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Subject: Trading - Basics

This article offers a very basic introduction to stock trading. It goes through the steps of buying and selling shares, and explains the fundamental issues of how an investor can make or lose money by buying and selling shares of stock. This article will simplify and generalize quite a bit; the goal is to get across the basic idea without cluttering the issue with too many details. In some places I've included links to other articles in the FAQ that explain the details, but feel free to skip those links the first time you read over this. You may know already that a share of stock is essentially a portion of a company. The stock holders are the owners of a company. In theory, the owners (stock holders) make money when the company makes money, and lose money when the company loses money. Once there was age of internet stocks where companies lost lots of money but the shareholders still made lots of money (and then lost money themselves), but let's just say that the main trick is to buy only stocks that go up. Next we will walk through a stock purchase and sale to illustrate how you, an investor in stocks, can make money--or lose money--by buying and selling stocks. 1. One fine day you decide to buy shares of some stock, let's pick on AT&T. Maybe you think that company will soon return to being the all-powerful, highly profitable "Ma Bell" that it once was. Or you just think their ads are cool. So now what? 2. Although there are many ways to buy shares of stock, you decide to take the oldfashioned route of using an old-fashioned stock broker who has an office in your town and (imagine!) takes your phone calls. You open an account with your friendly broker and deposit some good old-fashioned cash. Let's say you deposit $1,000. 3. You ask your broker about the current market price quoted for AT&T shares. Your broker is a good broker, and like any good broker he knows that AT&T's ticker symbol is the single letter 'T'. He punches T into his quote request system and asks for the current market price (supplied from the New York Stock Exchange, where T is primarily traded), and out pops a price of 20.25 (stocks were once quoted as fractions like 1/4 but are now done with decimals). Looks like your $1,000 will buy almost 50 shares, but because this is your very first stock trade, you decide to buy just 10 shares. 4. You ask your broker to buy 10 shares for you at the current market price. In the lingo of your broker, you give a market order for 10 shares of T. Your broker is a nice guy and only charges a commission on a single stock trade of $30 (not too bad for someone who takes your phone calls). Your broker enters the order, and his computer then figures the price you will ultimately pay for those 10 shares, which is 10 (the number of shares) times 20.25 (the current price for the shares on the open market) for a total of 202.50, plus 30 (the broker's commission, don't forget he has to eat too), for a grand total of $232.50.

5. Then magic happens: your broker instantly finds someone willing to sell you 10 shares at the current market price of 20.25 and buys them for you from that someone. Your broker takes money from your account and sends it off to that someone who sold you the shares. Your broker also takes his $30 commission from your account. In the end, your hard-earned money is gone, and your account has 10 shares of AT&T. A (very small) fraction of the company, as represented by those 10 shares, is now in your hands! Now it's time for a few details, which you can safely skip if you choose. The person who sold you the shares was a specialist ("spec") on the NYSE; for more information, look into the NYSE's auction trading system. Roughly, a specialist is a type of middleman and a member (like your broker) of the financial services industry. After you give the order, the shares do not appear instantly; they appear in your account three business days after you gave the order (called "T+3"). In other words, trades settle in three business days. Please pardon a fair amount of oversimplification here, but the trade and settlement procedures involved with making sure those 10 shares come to your account can happen in many, many different ways. You're paying that commission so things are easy for you, and indeed they are: for a relatively modest fee, your broker got you the shares. It may be important to point out here that AT&T, that big company from Bedminster, New Jersey, did not participate in this stock trade. Sure, their shares changed hands, but that's all. Shares of publicly traded companies that are bought on the open market never come from the company. Further, the money that you pay for shares bought on the open market does not go to the company. Sure, the company sold shares to the public at one point (an event called a public offering), but your trade was done on the open market. After the trade settles, then what? Your broker keeps some of the $30 commission personally, and some goes to the company he works for. The shares are in your brokerage account. This is called holding shares "in street name." If you really want to hold the stock certificates, your broker will be happy to arrange this, but he will probably charge you about another $30. Since you feel you've paid your broker enough already (and you're right), you decide to leave the shares in your account ("in street name"). 6. The next day, AT&T shares close at a price of 21, which is a rise of $0.75. Great, you think, I just made $7.50. And in some sense you're right. The value of your holdings has increased by that amount. This is a paper gain or unrealized gain; i.e., on paper, you're $7.50 wealthier. That money is not in your pocket, though, and you do not need

