Financial Markets Basics¶

🎯 Learning Objectives

Understand how financial markets work
Learn about different asset classes
Understand market participants
Learn about exchanges and trading mechanisms

Understanding financial markets is essential for quantitative trading. This chapter covers the fundamentals of how markets operate, what you can trade, and who participates.

What are Financial Markets?¶

Financial markets are places where buyers and sellers trade financial instruments (stocks, bonds, derivatives, etc.). They facilitate:

Price Discovery: Finding the fair price through supply and demand
Liquidity: Ability to buy/sell quickly without large price impact
Capital Allocation: Directing money to productive uses
Risk Transfer: Allowing participants to manage risk

Asset Classes¶

1. Stocks (Equities)¶

What they are: Ownership shares in a company

Characteristics: - Represent ownership stake - Can pay dividends - Price fluctuates based on company performance and market sentiment - Higher risk, higher potential return

Types: - Common Stock: Voting rights, dividends - Preferred Stock: Fixed dividends, no voting rights

Example:

# Stock price data
stock_data = {
    'symbol': 'AAPL',
    'price': 150.00,
    'shares_outstanding': 15_000_000_000,
    'market_cap': 150.00 * 15_000_000_000  # $2.25 trillion
}

2. Bonds (Fixed Income)¶

What they are: Loans to companies or governments

Characteristics: - Fixed interest payments (coupons) - Maturity date - Lower risk than stocks - Lower potential return

Types: - Government Bonds: Treasury bonds (very safe) - Corporate Bonds: Company debt (higher risk) - Municipal Bonds: Local government debt

Key Metrics: - Yield: Annual return percentage - Maturity: When bond is repaid - Credit Rating: Risk assessment (AAA to D)

3. Derivatives¶

What they are: Contracts whose value derives from underlying assets

Types:

Options¶

Call Option: Right to buy at strike price
Put Option: Right to sell at strike price
Expiration: When option expires
Strike Price: Price at which option can be exercised

Futures¶

Agreement to buy/sell at future date
Standardized contracts
Used for hedging and speculation

Swaps¶

Exchange cash flows
Interest rate swaps, currency swaps

4. Commodities¶

What they are: Physical goods (gold, oil, wheat, etc.)

Characteristics: - Physical delivery or cash settlement - Affected by supply/demand - Used for diversification

5. Currencies (Forex)¶

What they are: Trading currency pairs

Characteristics: - Largest market by volume - 24-hour trading - High leverage available - Major pairs: EUR/USD, GBP/USD, USD/JPY

6. Cryptocurrencies¶

What they are: Digital assets (Bitcoin, Ethereum, etc.)

Characteristics: - High volatility - 24/7 trading - Decentralized - Emerging asset class

Market Participants¶

1. Retail Traders¶

Who: Individual investors trading for themselves

Characteristics: - Small position sizes - Often use online brokers - May trade based on news/emotion - Growing segment

2. Institutional Investors¶

Who: Large organizations (pension funds, insurance companies)

Characteristics: - Large position sizes - Professional management - Long-term focus - Significant market impact

3. Hedge Funds¶

Who: Private investment funds

Characteristics: - Aggressive strategies - Use leverage and derivatives - High fees (2% management + 20% performance) - Sophisticated quant strategies

4. Market Makers¶

Who: Firms providing liquidity

Characteristics: - Buy and sell continuously - Profit from bid-ask spread - Essential for market liquidity - Use automated systems

5. High-Frequency Traders (HFT)¶

Who: Firms using algorithms for ultra-fast trading

Characteristics: - Microsecond execution - High volume, small profits per trade - Advanced technology - Significant market share

Exchanges and Trading Venues¶

Stock Exchanges¶

Major Exchanges: - NYSE (New York Stock Exchange): Largest by market cap - NASDAQ: Technology-focused - London Stock Exchange: UK market - Tokyo Stock Exchange: Japan market

How they work: - Centralized trading - Price discovery through auctions - Regulatory oversight - Settlement and clearing

Electronic Communication Networks (ECNs)¶

What they are: Electronic trading systems

Characteristics: - Direct matching of orders - Lower costs - Faster execution - Dark pools (private trading)

Over-the-Counter (OTC) Markets¶

What they are: Direct trading between parties

Characteristics: - Not exchange-traded - Less regulated - Custom contracts - Lower transparency

