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Exploring the Markets and the Stock Exchanges

Billions of shares of stock trade in the United States every day, and each trader is looking to get his or her small piece of that action. Before moving into the specifics of how to trade, we first want to introduce you not

only to the world of stock trading, but also to trading in other key markets — futures, options, and bonds. In this chapter, we also explain differences and similarities among key stock exchanges and how those factors impact your trading options. After providing you with a good overview of the key markets, we delve into the different types of orders you can place with each of the key exchanges.

Introducing the Broad Markets

You may think the foundation of the United States economy resides inside Fort Knox where the country holds its billions of dollars in gold, or possibly that it resides in our political center, Washington, D.C. But nope. The country’s true economic center is Wall Street, where billions of dollars change hands each and every day, thousands of companies are traded, and millions of people’s lives are affected.

Stocks are not the only things sold in the broad financial markets. Every day, futures, options, and bonds also are traded. Although we focus on stock exchanges in this chapter, we first need to briefly explain each type of market.

Stock markets

The stocks of almost every major U.S. corporation and many major foreign corporations are traded on a stock exchange in the United States each day, and none of the money involved in these trades goes directly into the companies being traded. Today numerous local and international stock exchanges trade stocks in publicly held corporations; moreover, the only major corporations not traded are those held privately — usually by families or original founding partners that chose not to sell shares on the public market. Forbes magazine’s top privately held corporations are Cargill, Koch Industries, Chrysler, GMAC, Price Waterhouse Coopers, and Mars. Many of the large private corporations that are not traded publicly do have provisions for employee ownership of stock and must report earnings to the SEC, so they straddle the line of public versus private corporations.

A share of stock is actually a portion of ownership in a given company. Few stockholders own large enough stakes in a company to play a major decisionmaking role. Instead, stockholders purchase stocks, hoping that their investments rise in price, so that those stocks can be sold at a profit some time in the future.

For the majority of this chapter, we focus on the three top stock exchanges in the United States: the New York Stock Exchange (NYSE), NASDAQ (the National Association of Securities Dealers Automated Quotation system), and the American Stock Exchange (Amex). We also introduce you to the evolving world of electronic communication networks (ECNs) on which you can trade stocks directly, thus bypassing brokers. You need only this tool.

Futures markets

Futures trading actually started in Japan in the 18th century to trade rice and silk. This trading instrument was first used in the United States in the 1850s for trading grains and other agricultural entities. Basically, futures trading means establishing a financial contract in which you try to predict the future value of a commodity that must be delivered at a specific time in the future. Yup, if you had a working crystal ball, it would be very useful here. This type of trading is done on a commodities exchange. The largest such exchange in the United States today is the Chicago Mercantile Exchange. Commodities include any product that can be bought and sold. Oil, cotton, and minerals are just a few of the products sold on a commodities exchange.

Futures contracts must have a seller (usually the person producing the commodity — a farmer or oil refinery, for example) and a buyer (usually a company that actually uses the commodity). You also can speculate on either side of the contract, basically meaning:

✓ When you buy a futures contract, you’re agreeing to buy a commodity that is not yet ready for sale or hasn’t yet been produced at a set price at a specific time in the future.

✓ When you sell a futures contact, you’re agreeing to provide a commodity that is not yet ready for sale or hasn’t yet been produced at a set price at a specific time in the future.

The futures contract states the price at which you agree to pay for or sell a certain amount of this future product when it’s delivered at a specific future date. Although most futures contracts are based on a physical commodity, the highest volume futures contracts are based on the future value of stock indexes and other financially related futures.

Unless you’re a commercial consumer who plans to use the commodity, you won’t actually take delivery of or provide the commodity for which you’re trading a futures contract. You’ll more than likely sell the futures contract you bought before you actually have to accept the commodity from a commercial customer. Futures contracts are used as financial instruments by producers, consumers, and speculators. We cover more about those players and futures contracts in much greater depth in Chapter 18.

Bond markets

Bonds are actually loan instruments. Companies sell bonds to borrow cash. If you buy a bond, you’re essentially holding a company’s debt or the debt of a governmental entity. The company or government entity that sells the bond agrees to pay you a certain amount of interest for a specific period of time in

exchange for the use of your money. The big difference between stocks and bonds is that bonds are debt obligations and stocks are equity. Stockholders actually own a share of the corporation. Bondholders lend money to the company with no right of ownership. Bonds, however, are considered safer, because if a company files bankruptcy, bondholders are paid before stockholders. Bonds are a safety net and not actually a part of the trading world for individual position traders, day traders, and swing traders. While a greater dollar volume of bonds is traded each day, the primary traders for this venue are large institutional traders. We want to mention them here but don’t discuss them any further in this book.

Options markets

An option is a contract that gives the buyer the right, but not the obligation, either to buy or to sell the underlying asset upon which the option is based at a specified price on or before a specified date. Sometime before the option period expires, a purchaser of an option must decide whether to exercise the option and buy (or sell) the asset (most commonly stocks) at the target price. Options also are called derivatives. We talk more about this investment alternative in Chapter 18.