competing with people who want to takeyour money away from you.Stocks have consistently outperformed all other forms of investment—period.The surging stock market in the last decade of the millennium has driven the markets higher than ever before—regardless of corrections. It’s hard to think of any reason why anyone with a certain level of disposable income wouldn’t utilize stocks asan investment vehicle. Investing in stocks has enhanced millions of people’s lives.But just because other people have made profitable investment decisions doesn’tguarantee the success of your future endeavors.From the institutional money manager with half a century of experience to thecyber-investing mom placing her first trade, every investor dreams of making akilling in the markets. Why do some succeed and others fail? Is it chance or skillthat makes the difference? I have spent years trying to figure out exactly what separates the winners from the losers, and in the process have discovered a few key explanations.1
2
WELCOME TO THE STOCK MARKET
Stocks: Securities or certificates representing fractional ownership of a companypurchased as an investment. How much you own depends on how many sharesof stock you possess versus how many shares have been issued.Stock market: A catchall name for the overall facilitation of the buying and selling of shares of ownership in companies.
The first key to winning as an investor is to develop a healthy respect for risk.It’s actually quite common for people who do not invest in the markets to considerstock trading a form of gambling. Webster’s New 20th Century Dictionary definesgambling as “an act that depends solely upon chance.” The stock market is anythingbut a roll of the dice or luck of the draw. Successful investing relies on an investor’sability to reason, weigh risks, spot opportunities, and make quick decisions. Andyes, chance can have an effect on performance. Choosing to take an unavoidablerisk is simply part of the decision-making process. Neglecting to assess risks beforeentering any trade is definitely a gamble.
Risk: In terms of an investment, risk represents the maximum potential financialloss inherent in the placement of an investment.
The second task is to develop a low-stress investment plan that will enable youto build your knowledge base systematically. Most investors start the same way.They read a few books, open a small account, and lose a chunk of money in no time.There is one way, however, to differentiate the winners from the losers: Winnerspersist at learning as much as they can by starting slow and collecting the tradingtools necessary to manifest a competitive edge. Successful traders first learn tocrawl, then walk; given enough time, they may eventually learn to fly.Third, beginners need to start by specializing in one or two markets at a time.Specialization allows traders to match winning strategies with recognizable marketconditions. Successful traders realize that similar market conditions will recur in thefuture and the same strategy can then be used to reap rewards.
Specialization: Focusing on mastering one or two stocks or trading strategies ata time before moving on to the next ones.
Fourth, define your limits in terms of the amount of money you can afford tolose. Before investing a single dollar, it is essential you make an honest appraisal ofyour financial assets and capabilities. Although real estate can be purchased with nomoney down, an investor needs cash to open a brokerage account. When you put up
WELCOME TO THE STOCK MARKET
3
cash to invest in stocks, you are coming face-to-face with risk. Hopefully, you’llnever lose your entire trading account. But you need to be prepared in the event thatyou do. In short, assess your financial capabilities and pinpoint your risk tolerance.You may think those two simple words—risk tolerance—are heading into oxymoron territory (up there with jumbo shrimp, military intelligence, and rich broker).But in truth, it is vital to assess the level of risk you can afford to take before placingyour first trade. Start by determining how much disposable income you earnmonthly. How much money do you need to set aside for life’s little (and big) emergencies? How much of your savings can you afford to lose?
Brokerage account: A trading account hosted by a firm that acts as an agent fora customer and charges the customer a commission for its services.
Novice investors need to acquire the information necessary to make intelligentinvestment decisions. Thanks to the advent of the Internet, the abundance of available information has increased tenfold and more. But the burgeoning of informationhas its downside. Investors now have a profusion of information to sift through andassess for reliability and accuracy. This information glut has driven many investorsto choose to leave investment decisions, and hence their financial futures, in thehands of someone else.The underlying objective of this book is to empower the readerthrough knowledge. Successful trading involves developing aninformation filter tailored to meet your financial goals.
My specific experience—as a stock market investor, instructor, and writer—hastaught me many lessons. Perhaps the most significant involves developing the ability to discriminate between what information is useful in making investment decisions and what is not. There is little doubt that advances in information technologyand communications have provided investors with more power and resources thanever before. In the past, investors were limited to the business section of one or twonewspapers and occasional comments on the television news. Today there are financial web sites, e-mail services, and even financial updates delivered via pagers. Thisabundance of information, ironically, has created a different set of problems: Whatinformation is truly valuable and worthwhile? Having access to a lot of informationis great, but if it doesn’t help make better investment decisions, it’s useless. Howdoes one filter out the bad from the good? One of the goals of this book is to helpyou answer that question by providing a solid foundation in stock market basics.Bottom line: To play the investment game well, you haveto learn the rules by which the game is played!
