Equity 1: Market Basics

Pooled investment vehicles

Mutual funds, trusts, depositories, and hedge funds issue securities (shares, units, depository receipts, or limited partnership interests) representing shared ownership in pooled assets, giving investors professional management and diversification. Open-end funds issue/redeem shares on demand at NAV (assets minus liabilities, per share); closed-end funds issue shares once and then trade in the secondary market, often at a discount (sometimes premium) to NAV. ETFs are open-end funds that trade like closed-end funds, but authorized participants arbitrage between market price and NAV (often via in-kind creation/redemption), keeping the two closely aligned. Hedge funds are typically limited partnerships (manager = general partner, investors = limited partners) open only to qualified investors, distinguished by an asset-based fee plus a performance fee, and often by the use of leverage.

Real assets

Tangible properties (real estate, airplanes, machinery, lumber) held directly or indirectly (e.g. REITs, MLPs) by investors for income/tax benefits and low correlation with other holdings. They are heterogeneous and illiquid, with costly management, making direct ownership unsuitable for most portfolios. Securitizing them into REITs/MLPs makes the resulting securities more homogeneous, divisible, and liquid than the real assets themselves.

Futures contracts

A futures contract is a standardized forward contract guaranteed by a clearinghouse, which acts as buyer to every seller and seller to every buyer, removing counterparty risk and letting traders close out by trading with anyone (an offsetting position). Participants post initial margin at entry; margin accounts settle daily (losses deducted, gains credited), and if margin falls below the maintenance margin, the participant must post variation margin to top back up to the initial margin level, or the broker offsets their position. Futures are actively traded so liquid unlike private forward contracts which need both party agreement to trade leading to illiquidity.

Swap contracts

A swap is an agreement to exchange periodic cash flows depending on future asset prices or interest rates. Interest rate swap: fixed payments exchanged for variable payments tied to a reference rate (e.g. SOFR). Commodity swap: fixed payments exchanged for payments tied to a commodity's future price. Currency swap: payments in different currencies exchanged (fixed or variable). Equity swap: fixed payments exchanged for payments tied to a stock or index's returns. Investment managers use swaps (especially interest rate swaps) to convert their exposure between fixed and variable cash flows and reduce interest rate risk.

Option contracts — calls and puts

An option gives the holder (buyer) the right, not the obligation, to buy or sell an underlying instrument at the strike (exercise) price on or before a future date; exercising means using that right. A call option = right to buy; a put option = right to sell. European-style options can only be exercised at maturity; American-style can be exercised any time up to maturity. Holders exercise calls when the strike is below the market price, and puts when the strike is above the market price — otherwise they let the option expire worthless. The buyer pays the seller (the option writer) a premium, compensating the writer for taking on the (potentially substantial) obligation to trade if the holder exercises.

Brokers, exchanges, alternative trading systems, and dealers

Brokers are agents who fill client orders by finding counterparties, without trading against their own clients; block brokers do this for large orders, which trade at a premium (buys) or discount (sells) to compensate counterparties and are managed carefully to avoid moving the market. Exchanges are venues where brokers/dealers arrange trades and increasingly also regulate members' trading behavior and listed issuers (e.g. requiring timely financial disclosure, restricting concentrated voting structures) — deriving authority from government or member/issuer agreement. Alternative trading systems (ATS), also called electronic communication networks (ECNs) or multilateral trading facilities (MTFs), function like exchanges but don't regulate subscribers beyond their own trading conduct; many are "dark pools" that don't display client orders, which large investment managers favor to avoid moving prices against themselves. Dealers also facilitate trades, but unlike brokers they take the other side of the trade themselves (the opposite position) and then try to offload it later — dealers are often investment banks.

