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Web Links & Resources
|Newsletters - Daryl Guppy & JustData Newsletters|
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|MetaStock - Technical Analysis from A to Z|
Definitions & Information
|What is a Share?||The First Shares||The Stock Exchange|
|Opening an Account||Brokerage Fees||The Rights of Shareholders|
|Securities Traded on the Exchange||Booms and Crashes|
|Charting Methods||Economic Cycles||Indices|
|Authors & Traders:|
|Daryl Guppy||Alan Hull|
What is a Share?
To the uninitiated, shares may seem a little like some imaginary game that people play. In the days of share certificates one could be forgiven for thinking that people were buying and selling pieces of paper. These days there are no longer even pieces of paper to recognise ownership, just electronic 'blips' on a computer system. This may create an appearance of insubstantiality, but keep in mind that any apparent lack of substance is only that - an appearance.
Real estate enthusiasts sometimes use the expression 'kick the bricks', implying that a house is a real object and that therefore it is somehow safer as an investment. However, the ownership of any particular property is registered on a contract (or a piece of paper), which is then turned into a computer 'blip'. Buying and selling real estate is nothing more than changing signatures on pieces of paper.
A share is also nothing more than a registration of ownership. The ownership in this case is of a company. A company in turn is simply a legal identity which owns real things. These real things include objects such as real estate, land, cash, and inventories.
Please do not think that there is any argument here that shares are better than real estate or vice-versa. As investors and traders, our interest is purely to sell something at a higher price than we paid. What that something happens to be is of minor concern. If real estate prices are booming and shares are falling, then clearly real estate is the better investment. However, if shares are running up strongly and real estate is weak, clearly shares are the better investment. Also on the point of risk, there are shares that are 'safer than houses'. There are also property deals that are more risky than the most speculative of shares. The same concept applies across all investment classes including bonds and cash at the bank. An argument over asset classes per say is an exercise in futility. The real issues are simply timing and risk - is it an appropriate time to invest in this asset class, and within that class, how much risk is being taken by the specific investment choice. These are the issues that really count. Our topic of interest is however shares. To begin, a little history will be helpful.
The First Shares
By the late 1500's merchants were transporting goods from many corners of the earth for sale on the local markets of Europe and England. Financing such voyages could of course be a risky venture. Some ships didn't return after mutinies, pirates, reefs, storms, and belligerent natives took their toll. Merchants soon realised that they could lower the impact of such events on their personal wealth by funding a voyage with the help of investors. In this way, an individual or merchant could be involved in a number of voyages to various places. The loss of a ship every now and then need not be a major catastrophe (unless you happened to be a sailor).
The first company to finance such expeditions through the sale of shares was the Indian Oriental Company founded in Amsterdam in the early 17th century. In 1611 a building was set aside for the purpose of trading shares in Holland and so the first fixed stock exchange came into being. This building became the scene of the first major financial transactions in shares. Stock was traded previous to this, but the markets tended to be loose gatherings of investors. In fact, the world's first joint-stock company, the Muscovy Company was founded in England in 1553. Stock in these companies was traded through brokers in coffee shops, docks and alleyways.
The shares we now trade are simply a portion of the ownership of companies - the key vehicle of trade and merchant activity of today. Similar risks still exist, we now have strikes, corporate raiders, regulatory and project glitches, natural disasters, and a whole host of international risks - it appears that things have not changed all that much over the centuries.
The Stock Exchange
An exchange is simply a single place where people meet to exchange ownership of shares and for businesses to raise capital (called a 'float'). To trade on the exchange however, one must be a member. There are rules and regulations to maintaining membership, not to mention a cost. Members who offer to transact share trades for the public are called brokers. As private citizens, we can only trade through a broker, unless we purchase a seat on the exchange.
The first Australian exchange began in 1837 in Sydney. Another five exchanges were established in each state until in 1987 the exchanges were amalgamated to create the ASX. The stated purpose of the ASX is to:
Up until 1998 the exchange was owned by a mutual organisation of its members, the stockbrokers. On the 13th of October the ASX converted to a company limited by shares and listed on the exchange the following day. Now anyone can be a shareholder of the exchange.
The Australian stock market is no longer a gathering of people who auction for shares. Through SEATS (Stock Exchange Automatic Trading System), brokers execute orders via computer connections to the stock exchange's trading computer. The computer market allows automatic processing of orders directly onto the market. This is a more efficient system than series of phone calls and 'on-floor' auctioning process that operated up until 1990.
Along with a computer-based market, the ASX developed a system of electronic registry of ownership. This is known as the CHESS system (Clearing House Electronic Subregister System), which replaced the older paper share certificates. Although share certificates looked and felt like money, were quite ornate, and so were 'comforting' to hold - the electronic system is far more efficient. Share certificates could be lost and delivery or replacement from the company registry used to take weeks. With the CHESS system, registry of ownership is immediate.
