquid. This is in contrast to mutual funds which can only be bought or sold at their end-of-day closing price. Tax Efficiency: Generally, ETFs pose a major tax advantage over mutual funds for two main reasons. First, ETFs reduce portfolio turnover and offer the ability to avoid short-term capital gains that incur a higher tax rate. Second, ETFs can overcome rules that prohibit selling and corporatefinanceinstitute.com 29 The Corporate Finance Institute The Complete Guide to Trading claiming a loss on a security if a very similar security is bought within a 30-day window. Potential Drawbacks of ETFS Despite the abovementioned benefits, ETFs encounter some challenges as well. For instance, they provide higher exposure to previously unattended asset classes that could bear risks that equity investors might not be familiar with. Some sophisticated examples such as leveraged ETFs involve complex or unfamiliar portfolio structures, tax treatments, or counterparty risks, which require clear understanding of the underlying assets. Additionally, ETFs carry transaction costs that should be carefully considered in the process of portfolio creations, such as Bid/Ask spreads and commissions. Who are the biggest ETF management companies? As of 2017, there are thousands of ETFs in existence. If you want to know who the largest ETF management companies are, here is a list of the top 10 fund companies ranked by assets under management. 1. BlackRock 2. Vanguard 3. State Street Global Advisors 4. Invesco PowerShares 5. Charles Schwab 6. First Trust 7. WisdomTree 8. Guggenheim 9. VanEck 10. ProShares corporatefinanceinstitute.com 30 The Corporate Finance Institute The Complete Guide to Trading Commodity Futures Trading Commodity futures trading is an often-overlooked investment arena. There are a number of reasons for this. First of all, it’s simply not an investment that’s publicly touted as widely as stock trading and other more common investments. Commodity futures trading is different from stock trading, so it does require traders to learn how to handle investments in a different type of market. Also, many investors have been scared away from commodity trading by horror stories from investors who lost huge sums in the commodity markets. The truth is that while commodity trading is a higher risk venture than conservative fixed-income investments or traditional stock trading, it is nonetheless a market in which it is possible to generate high returns that more than justify the additional risk. Understanding Futures Contracts Commodity futures are traded in the form of contracts of a standardized size (for example, 5,000 bushels of wheat) that expire in different months. This is obviously different from stock shares that have no expiration date and can be held indefinitely. Futures for a given commodity can usually be traded as far ahead in time as two to three years, however, the vast majority of trading nearly always occurs in the contract with the closest expiration date, known as the “front month”. Futures prices are more subject to sudden, volatile price changes than stocks typically are. A stock that has a long history of steady price appreciation or dividend payouts is likely to continue that trend. But with commodity futures, a downtrend in price can change to an uptrend literally overnight due to factors such as an unexpected freeze or drought during growing season. Futures contracts are divided into five main categories: Agricultural futures, such as corn, wheat, orange juice, and cocoa Livestock futures, such as lean hogs and live cattle Energy futures, such as oil, heating oil, and natural gas Metals futures, such as gold, silver, and copper Financial futures, such as Treasury bonds, stock indexes, and currencies Fundamental and Technical Analysis in Commodity Trading Fundamental forces of supply and demand are what ultimately move commodity prices. Therefore, there is a high percentage of corporatefinanceinstitute.com 31 The Corporate Finance Institute The Complete Guide to Trading commodity traders who use fundamental analysis to attempt to predict futures prices. Commodity traders glean information on the commodity markets from sources such as financial newspapers, research information from brokers, and government reports. Advisory services that traders can subscribe to are an important source of information. Some advisory services feature their own expert meteorologists offering weather forecasts for important crop-growing regions, and send their own investigators out to make personal estimates of eventual expected crop sizes. Despite the fact that genuine supply and demand factors are what drive commodity prices, technical trading is still enormously popular among commodity traders. In fact, many of the most wellknown technical indicators that are applied across many other investing markets, such as stocks and forex, were first developed by commodity traders. Advantages of Commodity Trading Unlike stock trading or investing in mutual funds or ETFs, commodity trading offers tremendous leverage. In trading commodity futures, you typically only have to put up about 