4
WELCOME TO THE STOCK MARKET
TAKING RISKS IN THE STOCK MARKETRisk is easily one of the most misunderstood investment concepts because it comesin many forms, including market risk, opportunity risk, and inflation risk. Marketrisk is a catchall phrase for the inherent risk associated with market forces. Opportunity risk involves the economic sacrifice that arises from having to forgo the benefits of alternate investments. For example, if you have $10,000 tied up in oneinvestment, that’s $10,000 that can’t be used elsewhere. Inflation risk affects all investments—some more than others. Inflation refers to the overall economic increase in the general price level of goods and services. Investments have toovercome inflation risk by making a higher return than the rate of inflation (see Figure 1.1). Before you invest a penny, make sure that you assess all of the risks involved. Bottom line—if you can’t afford the risk, you can’t afford the investment.My subjective reason for consistently assessing risk is a simple one. Risk is directlytied to what I believe is an investor’s worst enemy: stress. Stress produces incompleteknowledge access. This one sentence sums up why trading coupled with stress can produce only one result—loss of capital. It certainly seems ironic that individuals whotake up trading in order to reduce the stress of not making enough money from theirday jobs often end up creating more. Unfortunately, trading can be an extremely stressful endeavor. If you don’t really know what you’re doing, stress will be pervasive andthe ultimate enjoyment of trading will be greatly diminished. Improper decisions canlead to rapid losses and depletion of your hard-earned cash. This can produce a higherlevel of stress than you have ever experienced. In today’s highly volatile markets, successful trading requires a low-stress trading approach that fits a trader’s unique lifestyleand risk tolerance. This book is designed to help you get started on the right foot byshowing you what it takes to compete in the investing arena. The number one rule is toassess the risks involved and determine how much risk you can handle.Serious risk assessment can reduce the stress inherentin trading and help you to invest intelligently.
On average, almost two billion shares trade hands on the three major U.S. exchanges every day. It really is a fascinating process, considering each trade reflects
Value of Today’s $100 after the Impact of InflationRate of
After Number of Years
Inflation (per Year)3.0%3.5%4.0%Figure 1.1
5
10
15
20
25
$86.26$84.19$82.19
$74.41$70.89$67.56
$64.19$59.69$55.53
$55.37$50.25$45.64
$47.76$42.31$37.51
Inflation and the Real Rate of Return
THE INVESTMENT SETTING
5
the views or expectations of two particular investors (buyer and seller). Consequently, one of the interesting things about the stock market is its ability to digestinformation. When information concerning a company is disseminated, the stockprice may react favorably (go up) or unfavorably (go down). For example, newsthat Intel Corp. (INTC) has developed a new and faster computer chip made thestock rise, while news that Microsoft was being investigated by the U.S. Department of Justice sent the stock price of Microsoft (MSFT) down. Many investorschoose to sit on the sidelines until the uncertainty dissipates.When news concerning a company is considered to be unfavorable, the result isa drop in stock price. If you purchased shares in a particular company the day before bad news is released, the value of your stock holdings will fall upon the news.That is the risk of owning stocks—that they can, periodically, decline in value. Youhope they recover, but sometimes they don’t, and if they do they may take an incredible amount of time to do so. Simply put, in an effort to buy a stock and sell it ata higher price, investors run the risk of seeing the stock price fall instead.One of the most important lessons to be encountered in trading is theconcept of the risk to reward ratio (i.e., there is a certain level of risk and thepotential for a certain reward associated with every investment). Calculatingthis ratio provides essential information as to the viability of the trade.
THE INVESTMENT SETTINGStock represents an ownership share in a corporation, so when you purchase stock,you become a partial owner in a corporation. The percentage you own depends onthe number of shares purchased and the size of the company. For instance, the totalnumber of shares in existence of Intel is roughly 3,349,000,000. If you purchase100 shares, you become a fractional owner. Your ownership amounts to1/33,490,000. As small and insignificant as that might seem, you still have rights asa shareholder:1. Right to profits2. Right to vote3. Right to informationPerhaps the most important right shareholders have is the right to share in thecompany’s net profits. In theory, the value of a company is a direct function of theprofits that it is able to generate. Consider, for instance, if someone offered to sellyou a corner grocery store in your neighborhood. After looking over the books, youfigure out that the store has failed to make any money for the past 10 years. If youdecide to buy the store anyway, either you are going to suffer financial losses or youmust turn the business around so that it makes money and you can get paid.