not yet. and sells your shares to that someone. . AT&T shares close at a price of 22. The IRS only cares about actual (realized) gains. a member of the financial services industry. so although the share price rose about that much in just a couple of days.50. Magic happens again: instantly your broker finds someone willing to buy the 10 shares of AT&T from you at the current price. Fantastic. 7.to tell the IRS. Now you should understand the basic mechanics of buying and selling shares of stock. You make a call the next morning..50. Gee. although shares (and fractional ownership of the company represented by those 10 shares) changed hands. Eventually you do your taxes. This is the problem with commissions: they reduce your returns. so eventually the shares of AT&T disappear from your account and a credit of $195 appears.25) + 30 is 1042. That someone sends you $225. Your broker accepts your order to sell T at the market.' The current market price for AT&T on the NYSE is 22. that someone was a person at the NYSE called a specialist ("spec"). 10. which is another rise over the price you paid and a rise over the previous day. You have a short-term capital loss of $37. he's obliging (after all. The trade will be settled in exactly 3 business days (upon settlement. That evening you decide that maybe AT&T really isn't such a great wireless phone company after all and it's time to sell. Note again that the company did not participate in this trade. but I only received $195. boy can I pick them. and you see the importance of commissions. you have a paper gain of 10 times 1. less his commission of 30. Not too bad for two days. You paid over 15% of your capital in commissions. The following day.. As explained above. you think. let's run the numbers if you had bought 50 shares instead of just 10 (maybe you found another few dollars).. Just for comparison. even though you had a paper gain every day.and I paid $232.75 which is 17. and pretty quickly you come to the inescapable conclusion that you lost $37. Again your broker asks for a quote of the current market price for 'T. 9.50.50 (the current market price) for a total of 225. and you don't have any.50. Depending on your tax situation. 11. for a grand total of 195. the stock went up every day. you may be able to deduct your loss from your gross income.50 (wow. Again his computer figures the money you will receive from the sale: 10 (the number of shares) times 22. another rise). you lost money because the commissions exceeded the gains. So you calculate the result. and although your broker is a bit surprised to hear from you again so soon. Your broker deducts his commission of $30 from the proceeds of the sale. The purchase price of (50 * 20.50 from this pair of trades. it's your money). the shares are gone and you have the cash). today I made another $10! At this point. you think. Again I apologize for the oversimplification here. 8.

An IPO is when a company sells stock in itself for the first time. IPO: Short for Initial Public Offering. The difference is $52. and is a good reason for really small investors to consider investing via no-load mutual funds or direct investment plans (DRIPs). along with the right to share in dividends. preferred stock has fewer rights than common stock. Ticker Symbol: A short group of letters that represents a particular stock (e.50) . Bear: An investor who believes the market as a whole or a particular stock will decline.The sales price of (50 * 22. What this says is that commissions can really hurt the small investor. A share of stock is the smallest unit of ownership in a company There are two types of stock: Common Stock: y Common stock represents the majority of stock held by the public. It is created when a business carves itself into pieces and sells them to investors in exchange for cash. except in one important area ± dividends. losses. . (To calculate market cap. "Coca Cola" is referred to as "KO".50 in your favor. Market Cap: The amount of money you would have to pay if you bought ever share of stock in a company.30 is 1095.) Short for Market Capitalization Share: A share represents an investor's ownership in a "share" of the profits. and assets of a company. Going Public: Slang for when a company is planning an IPO.g. Companies that issue preferred stocks usually pay consistent dividends and preferred stock has first call on dividends over common stock. multiply the number of shares by the price per share.) Underwriter: The financial institution or investment bank that is doing all of the paperwork and orchestrating a company's IPO. It has voting rights. Ask: The lowest price a seller is willing to accept when selling a security (stock).. A bear is the opposite of a Bull. Earnings per Share: The amount of profit to which each share is entitled. Preferred stock: Despite its name.

Book Value: The value of the company if all liabilities were subtracted from assets and common stock equity. In other words. and an impeccable balance sheet. In other words. futures. Yield: When a company pays a dividend the yield is the percentage of the stock price in relation to the dividend paid. A business is divided up into shares of stock and parts of the company (the shares) are sold to investors to raise money. Stock Market. Bull: An investor who believes the general market or a particular stock is going to increase in price. bonds. the P/E ratio is 10 because you are paying ten-times earnings ($20 per share divided by $2 per share earnings = 10 P/E. Stock: Stock is ownership. and shares in stocks. if a company is reporting a profit of $2 per share. An exchange is a place where options. indexes. bonds.. Dow Jones Industrial Average: The Dow Jones Industrial Average (or DJIA for short) is by far the most popular and widely used gauge of the U. P/E Ratio: How much money you are paying for $1 of the company's earnings. We have an entire subject area dedicated to Blue Chip stocks! Go Here. regular and increasing dividends.) in exchange for a fee which is called a commission. Blue Chip: A company that has a history of solid earnings. In industries in the technology sector. The book value has very little relation to the market value. Market Capitalization: A company's market capitalization (or "market cap" as it s frequently called) is calculated by taking the number of outstanding shares of stock multiplied by the current price-per-share. It consists of a priceweighted list of 30 highly-traded Blue Chip companies. Examples: Coca-Cola. & Gillette. Berkshire Hathaway. commodities. check out the investing lessons.S. and commodities are traded. Broker: A person that buys or sells an investment vehicle for you (securities. For more information. etc. and the stock is selling for $20 per share. this number is almost always miniscule compared to market capitalization. Dividend: A portion of a company's income that is paid out to shareholders on a quarterly or annual basis. Dividends are declared by the Board of Directors.) Spread: The difference between the Ask and the Bid. The most famous in the United States is the New York Stock Exchange. NASDAQ: A stock exchange where mostly shares of technology companies such as Microsoft and Cisco are traded.Bid: The highest price a buyer is willing to accept when purchasing a security. if a stock is trading for $10 and pays a .

