Stocks, ExchangeâTraded Funds, and Options
From swaptions to nonâfungible tokens (NFTs), new instruments and opportunities frequently emerge as markets evolve. By the time this book reaches the shelf, the financial landscape and the instruments occupying it may be very different from when it was written. Rather than focus on a wide range of instruments, this book discusses fundamental trading concepts using a small selection of asset classes (stocks, exchangeâtraded funds, and options) to formulate examples.
A share of stock is a security that represents a fraction of ownership of a corporation. Stock shares are normally issued by the corporation as a source of funding, and these instruments are usually publicly traded on stock exchanges, such as the New York Stock Exchange (NYSE) and the Nasdaq. Shareholders are entitled to a fraction of the company's assets and profits based on the proportion of shares they own relative to the number of outstanding shares.
An exchangeâtraded fund (ETF) is a basket of securities, such as stocks, bonds, or commodities. Like stocks, shares of ETFs are traded publicly on stock exchanges. Similar to mutual funds, these instruments represent a fraction of ownership of a diversified portfolio that is usually managed professionally. These assets track aspects of the market such as an index, sector, industry, or commodity. For example, SPDR S&P 500 (SPY) is a market index ETF tracking the S&P 500, Energy Select Sector SPDR Fund (XLE) is a sector ETF tracking the energy sector, and SPDR Gold Trust (GLD) is a commodity ETF tracking gold. ETFs are typically much cheaper to trade than the individual assets in an ETF portfolio and are inherently diversified. For instance, a share of stock for an energy company is subject to companyâspecific risk factors, while a share of an energy ETF is diversified over several energy companies.
When assessing the price dynamics of a stock or ETF and comparing the dynamics of different assets, it is common to convert price information into returns. The return of a stock is the amount the stock price increased or decreased as a proportion of its value rather than a dollar amount. Returns can be scaled over any time frame (daily, monthly, annual), with calculations typically calling for daily returns. The two most common types of returns are simple returns, represented as a percentage and calculated using Equation (1.1), and log returns, calculated using Equation (1.2). The logarithm's mathematical definition and properties are covered in the appendix for those interested, but that information is not necessary to know to follow the remainder of the book.
where
is the price of the asset on day
and
is the price of the asset the prior day. For example, an asset priced at $100 on day 1 and $101 on day 2 has a simple daily return of 0.01 (1%) and a log retu...