10% of the total futures contract value. This enables you to make much higher percentage gains with your trading capital. For example, you could hold one S&P 500 Index futures contract with a margin deposit of just over $20,000, while it would take several hundred thousand dollars to buy each of the actual stocks contained in the index. A 20% rise in the Index would return you a more than 100% profit from buying a futures contract – you’d realize approximately the same absolute dollar amount in profit as from buying the stocks in the index, but you would have made that profit with a much smaller investment. Commodity futures trading may also offer lower commissions and trading costs, although, with all the discount stock brokerages that exist now, that’s not as much an issue as it was 20 years ago. Commodity trading holds an advantage over illiquid investments such as real estate since any money in your account that is not being used to margin market positions that you’re holding is readily available to you at any time. One really key advantage – a double advantage, actually – that commodity trading offers is diversification within simplicity. There are commodity futures available to trade that cover virtually every sector of the economy – agriculture, energy, precious metals, foreign exchange, and stock indexes. However, unlike the stock corporatefinanceinstitute.com 32 The Corporate Finance Institute The Complete Guide to Trading market where there are thousands of stocks to choose from – often hundreds within any given industry – there are only a few dozen commodity futures contracts to choose from. So, for example, if cotton prices rise, then you can profit handsomely by being invested in cotton futures contracts, whereas if you were trading stocks, there are hundreds of companies to choose from whose fortunes might be affected by the price of cotton but that would also be affected by other market factors. You might end up buying stock in a company whose share price falls due to other market factors, despite a favorable change for the company in terms of cotton prices. Finally, in commodity trading, it is just as easy to profit selling short as buying long. There are no restrictions on short selling as there are in the stock markets. Having the potential to profit just as easily from falling prices as from rising prices is a major advantage for traders. Commodity Trading Secrets – Find Your Market Here is a little-known secret about consistently successful commodity traders: They almost always specialize in trading either a single market, such as cotton, or a small market segment, such as precious metals or grain futures. No one has yet offered a completely satisfactory reason for this fact, but it remains a fact that very few traders seem capable of trading all commodity markets equally well. There was a fairly wellknown trader back in the 1980s who had a nearly flawless trading record in the cotton market. Copying his cotton trades back then would have been about the closest thing to just printing piles of money for yourself. Year in and year out, he called market highs and lows and trend changes almost as if he’d traveled into the future and already seen them all unfold. However, this uncannily brilliant cotton trader had one fatal flaw: He also loved trading the silver market. Unfortunately for him, he was just as outrageously bad at trading silver as he was outrageously good at trading cotton. His weakness was compounded by the fact that while he typically traded long-term trends in the cotton market, he day traded the silver market, which provided him with fresh opportunities to lose money every trading day of the week. How did this all play out for him? Well, in one year when he made over a million dollars trading cotton futures, he ended up filing a net loss in trading for the year. That’s right – his horrifically bad corporatefinanceinstitute.com 33 The Corporate Finance Institute The Complete Guide to Trading silver trading had more than wiped out every bit of his huge profits from trading cotton. (Fortunately, this story does have a happy ending. After two or three years of stubbornly losing money trading the silver market, the gentleman did finally accept the fact that, “I just can’t trade silver,” and very wisely stopped doing so. He continued piling up a fortune trading cotton over the next several years, and finally retired from trading with the very concise proclamation that, “I’ve made enough money and I’ve had enough fun.”) And so we say: Find your market. It may take some time – and some losing trades – to do this, but it isn’t really all that difficult to determine, over a reasonable period of time, what you seem to have a knack for trading – and what you don’t have a knack for trading. A simple review of your trades over, say, a six-month period should pretty clearly show you what markets you’re frequently doing well in and what markets you aren’t having success with. As you trade, you’ll probably also develop a feel for which markets you feel most confident in trading. Trust your instincts on that score. If profitably trading oil futures c