on the other hand. companies. These shares trade on the open market. in mutual fund speak. the latter is subdivided into load and no load. is a sales commission. the yield is 5%. should attempt to beat the Dow Jones Industrial Average or the S&P 500 in a fiscal year Closed vs. If a fund charges a load. for example. In simple terms. a mutual fund is a pool of money provided by individual investors. A fund manager is hired to invest the cash the investors have contributed. Load vs. Open-End Funds A majority of mutual funds are open-ended. y What are the benefits of investing through a mutual fund? Mutual funds are actively managed by a professional money manager who constantly monitors the stocks and bonds in the fund's portfolio. you would receive 5% back annually in the form of a fifty-cent dividend Mutual Funds: What is a mutual fund? Put simply. subjects the fund shares to the laws of supply and demand. this means that the fund does not have a set number of shares. they can devote considerably more time to selecting investments than an individual investor. This provides the peace of mind that comes with informed investing without the stress of analyzing financial statements or calculating financial ratios. combined with the fact that a closed-end fund does not redeem or issue new shares like a normal mutual fund. No-Load Mutual funds are divided along four lines: closed-end and open-ended funds. shares of closedend funds normally trade at a discount to net asset value. the investor will pay the sales commission on top of the net asset value of the fund¶s shares. A long-term growth manager. a fixedincome fund manager. and other organizations.50. The goal of the manager depends upon the type of fund. because for every $10 you invest. Load vs. No load funds tend to generate higher returns for investors due to the lower expenses associated with ownership. y Closed-End Funds This type of fund has a set number of shares issued to the public through an initial public offering. As a result. would strive to provide the highest yield at the lowest risk. the fund will issue new shares to an investor based upon the current net asset value and redeem the shares when the investor decides to sell. Open-end funds always reflect the net asset value of the fund's underlying investments because shares are created and destroyed as necessary. No Load A load. . Instead. Open-Ended Funds. Because this is his or her primary occupation.dividend of $0. this.

you can purchase mutual fund shares as you would a share of stock. you can visit the fund's web page or call them and request information and an application. for instance. If you don't. After you¶ve settled upon a type of fund. How do I begin investing in a fund? If you already have a brokerage account. and / or the investor agrees to automatic.How do I select a fund that's right for me? Every fund has a particular investing strategy. Both of these companies issue fund rankings based on past record. traditional IRA or Roth IRA.000+ with most in the $1. some. Most funds have a minimum initial investment which can vary from $25 . turn to Morningstar or Standard and Poors (S&P). reoccurring deductions from a checking or savings account to invest in the fund. Past success is no indication of the future. .000 . especially if the fund manager has recently changed. Others invest in start-up businesses or specific sectors. style or purpose.$5. You must know and understand your investment. if you don't know anything about biotechnology. Finding a mutual fund that fits your investment criteria and style is absolutely vital.000 range (the minimum initial investment may be substantially lowered or waived altogether if the investment is for a retirement account such as a 401k. You must take these rankings with a grain of salt. you have no business investing in a biotech fund. invest only in blue chip companies.$100.

you have been issued a fixed-income security. there is some important terminology used by the fixed-income industry: y y y y y y The issuer is the entity (company or govt. In order for a company to grow as a business. or the company can give a promise to pay regular interest and repay principal on the loan (bond or bank loan) or (preferred stock).also known as maturity value. Securitized bank lending (e. the term "fixed income" can also carry the implication that they have relatively limited discretionary income or have little financial freedom to make large expenditures. For example.[1] The coupon (of a bond) is the interest that the issuer must pay. The indenture is the contract that states all of the terms of the bond . The company can either pledge a part of itself. face value. Local governments issue municipal bonds to finance themselves. The issue is another term for the bond itself. credit card debt. This can include income derived from fixed-income investments such as bonds and preferred stocks or pensions that guarantee a fixed income. to finance an acquisition.g. Governments issue government bonds in their own currency and sovereign bonds in foreign currencies.) who borrows an amount of money (issuing the bond) and pays the interest. Investors will only give money to the company if they believe that they will be given something in return commensurate with the risk profile of the company. the date that the issuer must return the principal. if you lend money to a borrower and the borrower has to pay interest once a month. by giving equity in the company (stock). The maturity is the end of the bond. it often must raise money. car loans or mortgages) can be structured into other types of fixed income products such as ABS . While a bond is simply a promise to pay interest on borrowed money.asset backed securities which can be traded on exchanges just like corporate and government bonds.Fixed income: Fixed income refers to any type of investment that yields a regular (or fixed) return.is the amount that the issuer borrows which must be repaid to the lender. Companies can issue a corporate bond or get money from a bank through a corporate loan ("preferred stock" is also sometimes considered to be fixed income). The term fixed income is also applied to a person's income that does not vary with each period. When pensioners or retirees are dependent on their pension as their dominant source of income. Debt issued by government-backed agencies is called an agency bond. Fixed-income securities can be contrasted with variable return securities such as stocks. par value . buy equipment or land or invest in new product development. The principal of a bond .

