Stocks
Nathan is known for his delicious momos. It's been his dream to open a momo shop. He figures that it'll cost him $100,000 to start his business with all the supplies, staff, and other costs of starting a business. The problem is that Nathan only has $10000 to put into the momo shop. He can't build his business on $100,000.
Nathan decides to issue stocks to investors to help raise money. Stocks are pieces or shares of ownership in a company. Each share is worth a certain amount based on the company's value. A company issues shares to investors in order to raise money. Nathan decides to enlist the help of nine of his friends to invest the remaining $90000.However, to do this, Nathan must give away 90% of his business in shares. Nathan and his friends each own 10% of the business.
Five years later, Nathan Momo Shop is booming. His momo shop is now worth $1 million. Nathan got the money he needed to create the business without any additional risks or debt. Also, Nathan and his friends each turn their $10000 investment into $100000.Just like Nathan's friends bought shares in his shop, you can buy shares of publicly traded companies like Apple. If Apple has 100 shares and you own one, you own 1% of Apple.
Financial Instruments
They are monetary contract between two parties.They can be cash or evidence of ownership interest in an entity or a contractual right to receive or pay.It is any contract that gives rise to both of financial asset of one entity and financial liability of another entity.These financial instrument include primary instruments which covers receivable, payable and equity securities.Another is derivative instruments which covers options, futures and forwards and swaps.
The term contract is the arrangement between two or more parties that has clear economic consequences.The financial instruments are classified into financial assets, financial liabilities and equity instruments.Financial assets is any asset that is cash or contractual right or an equity instrument of another entity or certain contracts that will or maybe settle in entity's own equity instruments.That is a company might exchange it's own equity shares for a fixed amount of cash or another financial asset.The contractual right is the right to receive cash or the right to receive another financial asset from another entity or it's a right to exchange financial instrument with another entity on a condition that it's potentially favourable to the entity.Common example of financial assets are cash, investment in bonds and deposists, trade receivables, investment in equity instruments and loan receivables.
Financial liabilites is any liability that is a contractual obligation to deliver cash or another financial asset to another entity or to exchange financial instruments with another entity under condition that are potentially unfavourable or certain contracts that will or maybe settled in entity's own equity instruments.Some common example of financial liabilites are loans and borrowings, trade payables, finance lease liabilities, redeemable instruments - preference shares, debentures etc, and gurantee.
Equity instruments are any contract that evidences the residual interest in the assets of an entity after deducting all of it's liability.Some common examples are equity shares issued, warrants to issue fixed number of shares at a fixed price against each warrant or other instruments which are convertible into fixed number of equity shares.
Financial asset is any asset that is right to exchange financial instruments with another entity under condition that are potentially favourable to the entity where as financial liabilities is a contractual obligation to exchange financial instrument with another entity under condition that are potentially unfavourable.Usually the classification of an item as financial asset or financial liabilities is understood from the point of view of the issuer.So if the exchange of the financial instrument happen under condition which will favourable to the issuer then it constitutes as financial assets else it's considered as a financial liablity.
For the users of financial statements, the accounting treatment of this instrument is crucial importance.In order to take care of the presentation, recognition and measurement and discloures of these financial instruments, there're standards by accounting bodies around the world.
Order Book
Assume we have a marketable instrument (stock, bond, or cryptocurrency). The order book for that instrument is going to be a set of all open orders. Understanding these outstanding orders is the most important part of trading. Many people start out by looking at historical data and charts. They try to predict prices, but once they get into the nitty-gritty of actually submitting orders, they run into trouble. We're starting with the order book because it allows us to understand what we're doing when we begin actually submitting orders, trying to take advantage of price movements.
Order books can be really intimidating when you look at them for the first time. They typically have a lot going on—changing numbers, flashing indicators. It's really hard to keep up if you've never looked at one before. Here is the [order book] (https://www.binance.com/en/orderbook/ETH_USDT) of ETH/USDT.
You can notice that you see some flashes and movements going on. When you try, it's difficult to see and understand what's going on. We'll look at an order book as an example. This is static; it doesn't have any movements, and it's got round numbers so that we can easily read it and understand what is going on.
