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The specialist system obviously predates computers; the advent of computers naturally brought new, faster, and more transparent technologies to stock trading practice. The first change came in 1971 with the advent of the NASDAQ. Prior to the NASDAQ, the only alternative to the specialist system was a network of securities dealers hooked to each other by telephone; these dealers traded the stock, mostly of small or emerging companies “over the counter.” The NASDAQ created a virtual marketplace accessed by computers where buyers and sellers, mostly dealers, posted quotes and executed trades against those quotes. Dealers could trade with the big brokerage houses to fill end-customer orders, and the late 1990s advent of personal computer and networking technology enabled individual traders to also access these markets. The day-trading craze of the late 1990s was the end result, and such high-powered direct access trading still goes on today.
Gradually and not surprisingly the specialist system is quickly becoming outmoded and replaced by faster, cheaper, and more transparent electronic tools; even the NYSE has evolved to electronic trading for a significant share of its volume. The specialist system still survives mostly to handle larger institutional trades.
Why You Should Care
The stock market and its effective operation are vital to a capitalist society. It is how capital is allocated between individuals, their representatives, and the corporations that need that capital. Without a fair or efficient market, that allocation wouldn’t work well, and people would be fearful of investing in companies.
79. BONDS AND BOND MARKETS
Bonds are securities bought and sold by investors promising repayment by a certain date (maturity) with a certain yield, or interest amount, paid usually semia
What You Should Know
Trading in the bond market sets the price of the bond, which in turn sets the effective yield on the bond. Suppose a bond pays 7 percent at par—that is, at $100 in price, the typical original sale amount and ultimate value paid back at maturity. That means that the bond pays $70 per year in interest on a $1,000 bond (the normal trading increment). If the market thinks that bonds are worth less, and drives the price down to $95 ($950 face value), the effective yield rises to 7.37 percent—interest rates go up. Remember, when bond prices go down, interest rates go up, and vice versa.
Carrying the discussion one step further, even if the bond falls to $95 ($950), eventually $1,000 will be repaid to the bondholder. So the yield to maturity captures not just the interest paid, but also the additional $50 recovered at maturity. Suppose the 7 percent bond matures in ten years. The yield to maturity would be 7.72 percent—a fairly complex calculation best done on a financial calculator.
Most bonds are traded “over the counter” between individual securities dealers, rather than on a transparent, electronic-driven market like the NYSE or the NASDAQ. Today’s bond market looks more like the stock market of the 1960s and 1970s. Bonds are traded this way because each is unique—different issuer, different interest rate, maturity, and other terms and conditions. And most bonds are held longer and traded less frequently than stocks. The bond markets are less consumer-friendly—in part because consumers participate less in the bond markets; it is more of an institutional investor playground (see #75 Institutional Investors).
There are four categories of bonds and bond markets—corporate, government and agency, municipal, and asset-backed securities (see #67). The U.S. Treasury sells a lot of bonds, and has made the purchase of Treasury bonds among the most friendly of bond markets for the average consumer with its bond purchase website www.treasurydirect.gov.
Why You Should Care
Aside from being a place to buy and sell bonds by matching supply and demand for bonds, the bond market effectively determines interest rates. A rising bond market means falling interest rates; a falling bond market signals that interest rates are on the rise. If you’re in the market yourself to “sell a bond of your own”—that is, to get a mortgage or some other large loan—watching the bond markets to see the direction of interest rates can be especially helpful.
80. COMMODITIES, FUTURES, AND FUTURES MARKETS
Commodities are physical materials and assets used in production of goods and services (like oil or corn or platinum) or as a store of value (like gold) or both (like silver). Many businesses buy commodities in large quantities to support their production, while other businesses, like mining companies or farms or agricultural producers, sell commodities in large quantities; that’s their business.
Commodity futures are derivatives (see #66), securities products designed to provide a convenient way to buy and sell commodities, while commodity futures markets provide a way for buyers and sellers to trade those commodity futures.
What You Should Know
Futures contracts are standardized contracts to buy or sell a specified item, usually but not always a commodity, in a standardized quantity on a specific date. Commodity futures include agricultural products, shown in some listings as grains; “softs,” like cotton, sugar, and coffee; meats; and mineral and mining products like metals and energy products. Futures contracts also go beyond commodities into financial futures, which include interest rates, currencies (see #81 Currency Markets/FOREX), and stock index futures. In fact, many more exotic futures products are coming to market for things like the weather, pollution credits, and so forth.
Futures contracts are typically set up for larger quantities of a commodity than any individual consumer would normally need. For instance, the standard contract size for gasoline futures is 42,000 gallons, quite a bit more than you’ll need, even if you own the largest SUV. At $3 a gallon or so, on paper this is a $126,000 investment that few individuals would be able to make. So doesn’t this discourage participation in the market? Not really, because commodities traders can borrow on margin (see #86) to finance most of the purchase. In the case of gasoline futures, a $6,000 upfront cash payment gets you in. As you can see, the leverage is high—a 10 percent increase in the price of gas ($12,600 on the contract) would almost triple the initial investment. However, if the price goes down, your $6,000 disappears quickly; when gone, your position is liquidated. That affords some downside protection.
Futures contracts are bought and sold by producers and consumers of the commodities involved. Producers like farmers or energy companies are looking to hedge, or protect, against future price decreases, while consumers like manufacturing companies are hedging against price increases. But there aren’t that many producing or consuming businesses in the market at any given time for, say, copper. The markets are made complete by speculators, short-term investors trying to make a profit by guessing the future direction of the price of a commodity. While many speculators rarely see the actual cotton, they do play an important role in the determination of the price of cotton.
In many cases, the underlying assets to a futures contract may not be traditional commodities at all. For financial futures, the underlying assets or items can be currencies, securities, or financial instruments and intangible assets or referenced items such as stock indexes and interest rates. The “future” is the future price of the instrument, not the physical commodity.