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How the Market Works

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How the Market Works

Pertaining to the title of this article, we’re talking about the capital markets and the way they work. Before going any further, a clear understanding of the capital markets is essential.

Capital markets are financial markets where investments and other financial assets are bought and sold. These include long-term debt instruments and equity-backed securities. Capital markets include primary markets and secondary markets.

An Overview of Primary and Secondary Capital Markets

New stocks and bonds sold by a company for the first time always happen in the primary markets. The new issues are initial public offerings and, potential investors purchase these securities subject to review by an underwriting firm.

The IPOs issued in primary markets are priced low and are highly volatile in nature since demand cannot be predicted. A primary market is a place where companies go all out to sell all the securities in a short period to meet their targets.

A company that wishes to raise equity in the primary market should first enter the secondary market. They can achieve this through a rights issue or rights offering. Companies can sell directly through a hedge fund and, shares are not available for public offering.

Secondary markets are where company securities are traded after selling the initial offering on the primary markets. The most common secondary markets are the Stock Markets. Small investors and almost anyone can purchase securities on the secondary market.

Prices of securities on the secondary markets fluctuate depending on supply and demand. It’s different from the primary markets where IPOs are set beforehand. Post the initial offering the issuing company is not involved in any way for trading between investors.

Secondary Market Categories

The secondary market comprises of:

The Auction Market includes competitive bids by the buyers and competitive offers by the sellers. In other words, it’s a place of trade where buyers and sellers negotiate between the highest price willing to pay and the lowest price willing to accept, respectively.

The Dealer Market is a financial market where several dealers trade electronically through dealers called market makers. Dealers trade on their own behalf and provide transparency of prices they are willing to accept to buy or sell securities.

The auction market is different from the deal market in the sense that there is a single and centralized point of contact facilitating trading by tying up buyers and sellers.

Broker Market

This is yet another category of financial markets that calls for a specific level of expertise to facilitate a transaction. A defined buyer and seller are the prerequisite for a trade to happen in a dealer market.

The primary differences between dealer markets and broker markets are:

  • Brokers trade on behalf of others and, dealers trade for themselves
  • Brokers are the intermediaries between two parties and, dealers are the primary buyers and sellers
  • Brokers cannot buy or sell securities but, dealers have the right to do so
  • Since brokers are the intermediaries between buyers and sellers, they earn a commission. Dealers are the primary traders and hence, receive no commission

Capital Markets and Stock Markets

We often use the terms capital market and stock market interchangeably. However, there is a principal difference between the two commonly misunderstood terms.

Capital market is a comprehensive spectrum comprising of tradable assets and financial securities like bonds, contracts, derivatives, futures and other debt instruments. Coming to stock markets, they are the specific category of capital markets that trade only in shares of corporations.

More than a difference, the stock market is a major division of the capital markets.

Stocks and their Significance

Stocks are a type of financial security signifying proportionate ownership in the issuing company. Companies primarily issue stocks to the public to raise capital for day-to-day business operations. The buyer of the stock is the shareholder and, he/she is entitled to claim the company’s earnings in proportion to the number of stocks owned.

Stockholders have ownership in the issuing company. However, they own only the shares issued by the company and, not the company itself. Corporations are considered to be legal persons that own their own assets. This stresses on the fact that corporate property is distinct from shareholders property.

This significantly reduces the liability of the shareholders and the corporations. Even if the company goes bankrupt, your personal assets and your shares are not affected. Of course, the value of shares does reduce drastically. In case a shareholder goes bankrupt, he/she cannot sell company assets to compensate for the same.

How do Stock Markets Work?

Stock markets operate similarly to an auction house and, through a network of stock exchanges. Several corporations list their shares and stocks on a stock exchange platform to raise funds for their operations and expansion.

The most popular stock exchanges in the world are the New York Stock Exchange and Nasdaq.

Buyers and sellers come together to trade in shares and, the stock exchange keeps track of supply and demand for all the listed stocks. The supply and demand are the driving force behind the price for securities. It also helps determine the level of market participation by the buyers and sellers.

The bid-ask spread takes place comprising of the amount buyers are willing to pay and, sellers are willing to accept.

Remember, stock exchanges are secondary markets and, companies do not trade their own stocks regularly except in case of buybacks. So, the moment you buy stocks through the stock exchange, you are actually buying it from an existing shareholder and not directly from the company. The selling also happens to another investor and not to the company.

