The system of buying and selling stocks and shares; also, a building in which these transactions take place (the stock exchange). A stock market crash refers to a situation when the prices of stocks fall dramatically, resulting in many bankruptcies. The most famous case was the Wall Street crash of 1929; a less dramatic crash also occurred in October 1987 in most world stock markets.
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.
Definition
The term 'the stock market' is a concept for the mechanism that enables the trading of company stocks, 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 'stock market' is estimated as about half that. 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.
Trading
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.
Most stocks are traded on exchanges, which are places where buyers and sellers meet and decide on a price. (You've probably seen pictures of a trading floor, in which traders are wildly throwing their arms up, waving, yelling, and signaling to each other.) This type of auction is used in stock exchanges and commodity exchanges where traders may enter "verbal" bids and offers simultaneously.
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). Really, a stock exchange is nothing more than a super-sophisticated farmers' market providing a meeting place for buyers and sellers.
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. 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 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 sent back to the brokerage firm, who then notifies the investor who placed the order.
The Nasdaq is a virtual (listed) exchange, where all of the trading is done by computers.
The Paris Bourse, now part of Euronext is an order-driven, electronic stock exchange.
Market participants
Many years ago, worldwide, buyers and sellers were individual investors, such as wealthy businessmen, with long family histories (and emotional ties) to particular corporations.
However, corporate governance (at least in the West) has been greatly affected by the rise of institutional 'owners.'
History
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 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", instituionalizing what had been, until then, an informal meeting.
In the middle of the 13th century Venetian bankers began to trade in government securities.
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 bonds.
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.
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(Hongkong), UK, Germany, France, India and Japan.
Importance of stock markets
Function and purpose
Just as it is important that networks for transport, electricity and telecommunications function properly, so is it essential that, for example, payments can be transacted, capital can be saved and channeled to the most profitable investment projects and that both households and firms get help in handling financial uncertainty and risk as well as possibilities of spreading consumption over time. Therefore, central banks tend to keep an Argus eye on the control and behavior of the stock market and, in general, on the smooth operation of financial system functions.
Relation of the stock market to the modern financial system
The financial system in most western countries has undergone a remarkable transformation. 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.
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. 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. 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. The quote illustrates something of what has been going on in the stock market during the end of the 20th century and the beginning of the 21st.
The behavior of the stock market
From experience we know that investors may temporarily pull financial prices away from their long term trend level.
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 per cent— the largest-ever one-day fall in the United States. (However, this was part of a world-wide crash of stock markets which did not originate in the US.) 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. 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 or longer.
Various explanations for large price movements have been promulgated.
Other research has shown that psychological factors may result in exaggerated stock price movements. An example is when supporters of a national football team (or a favourite stock), for instance, are overconfident about the chances of winning (or the stock moving up).
The stock market, as any other business, is quite unforgiving of amateurs. 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.)
Irrational behavior
Because a considerable part of the stock market is comprised of non-professional investors, 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, turning the stock market in a generally dangerous and difficult to predict environment for those people whose lack of financial investment skills and time does not permit reading the technical signs of the market.
Conclusion
There have been innumerable recommendations about how to make the stock market easier and safer for the casual, non-professional investor.
Today, average individuals face sometimes very difficult risk management decisions that were not required of previous generations.
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.
Derivative instruments
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.
Leveraged Strategies
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 sale.
Short selling
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. The practice of naked shorting is illegal in most (but not all) stock markets.
Margin buying
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. Before that, speculators typically only needed to put up as little as ten 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).
New issuance
Global issuance of equity and equity-related instruments totaled $505 billion in 2004, a 29.8% increase over the $389 billion raised in 2003.
Investment strategies
One of the many things people always want to know about the stock market is, "How do I make money investing?" 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. 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).
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