6
WELCOME TO THE STOCK MARKET
Earnings: Net income for the company during a specific period.Dividends: When a corporation pays a fraction of its profits to its shareholders,those payments are called dividends. The amount is announced before it ispaid, and is distributed to shareholders of record on a per share basis.
The same holds true for stock ownership. A profitable company has earnings,which are either reinvested back into the company or distributed to stockholders (ora combination of the two). When a company distributes a portion of its earnings, thepayment is referred to as a dividend. If none of the earnings are being passed on tostockholders as dividends, then they are most likely being reinvested to fuel thecompany’s future success and profitability.As a stockholder, you also have the right to information. Annual and quarterlyreports are provided to all shareholders and are available to the financial public atlarge. These reports provide information that includes: business developments; updated financials (see Chapter 8 for a closer look at reading financial reports); and anassessment of the business outlook for the coming quarter and year.
Annual report: A report issued by a company to its shareholders at the end ofthe fiscal year, which contains an income statement, balance sheet, statement ofchanges in financial position, changes in the stockholder’s equity account, asummary of the significant accounting principles used by the firm, the auditor’sreport, and comments from management about the significant business and financial events of the year, as well as various other data pertinent to the financialhealth of the firm. A more detailed (and numbers-oriented) version is the 10-Kreport required to be filed with the Securities and Exchange Commission (SEC)and made available to all stockholders who request it. The 10-K report is alsoavailable online and from the SEC to all interested parties.
Stockholders also have the right to vote on major issues facing the company suchas the selection of accountants, whether to accept takeover offers from other companies, or authorizing the distribution of additional shares. In most cases, the votesfrom individual investors on such matters are relatively inconsequential.
THE EXCHANGESStocks, futures, and options are traded on organized exchanges throughout theworld, or on a computerized system. These exchanges establish rules and procedures that foster a safe and fair method of determining the prices as well as provide
THE EXCHANGES
7
an arena for the trading of stocks. Advancements in technology have inspiredmany of these exchanges to update their systems in order to stay competitive on aglobal basis.A stock exchange is an actual physical location (or computerized system) for theorganized buying and selling of stocks. There are three main U.S. exchanges fortrading stocks: the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), and the Nasdaq (National Association of Securities Dealers Automated Quotations system). Exchanges are businesses. They provide the public witha place to trade. Each exchange has a unique personality and competes with otherexchanges for business. This competitiveness keeps the exchanges on their toes.Exchanges rent booths on the exchange floor to brokerage firms and specialists andmust be able to react to the demands of the marketplace with innovative products,services, and technological innovations.The Securities and Exchange Commission (SEC) regulates U.S. exchanges. TheCommission was created by Congress during the Great Depression in 1934 and ischarged with making sure that securities markets operate fairly and protect investors. It is composed of five commissioners appointed by the President and approved by the Senate. The SEC enforces, among other acts, the Securities Act of1933, the Securities Exchange Act of 1934, the Maloney Act of 1938, the Trust Indenture Act of 1939, the Investment Company Act of 1940, the Investment AdvisersAct of 1940, the Securities Investor Protection Act of 1970, and the Securities ActAmendments of 1975.Founded in 1792, the New York Stock Exchange is the largest and most familiarauction-style exchange in the world. It currently lists approximately 3,050 companies trading more than 206.6 billion shares worth approximately $8.9 trillion (as ofApril 2000). The average daily turnover is roughly one billion shares, which givesan idea of the sheer size of today’s markets. The NYSE is a corporation overseen bya board of directors who are responsible for setting policy, supervising Exchangeand member activities, listing securities, and overseeing the transfer of members’seats on the Exchange.Auction-style market: The facilitation of executing trading orders in which buyers enter competitive bids and sellers enter competitive offers simultaneously.The stock market is like a giant garage sale—if you don’t like the price listed,you can make your own bid for the item and wait to see if someone is willing tomatch it.
