Financial Market Analysis
U N I T 2 – T H E S T O C K M A R K E T A N D I T S O P E R A T I O N S
Financial Market Analysis ACCT3602
1
Buying and Selling Shares
Specific to the Jamaican Stock Exchange (JSE)
A potential investor must contact a broker to buy or sell shares on their behalf.
The buying/selling process begins when an order is placed with the stockbroker for a specified number of shares in a company.
The trade is complete when the price matches a trade that is placed by a buying broker on the electronic trading platform with the price placed by a selling broker. Settlement is done T +2 days.
Trading on the Jamaica Stock Exchange is conducted on Monday to Friday between 9:30 a.m. and 1:30 p.m. through an electronic trading platform which was introduced in 2000.
The Jamaica Central Securities Depository 3
In 1998 the Jamaica Central Securities Depository (JCSD), a wholly owned subsidiary of the Jamaica Stock Exchange was established.
It is a facility for holding securities which enables share transactions to be processed by book entry.
A book entry system is an accounting system which facilitates the change of ownership of securities electronically between parties without the need for movement of physical documents.
Buying and Selling Shares 4
There are three types of orders that you can place:
A Market Order – asks your broker to buy or sell stock at the market price.
A Limit Order – sets the price at which you want stocks to be bought or sold.
A Stop Order – gives an approximate buying or selling price of stock.
When the approximate price is reached the stop order becomes a market order.
You will then receive a contract note that states the company whose stock you have bought or sold, the price paid or received, the commission and other fees and the settlement date.
You should pay your bill by the settlement date.
Placing an Order: Market Orders 5
Market Order is the simplest and most common. It is an order to buy or sell a security immediately at the best obtainable price.
The investor has no control on the amount paid for the stock’s purchase or sale as the price is set by the market.
For example, if an investor places an order to purchase 100 shares, they receive 100 shares at the stock’s asking price.
It requires that the shares should be traded at the most favourable price available which is the lowest obtainable price for a purchase, and the highest available price for a sale shares.
A market order poses a high slippage risk in a fast-moving market.
If a stock is heavily traded, there may be trade orders being executed ahead of yours, changing the price that you pay.
Placing an Order: Market Orders 6
Market-if Touched (MIT) Order
an order that will be executed only if a security reaches (touches) a specific price. For example, suppose Bob would like to purchase 100 shares of stock in Fortis, whose
share is currently trading for $25.50 but only after the stock price reaches $25.10 per share (trigger price). Bob will place a MIT order with a broker for these 100 shares. Once stocks of Fortis reaches $25.10 per share, the broker executes Bob's order as a regular market order.
MIT is used when investors wish to delay buying or selling a security until its price becomes more advantageous. A MIT buy order instructs a broker to execute the buy order once the security's market
price has fallen to a desired price.
A MIT sell order instructs a broker to execute the sell order once the market price has risen to a desired price.
Placing an Order: Limit Orders 7
Limit Orders
Places a limit on the price at which shares can be bought or sold. Thus it specifies purchase or sale of shares at maximum buying price or minimum
selling price, respectively. i.e. lower for a buy order and higher for a sell order.
It prevents investors from potentially purchasing or selling stocks at a price that they do not want. if the market price is not in line with the limit order price, the order will not be
executed.
A limit order can be referred to as: a buy limit order
a sell limit order
Placing an Order: Limit Orders 8
Buy limit order
specifies that the purchase should take place only if the price is at, or below, a specified level.
For example, consider a stock whose price is $11. An investor sets a limit order to purchase 100 shares at $10. In this scenario, only when the stock price hits $10 or lower will the trade be executed.
Sell limit order
specifies a minimum selling price such that the trade should not take place unless that price, or more, can be obtained.
Consider the stock above. An investor sets a limit order to sell 100 shares at $12. In this scenario, only when the stock price hits $12 or higher will the trade be executed.
A Limit order, therefore, ensures that if the order is filled it will not be filled
at a price less favorable than your limit price, but it does not guarantee a fill.
Placing an Order: Stop Orders 9
Stop Order or Stop-Loss Order is designed to limit or protect profits
and limit an investor’s loss on a trade.
