Shawn has a masters of public administration, JD, and a BA in political science.
Stocks are traded all over the world seven days a week, 24 hours a day on stock exchanges located in the world's financial capitals, such as New York, London, Tokyo and Hong Kong. In this lesson, you'll learn how stocks are traded.
Brokers & Dealers
Meet Cynthia. She's a stockbroker at a large brokerage firm in New York. A broker is a person or company that buys and sells securities for a client. A security is a type of asset that is purchased for investment purposes and can be traded. Stock is just one type of security. Some brokers are also dealers who buy stock or sell stock for their own account. A dealer may sell such stock to clients and other firms or may keep them as part of its own portfolio.
Since Cynthia is a broker, she had to become licensed by passing securities exams. She also had to register with the Securities and Exchange Commission (SEC) pursuant to the Securities Exchange Act of 1934. The SEC is responsible for regulating the securities industry, including its brokers and dealers.
Cynthia buys or sells stock for her clients on a stock exchange. In fact, at least one officer of her brokerage firm has to be a member of the exchange for her to trade on that exchange. A stock exchange is an organization that provides the marketplace where stocks are traded. The New York Stock Exchange is probably the best example, but stock exchanges exist all over the world in many different countries.
Floor & Electronic Trading
Cynthia can trade stock through floor trading and electronic trading. Floor trading is the traditional method of trading stocks at an exchange where traders buy and sell stock in an auction-like setting on the trading floor of the exchange. While floor trading still is practiced today, Cynthia does most of her trades with electronic trading through a computer system. In fact, most stocks are bought and sold electronically nowadays.
While most of Cynthia's clients buy stock with cash, some buy through a margin account. A margin account is a brokerage account in which Cynthia's brokerage loans money to her clients to buy stocks. If the value of the stocks purchased fall below a certain amount, Cynthia's brokerage firm will make a margin call where the client is required to put money or securities into the account to bring it up to a set minimum value.
Investing with a margin account allows you to use leverage to increase your gains because you have more money to invest. More money invested means your potential returns are higher. Of course, this also means your risks are much higher because you are investing with other people's money and may have to sell off assets to cover a margin call.
Short & Long Positions
Cynthia's clients usually take a long position on a stock, but some do take short positions. A long position occurs when an investor buys a stock believing that it will increase in value over time. You can think of taking a long position as taking a long view and picking a winner. On the other hand, taking a short position involves selling borrowed stock that you think is going to go down in value and buying it back when it actually drops in value. You return the shares and pocket the profit. In other words, you're betting on a loser. Here's how it works.
Let's say that Cynthia has a client, Sharon, who thinks that a certain tech company's stock is going to decrease in value, and she wants to take a short position by short selling it. Sharon contacts Cynthia and finds out the stock is currently trading at $50 per share. She's betting it will go down to $40 a share. Cynthia agrees to let Sharon 'borrow' 100 shares that her firm holds. Sharon tells Cynthia to sell the borrowed shares at $50 a share.
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Sharon now has made $5,000 off of the borrowed shares, but is 'short' 100 shares because she sold something she really didn't own. And the owner will eventually ask for the shares back, which means that Sharon will have to purchase the same number and type of shares to close her short position. In fact, a few weeks later, Sharon sees the stock is now trading at $40 a share and instructs Cynthia to buy 100 shares to cover her short position. Sharon spends $4,000 for the shares and gives them to Cynthia's firm. Sharon made $1,000, which is the difference between the price she sold the borrowed shares and the price at which she closed her short position.
While the payoffs of short selling can be huge, the risk is just as huge. If Sharon lost her bet and the stock went up to $60 a share, she would of had to spend $6,000 to close her short position and would lose $1,000. This can be even worse if Sharon already spent the $5,000 she made on the sale and had to come up the total $6,000 purchase price.
Let's review what we've learned. Many investors hire stock brokers to buy or sell stock on their behalf. Some stockbrokers may also be dealers, which are people that buy stock on their own account. Brokers and dealers must be licensed and registered with the Securities and Exchange Commission. They buy and sell stock on stock exchanges, which are formal organizations that serve as the marketplace for stocks. While most trades are made electronically today, some are still made on the trading room floor of the exchange.
Investors will either take a long position or a short position on a stock. If an investor takes a long position on a stock, he is purchasing the stock with the belief it will appreciate in value. On the other hand, if an investor takes a short position, he thinks the stock will go down in value and will sell the stock short. Short selling involves selling borrowed stock and then, hopefully, buying replacement shares at a lower price than the loaned shares were sold to return to the person that loaned the stock. The difference between the two prices is the profit (or loss) from the short sale.
After completion of this lesson, you should be able to:
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