All about Share Prices and Supply and Demand

There are multiple factors affecting the prices of shares listed on a stock exchange. The most common is through the process of auction where buyers and sellers quote their bids and offers. Millions of investors with different mindsets influence the value of a stock. The stock exchange records the information through computer-generated algorithms.

The law of supply and demand work perfectly in real-time in a stock exchange. If a certain stock has more buyers than sellers, the price of the stock will increase. On the contrary, if the stock has more sellers than buyers, the price will decrease.

Matching Buyers and Sellers

Most stock markets have professional traders called market makers to keep the bids going. Matching buyers with sellers started off manually called open outcry. Verbal communication and hand signals were used to trade in stocks.

However, now the electronic trading system has taken over to do the job. It is far more efficient and much quicker than the manual process enabling lower trading costs. Trade execution is also much faster.

Let us chalk out the advantages and disadvantages of stock exchange listings.

Advantages of Stock Exchange Listings

  • Liquidity of shares are readily available for shareholders
  • Companies can raise funds by increasing the issue of shares
  • Publicly traded shares attract more talent and diligent employees
  • Companies listed on the stock exchange enjoy more visibility in the marketplace
  • Companies can use their listed shares as currency to make purchases

Disadvantages of Stock Exchange Listings

  • Significant costs are involved, including listing fees, compliance fees and other reporting costs
  • Stringent rules and regulations stifle a company’s ability to perform as expected
  • Short-term goals of investors force companies to take a hurried approach rather than concentrate on long-term goals

However, investing in stocks over longer periods generate higher returns compared to other asset classes. Shareholders enjoy capital gains and dividends from shares traded professionally over a period of time.

Stock Market and the Economy

The condition of the economy does influence the stock market scenario. If the economy is expanding, people will be willing to invest in stocks. That’s because companies can enhance their earnings while the economy is strong. This makes for what is called a bull market.

Investing in bonds is a safer option when the economy is dipping. Bonds give a fixed rate of income up to the maturity period. During this phase, stocks lose their value and, the phase is called the bear market.

Stock Market Correction

This happens when share prices drop by 10% or more. The pullback helps consolidate the market and encourages it to go much higher. It’s a part and parcel of every market cycle. In extreme cases, a stock market crash can occur where prices drop drastically in a single day. It can also lead to a recession since corporations raise funds by issuing stocks. Hence, a fall in stocks has a direct effect on the companies’ ability to grow. This, in turn, leads to lay off and unemployment sets in.

However, even during a crash, you should not sell your shares. This is because the stock markets will make up for the losses in a couple of months. By selling your shares during a crash, you miss out on time required to make up for the losses.

Trading

How has the online trading landscape changed in 2020?

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How has the online trading landscape changed in 2020? 1

By Dáire Ferguson, CEO, AvaTrade 

This year has been all about change following the outbreak of coronavirus and the subsequent global economic downturn which has impacted nearly every aspect of personal and business life. The online trading world has been no exception to this change as volatility in the financial markets has soared.

Although the global markets have been on a rollercoaster for some time with various geopolitical tensions, the market swings that we have witnessed since March have undoubtedly been unlike anything seen before. While these are indeed challenging times, for the online trading community, the increased volatility has proven tempting for those looking to profit handsomely.

However, with the opportunity to make greater profits also comes the possibility to make a loss, so how has 2020 changed the online trading landscape and how can retail investors stay safe?

Lockdown boost

Interest rates offered by banks and other traditional forms of consumer investments have been uninspiring for some time, but with the current economic frailty, the Bank of England cut interest rates to an all-time low. This has left many people in search of more exciting and rewarding ways to grow their savings which is indeed something online trading can provide.

When the pandemic hit earlier this year, it was widely reported that user numbers for online trading rocketed due to disappointing savings rates but also because the enforced lockdown gave more people the time to learn a new skill and educate themselves on online trading.

Dáire Ferguson

Dáire Ferguson

A volatile market certainly offers great scope for profit and new sources of revenue for those that are savvy enough to put their convictions to the test. However, where people stand the chance to profit greatly from market volatility, there is also the possibility to make a loss, particularly for those that are new to online trading or who are still developing their understanding of the market.

The sharp rise in online trading over lockdown paired with this year’s unpredictable global economy has led to some financial losses, but with a number of risk management tools now available this does not necessarily have to be the case.