A 'T+3' settlement system was introduced on the 1st of February 1999. This means that payment and receipt of funds from a sale will be available to the trader on a 'trade+3 days' basis. Brokers must pay for their clients' purchases within 3 days. Naturally, this means that we as clients must have a cheque to the broker within 3 days of placing an order. Most brokerage firms run, or have agreements with, cash management trusts through which clients may pay for purchases and funds are deposited. These operate much like a bank account and pay interest at a rate a little better than the average bank account. Anyone can take advantage of the rates by opening a cash management trust through a broker, even though the funds may never be used for shares.
Opening an Account
To trade shares, one must open an account with a broker. This is a very easy process and any broker would only be too happy to help. The first step is however, to find a broker. The ASX provides a list of all member brokers and it can be obtained from their website or by phone call. The choice of which broker to use will be a function of the fees charged by the firm and your confidence in the particular individual. It is best to meet your broker in person to help with this judgement.
To open an account, the prospective trader will need to fill out two forms. A CHESS sponsorship agreement and an application form. The sponsorship agreement essentially allows the broker to register the purchase and sale of shares with the CHESS system on your behalf. There is no need to feel tied to a particular broker just because a sponsorship agreement has been signed. The investor may be sponsored by as many brokers as desired. There is no obligation to sell shares, for instance, through the purchasing broker.
The application form will vary with firms and it is for their records. If the broker is to offer advice, then they will need some background information and some understanding of your investment goals. The forms will usually ask for such information, though you may decline to answer. There is no obligation to provide personal financial information if you intend to make your own decisions. You will then be issued with an account number and will be able to buy and sell shares.
Once an account is opened with a brokerage firm, executing a trade is a very simple process. Phone the broker and state your account number, the company to be bought and/or sold, and the number of shares traded. Some companies provide Internet trading access, which has removed the necessity of dealing with a person. Internet sites provide a form for submission, which requires the same details as a phone call. You will be notified of the receipt of orders and execution of trades via E-mail. The main advantage offered by Internet trading is the lower brokerage rates.
Brokers naturally charge a fee for the services offered. This is mostly through the execution of trades and a fee is charged for each order that is 'filled' or executed on your behalf. We pay a brokerage fee each time we buy and each time we sell a parcel of shares. Brokers do not generally charge for advice or for information provided.
Some firms charge high fees for retail clients, most probably as a disincentive. Their strategy is to focus on investment institutions and fund managers - this type of firm is best avoided if you are a smaller trader. Other firms will have a more reasonable scale, which may be as low as $50 per transaction for amounts under $5,000 and from 1% to 2% per transaction above $5,000. Lower rates can be negotiated for larger amounts and the environment is quite competitive. Do not be afraid to negotiate for lower fees, particularly if you are a larger trader.
Trading via the Internet is usually cheaper. Some Internet trading firms are offering minimum rates below $30 per transaction for trades up to $10,000. The speed and effectiveness of these systems is improving all the time, as is the availability of information and access to foreign markets. The Internet now makes it relatively simple and inexpensive for a small private trader to become an international investor.
The Rights of Shareholders
Listed companies will naturally have many shareholders. If you were the owner of a parcel of BHP shares, it is unlikely that you would receive much gratitude for phoning the CEO and demanding that he sell specific assets or sack a staff member. In other words, individual shareholders do not usually become involved in day to day management of a company. Most of us would not be particularly interested anyway; this is not why we buy shares off the exchange. Shareholders elect representatives, called directors, to run the company on their behalf. Hence the first right of shareholders:
Director responsibilities are particularly onerous and the courts generally enforce higher standards of ethics and behaviour from directors than from the general community. Director responsibilities are outlined in the corporations' law, which is monitored and enforced by a government body, the Australian Securities and Investment Commission (ASIC). Individual shareholders that have grievances but cannot afford to take a company to court themselves, may complain to the ASIC who will investigate the case at taxpayers expense. Directors of companies frequently have their own private assets at risk in business dealings. This leads to the second right of shareholders:
Shareholders are the legal and rightful owners of a company. As such, they have a right to a share of the profits if this is appropriate. This share of the profits paid to shareholders is called a dividend and they are declared by the board of directors each 6 months (called the interim and final dividends). If profits are non-existent, or the directors feel that profits may be effectively utilised within the company (eg. Invest or pay off debt), dividends may not be declared. However, if there are dividends, shareholders have the right to receive their appropriate share of those dividends.
Investors using a secure and well-regulated exchange, such as the Australian Stock Exchange, need not hold any fears of their funds disappearing through unscrupulous means. Of course there is investment risk - poor business environments can impact any company. Also, the existence of protection does not necessarily guarantee that some devious operators and employees do not try to defraud a company. However, there are legal remedies available and the company will pursue their rights under the law on behalf of the shareholders. In addition, the ASIC has wide investigative powers and exists to protect the rights of the small player.
