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INVESTING IN STOCK MARKET.
Term Paper ID:28832
Essay Subject:
Examines 2 common investment vehicles & guidelines: stocks & commodities. The Stock Market, Future Markets, Types of investors, Principles of trading, Risk factors. Table of Contents.... More...
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Paper Abstract:
Examines 2 common investment vehicles & guidelines: stocks & commodities. The Stock Market, Future Markets, Types of investors, Principles of trading, Risk factors. Table of Contents.
Paper Introduction:
Table of Contents
Introduction
Stocks
The Stock Market
Types of Investors
Futures Markets
Futures Markets and Risk Aversion
The Reliability of the Risk Aversion Model
Principles of Trading
Trade with the Trend
Cut Losses Short
Let Profits Run
Manage Risk
Conclusion
Bibliography
Text of the Paper:
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These participants in the market are interested inmaking a profit based on the difference between the price of the contracttoday, and the future price of the commodity. If the market is "bullish" on a stock (thatis, the market favors the stock), the price is likely to rise and fundmanagers are likely to purchase shares. The result is that more people than ever are now participatingin these markets, but many lack the experience to understand fully theramifications of their actions. There are guidelines for commoditiestrading which can be expanded to include investing in stocks, as well, andthese guidelines also highlight the difficulties associated with realizingprofits in these markets. Thesemutual funds are run by fund managers, who handle very large sums of moneyand who exercise a great deal of influence over the market. Nearly all of the traders thatBabcock interviewed indicated that they enter trades with acceptable lossesin mind, and many built stops into their trade to keep their losses to aminimum.[14] As with other types of transactions, the key to keepinglosses to a minimum in commodities is defining ahead of time at what pointthe investor will end the trade. Such aversion is held to allow futures prices to diverge from theexpected future spot price. With legislation favoring retirement accounts, individuals arealso investing through individual retirement accounts (IRAs) and 4 1(k)plans as well as through their pension plans offered at companies. This action alone can drive up the priceof a stock, and the goal of these investors may not be to make money on thestock itself, but to gain control of the company and change the way inwhich the company is run. The art here isto allow the profits to run so long as they are moving upward, and not tostop the trade prior to exhausting the run of the profits, even when theremay be a temporary downturn. Miami: KolbPublishing Co., 1994, 1 8. This means that variables suchas seasonality is taken into account, but that contratrend trading is keptto a minimum. Over the years, secondary markets have evolved for commodities inwhich the buyers have no intention of actually taking delivery of thecommodity in question. The opposite is true when a stockis perceived as "bearish." The market as a whole has typically gonethrough similar cycles throughout this century, although its recentperformance has been marked by record highs and one of the longest andstrongest bull markets in anyone's memory. If the managerof a major fund moves out of a stock, that can trigger a significantdownward effect on the stock's price.[4] Fund managers (who also include those responsible for corporatepensions and insurance funds) are interested not only in the fundamentalfinancial strength of a particular company, but also in how the "market"views a stock and an industry. Stocks Companies have two ways to raise capital: they bring in additionalowners, each of whom contributes capital; or, they can borrow the money.The instrument most often used for the first option is stock; bonds(commercial paper) or loans are the typical ways in which companiesborrow.[1] When someone purchases stock in a company, they are becoming anowner of the corporation in exchange for their investment. A risk-averse investor, for example, mayown shares of competitors (such as Wal-Mart and Kmart) to hedge the riskassociated with either one. New York: McGraw-Hill, 1996.Deaves, Richard, and Itzhak Krinsky. There is also a high level ofmargin trading in the commodities markets, which means that participants donot pay the full amount for the contract, but only a percentage; the restcomes due when the contract is to be fulfilled, or when it is sold again.The rise of the secondary markets, similar to the stock markets, has led tocomplex transactions and a high level of risk for participants in somecases.[6] Futures Markets and Risk Aversion Traditional analysts hold that risk aversion does affect futuresprices. Fund managers comprise another important segment of investors. "Do Futures Prices for Commodities Embody Risk Premiums? Kolb, Understanding Futures Markets. NY: Cambridge, 1994.----------------------- [1]Roger McNamee, "Your Road Map to Spectacular Returns," Forbes, 2December 1996, S235. In the meantime, theshareholders are responsible for hiring a board of directors to protecttheir interests; the board, in turn, hires managers to run the company on aday-to-day basis in accordance with the direction that the board has set onbehalf of the investors. All of the tradersthat Babcock interviewed agree that risk management is critical tosuccessful trading since failure to account for risk will result in long-term failure overall. If the price of lumber hasgone up, the buyer has effectively made a profit (if he is reselling thelumber); if the price goes down, it means that the buyer could have boughtthe lumber for less money if he had waited and paid the "spot" (current)price for the lumber. [16]Ibid., 142. [6]James Unterschultz, Frank Novak, Donald Bresee and Stephen Koontz."Design, Pricing and Returns of Short-Term Hog Marketing Window Contracts."Journal of Futures Markets, September 1998, 725. [11]Ibid., 78. Globalization, including advances intransportation and telecommunications, has resulted in investors being ableto purchase stocks and commodities around the world, and even through theInternet. Theseinvestors may check their stocks daily, but are not able to respond quicklyto sudden changes in the market. [3]Cheryl Strauss Einhorn, "The Lows are In," Barron's, June 14,1999, MW11. The traders that Babcock interviewed are less uniform inthe ways that they manage profits, but all agree that allowing profits torun is, to some degree, critical to long-term success.