The American Stock Exchange (AMEX) is the second-largest auction-style equities market in the world. A private, not-for-profit corporation located in New YorkCity, AMEX handles approximately one-fifth of all securities trades within theUnited States—approximately 1,750 companies trading over 5 billion shares annually worth around $92 billion. Most of the companies AMEX offers are too small tobe listed on the New York Stock Exchange.
8
WELCOME TO THE STOCK MARKETTo be an exchange member at either the AMEX or NYSE requires the purchaseof a seat on the exchange that cost upwards of $500,000.
There are six regional exchanges—in Boston, Chicago, Cincinnati, Philadelphia,Los Angeles, and San Francisco. Some of these exchanges use an open-outcry auction-style system where buyers and sellers come together to trade shares of stocksand option contracts. Others are evolving into fully automated systems that electronically match buyers and sellers.The Nasdaq exchange is not a physical location, but a computerized network thatstores and displays stock price quotes. Originally created at the request of the SECin 1971, it facilitates the trading of stocks over the telephone and via computer directly from brokers all over the country. Nasdaq utilizes a vast telecommunicationsnetwork to continuously broadcast price fluctuations directly to the computers ofmarket participants. Listing more than 5,540 foreign and domestic companies, theNasdaq offers more stocks than any other exchange. The Nasdaq has experiencedphenomenal growth due to the large number of technology companies listed there.Each exchange has specific listing requirements—market cap, sales, and so on.The listing requirements vary from exchange to exchange. If you meet the listingrequirements for a particular exchange, you can list your stock there. If your company meets the listing requirements, but then later does not, you can be de-listedfrom the exchange. Once a stock is listed on an exchange, it is assigned a symbolfor trading. For instance, the stock symbol for America Online is AOL. These symbols are called ticker symbols.
Ticker symbols: Ticker symbols are composed of one to three letters for “listed”shares (those traded on the NYSE or AMEX exchanges) and four or five letters forthose on the Nasdaq. This is why Nasdaq stocks are sometimes referred to as“four-letter” stocks.
On June 25, 1998, the National Association of Securities Dealers (NASD)—theparent company of the Nasdaq—and the American Stock Exchange announced thatits members approved a plan to combine the AMEX with the Nasdaq system. Themerger was completed on November 2, 1998, and created what is now known as theNasdaq-Amex Market Group. Although the two exchanges still operate under separate managements, their new products and technological developments created amilestone event. One significant development was the creation of a new exchangetraded fund based on the Nasdaq 100. The fund is an average of the 100 largest nonfinancial stocks listed on Nasdaq and is called an index share. Known mainly by itsticker symbol, QQQ, it is one of the most actively traded securities on the AmericanStock Exchange. The merger also led to the development of one of the most popularfinancial web sites—www.nasdaq-amex.com. The site offers a host of informationincluding market data, research, and news any investor would find helpful.
THE EXCHANGES
9
National Association of Securities Dealers (NASD): This self-regulatory organization of the securities industry is responsible for the regulation of Nasdaq andthe over-the-counter markets.Index share: A share that secures ownership of a group of stocks traded as oneportfolio, such as the S&P 500. Broad-based indexes cover a wide range of industries and companies, and narrow-based indexes cover stocks in one industryor economic sector.
Smaller companies with a limited amount of shares (or float) are traded on theover-the-counter (OTC) market. The OTC market lists more than 30,000 stocks.Brokers who trade these smaller markets receive daily price updates called “PinkSheets” (the paper they were originally printed on was pink). Today brokers receivethe “Pinks” either by fax or electronically.Float: Refers to the number of shares of a company that are in public hands andare actively traded. Also known as “floating supply,” it is the amount of a company’s common stock that is traded in the marketplace. To calculate a stock’sfloat, deduct the shares held by insiders and owners, as well as Rule 144 sharesfrom the number of shares outstanding.Rule 144: A Securities and Exchange Commission (SEC) rule that says a corporate executive or insider who owns a large stake in his or her company—orshares not purchased in the open market—is allowed to sell a portion of thatstock every six months after a holding period of two years without reporting it tothe SEC. If an insider sells more than the allowable portion in the six-month period or prior to the two-year lock-out, it is known as Rule 144 stock, and the insider must file a formal registration with the SEC.