The stock exchange itself also has listing rules that apply to companies listed on the exchange. These relate to the type, quality, and quantity of information made available to the public. Listed companies must provide financial reports to shareholders and hold an Annual General Meeting to elect directors (if necessary) and discuss issues of importance to the company. All shareholders will be given notification of the meeting. In addition, directors must release any information (called announcements) that may materially affect a company. This information is available from the ASX as well as newspapers and other Internet sites.
In 1987 a National Guarantee Fund was established to protect clients of stockbrokers who are members of the exchange. This fund is available to compensate clients who suffer losses in relation to unscrupulous, incompetent or unfortunate broker activities. The fund guarantees completion of market transactions, compensates for loss arising from unauthorised transfer or cancellation of securities through the CHESS system, and losses arising from the insolvency of a brokerage firm. Some of the categories are limited to maximum payouts however.
In the Australian market, shareholders are clearly well protected. The rules and regulations, as well as the different bodies involved, cover practically any eventuality.
Securities Traded on the Exchange
The exchange offers trading in a number of different types of securities. These include shares, derivatives, and quasi-bond (or debt) investments. The list below provides a summary, though some of these products will be examined in much greater detail later in the course.
Ordinary Preference Shares
Cumulative Preference Shares
Converting Preference Shares
Options and Warrants
Booms and Crashes
New traders, and those unfamiliar with shares, may feel concerned about the infrequent but well publicised stock market event - a crash. These risks do exist, but a little understanding can go a long way towards unveiling the mystique. Below is a brief history of the most well known crashes.
South Sea Bubble
1929 and 1987
The above only represents a brief description of the most well known booms and crashes. There have been many others such as the Poseidon mining boom and the 60's technology fever. However, we have raised this issue for the purpose of education and understanding - forewarned is forearmed. Many of the uninitiated to the share market fear being caught in a crash. However, all crashes have something in common. Firstly, there is a huge gain in price before the event. For example, in Australia from 1982 to 1987 the stock market rose over 420%. Secondly, the particular investment in question becomes part of crowd psychology. Everyone has heard of it, and practically everyone is involved and/or talking about it. Stories of fantastic riches usually abound to spur people on and activate the greed factor. Prices move up to nonsensical levels as people fear missing out and jump on board in the heat of emotion. These are the signs of impending doom.
To avoid share trading because of the fear of a crash is much like avoiding driving for the same reason. Many worthwhile advantages are missed because of the fear of a relatively uncommon event. In addition, just because one does not drive does not mean one will not be affected by a car accident - the same applies to the stock market. In a crash, the whole economy is affected, including every person, even those who do not hold shares. It is far better to learn and gain the understanding necessary to trade markets successfully. In this way, one can control the risks through the knowledge gained. Even more importantly, later in the course you will learn how to profit on a falling market. Thus turning a market collapse into an opportunity for profit. With knowledge, the risks can be controlled and thus the benefits enjoyed.
A trade is essentially an agreement between two parties to transfer ownership of a parcel of shares (or contracts in the case of the derivatives markets). One party is the seller and the other the buyer with both traders agreeing on a price at one moment in time. A market is therefore composed of a continuous stream of prices that originate from such trades made through an exchange. In earlier times, these trades were transmitted to interested parties via a ticker tape machine. The 'ticker' is still available through some live computer programs and cable TV business channels.
There are a number of problems with this method of following a market, the most obvious being memory limitations. If the last 'tick' was say $10.60 for a share, is this price relatively low or high compared to prices one week ago, a year ago, or perhaps ten years ago? Most traders will not recall the price level last week if more than a few stocks are followed, let alone months or years. Although it is possible to trade without any historical price knowledge, such knowledge is certainly an advantage.
To overcome such problems technical analysts use various charting methods. The general approach is to represent the continuous stream of prices in a condensed form. There are four main methods:
The bar chart is the most common format for representing price action. It has the advantage of quickly representing as long a time period as required as well as holding all of the information of interest. The bar chart represents the first, last, highest and lowest trades in the following format.
Each bar may represent any period chosen by the trader. The most typical is daily - meaning that each bar represents one day's price action. As of the close of the market, a new day's price action is completed and added to the right of the last bar. Over time, a chart representing price movements and important levels unfolds.
Other common periods for a bar include weekly and monthly. In this case more history can be represented on a single page. Short-term traders frequently view intra-day charts where a single bar may represent 60, 15, or even 5 minutes duration.
The candlestick format is quite similar to the bar chart and all analysis techniques can be used on both chart types. The open, high, low and last prices are represented and as for the bar chart, various time frames may be chosen. The difference is that the space between the open and close is filled out in the shape of a candle body. If the close is above the open, the candle body is left clear, if the close is below the open, the candle body is coloured in.
This type of representation lends itself to technical analysis methods that focus on patterns. The Japanese are credited with inventing candlestick charts as well as the pattern recognition techniques that go with the method. They gave interesting names to many patterns such as 'hanging man' and 'dark cloud cover'. Of course bar charts could still be used.
