Tuesday, November 6, 2007

Irrational behavior

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.

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

Main article: 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

Main article: Derivative (finance)

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

Main article: 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. 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.

Margin buying

Main article: 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. 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).

New issuance

Main article: Thomson Financial league tables

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.

Investment strategies

Main article: Stock valuation

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.

Notes

1. ^ Hagstrom, Robert G. (2001). The Essential Buffett: Timeless Principles for the New Economy. New

York: John Wiley & Sons. ISBN 0-471-22703-X.
2. ^ Cutler, D. Poterba, J. & Summers, L. (1991). "Speculative dynamics". Review of Economic Studies

58.
3. ^ Tversky, A. & Kahneman, D. (1974). "Judgement under uncertainty: heuristics and biases". Science

185: 1124-1131.
4. ^ Stephen Morris and Hyun Song Shin, Oxford Review of Economic Policy, vol. 15, no 3, 1999.

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