It involves selling of shares after the price has fallen to a specified level, or buying after the price has risen to a certain level.
Therefore, it ensures that a selling price is not too low, or that a buying price is no too high.
For example, an investor is considering selling its position in a stock if it
declines to $8 from its current price of $12. The investor could place a stop order at $8. When the stock hits $8, the sell order would be executed.
Note that the stock will not necessarily sell at exactly $8 – it depends on the supply and demand of the stock. If the stock price is rapidly falling, the order may be executed at a price significantly lower than $8.
This type of problem can be minimized by a stop-limit order.
Placing an Order: Stop Orders 10
Stop-Limit Order
requires placing two prices – the stop price and the limit price. Once the stock hits the stop price, the order becomes a limit order.
Stop-limit orders, as opposed to a stop order, guarantee a price limit. On the other hand, a stop order guarantees an order execution but not necessarily at the stop order price.
For example, an investor currently owns a stock trading at $30. The investor would like to sell the stock if it dips below $25, but only if the stock can be sold at $24 or more. The investor sets a stop-limit order by setting a stop price of $25 and a limit price of $24. Once the stock drops below $25, the order becomes a $24 limit order.
Placing an Order: Timing 11
Another dimension to an order is the length of time for which it remains in force.
Fill-or-Kill Order
order is to be cancelled if it cannot be executed immediately.
Open Order, or Good-till-Cancelled Order
order remains in force until it is specifically cancelled by the investor.
Stock Market and its Operations 12
When a security is traded, a dealer, operating as a market-maker, quotes a price at which he/she is prepared to sell – the ask price – and a price at which he/she is willing to buy – the bid price.
In the transaction the investor pays the ask price and the dealer pays the bid price. Ask price – the price at which market maker is willing to sell a security, also called
an offer price.
Bid price – the price at which market maker is willing to buy a security.
The ask price is always above the bid price and the difference between the quoted bid and the ask price is called the bid–ask spread. This is the profit of the dealer: Spread = ask price – bid price.
Stock Market and its Operations 13
Example: Company’s shares are quoted by a dealer as bid and ask price for $49.2 and $50.00 respectively. The bid-ask spread in percentage is:
Spread = ($50.00 – $49.2)/ $49.2 = $0.8 / $49.2 = 1.63%
If investor purchases the share and then immediately sells it before the market price of the share changes, he will incur a cost of 1.63% of his investment for the round-trip transaction.
The market bid-ask spread is the excess of the lowest ask price over the highest bid price and is normally smaller than the spreads of individual market-makers.
Stock Market and its Operations 14
The bid-ask spread of dealers can be seen as the price to be paid by investors for his services.
From the perspective of the dealer the spread can be seen as a compensation for his costs and risks. The dealer typically holds an inventory of securities during the day to be able to sell (and
buy) immediately.
From his return (i.e., the bid–ask spread), the dealer has to cover the costs of holding his inventory (e.g., interest costs of financing the securities inventory) and the risks (e.g., prices may move while the securities are in the inventory).
From the perspective of investors, dealers (in their role as market-makers) provide two important services: possibility to execute a trade immediately from inventory, without having to wait for a
counterparty to emerge.
maintenance of price stability in the absence of corresponding sell or buy orders.
Stock Market and its Operations 15
By trading from their own stockholdings, dealers reduce price fluctuations. The dealer costs include the administrative costs of transferring shares.
The dealer risks arise from price fluctuations and information-based investors.
For shares that are infrequently traded, such as shares in smaller companies
the risks are greater, because positions are held for longer periods between trades.
If shares are held for a long time, the risk of losses from price falls is greater. the bid-ask spreads for such shares tend to be relatively high.
Stock Market and its Operations 16
Dealer risk is also related to the possibility of investors possessing information that the dealer does not. Such investors are able to make profit at the expense of the dealer.
Investor can sell shares to the dealer at a high price, while he is informed about a possible fall of share price. As a result the dealer may suffer the loss from a fall in the share price. The bid-offer
spread is to provide the dealer with compensation for bearing this kind of information risk.