Candlestick Chart Signals - some examples
A swing chart removes the time component to isolate the price swings. The purpose being to focus attention on the trend and remove the minor fluctuations that can trap traders into frequent speculation ('overtrading' is the term). The diagram below demonstrates swing chart production by comparison with a bar chart.
A swing chart can be filtered on either or both the time and price dimensions. In the case of time, requiring a greater number of price bars to form before drawing a new swing will filter out short-term moves. For instance, a 2-day filter is a common choice. In this case, two days of movement against the prevailing direction is required before a new swing is drawn on the chart and so moves counter to the trend which last only one day are ignored. The price filter requires a move to cover a minimum price distance before drawing a swing. For example, we may require a 3% (or 3 cents on a $1 stock) price move in a new direction to confirm the new swing. The addition of these filters will isolate the important moves within the chart construction.
Point & figure charts are very similar to swing charts. The difference is that the up legs of the swing are represented by a series of boxes or circles, and the down legs are drawn using crosses. The purpose, strengths and weaknesses, and filtering techniques are identical.
Swing and Point & Figure charts remove some of the contextual information from the price data and so are only useful for certain types of analysis techniques. However, please do not read a 'more is better' assumption into this statement. More can indeed be worse, particularly when it comes to trading. The strengths are in fact this removal of information, which is unnecessary for some analysis techniques. The weakness is that time analysis is obviously not possible.
The line chart is the simplest method and is commonly seen in newspapers and broker reports. One simply connects the daily closing prices on a price/time graph to represent the price history. The only consideration here is the generally accepted use of the close and not some other price formed during the day. The reason is that the close is an important price since most traders and companies use it to value a portfolio and to check stock prices.
Clearly a lot of useful information (such as highs and lows) is missing from the chart and so some analysis techniques will be impossible. For this reason line charts are not generally recommended to serious traders.
Even a casual glance at stock market indices will show the wave pattern or cycles in prices. The large waves on a long-term stock market chart show a cycle that moves from a low formed during the recession, rising to a peak, which usually happens during the ensuing economic boom. This boom-bust cycle in share markets is well known by laymen and professionals alike. Naturally, both the trader and investor need a clear understanding of these cycles to avoid buying shares near the peak.
The Economic Clock
The share market does not exist in a vacuum; it competes with other forms of investment for the available supply of funds. A prospective investor always has a choice, should the money be invested in fixed interest, real estate, shares, or some other more exotic product. The observant investor has often noticed that each of these markets also follow a cycle. These investment cycles thus interact throughout the cycle in economic activity. By understanding these processes individually and how they interact, the astute investor can get a step ahead of the crowd. The aim is to position oneself in the most profitable market at the appropriate time.
The Economic clock is a guide for investors who wish to achieve such a useful goal. It was first printed in the London Evening Standard over 100 years ago. Since then, the economic clock has shown its usefulness cycle after cycle. The diagram below illustrates the economic clock.
The Last Cycle - 1982 to 1991
1981 - 82 were recession years in Australia. The share market formed a low at 443 points on the All Ordinaries index in July 1982. This represents the 6 o'clock position on the economic clock as shown above. The share market rose from this low to a peak of 2312 in September 1987. By October 1987 the share market crashed, falling roughly 50% in value in a week. The 6 and 12 o'clock positions are the easiest to identify as the All Ordinaries provides a good standard to measure share prices and the low and high on the index are easily identified using a chart (with hindsight!).
During the 1987 stock market crash, investors panicked and sold shares. The money taken out of the shares had to find a home, and many opted for the security of real estate. As a result, the years 1988 to 1989 produced a spectacular real estate boom in Australia. Some properties increased by more than 100% in the two years. Although shares did rally from the 1987 low, they fell back to the same low later. Real estate was certainly the most profitable of the three major investment areas over this period.
As the real estate market heats up, so do the economy and the demand for loan funds. This typically leads to rising interest rates, which has a habit of dampening investors desire for borrowed money, and consumers desire to spend. The Real estate market naturally comes off the boil as people tighten their wallets and purses. A recession is soon to follow. As interest rates peak, the best strategy for the investor is to take advantage of the high rates and buy bonds. For those unfamiliar with bonds, it is much the same as using fixed interest. In 1990, short-term rates peaked at 16.6%. By the end of 1991, the rates were down to 7.7%. This represents a windfall gain for bondholders and those using fixed interest investment strategies. Interest rates kept declining throughout the nineties, however the fall described above represents the most profitable window for bonds. Considering that both shares and property were weak during the time, the best investment approach was to lock in the high interest rates in early 1990.
As many will be aware, 1990 to 1992 were recession years once again. The share market reached the recession low in January 1991 at around 1200 on the All Ordinaries index. This completes one cycle of the economic clock, which took almost nine years from stock market low to low.
1991 - ?