Clearinghouses and trade settlement

A clearinghouse arranges final settlement of trades; in futures markets it guarantees contract performance, and in other markets may act only as an escrow agent transferring money and securities between buyer and seller. It only settles trades for its own members, who must hold adequate capital and post margin; non-member brokers/dealers must settle through a member, which imposes the same capital/margin/monitoring requirements on them, and brokers/dealers in turn monitor their own customers — a hierarchy that ensures trades settle, with each level absorbing failures below it (a clearinghouse settles a failed member's trade using its own or other members' capital). This reduces counterparty risk (the risk a counterparty won't settle) and so increases market liquidity, since traders can safely deal with more counterparties.

Long and short positions

Long = own an asset/contract or hold the right to exercise (as an option holder); benefits from a price increase. Short = sold an asset you don't own, or wrote a contract (as an option writer, who must satisfy the obligation); benefits from a price decrease. Key liability difference: a long position's loss is capped at the amount invested, while a short position's potential loss is unlimited, since there's no ceiling on how high the price can rise before the short must buy back or deliver. For options, the long/short label refers to the contract itself, not necessarily the underlying: a put holder is long the put but has an indirect short exposure to the underlying (they gain as the underlying falls).

Total return on a margin (leveraged) transaction

Initial investment = (equity % of purchase price × total purchase price) + purchase commission, where equity % = 1 ÷ leverage ratio. Remaining equity = initial investment + trading gains/losses (price change × shares) − margin interest paid (loan amount × call money rate) + dividends/interest received − sale commission. Total return = (remaining equity − initial investment) ÷ initial investment. Equivalently, remaining equity can be found from: sale proceeds − loan payoff − margin interest paid + dividends received − sale commission.

Maintenance margin and the margin call price

Maintenance margin requirement = the minimum equity % a margin buyer must maintain in a position (often ~25%, but varies by instrument volatility and broker policy). A margin call is a request for additional equity, triggered when equity falls below this requirement; if the buyer doesn't post more equity in time, the broker closes the position to secure loan repayment. Margin call price formula (long position): find P where [initial equity/share + (P − initial price)] ÷ P = maintenance margin %, then solve for P. Short sellers face the same mechanism in reverse: their equity is lost as the price rises, and if it falls below the maintenance requirement, they must post more equity or the broker buys back the security to close the position.

Market orders, limit orders, and order aggressiveness

Market order: obtain the best price available immediately. Limit order: obtain the best price available, but never worse than a specified limit — trades faster/at a worse price with a market order, or waits for a better price (but may not fill) with a limit order. A marketable limit order is priced aggressively enough (buy above the best offer, or sell below the best bid) that at least part fills immediately, essentially acting like a market order. A limit order priced between the best bid and offer "makes a new market" (becomes the new best bid/offer); one priced at the best bid/offer "makes market"; one priced worse than the best bid/offer is "behind the market" and won't fill unless prices move. Unfilled limit orders waiting to trade are called standing limit orders.

Validity instructions

Day order: good only for the day submitted, expires unfilled if not filled by close. Good-till-cancelled (GTC): stays open until cancelled (though brokers often cap how long they'll manage it). Immediate-or-cancel (IOC)/fill-or-kill: must fill immediately, in part or whole, on receipt, or it's cancelled. Good-on-close (market-on-close): fillable only at the market close, used to trade at that day's official closing price. Good-on-open: the equivalent for the market open.

Stop orders (stop-loss orders)

A stop order only becomes active for execution once a trade occurs at/through the specified stop price — for a sell, at or below the stop price; for a buy, at or above it. Once triggered, it's subject to its other execution instructions (e.g. a stop paired with a market order fills at the best available price, which may be well past the stop price, so it doesn't guarantee a stop to losses at that price — pairing the stop with a limit order instead avoids trading at too poor a price, at the risk of not filling at all). A stop-buy order can be used to confirm a security is rising before buying into a belief it's undervalued. Because stop-sells trigger as prices fall and stop-buys trigger as prices rise, stop orders tend to reinforce market momentum, often producing poor execution prices.

Leverage Ratio

1/margin

New Leverage Ratio from a fall in share price