Basic Market Terminology And Concepts

In this post, we shall discuss some of the basic concepts related to markets and the terminology associated with trading.

Perfect Market: A market is said to be perfect, when all the potential sellers and buyers are promptly aware of the prices at which transaction takes place. Any buyer can purchase from any seller. The principle underlying perfect markets are as follows:

- Expectations that there must be a uniform price for anyone standardized asset or instrument at a particular time, at any one place.
- There should not be restriction on the movement of the asset.
- There must be a good number of buyers and sellers.

Imperfect Markets: Imperfect markets are where, some buyers or sellers both are not aware of the offers made by others. Restrictions for movement of goods exist and different price, rule in the market for the same at a particular time.

Monopoly Market: It is a market situation, wherein there is only one seller of a commodity.

Duopoly Market: It has two sellers of a commodity in the market.

Oligopoly Market: In this market there are more than two but still a few sellers of commodity.

Monopolistic Competition: A large number of sellers deal in heterogeneous.

Long Position: The term long position refers to buying an asset or security. The reason for the word “long” to be associated with buy is that traders usually are “longing” to take possession of an asset, when they have bought a futures or options contract.

Short Position: The word short position refers to the selling an asset or security. This is the opposite of long.

Price-Taker: A price taker is an investor who trades based on buy/sell price quoted by a bigger established counterparty – also referred to as the market maker (or price maker). The price taker’s trades do not have a significant impact on the market price movements. This is because price takers usually do not trade in high volumes or may be restricted by regulation. A firm that can alter its rate of production and sales, without significantly affecting the market price of its product is also a price-taker. In the context of the securities markets, individual investors are price-takers.

Market Maker: Market Maker refers to a broker-dealer firm that accepts the risk of holding a certain number of shares of a particular security, in order to facilitate trading in that security. Each market maker competes for customer order flow by displaying both buy and sell quotations for a guaranteed number of shares. Once an order is received, the market maker immediately sells from its inventory or seeks an offsetting order. This process takes place on electronic trading platform in less than a second.

The NASDAQ is the prime example of an operation of market makers. There are more than 500 member firms that act as NASDAQ market makers, keeping the financial markets running efficiently because they are willing to quote both bid and offer prices for an asset. Market makers are vital to the efficiency and liquidity of the marketplace. By quoting both bid and ask prices on the market, they always allow investors to buy or sell a security if they need to.

Bid: Bid is an offer made by an investor, a trader or a dealer to buy a security. The bid will stipulate both the price at which the buyer is willing to purchase the security and the quantity to be purchased.

Bid is also the price at which a market maker is willing to buy a security. The market maker will also display an ask price, or the amount and price at which it is willing to sell. This is the opposite of “Ask“, which stipulates the price a seller is willing to accept for a security and the quantity of the security to be sold at that price.

An example of a bid in the market would be Rs. 1,300 for buying 1 share of say, Reliance Industries Limited. This means that an investor is willing to purchase 1 share at the price of Rs. 1,300. If a seller in the market is willing to sell 1 share for that price, then the order is executed into a trade.

Ask: The ask price is the price that a seller is willing to accept for an asset / security, also known as the offer price. Along with the price, the ask quote will generally also stipulate the amount of the security willing to be sold at that price.

This is the opposite of bid. The ask price will always be higher than the bid. The terms “bid” and “ask” are used in nearly every financial market in the world covering stocks, bonds, currency and derivatives. An example of “Ask” in the stock market would be for example, Rs. 1,301 quoted for selling 1 share of Reliance Industries Limited. This means that the seller is offering to sell 1 share for Rs. 1,301.

Best Bid: The Best bid (best buy quote) is the highest of all buy quotes. Simply put, this is the highest price someone is willing to pay for buying an asset/security.

Best Ask: The best ask (best sell quote) is the lowest of all sell quotes. In layman’s terms, this is the lowest price at which the seller of asset/security is willing to sell.

Bid-Ask Spread: The bid-ask spread is the difference between the best buy quote and best sell quote.

Insider Information: Insider information is material information about a company’s activities that has not been disclosed to the public. It is illegal for anyone with access to insider information to make trades based on it.

Insider Trading: The buying or selling of a security by someone who has access to confidential material / non-public information about the security is usually referred to as Insider Trading.

Insider trading can be illegal or legal depending on when the insider makes the trade: it is illegal when the material information is still non-public, i.e., the insider has indulged in trading while having specific knowledge of the business activities or plans of the company. This is unfair to other investors, who do not have access to such information. Illegal insider trading therefore includes tipping others when you have any sort of non public information.