The last stock market low that coincided with the recession occurred in January 1991. From that time, the market has risen steadily as the economic clock predicts. Up until late 1999 (the time of writing), the market had rallied from 1200 to about 3150 as measured by the All Ordinaries index. This represents an increase of 162.5% over an eight-year period. Compared to the last cycle, this seems like a small percentage increase over quite a long time. In fact, the share cycle alone has taken almost as long as the entire cycle last time, and we may not even be at the 12 o'clock share market peak yet.
The present situation begs the question; how near to the share market peak are we or has the economic clock failed this time? To answer this question we need to compare more than just the one cycle. The economic clock does not work with clockwork precision. Each cycle has unique characteristics. The length of the cycle and the length of each of the three section varies from cycle to cycle. Naturally the economic environment is also different each time. This is what makes it difficult to tell exactly where we are at any point in time on the economic clock. The clock only tells us which investment area is likely to be the most productive next; that is, it is a model of the order.
Recent Economic Cycles
The table below shows the economic cycles in Australia since 1937. The 12 o'clock position indicated by a peak in the All Ordinaries index has been used as a reference. Both the times taken to complete a full cycle and the growth in the share market from peak to peak are calculated.
As you can see, the economic cycles studied range in length from 7 to 14 years and show a peak to peak price growth in the All Ordinaries ranging from 69% to 210%. These are pretty wide margins of error!
We can still glean some useful information from the table despite the margins. Firstly, the present cycle at over 12 years in length is on the long side, historically. Hence we would expect the share cycle to be almost over, if it is not already. The price growth on the other hand, is well under historical parameters. This would suggest a fair bit more growth in shares is yet to be had. How do we reconcile these divergent views? By noting that the last cycle peak of 2312 represented a growth of 210% from the last peak. This is the historical extreme for peak to peak growth. In statistical jargon, the last peak was an 'outlier'. One does not estimate future probabilities by using outlying numbers; we use averages for such estimations.
The usefulness of the economic clock is now apparent. Note that it was possible to follow this logic anytime since the 1987 stock market crash to estimate a peak for this cycle!
The move throughout the share cycle component is perhaps of more interest to the investor and trader. We wish to buy at the low during the recession and sell (and preferably go short) near the peak. Not buy right at the peak and hold through the declines until the next peak, as the above table represents. The table below isolates the share component of the economic clock. From this we can refine our analysis.
Once again we can see that time-wise, this is becoming an old cycle. Based on the historical parameters for percentage increase, we can see that this is a fairly typical cycle. Consequently, a peak may be expected shortly, if it has not in fact already occurred.
An interesting point to note is that the 40's, 50's, and 60's produced fairly long cycles with moderate growth. Whereas the 70's and 80's were both relatively short phases that produced large percentage increases. Once again, this cycle has been long in time and moderate in price growth, much more like the first three cycles covered than the previous two.
Those who only have a casual interest in economics will know the ways in which the nineties compare with the 50's and 60's - low inflation. In the 1970's and 80's we had a high inflation economic environment, which resulted in high growth and short cycles. In the 1990's we are back to a low inflation environment. Low inflation produces longer cycles with more moderate growth.
The price and time analysis could have been performed anytime since the low in 1991. The low inflation environment has been evident since 1993 to 1994. A knowledge of these two facts means that the conclusion drawn here could have been reached as early as 1994. I actually first performed this analysis in 1995 and used these historical parameters to estimate a share market peak between 3000 to 3600 on the All Ordinaries, due sometime in the years 1998 to 2000. Admittedly, the margin for error is still pretty wide, but at the time these estimations were well into the future and considered unlikely by some.
I shall leave it to the reader to arrive at their own conclusions in relation to where we presently lie on the economic clock, since this material could be read at anytime since it was written (September 1999). However, at this time, the historical parameters in the above paragraph still hold as a range for the share market peak. It is entirely possible that the high has already occurred, and this is the safest assumption for the investor. The trader however, would not rule out the possibility of one more rally before the final high.
The share market cycles covered above refer to the market as a whole or more specifically, the All Ordinaries index. As you are aware, the index is composed of a number of sector indices. The different sectors tend to experience their spurt of growth at differing times through the share phase. Knowledge of which sector is likely to run and where in the share cycle this is likely to occur is useful for both traders and investors.
The share market typically bottoms during the recession. Hence the market does tend to rally before the recession is over (note that the delay in economic data releases means that the recession is usually over before people realise it). The best performing sectors during this stage are typically paper & packaging and media. During the recession, businesses cut back on costs to become more efficient - those who do not often end up going out of business. As economic activity begins to recover, many businesses increase advertising to secure a share of the growing markets. Even in difficult times, many companies will increase their advertising to try to drive further sales to stay alive. Media revenues thus increase early in the recovery. Paper & packaging is also an early beneficiary of the drive for sales. The increase in goods manufactured and sold naturally need to be packaged.
The resource sector tends to come online about mid-way through the cycle. Economic growth needs to be well under way and secure before price growth in raw materials is seen. The main reason is that it takes a little while for stockpiles to be used up. But also, companies want to be sure of a strong economy before ordering large amounts of stock or machinery. The engineering sector may also experience growth at this time for the same reasons.