Protect your assets

Although not yet widely available across the retail market, risk management tools are slowly becoming more prevalent and being offered by online traders as an extra layer of security for those seeking to trade in riskier climates.

There are a range of options available for traders, but amongst the common tools are “take profit” orders in conjunction with “stop loss” orders. A take profit order is a type of limit order that specifies the exact price for traders to close out an open position for a profit, and if the price of the security does not reach the limit price, the take profit order will not be fulfilled. A stop loss order can limit the trader’s loss on a security position by buying or selling a stock when it reaches a certain price.

Take profit and stop loss orders are good for mitigating risk, but for those that are new to the game or who would prefer extra support, there are even some risk management tools, such as AvaProtect, that provide total protection against loss for a defined period. This means that if the market moves in the wrong direction than originally anticipated, traders can recoup their losses, minus the cost of taking out the protection.

Not a day has gone by this year without the news prompting a change in the financial markets. Until a cure for the coronavirus is discovered, we are unlikely to return to ‘normal’ and the global markets will continue to remain highly volatile. In addition, later this year we will witness one of the most critical US presidential elections in history and the UK’s transition period for Brexit will come to an end. The outcome of these events may well trigger further volatility.

Of course, this may also encourage more people to dip their toes into online trading for a chance to profit. As more people take an interest and sign up to online trading platforms, providers will certainly look to increase or improve the risk management tools on offer to try and keep new users on board, and this could spell a new era for the online trading world.

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Trading Strategies

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Trading Strategies 2

By Paddy Osborn, Academic Dean, London Academy of Trading

Whether you’re negotiating a business deal, playing a sport or trading financial markets, it’s vital that you have a plan. Top golfers will have a strategy to get around the course in the fewest number of shots possible, and without this plan, their score will undoubtedly be worse. It’s the same with trading. You can’t just open a trading account and trade off hunches and hopes. You need to create a structured and robust plan of attack. This will not only improve your profitability, but will also significantly reduce your stress levels during the decision-making process.

In my opinion, there are four stages to any trading strategy.

S – Set-up

T – Trigger

E – Execution

M – Management

Good trading performance STEMs from a structured trading process, so you should have one or more specific rules for each stage of this process.

Before executing any trades, you need to decide on your criteria for making your trading decisions. Should you base your trades off fundamental analysis, or maybe political news or macroeconomic data? If so, then you need to understand these subjects and how markets react to specific news events.

Alternatively, of course, there’s technical analysis, whereby you base your decisions off charts and previous price action, but again, you need a set of specific rules to enable you to trade with a consistent strategy. Many traders combine both fundamental and technical analysis to initiate their positions, which, I believe, has merit.

Set-up

What needs to happen for you to say “Ah, this looks interesting! Here’s a potential trade.”? It may be a news event, a major macro data announcement (such as interest rates, employment data or inflation), or a chart level breakout. The key ingredient throughout is to fix specific and measurable rules (not rough guidelines that can be over-ridden on a whim with an emotional decision). For me, I may take a view on the potential direction of an asset (i.e. whether to be long or short) through fundamental analysis, but the actual execution of the trade is always technical, based off a very specific set of rules.

To take a simple example, let’s assume an asset has been trending higher, but has stopped at a certain price, let’s say 150. The chart is telling us that, although buyers are in long-term control, sellers are dominant at 150, willing to sell each time the price touches this level. However, the uptrend may still be in place, since each time the price pulls back from the 150 level, the selling is weaker and the price makes a higher short-term low. This clearly suggests that upward pressure remains, and there’s potential to profit from the uptrend if the price breaks higher.

Trigger

Once you’ve found a potential new trade set-up, the next step is to decide when to pull the trigger on the trade. However, there are two steps to this process… finger on trigger, then pull the trigger to execute.

Paddy Osborn

Paddy Osborn

Continuing the example above, the trigger would be to buy if the price breaks above the resistance level at 150. This would indicate that the sellers at 150 have been exhausted, and the buyers have re-established control of the uptrend.  Also, it is often the case that after pause in a trend such as this, the pent-up buying returns and the price surges higher. So the trigger for this trade is a breakout above 150.

