Stock Market 101

From Bull and Bear Markets to Dividends, Shares, and Margins—Your Essential Guide to the Stock Market

Michele Cagan

• Publisher: Adams Media
• Year: 2016
• ISBN:
  9781440599200
• Topic: Business
• Subtopic: Trading
• Index: Business

All you need to know about buying and selling stocks! Too often, textbooks turn the noteworthy details of investing into tedious discourse that would put even a hedge fund manager to sleep. Stock Market 101 cuts out the boring explanations of basic investing, and instead provides hands-on lessons that keep you engaged as you learn how to build a portfolio and expand your wealth. From bull markets to bear markets to sideways markets, this primer is packed with hundreds of entertaining tidbits and concepts that you won't be able to get anywhere else. So whether you're looking to master the major principles of stock market investing or just want to learn more about how the market shifts over time, Stock Market 101 has all the answers--even the ones you didn't know you were looking for.

NASDAQ

The Exchange That Launched 1,000 Tech Companies

It was the first of its kind, operating in a way that hadn’t been seen before. For generations, stock markets were real places where traders got together to buy and sell shares face-to-face. Then the NASDAQ opened, and everything changed. Though it wasn’t widely recognized at the time, this plucky new-style stock exchange would shift the way markets traded, and vastly improve the speed and accuracy of trades.

When it first launched in February 1971, the NASDAQ hosted only 250 companies. Its first claim to fame: the NASDAQ opened as the first fully electronic stock market in the world. Through the turbulent 1970s, the exchange began to grow, and it became a beacon for young computer-based start-up companies, many of which disappeared as fast as they came on the scene. By the 1980s, computers were gaining ground, and two groundbreaking companies issued IPOs, a powerful indication of what was to come. Those two companies, Apple Inc. (1980) and Microsoft Corporation (1986), changed everything, each eventually becoming (at least for a time) the biggest corporation in the world.

The exchange hit a milestone in 1996, when its trading volume finally exceeded 500 million shares per day. Suddenly, the NYSE wasn’t the only exchange hosting successful, respected companies. Now the NASDAQ has grown into a full-fledged stock market, listing about 3,200 corporations, and it’s destined to keep growing. Out of all the U.S. stock markets, the NASDAQ (which is now officially known as the NASDAQ OMX Group) hosts the most initial public offerings (IPOs), and it is drawing in more companies all the time.

Taking Over

NASDAQ is the largest (by number of companies) and fastest-growing stock exchange in the United States, and it trades more shares in a day than any other U.S. exchange. On May 26, 2016, total trading volume topped 1.6 billion shares.

The NASDAQ is attractive to new and growing companies primarily because the listing requirements are less stringent than those of the NSYE, and the costs of listing can be considerably lower. Not surprisingly, you’ll find a lot of technology and biotech stocks listed on this exchange, as these types of companies typically fall squarely in the aggressive growth category. In fact, the NASDAQ boasts more than $9.5 trillion total market value, most of that coming from the technology sector. To catch a glimpse of the companies listed on this exchange, take a look at the NASDAQ Composite, a comprehensive stock index that follows all of the corporations listed there (more on that in the NASDAQ Composite chapter).

The NASDAQ is a dealer market, which means its securities are traded by dealers through telephone and computer networks as opposed to being facilitated by specialists on a physical exchange floor.

Dealer Market

Unlike the auction-style trading floor of the NYSE, the NASDAQ works with more than 600 securities dealers known as market makers. Market makers do just what it sounds like they do: they create a market for securities. They even put up their own capital in order to provide a liquid market for investors, making it easier for them to buy and sell shares.

Though the name seems to imply that market makers are individual traders, most are big investment companies (at least on the NASDAQ). That’s how they’re able to keep a large supply of stocks on hand that can be sold when orders are placed. There’s a lot of overlap in the companies that these market makers keep in inventory, which leads to robust competition. Because the exchange is fully computerized, market makers don’t conduct business face-to-face, or even over the phone. All trading on the NASDAQ is done electronically.

These market makers compete against one another to offer the best bid and ask prices (or quotes) over the NASDAQ’s complex electronic network, which joins buyers and sellers from all over the world. In fact, market makers must offer firm bid and ask prices, creating what’s called the “two-way” market (in FINRA terms). In other words, market makers have to trade shares at the bid and ask prices they have quoted. Between the two amounts is the bid-ask spread, the mathematical difference between the two quotes, and the spot where these market makers can make a lot of money. To level the playing field for investors, market makers are legally required to fill market orders at the best bid or ask price for the customer.

A Deal’s a Deal

When a market maker enters a bid or ask price for a particular stock, he has to buy or sell a minimum of 1,000 shares at that published price. After that’s accomplished, he can close out that “market,” and put in a new price for that stock.

A NASDAQ Deal

Let’s walk through the way a deal on the NASDAQ goes down. It starts with the market maker entering bid and ask prices, say a bid/ask of $85.20/$85.25 for a share of Netflix. That means the market maker will buy shares for the bid price of $85.20 and sell shares at the ask price of $85.25. The difference between those bid and ask prices is five cents per share, and that represents the market maker’s profit, known as the spread.

This looks a little different from the investor’s perspective. With those quotes, an investor looking to sell at the current market price would receive $85.20 per share, while an investor looking to buy would pay $85.25 per share.

The OTC Market

Murky, Shark-Infested Waters May Hide Buried Treasure

The over-the-counter market, or OTC market, includes securities known as “unlisted stock.” This unlisted designation means these stocks are not traded on the traditional stock exchanges like the NYSE or NASDAQ. Instead, securities bought and sold on the OTC are traded by individual broker-dealers, professionals who deal directly with each other via the Internet or by phone.