Sectors such as developers & contractors and building materials typically experience strong growth later in the share phase, when the economy is booming. At this stage, people are confident and will tend to purchase real estate and companies may embark upon large development projects. The demand for funds and the flow of money also clearly benefits banking. Both the banking and engineering sectors tend to also rally during this phase.
During the bear phase of the market, practically all shares will fall in value. People become worried about their financial future, and falling share prices lead many to decide to pull out of shares altogether. This creates opportunities for the astute investor. During periods of concern, there will tend to be a 'flight to quality'. People will invest in the bigger, safer companies. Major food and grocery firms as well as leisure are likely beneficiaries. However, any company that has a long history of surviving recessions will attract funds. Please note however, that these companies are still likely to fall in price, just by not as much.
The description of sectors given above is designed to provide an understanding of the likely scenario. However, each cycle is different and the way the growth or weakness in these various sectors unfolds is quite cycle specific. For example, banking produced good returns throughout most of the nineties. The low inflation of this cycle was particularly good for banking and the major firms managed to capitalise on this. However, the strongest growth was still in the latter stages, as we would expect. Also, some of the sector indices in Australia are dominated by only one or two companies. In this case a good or poor performance by one business can affect the whole sector index. This may have nothing to do with the cycle. The sector indices in this situation (as of Oct 1999) are: diversified resources, alcohol & tobacco, chemicals, paper & packaging, transport, and telecommunications. In the future this may change if any large companies are listed or de-listed.
We often hear statements like 'the stock market has risen 15% over the year', but what does this mean? The stock market is composed of many different stocks with companies operating in different sectors of the economy. Such statements certainly do not mean that each and every stock increased in value by 15%. What it does mean is that the market as measured by the All Ordinaries Index increased by 15%. To facilitate market analysis, the ASX divides the market into groups of indices that are made up of individual shares. Investors can then make statements about the stock market and sectors within the economy by reference to these indices.
All Ordinaries Index
The All Ordinaries (XAO or All Ords) is the most prominent index and is regularly published wherever stocks are discussed. This index is designed to measure the price movement of the overall market and at present includes Australia's largest 500 listed stocks in the calculation. This is not the entire market however, since there are over 1300 companies listed on the exchange. Despite this, the All Ords does represent the market quite well. It contains over 90% of the value of all stocks as well as over 90% of all trading activity.
Australian indices are weighted. This means that the largest companies, as measured by capitalisation, have a larger impact on movements in the index than smaller companies. Capitalisation is the value of a company that can be found by multiplying the number of shares by the price per share. This is sensible since a large movement in a relatively small company will not affect the index much, whereas a large movement in a share that is widely held will have a big impact. The index thus measures the movement in the worth or monetary value of the market, which is what naturally interests most traders and investors.
The XAO index is a broad measure, which as such will tend to mask movements in specific areas of the economy. Investors are interested in what may drive growth or weakness in the market. For example, is the recent fall in the market driven by banking companies, gold companies, or the retail sector? To answer this type of question, the ASX releases a series of indices which are essentially sub-indices of the All Ords.
The All Ords is first divided into the All Resources and the All Industrials indices. These indices are then broken down further into sectors. The sectors group together companies that operate in similar industries. The diagram below shows the breakdown and the relative representation by percentage of each sector.
In addition to the indices based on economic sectors, the ASX releases indices based on capitalisation or size of companies. These measures are useful for identifying where interest in the market lies. For example, in uncertain economic situations there will be a 'flight to safety' and capital being invested in the market will be focussed on the larger and more secure businesses. Traders and investors may sell out of smaller stocks to move money into the likes of News Corp, BHP and the big four banks. When business conditions are good, investors may allocate more funds to the smaller companies in search of opportunities. As one might expect, this type of information can be useful for many different types of investment and trading strategies. The diagram below shows the breakdown of this type of index and the representation in the All Ordinaries.
The Russell indices divide the All Ordinaries by the categories of 'growth' and 'value'. A growth stock is one that pays relatively low dividends - most of the profits go back into the company to reinvest. Such a strategy should, in theory, lead to a higher share price growth. Growth stocks are typically located in new and growing industries and investors may achieve a greater reward, however remember that the risk is also higher.
A value stock is one that pays most of the profits out in dividends. Typically the company has products in a mature market and little further investment is required. The directors therefore elect to distribute profits to the shareholders via dividends. These stocks will have a more stable share price - in theory.
There is no doubt that the price indices discussed so far are useful. However, they only represent the change in price of stock investments, that is, the capital gain/loss component. However some stocks pay dividends, which are genuine income returns received by investors. So when it comes to comparing stock investments with other income producing markets such as real estate and bonds, the income as well as the capital gain should be included for a fair comparison. The accumulation indices are designed for this and include income as well as the capital component in the calculation. The ASX provides an accumulation index as well as a price index for all of the various indices available.
