In This Chapter

The stock markets have come a long way from the days when stockbrokers had a lock on commissions and dictated terms of doing business. Beginning with deregulation in 1975, the financial services industry has exploded with new products, new services, lower prices, and technology that puts vast amounts of information in investors’ hands. While the service providers such as stockbrokers and financial planners evolved, the stock exchanges themselves trailed in innovation. However, when these bastions of American capitalism began reinventing themselves they did it in a big way. The Nasdaq, the first purely electronic market, led the way with an innovative trading platform that attracted investors interested in young, high-tech companies at just the right time.

The high-tech, Internet stock market explosion of the late 1990s propelled the Nasdaq into the financial big leagues. The venerable New York Stock Exchange has reached across the Atlantic seeking European partners to expand its reach, while the American Stock Exchange is home to the hot new exchange-traded funds. These are but a few of the examples of innovation in the face of consumer demand and global competition facing U.S. exchanges.

The New York Stock Exchange (NYSE), Nasdaq, and the American Stock Exchange (ASE) are the major national stock and bond exchanges. The exchanges have their own regulations and listing requirements. The regulations cover trading activities and financial reporting of listed companies. The exchanges monitor trading patterns to look for stock manipulation.

The New York Stock Exchange is the most prestigious securities trading center in the world. Its roots go back to 1792. The exchange is synonymous with the stock market and it is often referred to as “the Big Boar.” Although it was in danger of falling behind technologically, the exchange has made major moves in the past decade to upgrade its trading system to state of the art.

The Nasdaq (the name was formerly an acronym, but now is the official name of the exchange) is an electronic market where buyers and sellers are matched through a complex computer network. Designated brokers act as market makers for individual stocks to ensure that the system functions smoothly and fairly. Many of the stocks listed on the Nasdaq are younger, high-tech companies.

The American Stock Exchange was in danger of being lost in the race between the Nasdaq and the NYSE, but in recent years has experienced a rebirth through the issue of new types of securities such as exchange-traded funds.

The major U.S. stock exchanges were long regarded as the financial centers of the world. Indeed, a bull market that ran from 1990 to 2000, the longest in history, corresponded to a period of economic prosperity that made that decade one of the most profitable for investors in the stock market’s history. Political and economic instability around the world only highlighted how attractive investing in America was. Foreign investors also began to push innovations in their markets. Stock markets in the Far East from Japan to China experienced rapid growth, as did European markets, thanks in part to the adoption of the euro by a number of the European Union countries as a common currency.

However, U.S. exchanges began to see that like the companies that traded on their floors, globalization was in their future also. Thanks to technology, geographic barriers to trading in foreign financial markets disappeared. As foreign markets opened their exchanges to U.S. companies and investors, U.S. exchanges saw a major challenge to their dominance as the financial leaders of the world.

Many of the largest U.S. companies count most of their sales from foreign operations (for example, Coca Cola takes in about 70 percent of its sales from places other than its U.S. operations). The companies have expanded around the world and those operations are much larger than the original domestic business. In every sense of the word, these companies are global or multinational companies that happened to be head-quartered in the United States. In the same manner, U.S. stock exchanges have gone through a period of domestic consolidation and global outreach to expand their reach and resources.

Nasdaq attempted to buy the London Stock Exchange, but failed to win shareholder support. In the meantime, the exchange has merged with the Boston Stock Exchange and acquired other companies that provide a variety of services and products to the investment community. It is reasonable to expect Nasdaq will continue pursuing a global stock exchange. Nasdaq owns a piece of OMX, which is a holding group operating stock exchanges in several Scandinavian countries. It has opened an office in Beijing, China—a country with a growing investing class and a volatile stock market.

The New York Stock Exchange has managed to, in their words, form the largest, most liquid exchange group. Known as NYSE Euronext, the group was introduced in spring of 2007 and combines the NYSE with Euronext. According to their website: “NYSE Euronext, which brings together six cash equities [Paris, Lisbon, Brussels, Amsterdam, NYSE, NYSE Arca] exchanges in five countries and six derivatives exchanges [Paris, London, Brussels, Amsterdam, Lisbon, NYSE Arca], is a world leader for listings, trading in cash equities, equity and interest rate derivatives, bonds and the distribution of market data.”

The NYSE Euronext has strategic relationships with the Tokyo Stock Exchange and the National Stock Exchange of India, both enormously important financial centers in the global market. With this global expansion, the NYSE has joined the major U.S. companies listed on its exchange. It is now realizing a significant contribution to its gross revenues and operating income from the Euronext operations.