On the vertical axis, we have prices in the market place.In this particular book, we start at 85 and move up to 115. On the horizontal axis, we have size. The size is the number of units. These units depend upon what particular financial instruments we're dealing with. These units could be shares, dollars, or coins. It can be any particular financial instrument that we want to deal with. Together, when we look at both the horizontal and vertical axes, we have the number of units at each price.
At 85, we have 1100 units; at 86, we have 300 units, and so on. If we are talking stocks, we would say that at each price, we have this many shares available on the order book. With respect to the order book, the word "available" can be one or more things. The shares or crypto coins could be available to either buyers or for seller.That is why we have two different colors—red and green. All of the prices in red with their corresponding units represent the number of coins or shares that are available for buyers. These are sellers in the marketplace who make supply available for buyers to enter the market.
On the green side, we have the number of bidders in the marketplace. This represents the number of shares or coins that a seller could use to get out of the market. So we have the sell side of the order book and the buy side of the order book.
The first thing we care about whenever we're going to make a trade is whether we're on the buy side or the sell side. We need to be thinking about the order book when we're thinking about which side we're going to be on because we're going to be targeting the other side. If we're trying to sell, we're going to be looking at buyers, and if we're trying to buy, we're going to be looking at sellers.
Market
When trading begins, we usually say, "We're trading in the markets." We can refer to it as the collection of financial instruments like stock, bonds, or crypto. We're going to talk about the market for specific financial instruments. We're going to use the same example of an order book here too.
From an economics perspective, they lead off by saying that a market is one of the many varieties of systems where parties engage in exchange. Most markets rely on sellers offering their goods in exchange for money from buyers. If we look at the order book, we have a buy side and a sell side. In our case, the sell side is offering bitcoin, which is the supply. On the buy side, the buyers are offering their money for bitcoin. This market economy is really very similar to what the order book gives us. The order book gives us the market.
According to finance, a financial market is a place in which people trade at prices that reflect supply and demand. The term "market" means the aggregate of the possible buyers and sellers of a certain good and the transactions between them. So the order book is showing us the supply (seller prices) and the demand (buyer prices). This definition is really saying the same thing that we saw before using different terms.
The terms buy and sell are used in the definition of economics. The terms demand and supply are used in finance. So economics and finance are telling us that a market requires buyers and sellers. This is also known as "supply" and "demand." If we have supply and demand, we're on our way to having a market. The order book gives us just that. An order book can be thought of as a market building block. The order books are the way that we organize the buyers and sellers. In a market, we must consider the total, including all buyers and sellers.
Exchange
In order to participate in a market as a trader, we need to be able to interact with the order book. In order to trade, we need a window into the market. We require an interface for exchanges. Let's suppose that we have a market. This means that we have supply and demand, and somewhere in this market, there are also transactions that are occurring. So as traders, we're ready to go ahead and trade, but a couple of questions jump right out at us.
How do we do it? Where's the order book? How is it maintained? What are even the rules for interacting with the order book?
For this, we need an exchange. An exchange is an organized market. This is exactly what we need. We show up to a market, we know there's a supply and a demand, and we know that there are transactions, but there's no organization whatsoever. If we have an exchange, we have an authorized mark. So those pieces that supply that demand in the transactions are going to be organized for us.
The core function of an exchange is to ensure fair and orderly trading as well as efficient dissemination of price information for any securities trading on that exchange. We need an interface to actually interact with the order book with supply and demand, and we need rules that govern that interaction and also that data fed back to us. We need to see what the transactions are in the marketplace. So an exchange allows us to interact with the order book by providing fair and orderly trading. So fairness implies rules that are going to level the playing field. The order book is implied by the orderly trading. They will maintain and organize the order book so that we can interact with it. So we have rules and organization around the order book, and then they're also going to be giving us price information. They're going to tell us about the transactions that are happening within the marketplace.
This gives us the ability to trade. When a trade occurs, there is an exchange between a buyer and a seller. Hence the name. Exchanges allow traders to exchange.
