- [Instructor] What is a stock? You might have heard the term stocks or bonds perhaps, maybe friends or family have talked about investing over time. A stock is a fairly straight-forward concept. It's really just an ownership share in a company. If a firm has one million shares of stock outstanding and you buy one share, well then that one share gives you a one-one millionth ownership in the firm. That means that you're entitled to one-one millionth of the firm's profits and you own one-one millionth of the firm's assets.
There's a few basic terms that you need to know in order to understand stocks. First of these is price. Price simply refers to the cost of buying one share of stock. For example, a price for a stock might be $20. This relates to what we call, the market capitalization, or market cap. Market cap is simply equal to the price times the number of shares outstanding. So if the price of a stock is $20, and there's one million shares outstanding, well then the market capitalization is $20 million.
$20 times one million shares equals $20 million. That market capitalization represents the total value of all of the stock that is available in that particular company. It's really just a measure of the value of the equity in the firm. Third, you need to understand the concept of dividends. A dividend is a share of profits that are paid out to shareholders in a particular company.
So if a firm earns one million dollars and wants to pay that as a dividend, if it has one million shares of stock, every share of stock will get a $1 per share dividend. One million dollars in profit divided by one million shares means $1 per share in dividends. Similarly, you might think about the risk in owning a stock. We measure risk, not by the probability of bankruptcy, but instead, by how much the price of a stock moves up and down over time.
There's two metrics for this, standard deviation and volatility. Both of them measure, essentially, the same thing. They measure how much a stock's price fluctuates over time. Why is standard deviation or volatility the measure for risk? Because the more volatile the stock is, the greater the chance that you'll lose money in the future. That your stock will not be worth as much as it was when you bought it. Similarly, there are a couple of metrics that try to hone in on, not necessarily the price that a stock is trading at in the market, but it's intrinsic value.
These are the price-to-earnings ratio, or PE ratio and the price-to-book ratio, or PB ratio. The price-to-earnings ratio is just the stock's price in the market divided by it's earnings per share. If a stock costs $20 per share, and it earns $2 per share in profit, then it has a PE ratio of $20 divided by $2 or 10. The PE ratio in that case, would be 10 or 10 times.
Similarly, if the stock is trading for $20 per share, but the book value from an accounting point of view, is only $5 per share then the stock's price-to-book ratio is $20 per share divided by $5 per share or four times. The price-to-book ratio in this case is four times for that particular stock. These types of metrics are going to be critical as we start thinking about what we call, algorithmic trading.
Opportunities to identify stocks that are under-valued or over-valued based on fundamental values in the firm and based on data that we gather and use a computer to help us make decisions about.
Professor Michael McDonald provides a brief primer on securities markets. He explains how data helps investors forecast performance and automate trading. Then he moves into the practical steps: coming up with algorithmic trading rules and developing and testing an algorithm. Finally, he shows how the algorithm can be applied and eventually expanded to other securities. Anyone working in financial services, or interested in investing in the stock market, will be able to use these tutorials to understand and develop simple trading algorithms of their own.
- Define what a share of stock is.
- Classify the type of trading that attempts to capitalize on the bid-ask spread.
- Name the rule that can be used as a metric for Fed interference in the market.
- State the first step in a data analysis project.
- Identify the type of characteristic algorithmic trading relies on.
- Break down how VAR is used to manage risk.