in fact. the investment bank believes gold will rise so they speculate in gold futures. or purchase gold bullion outright for storage in secure vaults).g. an investment bank is nothing like the corner institution you're used to dealing with to get a business loan or deposit your paycheck. This was not the case in the rest of the world. Most of the problems you've read about as part of the credit crisis and massive bank failures were caused by the internal investment banks speculating heavily with leverage on collateralized debt obligations (CDOs). issuing bonds to help raise money for a factory expansion) Insure bonds or launching new products (e.g. commercial bank?" Unless you work in finance. along with a team of lawyers and accountants. investment banks in the United States were not allowed to be part of a larger commercial bank because the activities. To put it simply. These losses had to be covered by the parent bank .. Instead.Investment bank As the credit crisis unfolded. an investment bank would help them find buyers for the bonds and handle the paperwork. Countries such as Switzerland. and credit needs. If Coca-Cola Enterprises wanted to sell $10 billion worth of bonds to build new bottling plants in Asia. brokerage. you may not have come across the term investment bank before the global meltdown began.. often boasted asset management accounts that allowed investors to manage their entire financial life from a single account that combined banking.. In the next few minutes.g. for instance) to raise money for expansion or other needs. acquire call options on gold mining firms.. Activities of a Typical Investment Bank A typical investment bank will engage in some or all of the following activities: y Raise equity capital (e. y y y Up until ten years ago. although extremely profitable if managed well. cash management. helping launch an IPO or creating a special class of preferred stock that can be placed with sophisticated investors such as insurance companies or banks) Raise debt capital (e. posed far more risk than the traditional lending of money done by commercial banks.g. you're learn how investment banks make their money and why they helped cause one of the greatest financial meltdowns in history. I've heard a lot of investors asking the question "What is an investment bank and how does it differ from a regular. an investment bank is a special type of financial institution that works primarily in higher finance by helping company access the capital markets (stock market and bond market. such as credit default swaps) Engage in proprietary trading where teams of in-house money managers invests or trades the company's own money for its private account (e.

y y . diluting the existing stockholders. finance divisions. in some cases nearly wiping out regular stockholders. causing huge write-downs and the need for dilutive equity issuances. The sell side typically refers to selling shares of newly issued IPOs. which reported losses in excess of 21 billion CHF (Swiss Francs). A perfect example is the venerable Union Bank of Switzerland. Middle Office. placing new bond issues. engaging in market making services. or middle office services. to replace the more than 60% of shareholder equity that was obliterated during the meltdown.holding companies. professional investment management for institutions or high net worth individuals. and settled for the correct amounts. most of which originated in the investment bank. investment and capital market research reports prepared by professional analysts either for in-house use or for use for a group of highly selective clients. and Bank Office Many investment banks are divided into three categories that deal with front office. Back Office Investment Bank Services: The back office services include the nuts and bolts of the investment bank. It handles things such as trade confirmations. and strategy formulation including parameters such as asset allocation and risk limits. the software and technology platforms that allow traders to do their job are state-of-the-art and functional. Many investment banks offer both buy side and sell side services. Without them. The back office jobs are often considered unglamorous and some investment banks outsource to specialty shops such as custodial companies. ensuring that the correct securities are bought. corporate finance (such as issuing billions of dollars in commercial paper to help fund day-to-day operations. The buy side. they allow the whole thing to run. mutual funds. It also includes capital flows. Middle Office Investment Bank Services: Middle office investment banking services include compliance with government regulations and restrictions for professional clients such as banks. This is sometimes considered a back office function. y Front Office Investment Bank Services: Front office services typically consist of investment banking such as helping companies in mergers and acquisitions. sold. The team in charge of capital flows can use that information to restrict trades by reducing the buying / trading power available for other divisions. and more. The Buy Side vs. Sell Side of an Investment Bank Investment banks are often divided into two camps: the buy side and the sell side. and the investing public to help them maximize their returns when trading or investing in securities such as stocks and bonds. worked with pension funds. back office. The legendary institution was forced to issue shares as well as mandatory convertible securities. Nevertheless. or UBS. insurance companies. merchant banking (which is just a fancy word for private equity where the bank puts money into companies that are not publicly traded in exchange for ownership). These are the people that watch money coming into and out of the firm to determine the amount of liquidity the company needs to keep on hand so that it doesn't get into financial trouble. etc. Front Office. or helping clients facilitate transactions. nothing else would be possible. hedge funds. in contrast. the creation of new trading algorithms.