Broker-Dealer
Before trading begins, we need to have an account. This account is where all of our balances and transactions are maintained. Most of the time, traders are going to trade using a broker. Broker-dealers must meet certain financial responsibility requirements, including:
- a minimum amount of liquid assets, or net capital.
- taking certain steps to safeguard the customer funds and securities - This implies that the broker is going to be in custody of or have custody of customer funds and securities. So they hold those particular funds and securities for investors and traders.
- making and preserving accurate books and records - We saw that exchanges facilitate trading, and now we're seeing that brokers and dealers provide account management services for traders' accounts. When we trade, we usually open an account with a broker. We tell the broker what trades we'd like to make, and the broker executes these trades through an exchange on our behalf. On the backend, the broker may use multiple exchanges to execute our trade. On the front end, the brokers keep track of our balances and transactions.
A broker is any person engaged in the business of effecting transactions in securities for the account of others. In old movies, people can be seen calling their broker to buy or sell shares of a particular stock. Now we typically have online brokers where they're still brokering for us; it's a software relationship. We tell the software which trades we want to execute, and the software goes ahead and keeps track of our balances and transactions.
A dealer is any person engaged in the business of buying and selling securities for his own account, whether through a broker or otherwise. It's important to know that a dealer typically operates as a business. The definition of a dealer doesn't include a trader. A trader is a person who buys or sells securities for his or her own account, either individually or in a fiduciary capacity, but not as part of a regular business. A fiduciary capacity is when you're trading for someone else and are responsible for their funds, but not as a business. This could be a friend or a family member. In many cases, brokers also engage in dealing. Many online brokers that we're used to, like Interactive Brokers or TD Ameritrade, also trade for their own accounts. Dealing in a particular asset is usually part of a company's proprietary trading arm or market-making activities.
With stocks, we're used to saying that we trade with a broker. However, with crypto currencies, we more often hear about trades within exchanges. On the Coinbase home page, they tell us it's an exchange. However, we can see that they also give us the ability to open an account. This means that the account holder is dealing directly with an exchange and not a broker. This was not the case with the NYSE. We saw that in order to create an account or get a membership with the NYSE, you have to have a broker-dealer license.
Coinbase specifically states that they're not a broker. So it's an exchange, and they're not giving us advice. All they're doing is facilitating the ability to trade. We're fully responsible for understanding the implications of our actions while using the exchange.
Market Makers
Brokers can profit from their customers' purchases and sales of stock or other assets by charging a commission on those transactions. However, this isn't the only way for various market participants to make money from the sale of assets. There are entities called market makers who actually make the market viable by providing liquidity.
At any given point in time, they offer to both buy and sell certain assets. They offer $900 worth of company A shares to anyone who wants to sell them, and they charge $902 per share if you want to buy them. As can be seen, there's a difference between the $900, which is called the "bid price," and the $902, which is called the "ask price." That $2 difference is called the spread, and it's how market makers are rewarded for providing liquidity.
Are brokers automatically market-makers?
No. They can be, but don't have to be.
Assume Bill owns one share of company A, which he wishes to sell for $950, and Sarah wishes to purchase one share of company A for $850, with both placing their orders with broker A. Without the market maker, there'd be little liquidity, and if Bill wasn't hurrying to sell, he'd have to settle for $100 less than his asked price, except for Sarah's bid price. If market maker A, who owns a large number of company A shares and has a lot of money, steps in, Bil and Sarah suddenly have other options.
Market makers are high-frequency trading companies. Rather than an individual manually setting the bid and ask price, it tends to be done automatically through algorithms.
Market Index
You've likely heard news reporters say things like "The Dow is up 100 points" or "S&P is down 5 points." But what does that mean?
A stock market index measures the performance of a collection of stocks. Indices track how the overall market performs by measuring these stocks collectively rather than only looking at the performance of a single stock. Think of it this way: If you focus too closely on just one thing, you might not have a good understanding of the larger picture. This is why an index's performance provides more complete information than the performance of individual stocks. Indices provide a wider view of the stock market as a whole.
