Learn about CFDs - Determining Stock Values
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Stock prices can be a roller-coaster ride, and it is this movement that motivates people to trade stocks and CFDs. If stock prices didn't rise and fall, then you couldn't make money trading stocks and CFDs, and you wouldn't be here. And, without traders, much of industry and commerce would be starved of the funds and liquidity they need.
The market is a dynamic environment. Within it, stock prices incessantly move up and down so that they are worth one price at any given moment and yet another price a few seconds later. It may seem random, but stocks invariably move up and down for a reason. And the reason can be anything from an earnings announcement to a whim to a full-blown economic recession. But the root of all reasons is the need to balance the forces of supply and demand. To be successful, you have to pay attention that root of all reasons, but being able to zoom in and focus in minutiae is also extremely useful.
To explain why share prices move up and down in value we will look at the following:
- The forces of supply and demand
- Who is participating in the share and CFD market
- The factors traders look at when pricing a share
Supply and Demand in the Stock and CFD Markets
The forces of supply and demand drive prices. Supply is driven by the number of stocks or CFDs available to the investing public. Demand is driven by the wish of traders to buy or sell a stock or CFD.
Here you can see a typical supply and demand chart (see Figure 1 ). Demand is represented by the line sloping downward from left to right, whilst supply is represented by the line sloping upward from right to left. The intersection of these two lines represents the price the market will accept for the stock or CFD.
Figure 1-Supply and Demand Chart
Supply and demand can both fluctuate according to sundry market conditions. We are going to examine how movements in either supply or demand can influence the value of a stock or CFD as follows:
How Increasing Demand Affects Stock and CFD Values
Increasing demand for a stock or CFD pushes up its value.
On the supply and demand chart below (see Figure 2 ) it is evident that, when demand increases, the demand curve shifts to the right. As it does so, the point at which it intersects with the supply curve moves higher. This shows that increasing demand for a stock or CFD increases its value too.
Figure 2-Supply and Demand Chart (Increased Demand)
Demand for stocks and CFDs can increase when companies announce better-than-expected earnings for a quarter or the year. When Apple Inc. (AAPL:xnas) announced an earnings boost due to frenetic buying of its iPod, traders bought Apple shares in the hope that the company would have a record year and that Apple stock values and premiums would reflect that..
Unlike Apple and the iPod, market crazes are often due to surreal increases in demand that have little if anything to do with the true value of the product or service involved. A famous example is the Dutch Tulip Mania. Traders returning from the Ottoman Empire introduced tulips to Holland in the late 16th century. By the early 17 th century, tulips, and especially rare bulbs, were trading at ludicrous prices. The most expensive recorded sale was 6,000 florins for a Semper Augustus bulb. To put this in perspective, the average annual income at the time was 150 florins. That means 40 years' work would earn you a tulip bulb at a time when the average life expectancy certainly didn't accommodate 40 years' work. Assumedly, tulip brokers didn't dream of retiring to a country pile in Surrey but fantasized instead about retiring with their little black tulip. The irony is that, as anyone who has ever worked with bulbs would tell you, it is terribly hard to determine one tulip bulb from another (or, indeed, from daffodil bulbs). So it's difficult to fathom why anyone would sacrifice all for a little black bulb that's not discernibly better than its rivals. Never underestimate the effect of increasing demand.
How Increasing Supply Affects Stock and CFD Values
Increasing supply of a share or CFD decreases its value.
On the supply and demand chart below (see Figure 3 ) you can see that as supply increases the supply curve moves to the right. As it does the intersection with the demand curve moves down. Consequently increasing supply of a stock or CFD reduces its value.
Figure 3-Supply and Demand Chart (Increased Supply)
Supply of a stock or CFD can increase when a major share-market index delists a share. For example industrial supply manufacturer Honeywell (HON:xnys) used to be a component of the Dow Jones Industrial Average. As economic conditions made Honeywell a less significant share in the broader market the Dow Jones delisted it from its premier index. As a result of this delisting many fund managers who maintain portfolios based on the Dow Jones Industrial Average were forced to sell their Honeywell shares, increasing the supply for sale in the market and thus eroding the share price.
How Decreasing Demand Affects Stock and CFD Values
Decreasing demand for a sstock or CFD decreases its value.
On the supply and demand chart below (see Figure 4 ) you can see that as demand decreases the demand curve moves left. As it does so the intersection with the supply curve moves lower, showing that increasing demand for a stock or CFD decreases its value.