according to the company¶s operating agreement. let¶s take an extreme example. Perhaps I use the money to buy up local restaurants. The operating agreement. because the more I make him. gold. The manager of the hedge fund. He writes the company a check. the $100 million gain would be reduced by $4 million for that ³hurdle´ rate. typically the person that created it. or anything else of value. A Fictional Hedge Fund to Help You Understand What a Hedge Fund Is To make the idea easy to understand. startups. In this case. my purpose is to put my investor¶s capital to work at the highest rate possible (adjusted for risk. art. The net result is that I walk away with $24 million in compensation.for more information read The Basics of Shorting Stock). For argument¶s sake. the more I get to take home. ³Hedge Fund . mutual funds. I put it into our brokerage account. and invest the cash according to any guidelines that were spelled out in the operating agreement. Along comes a single investor that puts $100 million into my hedge fund. Either way. the creditors can't go after the investors for more money than they've put into the hedge fund. as it is often called on Wall Street (because you have to clear that ³hurdle´ as the hedge fund manager before you are ever paid a dime under an arrangement like this). the term hedge fund is a generic term used for any such arrangement. The news headlines are going to say. wine. It can take the legal form of a limited liability company or a limited partnership so that if the company goes bankrupt. Now. image that I made an unbelievable investment the first year. doubling the company¶s assets from $100 million to $200 million. bonds. the first 4% belongs to the investor with anything above that being split 25% to me 75% to my investor. Today. the point is that every day when I wake up and go to the office.Hedge fund: A hedge fund is simply a term used to describe an investment partnership setup by a money manager. which is the legal document that says how the company is managed. My investor gets the $4 million hurdle earned and $72 million from the split to which they are entitled above that hurdle for a grand total of $76 million. real estate. Maybe I start a new company. The term was originally used because the purpose of many of the first hedge funds was to make money regardless of if the market increased or decreased because the managers could either buy stocks or short them (shorting is a way to make money when a stock falls . is paid a percentage of the profits he or she earns on the money investors have deposited with his company. states that I will receive 25% of any profits over 4% per year and that I can invest in anything ± stocks. rare stamps. Imagine that I setup a company called ³Global Umbrella Investments. The remaining $96 million is split 25% to me and 75% to my investor. collectibles. LLC´ as a Delaware corporation. of course).

never once mentioning the massive payday I delivered to the people who entrusted me with their funds. So.Manager Earns $24 Million!´ yet it doesn¶t tell you that I earned my investors $76 million. The newspapers would write articles about how I was earning ridiculous amounts of money. . It¶s called the 2 and 20 and it is used by a large majority of hedge funds currently in operation according to some estimates.6 billion. If I were managing $10 billion. clients would defect before long so it really is in the best interest of the fund manager to maximize returns. Obviously. they are at least guaranteed the 2% return with little or no hurdle rate. That means that even if they lose money. The 2 and 20 formula basically means that the hedge fund¶s operating agreement calls for the hedge fund manager to receive 2% of assets and 20% of profits each year. my compensation would have been $2.4 billion and I would have made my investors $7. "what is a hedge fund?" then you are certainly going to need to know about the most famous compensation formula in the industry. The Infamous 2 and 20 Hedge Fund Arrangement If you ask the question. a manager earning $1 billion might make $20 million even if the company did nothing but park the money in the bank. with anemic returns like that.

these documents can be very difficult to come by. in return for which you will not only pay them back tomorrow. a broom for example. A bondholder is mailed a check from the company at set intervals. but buy them dinner as well.BONDS: A Bond is simply an 'IOU' in which an investor agrees to loan money to a company or government in exchange for a predetermined interest rate. it is common for bonds to pay interest twice a year. while a much less stable start-up pays 10%. pension funds. If a business wants to expand. a variety of institutions. The rate of interest a bondholder earns depends on the strength of the corporation that issued the bond. you ask your shopping buddy to borrow a few dollars so you can purchase the broom now. When companies such as Exxon Mobile. Unfortunately. a blue chip is more stable and has a lower risk of defaulting on its debt. or mutual funds. each having different features and characteristics." Who can issue bonds? Governments. It is entirely up to the "contract" that governs the bond offering. finding these terms acceptable. Your friend. In some other countries. General Electric. The company issues bonds at various interest rates and sells them to the public. A few of the most notable are zero coupon and convertible. and corporations. Still other bonds can pay monthly interest. What Are They? Say you are in the grocery store with a friend on a Thursday afternoon and see something you need for your house. For example. Although you get your paycheck the next day. one of its options is to borrow money from individual investors. bonds pay interest once a year. There are many types of bonds. issue bonds. loans you the money and you purchase the item. the riskier the bond. A general rule of thumb when investing in bonds is "the higher the interest rate. in the United States. et cetera. municipalities. . they may only pay 7% interest. Investors purchase them with the understanding that the company will pay back their original principal (the amount the investor loaned to the company) plus any interest that is due by a set date (this is called the "maturity" date). unlike the 10K or annual report of a share of stock.