The first index was the Dow Jones Industrial Average. Financial reporter Charles Dow added up the closing prices of the 12 largest stocks at the time and divided the total by 12 to get the average. Today, Dow consists of 30 of the largest and most successful companies in the US. These companies are handpicked by experts to represent a wide variety of industries. Some of these companies affect the average more than others, though, because many indices are weighted. Think of the idea of weighting like grades: a final exam is going to make up a larger portion of your grade than a daily homework assignment. In the Dow, companies with higher prices are given more weight.
While the Dow is the oldest and most known index, some believe that its measurement is less representative of the overall market than the S&P 500, even though they often perform similarly to each other. The S&P 500 measures the performance of 500 of the largest publicly traded companies in the US. Due to its broad exposure, some believe that the S&P 500 is the best measurement of the US stock market. The S&P 500 is weighted by market cap. The market cap is the number of a company's outstanding shares multiplied by the price per share. Because of this, the companies with the largest total market value have the greatest impact on the average of the S&P 500.
The Nasdaq Composite, also known as the Nasdaq, is comprised of approximately 3000 companies traded on the Nasdaq exchange. The Nasdaq includes more smaller companies than the other indices but also includes many of the largest tech companies like Apple, Microsoft, and Amazon. Some of these companies may also be included on the Dow, the S&P 500, or both. Each index helps to measure how the overall market is doing through the performance of the securities it tracks.
Long Trade vs. Short Trade
This is just a fancy way of saying whether the investor believes that the stock price will increase or decrease. Long trading looks to make money from the stock price increasing, while short trading looks to make money from the stock price decreasing. Long trades are often called being "bullish" on a stock, while short trades are often called being "bearish" on a stock.
A long trade is simply buying a stock and only requires you to have enough money to pay for the shares and the broker's commission. For example, being long 100 shares of Amazon means you purchased 100 shares with the intention of profiting from the stock as its price rises. Since Amazon stock can't go any lower than $0, your maximum potential loss is 100% of your money, but your potential profit is unlimited.
Short traders are traders who seek to profit from a stock's price decline. An account with special requirements and borrowing privileges called a margin account is required to be able to short sell a stock. This is because an investor technically borrows the shares from the stock brokerage, immediately sells them, and attempts to buy them back at a lower price with the intention of returning the borrowed shares and profiting from the difference. It happens instantly behind the scenes when you choose to short a stock.
A short sale can be riskier than buying a stock and is not recommended for inexperienced investors. This is because since you make money when a stock price falls and lose money when the stock price rises, potential gains are capped at 100% as a stock can go no lower than $0, but potential losses are technically unlimited as a stock price has no upper limit.
Leverage
The obvious everyday use of leverage is housing. There are not many of us who go out and pay cash when we're buying a house. So there's an element of leverage involved. If we're buying somewhere for, let's say, $200K, a deposit might be $20K, but we end up borrowing $180K. The second-biggest one after a house is a car, and again, there aren't many people who'll go out and spend $30K cash on a brand new BMW. So they'll go out and put down a deposit of $5,000 and borrow the rest. They're leveraging to get an asset.
Let's say you're convinced a certain share is going to go up in price, and you want to have as much exposure as possible to that share. You might decide that, over the next year, the share is going to go up 20%, so you decide to borrow $10K to invest in the share. It costs you 5% a year, but you're confident that you can beat the cost of the financing through the growth of the share price.
So the really basic principle of leverage is using a small sum of money and effectively borrowing more money, so magnifying the size of the money that you've got to get a bigger exposure to something, whether it's a car, a house, or an individual share. When it comes to investing or trading, there are clearly risks and rewards.
Let's go back to the example where we borrow our mythical $10,000 at 5% per year to gain exposure to a share. The plus point is if the share price goes up 20% over a year. So we've made 20% on our $10,000. We've made a profit of $2K, and it's only costing us $500 in interest. So the clear benefit is that we can get more exposure. So if we're correct, we make more money than if we were not using leverage. If we only put down $1000 and it goes up 20%, we've only made $200. So leverage, when we're right, gives us more bang for our buck.