Execution

We have a finger on the trigger, but now we need to decide when to squeeze it. What if the price touches 150.10 for 10 seconds only? Has our resistance level broken sufficiently to execute the trade? I’d say not, so you need to set rules to define exactly how far the price needs to break above 150 – or for how long it needs to stay above 150 – for you to execute the trade. You’re basically looking for sufficient evidence that the uptrend is continuing. Of course, the higher the price goes (or the longer it stays above 150), the more confident you can be that the breakout is valid, but the higher price you will need to pay. There’s no perfect solution to this decision, and it depends on many things, such as the amount of other supporting evidence that you have, your levels of aggression, and so on. The critical point here is to fix a set of specific rules and stick to those rules every time.

Management

Good trade management can save a bad trade, while poor trade management can turn an excellent trade entry into a loser. I could talk for days about in-trade management, since there are many different methods you can use, but the essential ingredient for every trade is a stop loss. This is an order to exit your position for a loss if the market doesn’t perform as expected. By setting a stop loss, you can fix your maximum risk on a trade, which is essential to preserving your capital and managing your overall risk limits. Some traders set their stop loss and target levels and let the trade run to its conclusion, while others manage their trades more actively, trailing stop losses, taking interim profits, or even adding to winning positions. No matter how you decide to manage each trade, it must be the same every time, following a structured and robust process.

Review

The final step in the process is to review every trade to see if you can learn anything, particularly from your losing trades. Are you sticking to your trading rules? Could you have done better? Should you have done the trade in the first place? Only by doing these reviews will you discover any patterns of errors in your trading, and hence be able to put them right. In this way, it’s possible to monitor the success of your strategy. If your trades are random and emotional, with lots of manual intervention, then there’s no fixed process for you to review. You also need to be honest with yourself, and face up to your bad decisions in order to learn from them.

In this way, using a structured and robust trading strategy, you’ll be able to develop your trading skills – and your profits – without the stress of a more random approach.

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Economic recovery likely to prove a ‘stuttering’ affair

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Economic recovery likely to prove a ‘stuttering’ affair 3

By Rupert Thompson, Chief Investment Officer at Kingswood

Equity markets continued their upward trend last week, with global equities gaining 1.2% in local currency terms. Beneath the surface, however, the recovery has been a choppy affair of late. China and the technology sector, the big outperformers year-to-date, retreated last week whereas the UK and Europe, the laggards so far this year, led the gains.

As for US equities, they have re-tested, but so far failed to break above, their post-Covid high in early June and their end-2019 level. The recent choppiness of markets is not that surprising given they are being buffeted by a whole series of conflicting forces.

Developments regarding Covid-19 as ever remain absolutely critical and it is a mixture of bad and good news at the moment. There have been reports of encouraging early trial results for a new treatment and potential vaccine but infection rates continue to climb in the US. Reopening has now been halted or reversed in states accounting for 80% of the population.

We are a long way away from a complete lockdown being re-imposed and these moves are not expected to throw the economy back into reverse. But they do emphasise that the economic recovery, not only in the US but also elsewhere, is likely to prove a ‘stuttering’ affair.

Indeed, the May GDP numbers in the UK undid some of the optimism which had been building recently. Rather than bouncing 5% m/m in May as had been expected, GDP rose a more meagre 1.8% and remains a massive 24.5% below its pre-Covid level in February.

Even in China, where the recovery is now well underway, there is room for some caution. GDP rose a larger than expected 11.5% q/q in the second quarter and regained all of its decline the previous quarter. However, the bounce back is being led by manufacturing and public sector investment, and the recovery in retail sales is proving much more hesitant.

China is not just a focus of attention at the moment because its economy is leading the global upturn but because of the increasing tensions with Hong Kong, the US and UK. UK telecoms companies have now been banned from using Huawei’s 5G equipment in the future and the US is talking of imposing restrictions on Tik Tok, the Chinese social media platform. While this escalation is not as yet a major problem, it is a potential source of market volatility and another, albeit as yet relatively small, unwelcome drag on the global economy.

Government support will be critical over coming months and longer if the global recovery is to be sustained. This week will be crucial in this respect for Europe and the US. The EU, at the time of writing, is still engaged in a marathon four-day summit, trying to reach an agreement on an economic recovery fund.  As is almost always the case, a messy compromise will probably end up being hammered out.

An agreement will be positive but the difficulty in reaching it does highlight the underlying tensions in the EU which have far from gone away with the departure of the UK. Meanwhile in the US, the Democrats and Republicans will this week be engaged in their own battle over extending the government support schemes which would otherwise come to an end this month.

Most of these tensions and uncertainties are not going away any time soon. Markets face a choppy period over the summer and autumn with equities remaining at risk of a correction.

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