Order Types¶

Market Orders¶

What: Execute immediately at current market price

Use: When speed is more important than price

Risk: Price may be worse than expected

Limit Orders¶

What: Execute only at specified price or better

Use: When price is more important than speed

Types: - Buy Limit: Buy at or below price - Sell Limit: Sell at or above price

Stop Orders¶

What: Trigger market order when price reached

Types: - Stop Loss: Limit losses - Stop Limit: Combine stop and limit

Other Order Types¶

Fill or Kill (FOK): Execute immediately or cancel
Immediate or Cancel (IOC): Fill what you can, cancel rest
Good Till Canceled (GTC): Order stays active until filled or canceled

Market Data¶

OHLCV Data¶

Components: - Open: First price of period - High: Highest price of period - Low: Lowest price of period - Close: Last price of period - Volume: Number of shares/contracts traded

import yfinance as yf

# Get OHLCV data
ticker = yf.Ticker("AAPL")
data = ticker.history(period="1mo")
print(data[['Open', 'High', 'Low', 'Close', 'Volume']].head())

Tick Data¶

What: Every single trade

Use: High-frequency trading, detailed analysis

Characteristics: - Very large datasets - Requires special infrastructure - Expensive

Level 2 Data¶

What: Order book with all bids and asks

Use: See market depth, better execution

Components: - Bid prices and sizes - Ask prices and sizes - Market maker IDs

Trading Sessions¶

Market Hours¶

US Stock Market: - Pre-Market: 4:00 AM - 9:30 AM ET - Regular Hours: 9:30 AM - 4:00 PM ET - After Hours: 4:00 PM - 8:00 PM ET

Forex Market: 24 hours (Sunday 5 PM - Friday 5 PM ET)

Futures Market: Nearly 24 hours

Market Phases¶

Pre-Market: Low volume, high volatility
Opening: High volume, price discovery
Regular Trading: Normal volume and volatility
Closing: High volume, final price discovery
After Hours: Low volume, news-driven

Market Mechanics¶

Bid-Ask Spread¶

What: Difference between highest bid and lowest ask

Components: - Bid: Highest price buyers will pay - Ask: Lowest price sellers will accept - Spread: Ask - Bid

Factors Affecting Spread: - Liquidity (more liquid = smaller spread) - Volatility (higher volatility = larger spread) - Market maker competition

# Example bid-ask spread
bid = 150.00
ask = 150.05
spread = ask - bid
spread_percent = (spread / bid) * 100
print(f"Spread: ${spread:.2f} ({spread_percent:.3f}%)")

Market Depth¶

What: Volume available at different price levels

Use: Understanding liquidity, execution impact

Slippage¶

What: Difference between expected and actual execution price

Causes: - Market movement during order - Large order size - Low liquidity

Minimizing: - Use limit orders - Split large orders - Trade during high liquidity

Market Indices¶

What They Are¶

Definition: Baskets of stocks representing market segments

Purpose: Benchmark performance, market indicators

Major Indices¶

US Indices: - S&P 500: 500 large US companies - Dow Jones: 30 large US companies - NASDAQ: Technology-focused - Russell 2000: Small-cap companies

International: - FTSE 100: UK - Nikkei 225: Japan - DAX: Germany

# Get index data
import yfinance as yf

sp500 = yf.Ticker("^GSPC")
data = sp500.history(period="1y")
print(f"S&P 500 Current: ${data['Close'].iloc[-1]:.2f}")

Market Regulations¶

Regulatory Bodies¶

US: - SEC (Securities and Exchange Commission): Stock market regulation - CFTC (Commodity Futures Trading Commission): Derivatives regulation - FINRA: Broker-dealer regulation

Key Regulations: - Insider Trading: Illegal use of non-public information - Market Manipulation: Illegal price manipulation - Disclosure Requirements: Public company reporting

Getting Market Data¶

Free Sources¶

Yahoo Finance:

import yfinance as yf
data = yf.download("AAPL", start="2020-01-01", end="2023-01-01")

Alpha Vantage: Free API with rate limits

Quandl: Some free datasets

Paid Sources¶

Bloomberg Terminal: Professional standard ($2,000+/month)

Refinitiv (formerly Reuters): Financial data

Interactive Brokers: Real-time data with account

Key Concepts Summary¶

Essential Market Concepts

Liquidity: Ease of buying/selling
Volatility: Price fluctuations
Volume: Trading activity
Market Cap: Total company value
Dividend Yield: Annual dividend / price
P/E Ratio: Price / Earnings per share

Key Takeaways: - Financial markets facilitate trading of various asset classes - Different participants have different goals and strategies - Understanding order types and execution is crucial - Market data (OHLCV) is essential for analysis - Regulations ensure fair and transparent markets

Previous: Mathematics Fundamentals | Next: Python for Quantitative Finance