Figure 4-Supply and Demand Chart (Decreased Demand)
Demand for a stock or CFD can slump if traders hear bad news or rumours about a company. For instance in 2004 the international pharmaceutical manufacturer Merck & Co. (MRK:xnys) withdraw its arthritis drug Vioxx amidst claims of increased coronary risk for users. Trader concern over loss of revenue and the likelihood of a class action dramatically undermined Merck's profitability, and their stock value plummeted.
How Decreasing Supply Affects Stock and CFD Values
Decreasing supply of a share or CFD increases the value of that stock or CFD.
The supply and demand chart below (see Figure 5 ) shows that as supply decreases the supply curve moves to the left. As it does so, the intersection of the demand and supply curves moves higher. This proves that restricting the supply of a stock or CFD increases its value.
Figure 5-Supply and Demand Chart (Decreased Supply)
Stock or CFD supply slumps as companies buy back shares. Cash-rich companies that feel their stock is underpriced often buy their own stock shares to drive up the price and therefore increase inward investment.
In summary, changes in supply and demand can affect stock and CFD prices. But no doubt you are asking what causes those changes in supply and demand. We shall explain.
Stock and CFD Market Participants
Stock and CFD markets could be compared with the Tower of Babel . Traders represent every ethnicity, every culture and every language. But all of these people must recognize, if they are to survive for long, the forces of supply and demand. Yet every participant has a personal agenda and individual needs. Some look for quick profits whilst others take a long-term view. Some have zillions to invest while others barely have enough to meet account minimums. You will never understand what is going on in every trader's head. Yet broadly understanding their motivations can help you to anticipate market developments and enable you to outperform it. And that is the key. Outperform the market, and you should be in marked profit.
For the purposes of this discussion, we will divide the major market participants into two groups:
Institutional investors are substantial professionals who typically control huge sums of money and involve themselves in mutual funds, hedge funds, pension funds and so forth. Being so influential, you should focus on them when trying to decode the market.
Individual investors are people like you who either trade for a living or as a sideline to boost income and net worth. This group should play a less significant role in your analysis.
Institutional investors drive markets. Having so much money in their portfolios, they are a potent influence on the market and its prices. Their ability as traders to buy shares in huge volumes will invariably drive prices more than traders who dabble ever could.
Institutional investors largely operate under strict mandates, they observe certain trading rules and they invest in specific classes of assets. For example some institutional investors only operate funds that are known as large-cap funds. This means that they exclusively contain shares in companies with a market capitalization exceeding $5 billion. Meanwhile other institutional investors stick to technology funds so they buy shares in technology-based companies such as Microsoft (MSFT:xnas) or Google (GOOG:xnas). Others operate only with ethical or green or fair-trade funds.
As an aside, and since we mentioned market capitalization, it equates the number of shares issued multiplied by the price per share. For example, General Electric (GE:xnys) has nearly 9.99 billion shares and a share price (at the time of writing) of $32.23. This gives the company a market cap (or capitalization) of more than $321 billion (i.e. 9.99 billion × $32.23 = $321+ billion).
Divining what institutional traders are doing with their portfolios enables you to determine how the forces of supply and demand are acting - and how those dynamics are going to influence stock prices. You are never going to know exactly what these institutional traders are doing. Certainly you would have to be privy to their deals to know. Yet, if you know what they are watching when they make their decisions, you can watch the same things and intelligently deduce what they might do next.
Factors that Affect Stock Prices
Many different factors influence stock prices. A handful of key factors play important roles in determining stock values, and the following are the four factors you should observe most closely:
- Earnings and other fundamentals
- Dividends
- Economic announcements
- General shifts in market/sector strength
Earnings and Other Fundamental Numbers
It is largely company performance that drives share prices. If you buy a stock, then you buy a slice of the company, a slice of its successes and failures. A company that performs well attracts more interest in its shares. Interest translates to demand, and demand translates into higher prices. The converse is true for a company that performs disappointingly.
To determine company performance, traders and analysts examine several fundamental figures (i.e. numbers derived from a company's balance sheet and income statement). A company's earnings - the amount it makes after paying its expenses - is typically the most important of these. Yet there are other fundamental numbers such as the return on equity (ROE) and the price-to-book ratio that present traders with an indication of the overall health of a company. There will be more about company fundamentals later.
Dividends
Companies can do two things with profits: they can keep and reinvest them or they can pay shareholders a dividend. Dividends are per-share payments so if a company with 1,000,000 shares issued pays a £5,000,000 dividend, each share receives £5.
Traders value dividends highly because, assuming the shares are held for a time, they represent regular cash returns on investments. Since dividends are prized, a company can boost share value by boosting its dividend (though investors will want to see that the company can afford this generosity). Companies increasing dividends generally enjoy stock-price increases, whilst the converse is equally true. Despite this, fewer companies pay dividends nowadays and instead retain earnings to reinvest in the company. In such cases, an investor who needs regular income is forced to sell at least some shares or invest, instead, in companies that do generate dividends.