[15] Manage Risk Risk management in the commodities markets can require everything frommanaging the portfolio's asset allocation to reading crop reports. These traders typically never take delivery of the productsin which they trade, but instead use highly sophisticated tools to helpthem realize the greatest benefit from their activities. Understanding Futures Markets. [2]Ibid., 236. [4]Jeffrey Williams, The Economic Function of Futures Markets. Table of ContentsIntroduction 2Stocks 2The Stock Market 3Types of Investors 5Futures Markets 6Futures Markets and Risk Aversion 7The Reliability of the Risk Aversion Model 9Principles of Trading 1 Trade with the Trend 1 Cut Losses Short 1 Let Profits Run 11Manage Risk 11Conclusion 12Bibliography 14 Introduction Today's headlines are filled with news of individuals who have becomemillionaires in initial public offerings as well as with news of companieswhich are breaking new technological ground. Some companiespay dividends on stock, which is how investors receive a return on theirinvestment; other investors expect to be able to sell their interest in thecompany for more than they initially invested. BibliographyBabcock, Bruce. NY:Cambridge, 1994, 17. Thenext investor might sell the stock again, and the cycle continues withlittle or no control exercised by the company whose stock is thus beingfreely traded in the open market. Riskaversion is not seen by traders interviewed by Babcock as being critical totrading success, but managing risk in general is a critical successfactor.[16] As with profit running, different traders have different approaches tomanaging risk with some basing their decisions on the amount of money theyhave in particular commodities while others use a percentage approach.Still others consider the risk not of the portfolio as a whole, but insteadof the individual trades at a particular point in time. While speculators mayoccasionally make mistakes in the way that the information they receive isprocessed, they generally process the information efficiently. The Economic Function of Futures Markets. Theinvestor contributes cash to the fund and the fund invests in variousstocks and bonds in order to offer strong returns to the investors (whocould easily sell their shares in the fund and move to another). Today, the stock market is an integral part of the American economy.Individuals are dependent on stocks not only of the companies where theyare employed, but also on stocks of companies that they may own throughmutual funds or pension programs. "Your Road Map to Spectacular Returns." Forbes, December 2, 1996, S235-S236.Unterschultz, James, Frank Novak, Donald Bresee and Stephen Koontz. [15]Ibid., 11 . This has led to futuresprices (based on delivery date) and futures spot prices (which is theactual price at the time of delivery). Thus successful traders are notnecessarily the first ones into a particular commodity, but they ensurethat there is a trend toward that commodity which will sustain trading.For some traders, this can mean watching 3 and 6 day averages.[13] Cut Losses Short Cutting losses short is an ideal goal for all investors, but the keyin the commodities markets is understanding when losses are indeedtemporary, and when today's losses are not likely to be made up in thefuture. In thisway, an investor in Company A can sell his stock to an individual that hemay never meet for a price higher than the original investor paid. Let Profits Run Letting profits run in the commodities market is not different fromletting profits run in the stock market. It is with a newly restructured company, perhapsone that is more appealing to the market, that these investors intend torealize their profit. [8]Ibid., 1 9 [9]Ibid., 111. Ifhedgers have a long position in a commodity, the futures price is above theexpected future spot price and the price of the contract falls over itsterm; this is called a contango commodity (when prices fall over thecontract term).[9] The Reliability of the Risk Aversion Model In recent years, some analysts have questioned the assumptionsassociated with the backwardation and contango approach to commodities.Specifically, these analysts hold that the basic assumption that futuresmarkets are isolated and explicit markets is in error.[1 ] The use of risk aversion in considering futures markets stems from thetendency of economists to consider commodities in the same way that theyconsider other types of trading. It is this secondary market which isreported on the evening news (such markets exist throughout the world) andpublicly held companies (those that are traded on these exchanges) workdiligently to put forth only positive information about their financial andmarketing performance.[3] Some investors are acutely aware of all of the stocks that they own;other investors choose to invest in mutual funds and have little or noknowledge of the stocks which are included in their portfolios. [1 ]Jeffrey Williams, The Economic Function of Futures Markets. In addition to thoseindividuals who participate in the stock market, there are also traders whoparticipate in the contracts and futures markets, which are involved withcommodities. [13]Ibid., 2 . Acting through their companies, these so-called"raiders" target companies for takeovers and then purchase a largepercentage of outstanding shares. Because ofthis, their expectations are generally realized and expectational errorsare randomly distributed around the true price that the commodity will havein the future.