Let's say a share has dropped 20% in a year. We've borrowed. It's now only worth $8K, and on top of that, we're paying a 5% charge. So for leverage, the obvious plus point is that it magnifies our profits, but if we're magnifying our profits, then we're doing the same with our losses. So increased exposure means we're going to end up potentially facing bigger losses if our decision turns out to be wrong, and this is true for investing and trading when we're using leverage.
Margin Trading
In something like foreign exchange, you might have a $10,000 position, and the initial margin requirement might only be 5%. So you're in a position where you are controlling $10,000 but only tying up $500 of your cash. Of course, if the position moves against you, you need more money in the account to cover losses. On things like shares, the margin requirement may be a bit higher because they can be a bit more volatile.
Let's say the margin requirement on an individual share is 10%. So you use contracts for difference CFDs to open a $1000 position on a specific share. The margin requirement is 10%. So 10% of $1000 is $100. You do get the $100 back when you close out the trade. This money is freed up and deposited into your account, plus any profit or loss. It's effectively just a deposit to secure that position, but if there are already running losses, they'll need free money in the account to cover those losses.
Counterparty risks
It's all about the banks. Let's have a bunch of school kids. We've got Alan and his friend John. John likes to eat sweets every single day. John's father obviously wants to make sure that his son doesn't swell up to a great size, so he restricts the amount of money that he gives John. So John is constantly running into liquidity issues in finance. He doesn't have enough money to buy the sweets he needs.
So he goes to his friend Alan. John has big bags of sweets he keeps underneath his bed, and Alan's always saying, "Why don't you eat those sweets?" John says, "That's my store, but I still need money to buy more sweets." "I need $10 to buy the sweets." Alan decides to give him $10, but John needs to put his sweet reserves in an escrow account. So if he doesn't pay him back in a week, then Alan is getting those sweets. So they find Julia, a friend of those who can run the escrow account for them. Julia will hold those sweets while John is borrowing that money, and when he pays the money back, John will get the sweet.
So banks put up collateral in return for the loans they get from other banks, just like in our example.
For example, let's say John's father is on the news. His company is having a few problems. Alan will be hesitant to trust John that he will return the $10 because his father is having difficulties. John says, "I will give you my whole bag of sweets." " It's more than those ten dollars." But there are problems with those bags of sweets because they could be old and made with corn syrup, which is not good for health, so Alan thinks John is not a good counter party.The same things are happening with the banks. They're looking at their counterparties, like JP Morgan said about the Spanish bank. "I don't know how much exposure you have to, you know, Greek debt, for example." In many cases, the parties are refusing to deal with each other.
Trade Slippage
You go out on the market and buy 100 shares for $10. Let's just say that you decide to sell. The price goes up to $10.50. You want to make a winning trade, so you move your stop to $10.25. But what needs to happen in order for you to sell at $10.25? Well, if the price goes to that level, you need to have at least some people out there willing to buy 100 shares at $10.25.
Let's say that at $10.25, we have a trader willing to purchase 25 shares. Then, at $10.20, we have somebody that's willing to purchase 50 shares, and at $10.10, they're willing to purchase 100 shares. So what's the actual slippage?
The original plan was that you wanted to sell 100 shares at $10.25, but behind the scenes, in all actuality, there were only 25 shares that someone wanted to buy at that price. So there's a problem with the math. So if the price hits your stop, you're going to get 25 at the $10.25 mark. That person is now gone, but you still have 75 shares left. The next buyer available is at $10.20.This person will purchase 50 shares, and we've got 25 shares left, which is known as slippage. You wanted to get out at $10.25, but now all of a sudden you're getting out at $10.20.
That's 5 cents of slippage. Slippage is simply the difference between what you want to get out of something and what you actually get out of it. The remaining shares will be sold at $10.10. How much slippage occurred in the last 25 shares? It's 15 cents. Just because you see certain stock prices doesn't mean that you're actually going to be able to get out at whatever price you see. The more volatile a stock is, the more slippage you can expect.