Dealers have a possibility to negotiate special prices for large transactions. The spread can be broader for particularly large transactions (i.e., block trades) to
cover the price risk of such block trades before the dealer can sell or buy the bought or sold securities to or from other dealers in the market.
Stock Market and its Operations 17
The spread is influenced by the following factors:
order costs – costs of processing orders, including clearing costs and costs of recording transactions;
inventory costs – include the costs of maintaining an inventory of particular shares;
competition – the larger the number of market makers, the greater their competition, and the narrower is the spread;
volume – the larger the trading volume, the more liquid are the shares, the less risk of share price change;
risk – the more risky are company operations, the more volatile are its shares, the higher spread is set.
Stock Market and its Operations 18
Several research studies showed that bid-ask spreads on specific large stock exchanges are wider as they should be. Due to specific trading practice, market makers kept their profits margins wide.
Some analysts called this phenomenon “under-the-table-payment” for order flow or the right to execute customers’ trades. Order flow – the right to execute customers’ trades.
Therefore it abuses small investors, who do not receive the best price for their quotes.
Margin Trading 19
Investors can borrow cash to buy securities and use the securities themselves as collateral.
A transaction in which an investor borrows to buy shares using the shares themselves as collateral is called margin trading or buying on margin.
Investor borrows money or shares from a broker to finance a transaction. Funds provided by the broker are borrowed from a bank.
The interest rate that bank charges broker for funds for this purpose is called the broker call rate or call money rate. The broker charges the borrowing investor the call money rate plus a service charge.
Margin Trading 20
Stock exchange regulations set margin requirement brokers cannot lend more than a specified percentage of the market value of the
securities.
The aims of margin requirement are: to discourage excessive speculation
ensure greater stability in the markets
Margin requirement has to ensure that investors can cover their position in case the value of their investments into shares reduces. the possibility of default on broker loans should also reduce
Margin Trading 21
In order to purchase shares on margin investors have to create a margin account with a broker.
They will then need to pay the initial deposit of cash (initial margin) The amount of cash or securities that must be deposited as guarantee on a futures
position. The margin is a returnable deposit.
Stock exchange regulations set initial margin requirement which is the proportion of the total market value of the securities that the investor
must pay as an equity share
the remainder is borrowed from the broker
Maintenance Margin the minimum margin that an investor must keep on deposit in a margin account at
all times.
Margin Trading 22
Important note:
For securities, the definition of margin includes 3 important concepts: The Margin Loan - the amount of money that an investor borrows from his broker to buy
securities.
The Margin Deposit - the amount of equity contributed by the investor toward the purchase of securities in a margin account.
The Margin Requirement - the minimum amount that a customer must deposit and it is commonly expressed as a percent of the current market value.
The Margin Deposit can be greater than or equal to the Margin Requirement.
We can express these as equations:
Margin Loan + Margin Deposit = Market Value of Security
Margin Deposit >= Margin Requirement
Short Selling 23
In a short selling, investor place an order to sell a security that is not owned by the investor at the time of sale. Investors sell the stock short (or short the stock) when they expect decline of the stock price. The investor borrows the security from the broker and sells it on the open market and plans to
buy it back later for less money.
To cover their short position, investors must subsequently purchase the stock and return it to the party that lent the stock. The owner of the stock is unaffected when his shares are borrowed and is not aware that the
shares were lent.
If the stock price declines by the time the short-seller repurchases it in the market, the short seller earns a profit from the difference between the initial selling price and the
subsequent repurchase price of the stock.
However, his profit will be less, if he has to pay to the owner of the borrowed stock dividends, which the investor would have received if he had not borrowed the stock.
Short Selling 24
The risk of a short sale is that the stock price may increase over time
forcing the short-seller to pay a higher price for the stock than the price at which it was initially sold.
Stock markets and financial analysts provide information on level of short sale.
Twice a month, brokerage firms are required to report the number of shares that have been shorted in their client accounts.
This information is compiled for each security and then released to the public.
By monitoring changes in a stock's short-interest figures, investors are able to gauge the public's level of pessimism toward the stock.