How to Use Indices
The first point to note about indices is that they change, both deliberately and naturally. The ASX periodically reviews the composition of the various indices and may make changes in order to create a better representative index. Large new floats, such as Telstra can substantially affect the weighting of a sector or index, and thus the percentage weighting's of all other indices.
The natural changes in percentage weighting's for sub-indices occur by virtue of the changing prices of the included stocks. For example, in the mid 1990's the All Resources index represented greater than 23% of the All Ordinaries. However weakness in commodity markets resulted in declines in many resource share prices in the second half of the nineties. By late 1999, the All Resources index was worth only 16% of the All Ords. At the same time, the economic environment was favourable for the banking sector. The representation of banking in the All Ords increased substantially as the share prices of banks rose.
Indices can be used for a number of purposes, the main ones are:
Comparison over time
The most common use of indices is for comparison, both over time and between sectors and markets. Without a logical and generally accepted index, it would be extremely difficult to compare share market performance over time. If the All Ordinaries was at say 1200 at some time in the past, and it is now at 2400, we know that the market has risen by 100% over the period. Most diversified share investments would produce capital growth within this ballpark.
Comparison with other investments
The All Ordinaries Accumulation index offers a benchmark with which to compare performance with other forms of investment. In practice, most people have some sort of diversified investment portfolio that includes cash, bonds, and real estate. The ability to compare the performance of various asset classes can prove useful with allocation decisions.
The All Ordinaries index provides the standard with which to compare performance of Australian share investment with stocks in other countries. All exchanges calculate indices and so comparison of performance becomes simple. A movement in relative currency values does tend to complicate the process a little.
Comparison between sectors
As alluded to above, certain economic conditions are better for some sectors than others. By comparing sector performance as measured by the indices, the trader can try to identify strength and weakness in entire areas. Technical analysis techniques can be used on the graphs of the sectors just as well as individual stocks. If a sector performs well, then most companies within the sector are also likely to perform well. This will be covered in much more detail later in the course.
The 'Top Down' Approach
The top down approach to investment is essentially an order of comparison. The investor analyses the fundamental economic conditions of various countries to find the best exchange to place funds, then looks at the various sectors in the economy to find the best opportunities. Once the sector or sectors are identified, individual company analysis is then used to find the specific investments. Indices are very useful tools all the way through the process.
Index Weighting Investment
Most passive share investment strategies rely on the fact that the market goes up in the long run. That is, the All Ordinaries rises in the long run. Those who wish to follow a 'set and forget' share investment strategy will look to the All Ordinaries as the model. Naturally, it is not practical to buy all of the shares in the index in the appropriate percentage weighting's. The most representative stocks of a sector are selected and then the funds are proportioned to the various sectors by approximating the XAO index weighting's.
What is a Warrant?
A warrant is a privately issued medium term leveraged security.
A warrant gives the holder the right, but not the obligation, to acquire (call warrant) or dispose of (put warrant) the underlying share at an agreed price known as the "exercise price" on or before an agreed date, known as the "expiry date".
Two types of Warrant
However, it is not necessary to actually exercise this right to acquire or dispose of the share in order to profit from trading the warrants. As the warrants are traded on the ASX, it is possible to profit from trading warrants, as it is with shares, but with significantly reduced costs.
Warrants are designed to capture a large part of the short term price movements in the underlying stock. Instead of paying the share price of $5, $10 or $20 for a blue chip share, warrants are priced much lower, often less than $1.
How will the Price Move?
Because each warrant has the right to acquire or dispose of a share, therefore the Warrant price will tend to move with the stock price.
If the stock price increases, the call warrant being the right to acquire the share is likely to become more valuable. Conversely, if the stock price falls, the value of the call warrant is likely to fall, as the right to acquire the share will become less attractive.
The reverse holds true for the put warrants. The value of the put warrants increases as the share price falls and vice versa. BENEFITS OF WARRANTS
Warrants are considerably cheaper than the shares but reflect usually between a quarter and three quarters of the price movements of the shares, warrants are an effective way to leverage your investment.
The term "leverage" means that for a given change in the share price, holders will achieve a greater potential profit (loss) as a percentage of capital invested.
Warrants give a greater return as a percentage of capital invested.
Warrants are priced much lower than shares, this means brokerage and interest costs are much lower. There is no stamp duty payable on trading warrants.
What happens if the share price increases?
For an outlay of just $4000, your net profit is $1325. This is almost double the profit that you would have realised on the share trade, on a capital outlay that is one fifth of the size.
What happens if the share price falls?
In the above example, if the share price of ZZZ falls to $18. The price of the warrant will also decline from $2 to $1. The loss on warrant trading will be around $2230 once brokerage on selling the Warrants is taken into account. However, the loss on trading ZZZ shares would be $3205 including brokerage and stamp duty on the sale.
Even if the ZZZ share price stays at $20, the cost of holding the 2000 ZZZ warrants for two months would be around $630, including interest, brokerage and time decay on the warrants. This compares to a cost of around $1195 from making the same investment in the share directly.