Insider trading is legal once the material information has been made public, at which time the insider has no direct advantage over other investors. SEBI requires all insiders to report all their transactions. So, as insiders have an insight into the workings of their company, it may be wise for an investor to look at these reports to see how insiders are legally trading their stock.

Market Timing: Market timing is described as the act of attempting to predict the future direction of the market, typically through the use of technical indicators or economic data. The practice of switching among mutual fund asset classes in an attempt to profit from the changes in their market outlook can also be called as market timing.

Some investors, especially academics, believe it is impossible to time the market. Other investors, notably active traders, believe strongly in market timing. Thus, whether market timing is possible is really a matter of opinion.

It is very difficult to be successful at market timing continuously over the long-run. For the average investor who doesn’t have the time (or desire) to watch the market on a daily basis, there are good reasons to avoid market timing and focus on investing for the long-run.

Market Value And Price: Markets exist to determine price for an asset. If the investors are of the view that the security would be in demand the prices would rise and if they are of the view that supply for the asset is high then the prices would fall. Information about the demand and supply of an asset or a security helps the market players to make their investment decisions this in turn helps discovery of prices in the market.

An asset value is the intrinsic value an asset gains by the benefits it provides to the investors or the value it gains due to the productivity of a firm. For example – A company which is performing well in operations will be valued high by the investors and thus would be pursued by the investors whereas a company with poor operations might not be valued as high as the former company. The price for an asset is determined by the value which investors attach to it.

Broker-Dealer: A person or firm in the business of buying and selling securities operating as both a broker and a dealer depending on the transaction is referred to as a broker-dealer. Technically, a broker is only an agent who executes orders on behalf of clients, whereas a dealer acts as a principal and trades for his or her own account. Because most brokerages act as both brokers and principals, the term broker-dealer is commonly used to describe them.

Primary Dealer: A pre-approved bank, broker/dealer or other financial institution that is able to make business deals with the central bank (RBI), such as underwriting new government debt. These dealers must meet certain liquidity and quality requirements as well as provide a valuable flow of information to the RBI about the state of the financial markets.

These primary dealers, which all bid for government securities competitively, purchase the majority of Treasuries at auction and then redistribute them to their clients, creating the initial market in the process.

Fundamentals: Information is qualitative and quantitative in nature that contributes to the economic well-being and the subsequent financial valuation of a company, security or currency. Analysts and investors analyze these fundamentals to develop an estimate as to whether the underlying asset is considered a worthwhile investment. For businesses, information such as revenue, earnings, assets, liabilities and growth are considered some of the fundamentals. By looking at the economics of a business, the balance sheet; the income statement, management and cash flow, investors are looking at a company’s fundamentals, which help determine a company’s health as well as its growth prospects. A company with little debt and a lot of cash is considered to have strong fundamentals.

Fundamentals are most often considered factors that relate to businesses. Securities and currencies also have fundamentals. For example, interest rates, GDP growth, trade balance surplus / deficits and Inflation levels are some macroeconomic factors that are considered to be fundamentals of a currency’s value.

Novation: Novation is a term conceptualized by exchanges to minimize counterparty risk or credit risk. In a transaction, the buyer has an obligation to take the delivery of the traded security in exchange for funds being paid to the seller while the seller has an obligation to give the delivery of the security in exchange of funds accepted from the buyer. If either of the counter party fails to honor his or her obligation the transactions fails. The risk arising out of the defaulting counterparties is termed as Counterparty risk or Credit Risk. The exchange operates to mitigate this risk by replacing the obligations of the counterparty by its own obligation i.e., it serves as a buyer to the seller or seller to the buyer and hence ensures completion of the transaction. By this mechanism it allows, smooth processing of trades contributing efficiency to the trading cycle.

Clearing: Clearing is one of the links of a trading cycle. Clearing serves to consolidate transactions or trades and then it computes the obligations that need to be settled. It uses multi lateral netting to do this. Clearing thus helps to reduce transaction costs and improves operating efficiency by employing multi lateral netting in the clearing process. In a trading cycle the clearing process takes T+1 i.e., 1 day after the trading day.