bonds have several traits that stocks simply can't match. are the bank.000 yearly). capital preservation. or they can 2. When a company issues bonds. considerations before adding them to your portfolio. They can either 1. Once you're ready to move beyond the very basics.) issue bonds.000 worth of bonds that paid 8% interest annually (that would be $8. etc. roads. a bondholder can be almost completely certain that they will receive the amount they originally invested. which are immune from most state taxes. or those who need the cash flow. Why Would Anyone Invest in Bonds? Most everyone knows that over the long-run. it doesn't generate enough cash internally to pay for the supplies and equipment necessary to keep it growing. US Savings Bonds: Get a broad education on savings bonds. and tax notes. why would anyone invest in bonds? Although they pale in comparison to equities in the long run. hospitals. Stocks. giving them money to live on or invest elsewhere. Unless a company goes bankrupt. is a great place to begin if you are in a middle to high tax bracket. The Ways to Invest in Bonds There are several types of bonds in which you can invest and even more ways you can hold these bonds. When a government or municipality issues various types of bonds to raise money to build bridges. Generally. it is the same thing as a mortgage only you.This is. you can not only help your community. when looking at a municipal bond investment. Bonds can also have large tax advantage for some people. . By investing in your local schools. it is borrowing money from investors in exchange for which it agrees to pay them interest at set intervals for a predetermined amount of time. bonds pay interest at set intervals of time. This can be especially advantageous for those whom are retired or want to minimize their total tax liability. It is our hope that it lowers your risk and helps you avoid expensive mistakes. individuals. This being the case. and municipalities. This article will teach you some of the calculations you can do. most businesses have one of two options. In essence. which can provide valuable income for retired couples. the interest that is earned is tax exempt. if someone owned $100. you can read Tests of Safety for Municipal Bonds. which are subordinate to bonds. but make money. a fraction of that interest would be sent to the bondholder either monthly or quarterly. Investing in Municipal Bonds: This complete beginner's guide to investing in municipal bonds. the considerations you should make.) sell a portion of the company to the general public by issuing additional shares of stock. Secondly. For instance. their history.. in essence. Because of this. what happens in the corporate world when a company issues bonds. nothing beats the stock market. First. Here are some resources and articles that you may want to consider. bear the brunt of unfavorable developments. as a business grows. the investor.

these dangerous bonds can lure you in with the promise of big checks in the mail. on and are backed by the taxing articles will teach you how to own them. a fixed rate of return for up to thirty years. Junk Bonds: One of the most alluring types of bonds new investors often spot is something known as a junk bond. and advantages? Take a few moments to read the article to discover the answers. What are the differences. power of the United States Government. Bonds: Many new investors don't know whether they should own bonds outright or invest in bonds through a special type of mutual fund known as a bond fund. tell you who is eligible to purchase limits. and more. . and explain the annual Bond Funds vs. in part. double-digit yields. To understand bond investing. compared to full 35%+ depending upon your tax bracket on interest income on bonds. Boasting high. This collection of invest in Series I savings bonds.Series EE Savings Bonds: These unique bonds offer tax advantages for education funding. interest rate based. Series I Savings Bonds: Series I savings bonds feature an changes in inflation. are guaranteed to never lose money. The Many Flavors of Preferred Stock: The preferred stock of many companies is actually very comparable to bond investments because both types of investments tend to behave the same way. benefits. the guarantee of the United States Treasury. yet leave you high and dry when the companies that issue them miss payments or go bankrupt. you need to understand preferred stocks because the tax laws allow you to pay only 15% on dividend income received from preferred stocks.

