THE STOCK MARKET

In this lesson, we learn the basics of the stock market. The easiest way to think about the stock market is to think that it’s like a market where people trade a share or business for money with other people. If we didn’t have a stock market, people would still be able to trade part of businesses, but it would be more complicated. You would have to match a buyer with a seller, and you would incur a lot of transactions costs while setting up every single deal. The stock market does all that for you. The buyer doesn’t even have to know each other, and a deal can be struck in less than a second. This lesson also teaches you the following points:

1) How Does the Stock Market Work: If you own a piece of a business, you can sell your share in the stock market. When a buyer and a seller agree on a price, the ownership of the stock is transferred and the money is going in the other direction. When you see that there are many sellers for a particular stock, the stock price will gradually decline, but it’s important to remember that there is always a buyer and a seller in each trade. If fewer people were interested in buying, the price would simply decline down to the best bidding price.

2) Who is Mr. Market: Benjamin Graham, Warren Buffett’s professor at Columbia, first introduced the fictitious character Mr. Market. Mr. Market is his metaphor for the mood of the stock market. When the market’s in a good mood and high in spirit, the prices soar. You can also advantage of that by selling your stock; however, when he is in a sour mood, the prices plummet; thereby letting you take advantage and buy at discounted prices. Graham taught Buffett that he should always remember that Mr. Market should be your servant and not your guide.

UNDERSTANDING THE STOCK MARKET

Here are two demonstrations to start with:

• The market where people trade money for food
• The market where people trade money for proportional ownership of real companies

Picture a mother with her little boy where he wants to buy a peach from a vendor. He asks about the price of one peach and the vendor says that it’s $1. Who determined the market price of the peach if the boy decided to buy it for $1? Was it the vendor or the boy? It was both of them. The boy had to agree to the price the vendor wanted. The value of something is only what people are willing to buy, sell, and meet in the middle.

How will the price of that peach change if we changed the sellers? Let’s assume that there are 5 different peach vendors lined up next to each other, competing for one consumer – the little boy. Every vendor wants to sell his peach to him. The more vendors with the same product, the more options the boy has. The boy can say, “You want one dollar, but the vendor beside you wants 90 cents. Can you beat the price?” Sellers compete with prices and the little boy has the control, simply because he is the buyer.

Now, if there’s just one peach vendor and there are a hundred little boys who want peach, the seller now has the ability to control the market price. This is what we call the buyers’ market versus the sellers’ market.

The stock market is exactly the same. There are buyers and sellers. When the sellers outnumber the buyer, it is called the buyers’ market. When there are fewer sellers than buyers, it is called the sellers’ market. In the last scenario where there are fewer sellers than buyers, the sellers are changing the value of the company or the shares. That’s something you need to understand because it is fundamental.

One share and one seller. You’ll see how stock markets really work. Here’s an example of what determines the market price:

A shareholder named Amy has one share from Johnson and Johnson, which she wants to sell for $65. She has the option to work with the broker, the bank. This could be a trade, e-trade, or just any other broker. Brokers break the deal by linking a seller and a buyer who will soon exchange their assets. Amy has the ability to put it on the market for one day for her $65$ share or set it up for a 30-day trade where she has 30 days to find a buyer.

First type: The stock order is when somebody is willing to buy Amy’s share for $65. Amy will say, “Broker, you are not allowed to trade my share, unless somebody is willing to buy it for 65$.” If she had a hundred shares and wanted to sell all of them, she would put it on a stock order of $65. If the first buyer only wanted to buy 10 shares for $65 and then another buyer wanted to buy the remaining 90 but is only willing to buy it for $64.90, Amy’s shares will all be executed under that stock order. Even though she set it for $65 and not all shares are executed in the first order, it will be executed in the second-order, regardless of the difference in price because that’s what the buyer wants.

Let’s assume that, Trevor, a buyer, comes in and puts up a stock order of $64 for Johnson & Johnson. Amy is trying to sell it for $65, but Trevor doesn’t want it to buy at $65, which means that there is a discrepancy.

Assume that all the sellers in the market want to sell their shares for $65 and if every single buyer would only buy it for $64, no trades will happen in this particular stock. For every transaction, the buyer and the seller both have to agree on the trading price for a trade to occur and the market price to display that.

Assume that Amy and Trevor stick to their stock order – Amy at $65 and Trevor at $64. All of a sudden, Kurt, another seller, wants to sell his share of Johnson & Johnson. He’s on the same sellers’ side as Amy. Instead of putting in stock order, he puts in a market order. Kurt is basically saying “Any buyer willing to buy one share of Johnson & Johnson from me will get it for whatever amount someone is willing to sell it for”. Since Kurt does that, the trade is executed between Kurt and Trevor for $64. Amy is still sitting there wanting to sell her share for $65, but the market price will now be displayed at $64 a share.