Short Selling 25
Several indicators are used to measure the short position on stock:
The degree of short positions
It is a ratio of the number of shares that are currently sold short, divided by the total number of shares outstanding.
Statistics shows, that most often this measure is in the range of 0.5- 2%.
A high measure of 3% shows a large number of short positions in the market, which may indicate that a large number of investors expect the stock price to decline.
Short Selling 26
Short interest ratio for specific shares The short interest ratio is a mathematical indicator of the average number of days it
takes for short sellers to repurchase borrowed securities in the open market; calculated as the number of shares which are currently sold short, divided by the average daily trading volume over a one-month period.
The higher the ratio, the higher the level of short sales. A ratio of 20 or more reflects an unusually high level of short sales, indicating that many
investors believe that the stock price is currently overvalued.
For some stock this ratio may exceed 100 at particular points in time.
Short interest ratio for the market The higher the ratio, the higher the level of short selling activity in the market
overall.
Investors, who have established a short position, quite often request a stop-buy order to limit their losses.
Stock Trading Regulations 27
Stock market regulations aim at ensuring fair treatment of all investors in the market.
Stock trading is regulated by national securities exchange commissions and by individual stock exchanges. It is widely understood, that the development of financial markets and success of new issues
of securities cannot be handled without efficient and fair secondary stock markets.
Analysis of average real returns on stock in the well developed markets indicate that historically it has been about 6% percent higher than return on Treasury bills, which reached on average only 1% p.a.
The difference between the return on stocks and the risk free- rate is a measure of risk premium on equities. However, the size of this risk premium is not justified by the stock market’s risk exposure if
only investors are assumed to be unreasonably averse to risk. The research has shown that only 0.35% of an equity premium can be justified as risk premium. Such persistent overpricing of risk premium is called an equity premium puzzle.
Stock Trading Regulations 28
Equity premium puzzle is the persistent overpricing of risk premium on stocks.
If the equity premium puzzle is the result of security mispricing, then there is an arbitrage opportunity. It means that investor can gain by borrowing at the Treasury bill rate and investing in stocks.
Borrowing limitations and transaction costs may reduce this arbitrage profit, but not eliminate it.
The concern about the fair and ethical stock market trading require imposing discipline on individuals and institutional investors. The organized stock exchanges introduce surveillance of all transactions at the exchanges.
Computerized systems are installed to detect unusual trading of any particular stock.
Any abnormal price or trading volume of particular stock or unusual trading practices of market participants is investigated.
Stock Trading Regulations 29
Additional regulations on imposing good corporate governance practice for listed companies are imposed through introduced corporate governance codes.
Regulations require disclosure of financial statements, having a majority of independent directors (not employees of the companies) on their boards of directors. Such requirements are aimed at reducing existing or potential conflicts of interest
between management and minority as well as majority shareholders, focusing management on maximizing stock value for company shareholders.
Specific regulation concerns are related to restrictions on trading in case of market downturns.
Stock Trading Regulations 30
Trading halts may be imposed on particular stocks if stock exchanges believe that market participants need more time to receive and absorb material information, which can affect stock price. Such trading halts are imposed on stocks that are associated with mergers and acquisitions,
earning reports, lawsuits and other important news. The purpose of them is to ensure that market has complete information before trading on the
news.
A halt may last a few minutes, hours or several days.
Trading is resumed after it is believed that the market has complete information. This does not prevent investors from a trading loss in response to the news. However, it can
prevent from excessive optimism or pessimism about a stock, and can reduce stock market volatility.
Drawbacks of trading halts are related to slowing down the inevitable adjustment of stock prices to the news.
Stock Trading Regulations 31
Stock exchanges can impose circuit breakers, which are restrictions on trading when stock prices or stock indexes reaches a specified threshold level. Circuit breakers – automatic halts or limitations in trading that are triggered upon the
attainment of certain stipulated price moves.
The necessity of such restriction became vivid during stock market crashes, e.g of NYSE in October 1987 and the later ones including Flash Crash in 2010. When market maker swamp market with sell orders, stock prices cannot reflect the fair value
any longer and move into a freefall.
The market experiences huge liquidity crisis, which feeds panic and exacerbates the price decline.