In addition, exchanges all over the world are linked together regardless of different time zones. The major international exchanges include Frankfurt, Hong Kong,Johannesburg, London, Singapore, Sydney, and Tokyo. Prices shift as trading endsin one time zone and activity moves to the next. This global dynamic explains whystocks close at one price and open the next day at a completely different price at thesame exchange. With the increased use of electronic trading in global markets,these price movements are becoming more unpredictable than ever before.If you’ve never had the chance to visit an exchange, I highly recommend it. Theexchange floor is a mammoth hall filled with representatives from all the major brokerages as well as floor traders, market makers, and specialists who cocreate the investment process. Orders are phoned or electronically communicated from theoutside world to floor traders, who take them to trading areas, or trading pits, to beexecuted. To an outsider’s eye, the order process may seem fraught with chaos, buta highly developed, organizational method to the madness actually exists.
10
WELCOME TO THE STOCK MARKET
Floor traders: Exchange members who execute transactions from the floors ofthe exchanges for the profits (or to the detriment) of their own accounts.Trading pits: Specific areas on the floors of exchanges where floor traders, market makers, and specialists meet to buy and sell the same security.Executed: The process of completing an order to buy or sell securities.
When investors want to buy or sell shares of AOL, the orders are executed on thefloor of the New York Stock Exchange. But don’t worry; if you want to buy shares ofAmerica Online, you don’t have to catch the next flight and go to New York. Instead,you instruct a broker to make the transaction for you. Then, the order is routed to thetrading floor of the New York Stock Exchange through your broker’s firm.
Brokerage firm: Where a trade takes place depends on whether that particularcompany is listed on the New York Stock Exchange, the Nasdaq, or the American Stock Exchange. One company may be listed on more than one exchange.
THE PLAYERSWhen you buy or sell a stock, it is called a trade. For instance, if you decide to buy100 shares of AOL and the stock price is $52, you are trading your money for thestock. In this case, the trade is $5,200 for 100 shares of stock (plus commission).However, many traders prefer to buy shares on margin. A trader then needs to putup only half the total amount to purchase shares, while the brokerage lends the otherhalf at a small interest rate.
Trade: The actual process of buying or selling a financial instrument in order toattempt to profit from it.Margin: The portion of a trade’s value that the customer must pay to initiate thetrade, with the remainder of the purchase price being borrowed from the broker.
Regardless of the exchange, each time a trade is executed, the price and numberof shares traded is logged. The number of shares, in turn, is referred to as volume.Each day, the total volume on each exchange is recorded. At the end of 1999, theaverage daily volume on the New York Stock Exchange was 809.2 million; on theNasdaq it was 1.07 billion; and on the American Stock Exchange, 32.7 million. Inone day’s trading, on the three exchanges, almost two billion shares are beingbought and sold! So who’s doing all this trading?
THE PLAYERS
11
The Story Volume Tells: Keeping an eye on the volume can help youanticipate the degree of price movement. If a stock surges up on heavy volume,it is a very good indicator of further price increases. A stock that sells off onheavy volume is a reliable indicator that further declines are in the offing.
There are three chief players in the stock market today: the professional, theshort-term trader, and the individual investor. The professional—sometimes referred to as an institutional investor—trades stocks on behalf of other people. Theseinvestors are hired to make buying and selling decisions and are paid for their work.In theory, professional investors have the academic and professional backgroundsnecessary to make superior stock selections. In actuality, most professionals fail todeliver superior results. Nevertheless, professional investors buy and sell largequantities of stocks and are important players in today’s market environment.
Institutional investor: A person or organization that trades large enough quantities of shares that the trades qualify for preferential treatment and lower commissions. Institutional investors enjoy fewer protective regulations and areusually more knowledgeable and better able to protect themselves from risk.Individual investors often follow sizable stock trades initiated by institutionalinvestors since they can have a significant effect on a stock’s price performance, not to mention market sentiment.
The words “trader” and “investor” are used to describe two types of market participants. An investor is someone like Warren Buffett—a classic buy-and-hold kindof guy. He keeps an investment through thick and thin, understanding that wealth iscreated over time, provided the company has solid management and is in an industry that’s likely to prosper. The trader, on the other hand, is seen as a person whobuys and sells often, even intraday, looking for price swings and situations he or shecan trade profitably. These are the people who constantly monitor every move themarket makes, looking for trends, trend reversals, breakouts, and all manner ofstock movements.
Trader: Someone who buys and sells stocks and options frequently with theobjective of short-term profit.Investor: Someone who looks at the Big Picture, ignoring the day-to day pricefluctuations, focusing instead on making investments for the long haul.