and options. forward. which have a theoretical face value that can be calculated using formulas. and the seller agrees. then a derivative has been created. equity derivatives. not now). the real definition of a derivative is an agreement between two parties that is contingent on a future outcome of the underlying. exchange-traded or over-the-counter) pay-off profile (Some derivatives have non-linear payoff diagrams due to embedded optionality) Another arbitrary distinction is between: y y vanilla derivatives (simple and more common) and exotic derivatives (more complicated and specialized) .Derivatives: In non-financial-expert terms.or more simply. Derivatives are usually broadly categorized by the: y y y y [2] relationship between the underlying and the derivative (e. with the most notable being swaps. a derivative is a financial instrument . since a derivative can be placed on any sort of security. are frequently traded on open markets before their expiration date as if they were assets. For example. a person goes to the grocery store. or true. both parties have something tangible. such as Black-Scholes. The agreement (derivative) is derived from a proposed exchange (trade money for apple in one hour. futures.g. a derivative is an agreement or contract that is not based on a real.. However. In financial terms.. that is being exchanged. some more commonplace derivatives. This is erroneous. the scope of all derivatives possible is near endless. and options. If the purchaser had called the store and asked for the apple to be held for one hour while the purchaser drives to the store. such as swaps. foreign exchange derivatives. or a product. exchange ie: There is nothing tangible like money. The exchange is complete. option.g.. since a derivative is incapable of having value of its own.such as a share or a currency. interest rate derivatives. exchanges a currency (money) for a commodity (say. an apple).[1] It is a financial contract with a value linked to the expected future price movements of the asset it is linked to . There are many kinds of derivatives. swap) type of underlying (e.g. futures.that has a value determined by the price of something else (called the underlying). Thus. However. A common misconception is to refer to derivatives as assets. commodity derivatives or credit derivatives) market in which they trade (e. an agreement between two people or two parties .

e. If the grain price falls sharply. Derivatives are used by investors to y y y y y provide leverage or gearing. A commonly used example is a grain (i. or similarly can reduce risk by buying or selling derivatives. Although it is crucial that a mechanism for delivery or settlement exists to tie the futures contract price to "the underlying". weather derivatives) create optionability where the value of the derivative is linked to a specific condition or event (e.. How are derivatives used? Derivatives are generally used to manage the risk of monetary loss or gain.Basics A derivative is a contract with financial performance that is derived from the performance of something else. thus eliminating the risk of the price falling between now and when the crop is ready for delivery. so the distinction is mostly a matter of custom. and the underlying asset is the edible grain such as wheat or corn. An example is a call option on a stock. The farmer obtains a guarantee he will be able to sell his grain for the agreed price. the underlying reaching a specific price level) Derivatives . moves in a given direction. A farmer who grows grains can enter into a contract that is an obligation to sell the grain at a fixed price at a date in the future. The contract is the derivative. and the investor loses money. That "something else" is an underlying asset commonly termed "the underlying" and may be another financial instrument. in which the option is the derivative and the stock is the underlying asset (also see the FAQ article on stock option basics). An investor takes the other side of the contract agreeing to buy the grain at that fixed price for delivery on that future date. reaches a certain level) hedge or mitigate risk in the underlying. A person or organization can take on additional risk by buying or selling derivatives. stays in or out of a specified range. commodity) future.g..g. the farmer still receives the payment specified in the contract. or an index of some kind. higher price. If the grain price rises sharply.g. another derivative. by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out obtain exposure to underlying where it is not possible to trade in the underlying (e.There is no definitive rule for distinguishing one from the other. again the farmer receives the payment specified in the contract. such that a small movement in the underlying value can cause a large difference in the value of the derivative speculate and to make a profit if the value of the underlying asset moves the way they expect (e. it is important to note that for most futures only a . and the investor may make a profit by reselling the grain at the current...

In derivatives-speak they are said to have approximately constant delta. Trading in OTC derivatives is generally only available to professional investors in the wholesale market. exchanging a stream of fixed rate payments (such as those received from a fixed rate bond) for a variable rate payment stream. Exchange Traded derivatives are standardized contracts. Most positions are closed before the delivery or settlement date. delta being the change in value of the derivative contract for the change in the price of the underlying instrument. There may be conditions that must be fulfilled before the right to enter in to the agreement is conferred. The clearinghouse is well capitalized and has rules regarding collateral that must be posted by each trader reflecting the financial performance of that trader's contracts so as to minimize the risk of losses by the clearinghouse. Banks. Swap contracts are agreements to exchange one asset or liability for another. without reference to an exchange or any other third party. In general. As with futures and forwards. options may be traced either on exchanges or OTC. To reduce the risk of default by either party to a contract. futures. Such a contract is called a "future" when traded on an exchange or a "forward" when traded OTC. insurance companies and hedge funds are active users of the OTC derivatives market. Exchanges for derivatives include the Chicago Mercantile Exchange (CME) and the London International Financial Futures Exchange (LIFFE). forwards and swaps have payoff profiles that are approximately linear functions of the performance of the underlying. Over-the-counter (or "OTC") derivatives are simply derivative contracts agreed by two counterparties between themselves. What are some types of derivatives? A future or forward contact is an agreement to enter into a financial transaction at a given price on a given date or dates in the future. pension funds. Options are the right but importantly not the obligation to enter into a pre-arranged financial agreement at a pre-defined price on a future date or dates. fund managers. for example. The asset or liability is usually a future payment or stream of payments. If it is an interest rate swap this may involve exchanging income flows. Credit default swaps (which are typically traded OTC) are a good example of this. These measures minimize the possibility of a clearinghouse defaulting. an exchange-traded derivatives contract usually goes through a clearing process whereby a clearinghouse becomes the counterparty to each of the traders rather than each other. however. How are derivatives traded? Derivatives may be traded on exchanges or over-the-counter. Options. Standardization should improve liquidity but obviously comes at the expense of the ability to customize a transaction to an individual trader's requirements.small fraction of the contracts traded are actually delivered or settled. If it is a foreign currency swap this may entail buying a currency on the spot market and simultaneously selling it forward. will have a payoff .