Transparency Due To Automated Trading: Today, Indian capital markets follow screen based trading provided by the stock exchanges which have made the markets transparent than before which used an open outcry system to trade. Open outcry systems allowed the traders to use different prices to conduct a favorable trade. But screen based trading allows uniform determination of prices which helps mitigating any informational asymmetry among the market participants. Thus, electronic systems have contributed towards improving efficiency.

Trading Cycle: Trading Cycle is the process followed by the exchanges to carry out trades. Today Indian Markets follow a T+2 trading cycle which comprises trading period, clearing, settlement, and post settlement period. Post settlement periods may vary depending upon the outcome of settlement in case of failure to deliver then the trading cycle would comprise of auctions and other related processes and would take up to 9 days depending upon the outcomes.

Price Discovery: Price discovery refers to the method of determining the fair value of a specific commodity or security. When large number of participants converge at a marketplace – it may be noted that the marketplace may be a physical marketplace or an electronic trading platform – a continuous auction process between the buyers and sellers leads to creation of active demand supply interest in the asset (security / financial instrument). This leads to the discovery of the fair value of the asset.

Disintermediation: Disintermediation is the removal of intermediaries which help to mediate funds from the savers to the borrowers. Disintermediation provides direct access for the borrowers to directly borrow from the investors. For example – By issuing bonds a firm can borrow funds to finance its projects without approaching the banks this allows the issuer of securities to borrow at lower costs. Disintermediation thus creates a lot of opportunities for firms like investment banks to help these firms in capital raising decisions.

Public Interest In Context Of Competition Issues And Mergers: In a market, an individual chooses to trade in a particular stock thinking that he/she would benefit from the trade in terms of high returns. He/she makes investment decisions depending upon how he evaluates the firm and whether he/she would be able to derive value from its operations. If a new firm is more productive than the company in which he/she is investing he might exit the firm and buy shares of the other firm. A merger or a takeover would mean change in management or structure of the firm. An investor is offered an opportunity to exit at the prevailing price depending upon how he views the proposal. If he/she feels the merger would add value to the firm by increasing productivity and employing good management practices then he would prefer to keep the stock with himself but if he thinks otherwise he would prefer to do away with the shares and would sell them.

Fungibility: Fungibility refers to the property/characteristic of a good or asset that describes its interchangeability with other individual goods/assets of the same type. Assets possessing this property simplify the exchange/trade process, as interchangeability assumes that everyone values all goods of that class as the same.

Example: Shares trading in NSE and BSE in the cash segment are fungible – because you can buy in NSE and sell in BSE or vice versa.

Equality Of Treatment: Equality of treatment stresses that all shareholders should be treated equally. Often it is found during times of takeovers, smaller (retail) shareholders are not treated equally. To discourage the same, SEBI came up with the Takeover Code in 1997. This ensured that the minority shareholders’ interests are protected as follows:

- There is fair and truthful disclosure of all information relating to the takeover.
- Shareholders get enough time to make informed decisions.
- No false market in the shares of the companies is created.
- Shareholders’ approval is taken for any action by the target company.

However, there have been several criticisms of the regulation of takeovers. Financial Institutions have been permitted to fund takeovers by foreign companies and this has come under criticism – a little erroneously because any change of management that leads more efficient management deserves to be encouraged. Secondly, figures show that only 17.6% of corporate restructuring has been through open offers, indicating that exemptions have been more common than the rule of open offers.

Agency Theory: Agency theory explains the relationship between principals (owners), such as a shareholders, and agents, such as a company’s executives. In this relationship, the principal delegates or hires an agent to perform work. The theory attempts to deal with two specific problems: first, that the goals of the principal and agent are not in conflict (agency problem), and second, that the principal and agent reconcile different tolerances for risk, for example, a manager opting for a risky investment, whereas majority of the shareholders are against it.

Behavioral Finance: Behavioral Finance is one of aspects of finance which explains different stock market events or happenings that come to light as an outcome of investor sentiments. Capital Markets are platforms which have emerged from buyers and sellers who have varied perceptions about how the prices or asset values would move. Investors take decisions depending upon their know how of the asset demand and supply in the market. In other words one can say that a market’s existence relies on what investors or the market participants think of the assets.

If all the investors think that if the prices of certain assets increase, then this would impact the overall market, which would follow in tandem, and vice versa. Behavioral Finance uses a number of psychological tools to analyze the investment strategies used by investors and their effectiveness.

The Herd Instinct is another market-phenomenon characterized by a lack of individuality, causing people to think and act as the general population does. This term is used in the investing world to refer to the forces that cause unsubstantiated rallies or sell-offs.