An Introduction to Financial Markets
In the financial world, a Market is an exchange where securities are traded. While we have all heard of Wall Street, the “Market,” is in fact just comprised of many smaller stock exchanges. In the financial world, a Market is an exchange where securities are traded. While we have all heard of Wall Street, the “Market,” is in fact just comprised of many smaller stock exchanges. Markets can be performed face to face, at a physical location such as the New York Stock Exchange, where individuals and companies bid or negotiate prices for securities, or they can take place in the electronic frontier like the NASDAQ.
New York Stock Exchange (NYSE)
Often referred to as “The Big Board”, the NYSE is perhaps the most well-known of all the exchanges. Founded in March of 1817 and located at 11 Wall Street in lower Manhattan, it is by far the largest exchange for securities in the world based on trading volume – in 2016 the NYSE traded an average of $1 trillion per month.
The NYSE employs traders to execute transactions on behalf of clients represented by the companies who are authorized to trade on the exchange. The traders gather around specific locations where specialist brokers conduct transactions in their assigned security in an open action format. The NYSE trades in a double-action format where brokers compete among themselves to execute trades at prices that are most favorable to the public.
Each exchange sets criteria for companies to meet before they are permitted to be listed on the exchange. Companies that do not meet these criteria need another way to be traded.
The National Association of Securities Dealers Automated Quotation system was created in February of 1971 as the world’s first electronic quotation system for securities and later became the first stock market in the United States to begin trading online. The addition of this technology to the market place helped lower the cost of transactions by competing against traditional brokerage firms. Most brokerage firms derive a substantial portion of their income from the spread (the difference between the bid and asking price of securities). Spreads were lower on the NASDAQ system and trading became faster.
Today NASDAQ operates a network to support securities dealers and is a licensed national securities exchange. It is an alternative to listing on a brick and mortar exchange, like the NYSE. Many smaller firms and technology companies often find it more attractive to be traded on NASDAQ, once they meet the requirements to do so.
Over the Counter, trading is where securities that are not listed on an exchange can still be traded. These securities are traded through an interdealer marketplace that consists of a computer network which interconnects securities firms across the country. In theory, each firm has instant access to the network. Stocks, bonds, all municipal and Government securities are traded OTC. Even securities of companies listed on an exchange can be traded Over the Counter. Products traded on exchanges must be standardized for transactional transparency, which can limit size, quality, and quantity of trading. This is not a problem for the OTC market as the transactions are negotiated between the buyer and seller. As an example, the OTC trade may consider an unusual (Odd Lot) number of shares in a particular transaction where an exchange-listed security may only transact in an even lot of shares.
People who wish to invest in foreign (International) companies can purchase an American Depository Receipt (ADR). ADRs facilitate trading of foreign stocks in US Markets. They are typically issued by an intermediary that has purchased the security – often a bank - and the ADR will trade just as a stock would where 1 ADR represents 1 share of the company.
Commodities Markets are any markets that trade in the supplies - or raw materials - used to make manufactured goods, food, energy or materials. Traditionally investors in commodities will buy a contract allowing them to buy or sell a particular commodity – say natural gas – at a specific price for a given amount of time. The person buying the contract typically believes gas will be getting more expensive, so they wish to lock down the cost now. Someone selling the contract will typically believe the price is going to fall and they feel the amount they would get from selling the contract now is greater than holding the contract to term and exercising it themselves.
Commodities contracts can be traded on an exchange – typically the Chicago Board of Trade - if listed, or can be traded OTC. Since 2003 you can purchase Exchange Traded Funds which make it simpler for the typical investor to participate in the commodities markets without putting out large sums of money or having to store the commodity itself.
Often times when people are referring to the “Market” they are referring to one of the prevalent market indices which track the performance of a basket of stocks. These baskets of stocks, depending on one’s perspective, give some level of indication of the overall performance of the stock market and the U.S. Economy.
The most prevalent of the market indices is the Dow Jones Industrial Average (DJIA). This price-weighted average of 30 significant U.S. stocks is the longest running indices, but also can be misleading at times. Because it only contains 30 large-company stocks, a large shift in any one of those stocks can affect the average making the overall market appear more volatile than it may be at a given time. The DJIA was invented by Charles Dow in 1896 and today includes recognizable companies such as General Electric, Exxon, Microsoft, and Disney.
* Investment in stocks will fluctuate with changes in market conditions and indices are unmanaged measures of market conditions. It is not possible to invest directly in an index. Past performance does not guarantee future results.
The second most popular of the market tracking indices is the S&P500. This is a basket of 500 stocks (much larger than the DJIA) said to more broadly represent the overall U.S. economy. While the grouping is chosen for market size, industry type and potential liquidity, it primarily represents very large companies (known as Large Cap) and therefore does not perfectly represent the stock market as a whole. Stocks included in the index are chosen based on their issuing company’s representation of U.S. economic activity. The companies are chosen by Standard and Poor’s Index Committee and are then market value weighted where each stock is proportionate to its market value.
Once you begin to understand how diverse and broad the stock market really can be, it’s nuances become more interesting. This is why when asked at a cocktail party, “How do you think the market is doing?” the answer could nearly always be, “It depends.” And now you know why!