While neither major U.S. exchange owns a large stake or is in partnership with a stock exchange from an Asian or Pacific Rim country, it seems just a matter of time before such a deal is cemented. NYSE’s span now covers more time zones than any exchange. It offers a wide variety of financial products both domestic and foreign, which allows investors to diversify across geo-political boundaries—an important feature in today’s volatile world. Investing in foreign markets was once considered a high-risk bet. However, with well-established and regulated international markets in many countries, this doesn’t need to be the case.

It may still be difficult to find the level of disclosure investors are accustomed to in the U.S. market; however, investing in developed and many developing countries can be a reasonably sound move. There are still risks that investing in domestic equities do not have, such as currency fluctuations and the potential of political instability in some countries.

Currency risk is the danger that you will lose money in exchanging dollars for the currency of a foreign stock. For example, if you buy a stock in one of the European Union countries that uses the euro, the U.S. dollar is converted to euros at the time of the purchase. When you sell the stock, it is quoted in euros, which must be converted to U.S. dollars. If between the time of purchase and sale of the stock, the euro has gained value against the dollar, you will get fewer dollars per euro. The loss in currency exchange could consume a significant portion of your profit.

When these factors are reflected as risk premium in foreign stocks, it makes an investment potentially more profitable (and correspondingly, more risky).

One of the other benefits for all investors, but in particular active traders, is that the trading day is extended. After-hours trading in U.S. markets (discussed in more detail later in this chapter) does not yet provide the volume or liquidity that open-market trading does. However, thanks to multiple time zones and technology, active traders can participate in open-market trading that is not confined to what is convenient for U.S. exchanges. Active trading in foreign markets is not for beginners, but it illustrates the benefits (and pitfalls) globalization of financial markets offers to those who are willing to extend their trading horizons. We’ll look at foreign markets and the risks and opportunities in more detail in Chapter 9.

Not too many years ago, if the U.S. stock market sneezed, the foreign markets got a cold. The dominance and wealth concentrated in the U.S. market set the tempo for other markets around the world. That has changed. As foreign markets and economies have grown at rates much faster than our own, events overseas begin to affect the U.S. market. This is particularly true of the Nikkei, Japan’s stock market; the Singapore Stock Exchange; Hong Kong Stock Exchange; and China’s stock markets. These exchanges aren’t necessarily open to U.S. investors, but major movement, especially negative news, can ripple through U.S. markets.

One of the prices of globalization is financial markets that may become more sensitive to events in other countries. This is not always a bad thing because it gives investors the opportunity to diversify geographically in ways that have not been possible in the past. It also allows active investors to capitalize on the relationship among markets for sophisticated trades. The other benefit to U.S. consumers is that this competition has pushed the major exchanges to become more user oriented. The exchanges are working harder to introduce products and services to retain their existing customer base. The exchanges also understand that many foreign investors still look to the United States as the most financially and politically stable country in the world. Attracting those investors becomes easier with a global footprint.

Active traders and regular investors are seeing global markets open to them in increasing numbers. Several online brokerage firms offer direct access to foreign exchanges through their trading systems. Despite the additional risks, trading in foreign stocks is often a good idea if you are an experienced hand. Beginning active traders would do well to stick to domestic stock markets until they have some solid experience.

However, trading on foreign markets opens some interesting possibilities given time zone differences and how the markets react to news. As those foreign markets become more open, they will add enhancements to attract American and other investors and traders. Traders create volume and liquidity for markets, although they are often called speculators. For some foreign markets, that volume and liquidity is just what is needed to provide a better trading environment for all customers. In other markets such as China’s rapidly growing exchanges, the explosive volatility can be a killer. Whether those markets will mature into less of a high-rolling speculator’s guessing game remains to be seen.

It is important to remember that active traders will succeed when they can predict stock or market movements, whether it is ultra-short up or downticks or longer swings. Active traders don’t guess. Trades are made on information and an understanding of how stocks or markets move and why. Wildly volatile stocks or markets that move irrationally because of an undisciplined market or economic/political upheaval make it difficult for traders to see where the movement is going.

The Pacific markets, stock exchanges on the other side of the Pacific Ocean, have exhibited the fastest growth in recent years. Japan’s Nikkei is the equivalent of the NYSE on that side of the world. It has grown up following World War II to be a major financial consideration in the global economy. Its daily results (the Nikkei 225 Index) are reported along with the Dow, Nasdaq 100, and S&P 500 as another major market. When Japan’s economy was in trouble, the Nikkei suffered losses and those ripples were felt in the U.S. market. A number of Japanese firms do significant business in the United States (think electronics and cars, for example) and difficulties in that economy and stock market can have repercussions in the United States. Active traders who make buy-sell decisions on economic news need to understand how important these relationships are and learn to exploit them.