Buying OTC stocks is very different than buying stocks traded on the major exchanges, in that there is no central exchange for them where buyers and sellers are matched up. Rather, you can only get shares through a market maker, who must actually keep an inventory of shares for sale.

To buy OTC shares, you typically must enlist the services of a broker who is willing to work with the OTC market, and not all of them will. Then your broker has to contact the market maker for the security you want to buy. The market maker will name his ask price, which is the amount he’s willing to accept for the shares. To sell OTC shares, the process works the same way: Your broker would contact the market maker to learn his bid (or offering) price. Bid and ask quotes appear on the OTCBB, the Over-the-Counter Bulletin Board, so that investors can monitor them.

The process seems simple, but it’s fraught with risk. Companies traded on the OTC market are usually too small to be listed on a formal exchange, and reliable information about them can be very hard to find. On top of that, OTC shares are not liquid, so it may be very hard to sell them when you’re ready to do so.

OTCBB

The OTCBB, or Over-the-Counter Bulletin Board, lists OTC securities that don’t quite make the cut for inclusion on a major exchange due to their listing requirements. On the OTCBB, there are no listing requirements except one: Companies listed on the OTCBB must be registered with the SEC, and thus be subject to its reporting requirements. Corporations that are late with SEC filings can be kicked off of this exchange, and moved down to the pink sheets, an unregulated electronic OTC market. If they catch up and remain current, they can come back to the OTCBB.

Owned and operated by NASDAQ, the OTCBB is a fully electronic system with real-time quotes, the most current pricing information, and the most current trading volume for all of the OTC stocks. Keep in mind that the most current information is based on the last time the stock was traded, which may have been a while ago. Securities listed here have the suffix “OB” attached to their ticker symbols, making it clear that they are only traded over the counter. Technically, the stocks here are quoted, not listed; the term “listed” implies that a security trades on a major exchange.

Part of NASDAQ, But Not NASDAQ

The OTCBB is owned and run by NASDAQ, but it is not part of the NASDAQ exchange. In other words, shares listed on OTCBB are not listed on NASDAQ. Unscrupulous market makers may not make that distinction clear, and use the NASDAQ name to make an investor feel more secure about a stock he’s thinking of buying.

Buying stocks listed on the OTCBB is inherently more risky than buying stocks quoted on the major exchanges for two very important reasons:

1. This is a much smaller market, and is therefore less liquid. In practical terms, this means investors may have a very hard time selling these stocks.
2. Because of the low liquidity, stocks trading over the OTCBB have much larger bid/ask spreads, which eats into investors’ returns.

From the investor’s perspective, buying stocks that trade on the OTCBB is like any other stock purchase: You simply call your broker and tell him what you want to buy. From there, the broker contacts the market maker, who quotes the current ask. If you’ve placed a market order (an immediate order filled at the current price), that ask will be the price for the stock you’re buying, and the trade will go through right away. Because this is such a thinly traded market, consider using limit orders (a special order to be filled at a predetermined price) when trading here, because they offer at least some built-in price protection.

Pink Sheets

To be listed on the pink sheets, an unregulated offshoot of the OTC market, all a company has to do is fill out a form (Form 211, to be specific) and file it with the OTC Compliance Unit. All the form asks for is some current financial information, supplied by the company. That’s it.

There are only a few reasons why a company would be traded here:

• The company is very small and can’t afford to be listed on a more prestigious exchange.
• The company has been kicked off a major exchange due to noncompliance.
• The company isn’t real, and its shares are part of a money-making scam.

Some companies give their market maker access to more detailed financial information, including open access to their accounting books. That makes it easier for the market maker to figure out the right stock price. But since corporations are not required to do that, many of them don’t. They don’t have to share any information with potential investors, and they also do not have to file any reports with the SEC, and so investors will have a hard time getting reliable or verifiable information before investing.

Ticker Trivia

“Pink sheets” are so called because the trading information used to be printed on pink paper.

On top of that, companies trading over the pink sheets are usually very small, and their shares are typically held by only a few people. With such a limited market, it can be very hard for investors to sell their shares when they want to.

So what makes pink sheets stock attractive to investors? For one thing, share prices are usually very low, often less than $1. With that minimal per-share cost, even tiny movements in price can bring sizeable returns. For example, say you buy 100 shares of stock in Tiny ABC Inc. for $1 per share, a total investment of $100. A few weeks later, the stock goes up by five cents a share, making your investment worth $105 now. That’s a 5% return on your investment. The same price movement on a more expensive stock, say one trading for $10 per share, would be barely noticeable.

Delisted Companies Land Here

When a company gets kicked off of a major exchange (like the NYSE), a process known as delisting, it lands on the pink sheets. This happens when the corporation no longer meets the minimum listing requirements, often as a result of an unfortunate financial event that endangers the company’s future. Investors who think the company will turn around can scoop up shares on the pink sheets, often at a fraction of its original listed share price.

The real attraction to pink sheet stocks is possibility—the chance that a tiny company will hit it big. In this age of innovation, where the next major breakthrough could come from one guy with a laptop working from his garage, the prospect of getting in on the ground floor of a future Twitter, Amazon.com, or the next big thing is very enticing. Even if the pink list stock never makes it onto a major exchange, it still has the potential to bring enormous returns due to the small initial investment.

Fairly recently, a tiered system was added to the pink sheets trading world to give investors a better idea of just how risky a potential investment may be. The five tiers are aptly named, giving investors crucial information with just a glance.

1. The trusted tier contains companies considered trustworthy. These companies adhere to listing guidelines and provide investors with information, and may even report to the SEC.
2. The transparent tier includes companies also listed on the OTCBB, which requires regular and current reporting to either the OTC Disclosure and News Service or the SEC. This reporting allows investors to see what’s going on w...