Depending on whether you are a share or CFD trader, Global Trading treats company dividends differently.
Dividends on Stock Positions
Global Trading credits dividend payments on share positions to your account with any applicable standard withholding taxes deducted. For obvious reasons, Global Trading cannot currently support or offer preferential withholding tax rates that may be available due to residency or legal status.
Dividends on CFD Positions
When dividends are paid on underlying shares, holders of long CFD positions qualify for proportional payouts. Holders of short CFD positions have to pay an amount equal to the full (gross) dividend paid on underlying shares.
All cash dividends for CFD positions are settled on pay date. Cash dividends are booked on ex-date to reflect market price movements on the ex-date, but the actual value of the payment is settled on pay date.
Dividends on CFD positions are cash adjustments paid or debited by Global Trading and not by the underlying company. Dividends paid on CFDs are not eligible for any preferential withholding tax rates sometimes associated with dividends paid on physical shares, so may differ from the dividends payable on underlying shares.
Dividends on Index Trackers
When underlying shares that are part of Index CFDs go ex-dividend, the Index CFD prices are adjusted to reflect dividends. The weighted proportion of the dividends within the Index are credited to client accounts for long positions and debited for short.
Note that the DAX30 is a Total Return Index, so the index is automatically adjusted for dividends.
Index Dividend = Share Dividend * Shares in index / Index Divisor*.
* Divisor: the amount used to stabilize the index value when its composition changes. The sum of all index members' prices is divided by the divisor to achieve the normalized index value. The divisor is adjusted when capitalization amendments are made to the index members, allowing the index value to remain comparable at all times. To prevent the value of an index from changing due to such events, all corporate actions affecting market capitalization of the index require divisor adjustment to ensure the index values remain unaffected by the event.
Economic Announcements
Economic announcements, usually released by governments and other large groups, include interest rates and gross domestic product (GDP). They often affect the economy as a whole, not just individual companies. Such news may well be important to you as a stock and CFD trader, but you should not miss it because it is scheduled months in advance. Traders know a year in advance when the U.S. Federal Open Market Committee (FOMC) will meet to discuss interest rate changes. Likewise in the UK , the government's budgets and mini-budgets are scheduled well ahead of the actual events. This gives you plenty of time to research the likely content of announcements and position your portfolio accordingly.
Fortunately for you, Global Trading provides an up-to-the-minute economic calendar so you can know exactly what news is scheduled for release today, tomorrow and into the future (see Figure 1 ).
Figure 6-Economic Calendar
A cursory glance at the calendar tells you about upcoming events that have the potential to influence the movement of the stocks and CFDs you are watching. These events might include announcements involving German unemployment data, U.K. money supply and U.S. gross domestic product (GDP), as is demonstrated by the figure above.
Investment analysts, economists and other market participants constantly analyse these announcements, trying to second-guess their content. Analysts seldom agree, but the body of opinion produces what is called the "consensus estimate" and is broadly reliable.
Familiarity with the consensus estimate lets traders take advantage of price movements once the economic announcement is released because the consensus estimate will already be "priced in" to the value of the stocks and CFDs. Investors will have placed trades before the announcement to take advantage of where they believe stocks and CFDs will move. If the economic announcement matches the consensus estimate, then prices will barely move because most institutional investors have already placed their trades. It is only really when the consensus estimate has been inaccurate because the market is wrong-footed that prices have to adjust to accommodate the new economic realities. At such a time, when market participants are scrambling to factor in the new information, you will have opportunities to capitalise on price movement. Yes this is flagrant opportunism, but that should become second nature.
General Shifts in Market/Sector Strength
Companies prefer their stock price to reflect their individual corporate performance, yet other general market forces can lift or lower share values regardless of that performance.
There's an old adage that every trader ought to know: "A rising tide floats all boats." Simply put, it means that in a bullish market most stocks go up because the market and the economy in general are going up. On the other hand, it means that in a bearish market, most shares go down because the market and the economy in general are going down.
This truism may apply to the market in general but not necessarily to certain sectors of it. For instance, healthcare stocks may be booming but retail shares may be slumping. Bullish and bearish forces within individual sectors can have the same impact on the stocks within those sectors as bullish and bearish forces can have on the overall market. Nothing is set in stone.
We will tell you more about the analysis of market and sector trends in a later section. Right now simply knowing that these forces exist will put you well ahead of most retail traders.