The stock exchanges in China are growing at a tremendous rate, just like the rest of the economy. U.S. markets have already felt the backlash of problems in Chinese markets. The idea of investing is still relatively new, as is the idea of a middle class with income to invest. Their market is highly volatile and at one point became a huge bubble that popped. Values plunged as Chinese investors learned a lesson that speculative markets rise and fall. The huge sell off caused a precipitous drop in U.S. markets on fears that the sell off fever would spread or Chinese investors would sell some of the huge cache of U.S. Treasury bonds they hold.

As witnessed by the NYSE’s partnership with Euronext and Nasdaq’s ownership of OMX, European stock exchanges also play an important role in the global financial markets. The European exchanges are gaining strength thanks to the adoption of the euro as a common currency among 13 countries on the European Union. The adoption of a common currency helps eliminate the currency exchange risk of trading in foreign stocks for residents in those 13 countries, as well as U.S. traders because there is only one currency conversion to be concerned with when trading stocks from these 13 countries instead of 13 currencies. Because the value of the euro is tied to the economies of multiple countries, it tends to be more stable. Even though the exchange rate between the U.S. dollar and the euro fluctuates, it is less volatile than the currency of some individual countries. This relative stability helps U.S. traders by reducing the currency risk and giving traders a single value (the euro) to follow.

There is a theory that capital seeks out the best return and will go where that return is available. Think of it as a natural selection process for money. When a sector of the stock market is hot, that’s where people sometimes irrationally put their money. For active traders, opening global financial markets means more places to find opportunities that may not be over-bought or oversold. If domestic markets are flat, foreign markets may be where traders can find the activity they need. Opening global markets is a two-way street. As countries grow their economies to the point where there is a significant investing class (people with more than enough income to meet basic needs), those people will be looking for places to put their money.

When trading stocks was controlled exclusively by humans, many of the markets now opening to U.S. traders were not viable for short-term transactions. Short-term trading has changed dramatically in U.S. markets also thanks to Congress-mandated Electronic Communication Networks, or ECNs. Authorized in 1998, these networks allow investors to bypass traditional stock exchanges and enter trades directly. ECNs match orders (buyers and sellers) and post orders for others who subscribe to the network to see.

The ECNs reduce expenses and offer a faster way to trade since there is no middle-man. The Nasdaq computerized ordering system could be thought of as the first ECN. As the industry has evolved, traders who need access to live price information and virtually instant execution have pushed ECNs to offer more services to individual investors. Active investors who trade on very short-term cycles should use a trading platform that operates with an ECN. Routing trades through any type of structure before execution is too time consuming, even if it can be done in less than a minute.

ECNs offer price transparency to a degree not previously available to individual investors. This price transparency allows short-term traders to see what orders are pending and where other traders believe the security is headed. For example, if the short-term trader sees sell orders building, that is a strong signal which direction the price is likely to head. Customers of traditional stock brokerage accounts seldom have access to this level of detail.

Advanced trading platforms take advantage of ECNs’ execution speed, price transparency, and other information to help short-term customers see the whole market for a particular stock or stock sector. This vision along with other tools allows short-term traders to make quick decisions based on price movement and the direction of perceived demand.

Active traders interested in foreign markets will find that ECNs and advanced trading platforms give them access to many opportunities. One area of active trading on a global scale is in the foreign currency markets, or forex. This market operates 24 hours a day, six days a week. Price transparency and rapid execution bring global and after-hours trading to anyone’s computer. More about the forex market in Chapter 9.

For a number of years, institutional investors and some high-net worth investors had been able to trade stocks after the close of the U.S. stock markets. Thanks to technology and pressure from individual investors, the exchanges now allow individuals to trade stocks after the markets have officially closed for the day. Known as after-hours trading, the practice has been growing in recent years, but is still a tiny fraction of the volume transacted during regular business hours. While opportunities exist for active traders in the after-hours market, it is also instructive in what may be coming in the near future—markets open on an expanded schedule. There are many reasons U.S. exchanges should stay open longer, including the competition from foreign exchanges. Expanded live hours would better accommodate American investors and traders not shackled to a stockbroker’s office to manage their accounts.

Before advanced trading platforms and online investing, traders were stuck with relying on stockbrokers to enter trades for them. Traders are now in control of the process and can enter trades and manage their account directly thanks to the technology of trading platforms. With this access and the ability to settle accounts electronically, there was not much reason to keep individuals out of the after-hours trading market that institutional investors used.

After-hours trading begins at the close of the live markets at 4 P.M. EST and runs until 6:30 P.M. There is also a pre-market trading session that runs from 8 to 9:30 A.M. before the live market opens. During these trading sessions, you can trade any stock listed on the appropriate exchange. Note: you can enter an order to buy or sell at the opening of the next live session any time, but this is not the same as after-hours trading.