Warrants give unlimited upside but limited downside exposure to changes in the share price.
Taking the case of the call warrant, and assuming the share price falls by 50% to $10. If you had purchased the 1000 shares, you would have lost $10000. If you had purchased the call warrants, you would have lost only $4000, being the value of the premium paid.
However, if the share price rises by 50% to $30, the share investment would have made you $10000, and the warrant $16000.
Warrants are listed securities on the ASX and therefore trade at the price set by the market. Usually the issuers of warrants guarantee to quote buy and sell prices for their warrants. The most well-known issuers of warrants are Macquarie Bank, Bankers' Trust, Deutsche Bank, and Jardine Fleming.
How to trade warrants?
Trading warrants is simple. They can be bought and sold through your PJW client adviser in the same way that you trade shares - the main difference being that they are cheaper to trade.
Consult your broker for more information.
What is the "Delta"?
The "delta" of the warrant is a technical term and represents the relative change in the value of the warrant to changes in the value of the underlying share price.
A delta of 1 means that the value of the warrant will change one cent for every one cent change in the underlying share price.
A delta of 0.5 means that the value of the warrant will change by 0.5 cents for every one cent change in the underlying share price.
Using example 1, the delta of XYZ warrant is 0.50 and the share price increases $2 to $22, the value of the XYZ warrant will move by $1 (ie. $2 x 0.50 = $1).
What is "Time Decay"?
A part of the value of a warrant is known as "time value" or "the time value of money".
The time value of a warrant can be expected to gradually decline in value to zero over the life of the warrant. This gradual decline in the time value is effectively the daily cost of holding a warrant.
What are "Conversion Ratios"?
The "conversion ratio" refers to the number of Warrants that must be exercised together in order to acquire one share at a predetermined price, the exercise price.
A warrant with a conversion ratio of one to one, or 1:1, requires that one warrant be exercised in order to acquire one share at the exercise price.
A warrant with a conversion ratio of five to one, or 5:1, requires that five warrants be exercised in order to acquire one share at the exercise price.
Warrants reflect changes in issued capital.
In the case of rights and bonus issues, the terms of the warrant are automatically adjusted so that the holder is not disadvantaged by any such dilutions or similar events that affect the underlying share.
However, the holders of the warrants do not receive the dividends paid on the underlying shares.
What are the Risks?
Warrants are primarily exposed to changes in the underlying share price. The value of a call warrant usually increases as the underlying share price rises and decreases as the underlying share price falls. In the case of a put warrant, the value of the warrant increases as the underlying share prices decreases and vice versa.
In addition to the exposure to changes in the underlying share price, the Warrants are exposed to changes in:
Warrants are a leveraged investment. Like other leveraged share investments, they provide increased exposure to both increases and decreases in the share price when compared with investing directly in the underlying shares. Investors should understand that they may lose their entire investment in warrants.
As warrants are privately issued securities, a level of issuer risk exists. Issuer risk refers to the issuers ability to deliver their obligation in physical stock upon expiry. The majority of the warrant issuers are Banks with AAA credit ratings and therefore have the ability to fulfil their obligations.
For further information concerning listed warrants, investors can obtain information from the ASX brochure "Understanding Warrants" which is enclosed in the PJW warrants package.
Daryl Guppy is the founder and Director of Guppytraders.com Pty Ltd. He is an active private position trader trading equities and associated derivatives markets. His most recent book is The 36 Strategies of the Chinese for Financial Traders. He is the author of several books including:
He developed the Guppy Multiple Moving Average Indicator (GMMA) which is included in EzyChart and other charting programs. He delivers accredited courses for the Singapore Stock Exchange and Society of Remisiers, Singapore. He is an appointed foundation member of the Australian Government Shareholders and Investors Advisory Council. He is a regular technical analyst commentator and guest host on CNBC Asia Squawk Box.
As a technical trader he relies mainly on chart and live market information to make trading decisions. He is the publisher of a weekly Internet newsletter Tutorials in Applied Technical Analysis, which explains technical analysis techniques and shows how they are applied to current markets. There are Australian; Asian; Chinese and Indian editions of the newsletter, with each concentrating on local market solutions and trading education.
Alan is a second generation share trader, fund manager, businessman, writer, mathematician, I.T. expert and popular speaker on the seminar circuit. Alan has also managed tens of Millions of dollars of other people's retirement funds, his performance beating all the major ASX market averages.
He developed the Hull Multiple Moving Average Indicator (HMMA) which is included in EzyChart and other charting programs.
Alan's newsletters are based on his trading strategies 'Active Fund Management' (which is explained in his book Blue Chip Investing) and 'Active Investing' (which is explained in his book Active Investing). They provide a complete solution for anyone who wants to trade or invest in Blue Chip shares.
Over the last ten years, Alan has been a key note speaker at numerous investment expos and in 2008 was featured on the Sky Business Channels program "You Money, Your Call'.
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