Commercial Paper (issued by companies) or Bankers Acceptances. For what types of underlying markets are derivatives traded? A wide variety of derivatives exist. Spot foreign exchange. Please see those sections. and crude oil. The market price of these bonds is typically much less than face value when a default occurs so the CDS buyer will profit and the CDS seller will lose.typically LIBOR (the London Interbank Offered Rate) or some other similar index of the rates at which banks are willing to enter OTC lending transactions with each other. unlike loans. forward foreign exchange contracts and credit default swaps (CDS) are the most widely traded OTC derivatives.a credit default swap (CDS). interest rate swaps (IRS). gold. This can make option trading much more complex than trading approximately linear derivatives. They may generally be freely traded without reference to the issuer of the security. They may be constructed with reference to financial assets (such as stock market indexes like the Dow Jones Industrial Average) or even to temperature or rainfall (in the case of weather derivatives). . Others include pork bellies. As these rates change relative to your "home currency" (dollars if you are in the US) you make or lose money. just as an option would if it was not worth exercising. The "underlying" may include the following. differing mainly in their maturity . y Credit risk . coffee beans.profile that is a non-linear function of the value of the underlying instrument. y Equities (termed stocks in the US). is actually more like an option or insurance contract. bill futures and government bond futures) and commodity futures are the most widely traded futures. y Commodities. y Indexes . y OTC money market indexes .always less than one year. If the named issuer does not default during the agreed period of the CDS the contract expires worthless.many index varieties are used as the underlying for derivative contracts. These are much like bonds. y Short term ("money market") negotiable debt securities such as Treasury Bills (issued by governments). orange juice. This is the buying and selling of foreign currency at the exchange rates that you see quoted on the news. silver. This FAQ offers many articles about futures and options. despite its name. y Stock index futures. Bonds are medium to long-term negotiable debt securities issued by national governments. y Government bonds. and typically less than 90 days. like grain discussed in the example above. Interest rate "forward rate agreements" (FRAs). interest rate futures (including deposit futures. In exchange for a stream of premium payments the buyer of a vanilla (or "single issuer") CDS obtains the right to require the CDS seller to purchase bonds of the issuer named in the agreement at a given price (usually the face value) but only if the named issuer triggers a default or other similar "credit event".

Derivatives.like interest rate swaps.all the time. Such a collapse could cascade. They try to balance all these promises (hedging). risk-taking and regulation In the last few years derivatives and their use by large institutions became a hot topic. typically we would still expect the index future to move in roughly the same fashion as the portfolio. and taxpayers around the world are being forced to pay huge sums so financial markets keep functioning. This is termed "systemic risk" . Many banks took on so much risk (bought assets that suffered losses) that they collapsed. for example. Although the stock portfolio may contain a different mix of stocks than the stock index. And of course although banks may be using derivatives to hedge (reduce) risk. There is significant basis risk when the correlation between the derivatives hedge and the risky position is weak. Taking on risk is how a bank makes money. they may also be using them as a way of increasing risk to make money. options on futures . What really concerns regulators is the fact that big banks swap all kinds of promises . profit) can ensue. However it is easy for a bank to take accidentally take on too much basis risk. as more and more institutions fail to meet their obligations because they were counting on the defaulted contracts to protect them from losses. especially to regulatory agencies.the risk that the failure of one institution could bring down many others in the financial system. An example is selling a stock index future to protect against a loss in a generalized (non sector specific) stock portfolio. Some hedging (risk reduction) with derivatives is done by offsetting an existing position with a related derivative that is strongly correlated with the position to be hedged. but there remains a danger that one large institution will go bankrupt and leave others holding worthless promises. or breaks down in a crisis . . As of this update (2009). issuing loans is a risk. Potentially big losses (or if the investor is lucky. derivatives are being blamed for many of the financial losses suffered by banks and other financial institutions around the world. forward currency swaps.exactly when effective hedging is needed most. The risk that the value of the derivatives position does not move in exactly the same way as that of the stock portfolio is termed "basis risk". New regulations are promised so that use of derivatives is more transparent.

Aims of regulation The specific aims of financial regulators are usually: y y y y y To enforce applicable laws To prosecute cases of market misconduct. restrictions and guidelines.Financial regulations: Financial regulations are a form of regulation or supervision. which subjects financial institutions to certain requirements. aiming to maintain the integrity of the financial system. This may be handled by either a government or non-government organization. and investigate complaints To maintain confidence in the financial system . such as insider trading To license providers of financial services To protect clients.