If you decide that you want to trade individual stocks, you have an importantdecision to make. You have to choose the style of trading (and risk) you want to pursue: long-term or short-term. Long-term investors enjoy a lower risk and reduced
12
WELCOME TO THE STOCK MARKET
stress. Investments are made with the intention of accumulating profits and dividends over the long run. Long-term investors need to do their homework carefullyin order to find companies that can potentially double and triple in the decadesahead. Focusing on long-term returns makes long-term investors relatively impervious to day-to-day price fluctuations—a much less stressful way to live.Short-term trading is a different scene altogether. There are varying degrees ofshort-term trading—anywhere from mere seconds to several months to a year.Short-term traders are generally speculators looking for advantageous trends andmomentum changes in highly volatile stocks to inspire profit-making opportunities.Many short-term traders integrate the use of options into their master trading plansto hedge risk and promote leveraging. Time is a big factor for short-term traders—not just time spent in a trade, but the time required to monitor the market in searchof golden opportunities. Short-term trading is an extremely active process. It requiresspecific tools to do the job right, including real-time streaming quote services, trading analysis software, and plenty of room on your computer’s hard drive. If youwant to compete in this arena, you have to be prepared. It’s more than a matter oftools. You need to have the right kind of psychological stamina to withstand thetests that will come your way.Until you become an expert investor, you should probably focus more on thebuy-and-hold approach; it’s far easier on the nerves and less likely to lose money.Pick a few companies that offer solid growth, or mutual funds that meet your owncriteria, and then hang onto them for as long as their outlooks and performancesremain positive. Later, in Chapter 4, we’ll discuss a variety of additional tradingapproaches that may pique your interest.
THE ORDER PROCESSAlthough technology has made the order process take but a few seconds, an extensive number of steps are involved in the execution of a trade (see Figure 1.2). Theinformation superhighway may be revolutionizing the entire operation as we speak,but an order still begins when a trader (or investor) contacts a broker. From there,the order jumps through a series of hoops on its way to execution. The process theorder goes through depends on the type of trade you want to execute, the kind of order that is placed, and the overall mood of the market.A trader places an order with his or broker—electronically or by phone or fax.The broker either submits the order to be executed electronically or transmits it tothe exchange floor where a floor ticket is prepared and passed along to a floor broker. The floor broker takes it to the appropriate trading pit and uses the open outcrysystem to try to find another floor broker who wants to buy or sell your order. Ifyour floor broker cannot fill your order, it is left with a specialist who keeps a list ofall the unfilled orders, matching them up as prices fluctuate. In this way, specialistsare brokers to the floor brokers and receive a commission for every transaction theycarry out. Groups of specialists trading similar markets are located near one another
THE ORDER PROCESS
13
Buyer
Seller
MemberFirm
MemberFirmBrokerendorsesorder andreturns tofirm.
Order
Order
Trading PitBid / AskTrade ExecutedFloorBroker
FloorBroker
PitReporterQuotationBoards
QuotationBoards
ClearinghouseTrade SubmissionFigure 1.2
How a Trade Is Made
Trade Submission
14
WELCOME TO THE STOCK MARKET
in trading pits. Once your order has been filled, the floor trader contacts your broker, who in turn calls you to confirm that your order has been placed.In addition to the specialists, there are also market makers who create liquidity bynarrowing the spread. Market makers trade for themselves or for a firm. Once an order hits the pit, the market makers participate with the other players on a competitivebasis. If there isn’t much action in the pit, market makers are obligated to make themarket happen. Market makers derive the bulk of their profits by mastering the dynamics of the bid/ask spread. The bid is the highest price a prospective buyer is prepared to pay for a share of a specified security. The ask is the lowest price acceptableto a prospective seller of the same security. These two prices constitute a quotation or“quote.” The difference between the bid and ask is called the spread, and that’s wherethe market maker makes his or her living. This difference may be only $0.25 ( 1/4point) or less, but it accumulates quickly when you’re dealing in tens of thousands ofshares. Market makers are also experts at hedging their positions for protection.
Market maker: An independent trader or trading firm that is prepared to buyand sell shares or contracts in a designated market. Market makers must make atwo-sided market (bid and ask) in order to facilitate trading.Bid: The highest price at which a floor broker, trader, or dealer is willing to buya security or commodity for a specified time.Ask: The lowest price at which market makers and floor traders of a specificmarket are willing to sell