Lecture Two Essentials of Trading. Andy Bower

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1 Lecture Two Essentials of Trading Andy Bower

2 Essentials of Trading Why People Trade Money What People Trade Market Where People Trade Exchanges How People Trade Brokers Orders Margin Shorting Strategies

3 Money: Why People Trade Investments Pension Funds Insurance Funds Trusts Individuals Borrowers House Buyers Companies Students Hedgers Producers Exchange wealth now for (more) wealth in the future Exchange wealth in the future for wealth (facilities) now Unknown future risk reduction

4 Market: What People Trade Securities Stocks Shares issued to raise capital now Regular dividend (interest) payment Redeemable by selling to other investors at market price. Exchange Traded Funds (ETFs) Funds hold portfolios matching common indices QQQQ, DIA, SPY (US funds) Bonds Bonds, Notes issued to raise capital now Bought (usually) for face value Regular coupon (interest) payment At term redeemed (usually) at face value

5 Options Market: What People Trade Derivatives Call Option A right to purchase an asset at a strike price on or before the expiration date. Cost of option is the premium. Put Option A right to sell an asset at a strike price on or before the expiration date. Cost of option is the premium. Futures Futures Contract - agreement to purchase a commodity (item) for delivery in the future. Leverage Derivatives yield an amplification of gain or loss.

6 Market: What People Trade Currencies Exchange Rates Profit from single exchange rate changes Arbitrage Exploit discrepancies in 3 way markets E.g. yen-euro, euro-dollar, dollar-yen

7 Market: Where People Trade Exchanges UK: LIFFE, LSE US: Amex, NYSE, CME OTC Over-the-Counter Brokers and dealers negotiate trades NASDAQ is a price quotation system for OTC trades L1:Market Makers/L2:Brokers/L3:Investors ECNs Electronic Communication Networks US ECNs Island, Instinet, Archipelago etc.

8 Brokers: How People Trade Traders Investors Borrowers Hedgers Trading Services Market Makers/Specialists Cross outstanding trades Otherwise deal from own inventory (25%) Set bid & ask prices and profit from spread Brokers Interface between traders and market makers Profit from commission charges for orders filled Traders effectively buy liquidity from Trading Services

9 Brokers: How People Trade Full Service Broker $100-$200 $200 per trade Additional research services Web-based based Discount Broker $10-$20 $20 per trade Automatically routed to dealer Direct Access Broker $0.005 $0.01 per share Route direct to dealer

10 Brokers: How People Trade Spread Betting Web-based based Spread Betting Larger Bid/Ask Spread Not actually trading securities TAX FREE

11 Bid/Ask Prices Bid Price Price offered to buy your asset i.e. Price at which you can sell Ask Price Price offered to sell you an asset i.e. Price at which you can buy Bid <= Ask

12 Orders Market Orders Buy (initially) at inside ask Sell (initially) at inside bid Usually immediate fill during market hours Limit Orders Buy or Sell at specified limit price Stop Orders Sell triggered when price falls below stop price Converted to market order when triggered Used to manage risk. Stop Limit Orders Sell at a limit price when price falls below stop price May not fill in fast moving market

13 3 Orders: Examples Close=32.71 Open=31.48 High=32.95 Low= Buy Market Sell 32 Limit Sell 29 Stop 2. Buy Limit Sell 33 Limit Sell Stop 3. Buy 32.6 Stop Sell Limit Sell Stop

14 Margin Standard Margin (US equity) Margin accounts can borrow 100% of the account size (2:1) Use of margin provides leverage: extra risk extra gain Day Trader Margin (US equity) Accounts marked as pattern day trading must have a minimum $25,000 balance Day Trader Margin accounts can borrow 400% of the account size (4:1) Margin Calls Accounts that exceed margin receive a margin call Some brokers liquidate positions directly

15 Short Selling Margin accounts can sell short Borrow security from dealer with the aim to buy it back at a lower price. Shorting Advantages An obvious way to profit in a falling market Shorting an ETF index fund profits when general market is bearish Shorting Disadvantages Unlimited potential for loss Dividends must be paid out Up-tick rule

16 Shorting Orders Market Orders Sell Short (initially) at inside bid Cover (initially) at inside ask Limit Orders Sell or Cover at specified limit price Stop Orders Cover triggered when price rise above stop price Converted to market order when triggered Stop Limit Orders Cover at a limit price when price rise above stop price May not fill in fast moving market

17 Trading Styles Buy & Hold or Position Trading Buy and hold for long periods (years) Portfolios accrue profits from general market direction (on avg. 11%APR since 1920) Often used by investment managers Swing Trading Buy or sell short and hold for up to several weeks Attempt to capture profits from the price swings Main vehicle of Hedge Funds Day Trading Buy or sell short and close positions by end of day Scalpers attempt to scalp profits from small price movements using large position sizes.

18 Trading Styles: Hedging Buy or Sell a correlated instrument to manage downside risk. Industrial/Agricultural Hedging Sell future contract against commodity. Insure against price falls after upfront investment. Limits upside and downside. Stock hedging with futures contracts Sell futures contract against correlated index Insure again overall market fall/crash Limits upside and downside. Stock hedging with options Buy put option to sell at a minimum future price Limits downside, preserves upside (for premium).

19 Options Leverage/Hedging Examples Feb 2005: Invest $10,400 in Apple Computer Current price $44.86 per share 1. Purchase entirely as shares in AAPL 2. Purchase 200 July 16 th (QAAGW) call options Strike price $47.50, premium $ Purchase entirely as AAPL shares and write July 16th QAAGW call options to cover (COVERED CALLS) 4. Purchase 100 call options and invest the remainder in half yearly Treasury Bonds paying 2% per six months Plot returns for August share price of $35, 40, 45, 50, in each strategy

20 Reading Essentials of Investments PART ONE: Investments Background and Issues McGraw Hill: Bodie, Kane, Marcus

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