It is smart to stick with limit orders (see Chapter 13) in most cases (many trading platforms won’t accept any other kind during after-hours trading). Realize that if your order is not filled during after-hours trading, either after the close of the market or before the market opens, it may or may not carry over to the next session of live trading. Check with your broker for their policy.

The after-hours market can be a very volatile environment because major news stories are often released after the market closes for the day or before it opens. For example, earnings reports, especially if they are a surprise, may come out after the market closes. Likewise, news of mergers or other significant events that could move individual stocks or the whole market is often released after the market is closed. This illustrates an important fact: after-hours market trading is frequently news driven.

Like the live stock market, after-hours trading is dominated by large institutional investors, but more so. There are fewer “amateur” investors trading, so your competitors are professional mutual fund, pension, and insurance account traders. These traders move large amounts of stock and can have a dramatic impact on an individual stock’s price. These professionals may also have access to information you may not possess. When they move for or against a stock, things happen in a hurry.

With most advanced trading platforms, short-term traders can see what is happening as it unfolds and react. That is not always the case with after-hours trading. When only institutional investors could trade after hours, they enjoyed anonymity. That secrecy is still there since many companies won’t let you see any quotes except from the ECN it uses. Even if you can see quotes from other ECNs, you may not be able to trade on them or with other investors using competing systems. This means you may not get the best price for your order.

Part of this problem is related to a larger problem in the after-hours market and that is the lack of liquidity. In this sense, lack of liquidity means finding a willing buyer or seller for a particular stock. Unlike live market trading, where almost any stock can be easily bought or sold, the after-hours market does not have the volume to assure that will be the case. Many stocks may not trade at all during the after hours. You could be in a situation where you wanted to act quickly on a stock, but could find no buyers or sellers in the after-hours market. Another manifestation of the liquidity issue is larger spreads between the bid and ask prices. This can make it hard to get your order filled at your price.

Active traders look at the after-hours market with caution. One of the major concerns is the possibility of low liquidity in a stock. Traders rely on being able to get into and out of a stock when they choose. If the market for a particular stock suddenly loses its liquidity because the few interested traders have exited, other traders may be stuck in a bad position or be forced to exit at a price that is not to their liking. During active trading, short-term traders in particular must have a completely liquid market in the stock they are trading.

The after-hours market is particularly ill-suited for quick profit taking except in circumstances of a very active stock. Even then, other factors (potentially wide spreads and unexplained volatility) put short-term traders at a disadvantage over the position they normally hold during a live market. The volume of after-hours trading has never reached more than 1 percent of the daily live market volume of the NYSE, and many brokers report similar numbers for their customers trading after hours.

Some experienced active traders will take positions in the after-hours market; however, beginners should stick to the live market until they have some experience. Most of the activity will happen in the first hour after the live market closes. This is when quarterly earnings are announced and it can make for some interesting activity.

Active traders should keep an eye on the after-hours market for a different reason. Trading activity in the after-hours market may give you a clue about what to expect when the market opens for live trading. The operative word here is “may.” For many of the reasons listed previously (lack of liquidity, domination of institutional investors, high volatility, and so on), you can’t count on an after-hours price carrying over to the opening price for the next live market session.

This is where your observation skills and understanding of the market will work to your advantage. Big movements in a stock during after-hours trading may be a sign that can be read several different ways. Often inexperienced investors will see a big jump in a stock as a sign that they need to get on board, when an experienced trader knows this is the right time to short the stock. Regardless of what happens in the after-hours market, the stock does not have to open at that closing level anymore than it has to open at the closing level from the previous live trading session.

Some market watchers thought that the opening of after-hours trading to individuals combined with the advanced technology of trading platforms and trading networks meant that 24/7 trading was just around the corner. There is no real technology barrier to offering 24/7 or at least 24/5 trading. Before the Internet and electronic networks, trades had to clear within three business days, which was to allow time to process the order, collect money from the customer, and so on. With electronic processing of orders directly to the trading floor and more sophisticated means of settling trades, there is no reason to trade on “banker’s hours.” However, the lack of interest in after-market trading suggests that it may be a “chicken or the egg” problem.

The volume won’t come until more traders are involved, and more traders won’t become involved until there is more volume. There may be other equally valid reasons. For traders seeking activity in live markets, foreign markets are trading when U.S. markets are closed. There are 7 to 10 hours’ difference between U.S. markets and European markets—they are ahead of us. The Pacific and Asian markets are a day ahead of U.S. markets and many hours’ difference.

However, this is just the very short-term outlook. A reality not readily accepted by many of the old hands on Wall Street is that the global financial markets are growing at a tremendous pace and may soon be more of an influence on the financial services industry than in the past. The financial press is full of excited stories from India, Singapore, and other growing economies of the growth of their stock markets. As young people earn more money in those markets, they are learning to invest it, which creates opportunities for active investors in the United States.

The Least You Need to Know