Trading Stocks

How do I buy shares?

• There are two main ways that you can buy shares in a publicly traded company; a) directly from the company via either an initial public offering or a later financing round (referred to as a seasoned equity offering) or b) from an existing shareholder.
• Let’s consider investing via initial public offerings.

Initial Public Offerings (IPO)

• Companies when they first list on a public exchange will offer the opportunity for financial institutions and individuals to buy shares directly from the company. This process is usually facilitated by an investment bank who manages much of the process.
• Buying shares via an IPO usually involves putting in an indication of the number of shares that you are willing to buy, or alternatively of the amount of money you want to invest in total. The company will either determine an exact price for each share or will offer an indicative price range that will be determined just prior to the listing.
• It is worth noting that pricing an unlisted company is extremely difficult. As a result, we often see that IPOs are on average under-priced, the price you pay for the share is below the price at the end of the first day of trading. However, while on average we observe under-pricing, there is a considerable range in outcomes with many IPO’s winding up overpriced.
• Compounding this problem is an issue called the winner’s curse. The winners curse notes that the most under-priced IPOs are often highly demanded resulting in rationing, where investors get only a proportion of the shares they requested. As a result, the best IPO’s result in earning great initial returns but on only a fraction of the desired investment, limiting the overall returns.
• Conversely, when you do get all the shares you requested it is often because the IPO has not been popular and as a result the price falls on the first trading day resulting in losses.
• Additionally, there is considerable research proving that IPO firms typically under perform for up to five years following the listing. Even when we match IPO firms against existing firms with similar characteristics, we find that the stock performance of the IPO lags.
• This means we are often better off not investing in an IPO firm.

Trading on Exchanges

• The predominant method of buying or selling shares is to use a stock exchange. As the name suggests, stock exchanges are designed to allow those wishing to buy a specific stock to locate someone willing to sell.
• The first exchange was founded in 1609 in Amsterdam in the Netherlands and was a physical location where buyers and sellers would meet. Today most exchanges are electronic markets but still serve the same primary purpose, enabling trades.
• There are hundreds of stock exchanges located around the world, and except for less than 30 countries, every country has at least one stock exchange.
• These range in size from the New York Stock Exchange, which is the largest exchange in the world with the companies listed on it worth nearly USD$25 trillion, to exchanges like Myanmar which in 2019 welcomed it’s seventh company on to its exchange. These exchanges, collectively, did over 60 trillion in trades in 2019!
• As an individual we cannot directly access the exchange, we need to go through a broker. In the past this involved calling your stockbroker, placing an order, and having them try to fill that order on the exchange on your behalf. While this can still occur, increasingly people are using online electronic brokers such as Robinhood, Webull or eTrade in the US, Saxo Bank or NinjaTrader in the EU or whatever is available in your location.

Trading Shares

• Market Order vs Limit Order
• Market Order – we trade immediately at the best available price. We could pay more than the current best price if there are not enough shares available at that price.
• Limit Order – an offer to trade at a specific price. A limit order may not execute if no one is willing to match your price. Limit orders are executed in the order of best to worst price, and if multiple limit orders at the same price, based on first in first out. Limit orders can protect buyers and sellers from sudden price changes when executing trades.
• Price Quotation
• The Order Book

Price Setting

• In addition to enabling trading, exchanges also play a key role in pricing stocks.
• The price of a stock is largely determined by demand and supply.
• The price is determined by the price at which people are willing to buy and the price at which people are willing to sell.
• When a buyer is prepared to match the price of a seller then a trade occurs, and this becomes the current price for the stock.
• The price will eventually settle at the point at which there are no buyers willing to match the price of sellers or vice versa.
• But what determines at what price someone is willing to either buy or sell?

What Drives Prices

• The price of a stock represents the present value of future cashflows.
• We can estimate price based on three variables: expected future cashflows, an appropriate risk premium, and an estimate of growth.
• Different traders will take different views on these factors resulting in different prices. They then compare their estimate with the current market price and buy or sell accordingly. Some will want to buy, some will want to sell based on the current price
• As new information comes to the market it will cause traders to adjust their view of the price. For instance, Apple announces a new iPhone traders will estimate future sales and adjust cashflows accordingly.

What information changes prices

• Anything and everything!
• Firm specific information. Such as earnings projections, new products, executive changes, strategy changes
• Industry information – news about competitors, and industry outlook i.e. changes from new technology or regulations etc.
• Macroeconomic -GDP, unemployment, inflation, business confidence etc. Tends to affect all companies. Legislation announcements/ government policies.
• In short anything that might impact cashflows, risk or growth for a company. As a result prices change frequently resulting in high volatility.

Summary

• It is worth noting that we have covered the basics of trading. There are more advanced trading options that electronic platforms allow people to engage in. For instance, people can engage in margin trading.
• Margin trading involves using your initial investment capital as security and allowing you to borrow against that security so you can buy even more shares. Effectively you borrow money to invest. The advantage of this is that you can dramatically increase your returns when the market increases, but the downside is that you can dramatically increase your losses if the market moves against you.

Activity

Watch the video that explains the pitfalls and perils of margin trading.

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