As a result of such experience, in order to provide time for market participants to regroup and obtain backup sources of liquidity, a series of circuit breakers are put to use.
Stock Trading Regulations 32
In February 2013, the U.S. Securities and Exchange Commission (SEC) introduced new market-wide circuit breakers rules. The S&P 500 index was chosen as the new benchmark, replacing the Dow Jones . The percentage decline of the market index is calculated based on the prior-day closing price of the
S&P 500.
The market index percentage changes were split into three tiers. Level 1 tier sets up a threshold of 7% decline, level 2 circuit breaker triggers at a 13% decline, and
level 3 sets up a benchmark of a 20% slump. Levels 1 and 2 halt the trading for 15 minutes if a market drop occurs before 3:25 p.m. If the
decline occurs at or after 3:25 p.m., the trading continues. Level 3 stops the trading for the remainder of the trading day in any circumstances.
NASDAQ and other large international exchanges impose similar circuit breakers. 50 point collar – provision that prohibits computer assisted trading if Dow Jones Industrial
average index rises or falls by 50 points. 250 point rule – provision that halts all trading for one hour if Dow Jones Industrial average
index falls by 250 points in a day.
Stock Trading Regulations 33
JSE Circuit Breaker Rule
No stock should trade +/-15% from the close price or the effective close price at the opening of the market. The effective close price is determined whenever the closing bid
is greater than the close price or whenever the closing ask is less than the close price.
Use the closing bid as the effective close price, if the value is greater than the close price or use the closing ask as the effective close price, if the value is less than the close price.
However, during the day if the Circuit Breaker is triggered for a security, the security will be halted for an hour to allow for the release, circulation and absorption of any
relevant market news and a cool down period while investors consider their options.
After the hour has passed the security will be released for trading and the new reference price, which is a simple average of the trigger price and the close price, will be used to determine the trade range for the remainder of the day. The price of the trade that triggered the Circuit Breaker should not be +/-15% outside of the original prescribed price band. The stock will not be allowed to trade +/- 15% of the new reference price.
The Stock Market and Covid-19 34
The market has reacted to recent unpredictability with large drops, triggering
a market wide circuit breaker four times in March 2020.
The safeguard pauses trading for 15 minutes in hopes the market will calm.
The U.S. Securities and Exchange Commission mandated the creation of market-wide circuit-breakers to prevent a repeat of the Oct. 19, 1987 market
crash, in which the Dow Jones plunged 22.6%. Since then, they have only been triggered once in 1997 before the four times March 2020.
The S&P 500 triggered level 1 market wide circuit breakers during the
opening hour on March 9, 12 and 16 based on drops of 7% from the previous close, and tripped later in the day on the 18th. Trading also halts on both the
Dow and the Nasdaq when a circuit-breaker is triggered on the S&P 500.
The Role of Speculation 35
Speculation is the practice of engaging in risky financial transactions With an attempt to profit from fluctuations in the market value of tradable goods
such as a financial instruments
rather than attempting to profit from the underlying financial attributes embodied in the instrument such as capital gains, interest, or dividends.
When investors become speculators they are purchasing a stock (speculative stock) with the sole purpose of selling it to
someone else at a higher price.
At the same time, it carries an unusually high level of risk.
The concepts of hedging and the futures market become relevant in explaining the role of speculation in determining stock prices
Speculative Stocks 36
There is a relationship between risk and expected return, as we have seen. Speculation by definition involves a short time horizon, and a speculative stock is
one with the potential to make its owners a lot of money quickly. At the same time it carries an unusually high degree of risk. In other words a speculative stock has a high probability of a loss and a small probability of a
large profit. The potential for a large profit is the attraction.
Some analysts consider speculative stocks to be a growth stock at the far end of the risks spectrum. Most people would classify the computer company DELL (DELL, NASDAQ) as a growth stock
rather than a speculative stock. DELL has never paid a dividend so it clearly is not an income stock.
A new formal computer software company also paying no dividends would probably be considered a speculative rather than a growth stock by most investors. Speculative stocks tend to be relatively new companies and in recent years have been heavily
represented by electronic and technology terms.