[7] Speculators might consider the prices in a futures market and findthat those prices match the expected future spot prices. Companies today not onlypurchase their own stocks, but the stocks of other companies, and theentire stock market system is now integrally and inextricably tied to theeconomy as a whole in a global manner that cannot be undone. Thesemanagers are responsible for millions of dollars and invest it on behalf ofothers; when the funds perform well, the managers are doing their jobs.Because of the size of the accounts involved, these investors are highlyinfluential in determining whether a stock moves up or down in the market.Large individual investors, while rare, have also played a significant rolein the stock market. [12]Bruce Babcock, The Four Cardinal Principles of Trading, New York:McGraw-Hill, 1996, 2. As with minimizing losses, itrequires that the investor define a successful trade ahead of time and bewilling to modify that information as the market changes. "The Lows are In." Barron's, June 14, 1999, MW11.Kolb, Robert W. When the commodity is agricultural (such as corn), the harvest might notbe as strong as initially anticipated, leading to an increase in prices.On the other hand, if farmers raise a bumper crop, prices fall. With the advent of modern computers and telecommunications, it is nowpossible for individuals and institutions throughout the world to invest incompanies located on the other side of the globe, and to do so usingentirely electronic transactions, with only paper receipts detailing themillions of dollars which may be involved. NY:Cambridge, 1994, 111. The contract ispaid for now, and in six months, the buyer takes delivery of the lumber.However, the nature of commodity markets means that there have likely beenchanges in the price of lumber in the meantime. For most successful traders, trading with the trend meansbeing able to identify a trend as it is developing, and monitoring thetrend to ensure that it does develop. Large institutions, including insurancefunds and others with large sums of cash, have turned to the stock marketas a way to realize strong rates of return on their investments. Principles of Trading In his book, Bruce Babcock puts forth four principles associatedprimarily with commodity trading, but which can be applied to the stockmarket, as well: trade with the trend, cut losses short, let profits run,and manage risk.[12] Trade with the Trend Trading with the trend is, according to the traders interviewed byBabcock, critical to success in the market. However, entering the market despite these conditions doesentail a certain amount of risk for the speculator since his expectationsmight be incorrect. "Design, Pricing and Returns of Short-Term Hog Marketing Window Contracts." Journal of Futures Markets, September 1998, 723-742.Williams, Jeffrey. Miami: Kolb Publishing Co., 1994.McNamee, Roger. In this situation, risk averse speculators would notenter the market because there is additional risk (the risk that theexpectations are incorrect) without compensation.[8] Futures prices tend to rise over the life of a contract because of thehedgers' desire to be short; this is called normal backwardation and is atendency that is associated with John Maynard Keynes. It is because of this price volatility thatcommodity contracts have taken on their peculiar nature.[5] There can be several reasons which contribute to the change in prices. [7]Robert W. Types of Investors Investors in the financial markets include the "little" investor, whois an individual with some savings that he is willing to put into the stockmarket. This risk aversion is generally held to be dueto the idea that speculators make assessments for expected future pricesbased on rational and available information. When this is thecase, there is no reason to speculate in futures because there is no profitto be made. [5]Richard Deaves and Itzhak Krinsky. "Do Futures Prices forCommodities Embody Risk Premiums?" Journal of Futures Markets, September1995, 637. This leads economists to consider that the multiplepositions represents portfolio diversification, which stems from riskaversion. The Four Cardinal Principles of Trading. In this way, forexample, a buyer might agree to buy 1 , board feet of Canadian lumberfor some amount per foot for delivery six months from now. This means that participants who sell futures contracts do sobecause they are risk averse.[11] However, critics of the risk aversion approach to commodities willcite that the investor who holds both Wal-Mart and Kmart stocks may wellhave taken a short position in one (such as Wal-Mart) and is actually notrisk averse so much as he is speculating on the performance of Wal-Martrelative to Kmart. Futures Markets Fundamentally, the futures markets deal in contracts: the buyer of afutures contract agrees to pay a particular price for a particular good (ina particular quantity) at some point in the future. Over the term of afutures contract, the price moves toward the cash price, thus rising. This researchexamines these two common investment vehicles and considers guidelineswhich might help individuals and companies realize the greatest benefit. Thus combinations of positions may not indicate riskaversion. Similarchanges in production account for changes across most of the commodities(changes in currency prices are due to government policy rather than achange in production, but can also be related to supply and demand ascentral banks tighten or loosen monetary controls). [14]Ibid., 98. For successful traders, this means having an exit strategy inplace, or at least entering a trade with the understanding of whatconstitutes both success and failure. However, greed and caution can get the betterof some traders who will end a trade prior to realizing the full potentialof the profits. Journal of Futures Markets, September 1995, 637-648.Einhorn, Cheryl Strauss. At this level, stockholders are interested in theperformance of the company from both a short-term and long-term basis, andare likely to consider the company's financial performance and market planas key factors when determining where to invest their money.[2] The Stock Market Stock markets make it possible for investors to buy and sell stockswithout ever dealing directly with the company issuing the stock. A hedger in the commodities market may wellhave several positions, including the physical commodity as well as afutures contract. Conclusion Understanding the various investment instruments, including stocks andcommodities, available to investors can help individuals and companiesmanage their assets better. For those traders who are able to put theseguidelines into practice, however, the rewards can be considerable. EvenOrange County, California, a municipality, invested in the stock marketthrough derivatives, and ended up declaring bankruptcy because of poorinvestment choices.
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