Let’s look at this from the opposite perspective. Amy is the only seller offering her one share for 65$. Trevor and Linda are buyers and though Trevor has the stock order for $64, it’s not what Amy wants. Linda comes along and puts in a market order saying “I’ll buy a share at whatever price the seller wants.” Linda executes the share at $65 and this makes the market price move to $65.

Both sellers have executed their shares. While Kurt sold his shares to Trevor, Amy sold hers to Linda. During that cycle where we saw three shares being traded, the market price went to $64$ and then to $65. Does this mean that the company is worth $65 a share or did people trade it for $65 and now it’s nothing more than the trading price? Most value investors argue that the latter is just a price that people establish. However, considering the number of owners out there trading their shares, the conclusion is that they agree with the market price or else they won’t be selling or buying their shares. Just because something is trading at $65 a share, it doesn’t necessarily mean that the company is worth $65 a share. Value investing is determining what the share is worth. It’s about identifying people who are willing to buy and sell it and capitalizing on that.

Here is a demonstration of a limit order. Let’s assume that Amy still wants to sell her share for $64 or higher. If the price is $65.10, she will still sell it. As long as the price is higher than $65, she wants to sell her share. Now, Trevor wants to buy one share and he puts in a limit order for $64. If he wants to buy, it can’t exceed $64, which means that he won’t pay a penny more than $64. In this scenario, there was the only seller and the only buyer of that one share. You’d see no trades executed because they can’t agree on the price. Once again, Kurt enters and puts a market order saying he’s willing to sell his share for any amount the buyer wants. Now, the market price displayed is $64.

For every single trade, there’s always a seller and a buyer. For Amy, she sold her share because she couldn’t make any money off it. Linda buys it because this company will make a lot of money, according to her. They trade the shares and while one thinks it’s a piece of junk, the other thinks that it’s a great company that makes lots of money. Kurt was selling his share because he needed money. Although he still thinks that the company is great, he sold it because he needed the money. Trevor buys it because he thinks it makes money. You see, sellers have different reasons, but buyers only have one: “I’m buying this because this is a good company.”

The majority of people don’t determine the price, but only a few do. When you notice that it’s going up and down, it’s because sellers don’t want to sell their shares for any less than what they could make, and buyers don’t want to buy their shares for any more than what they would have to pay for.

One of the things Benjamin Graham taught in his class with Warren Buffett was this idea of Mr. Market. Mr. Market is his emotionally disturbed business partner and you can’t change his behavior. All you can do is react to it. Mr. Market is your servant, not your guide. Graham describes him this way: Mr. Market might come out and say, “Hey, guys! Buy stocks and make lots of money!” He creates these plans and motions behind the market, telling everybody that he’s not just making tons of money, but his neighbors are benefitting as well. Mr. Market can also be someone who has a horrible attitude. “Watch out, I’ll take all your money, and tomorrow is even worse than today! Don’t even ask. If you thought you’ll make money in the stock market, you’re just kidding yourself!” These are the personalities Mr. Market has.

Never follow Mr. Market’s emotions, because he’s fooling you. What you have to do is go in there and look at what Mr. Market is offering you. Remain calm and competent. Figure out what the company’s worth and don’t get wrapped up behind the illusions he creates. Mr. Market is your servant because he either provides you with very good deals or really crappy deals. He’s not your guy so you don’t fall for his emotions. Capitalize on what he’s doing. The market sometimes gives you great deals, and you just got to take them. Other times it gives you horrible deals, and you can’t be fooled by the emotions of everybody else. You have to determine the value of the stock.

In Unit 3, Lesson 1, we learned what a stock market is. Although many people might not view a stock market the same way as a food market, they’re actually more related than you might think. Like any market, in order for a trade to occur, there always needs to be a buyer and a seller.

The selling and buying of 1 share lead to the methods investors use to conduct trades. We first learned about a stop order, where buying or selling a stock stops once the price of the stock reaches a specified price, known as the stop price. Before using a stop order, investors should consider the following:

Short-term market fluctuations in a stock’s price can activate a stop order, so a stop price should be selected carefully. The execution price an investor receives for this market order can deviate significantly from the stop price in a fast-moving market where prices change rapidly. An investor can avoid the risk of a stop order executing at an unexpected price by placing a stop-limit order, but the limit price may prevent the order from being executed. Some brokerage firms have different standards for determining whether a stop price has been reached. For these stocks, some brokerage firms use only last-sale prices to trigger a stop order, while other firms use quotation prices. Investors should check with their brokerage firms to determine the specific rules that will apply to stop orders.

A limit order is an order to buy or sell a stock at a specific price or better. A buy limit order can only be executed at the limit price or lower, and a sell limit order can only be executed at the limit price or higher.

Example: An investor wants to purchase shares of ABC stock for no more than $10. The investor can place a limit order for this amount that will only execute if the price of ABC stock is $10 or lower.

As buyers and sellers move the market price of a stock through the use of these orders, the market will offer great deals or very expensive prices. Graham used the idea of Mr. Market to represent a stubborn business partner who offers great deals sometimes and horrible deals the next. Your job as an intelligent investor is to determine which deals are of great value.