INVESTMENTS

Lecture 3

How Securities Are Traded

Objectives

Explain brokers’ roles and how brokerage firms operate

appreciate the changing nature of the securities business

understand how orders to buy and sell securities work in various marketplaces

assess the role of regulation in the securities markets

understand how margin trading and short selling contribute to investor opportunities

Investing Your Money

Where do you go to invest and what type of account do you want to use?

Where• Full service broker• Discount broker• On-line brokerage service

What type of account• Cash account• Margin account• Asset management account• Wrap account

Market Mechanics

Types of orders 1. Market order

• Order to buy or sell a stock at the best available price

• Most common order type

• May be issued as a discretionary order, where your broker has the right to hold the order in order to get a better price.

Example #1

Assume we want to buy 1000 shares of Disney. We call our broker and enter a market order for Disney.

At the time of the order the quotes on Disney are 33½

bid and 33¾ ask. This means the highest quote the Disney specialist has

to buy Disney is 33½ and the lowest price anyone will sell at is 33¾.

Our market order will be filled at 33¾ so our transaction will cost $33750 plus commissions.

Example #2

I am aware of some anecdotal evidence regarding an investor who wanted to purchase an internet stock. A market order was placed for 1000 shares at

$9 (the current price) The order was filled at $90 The stock closed the next day at $40

Market Mechanics

Types of orders 2. Limit Order

• A limit order is a buy or sell order that is executed at a specified price or a more favorable price. The limit order is given to the specialist who executes the order when the price is met.

• Limit orders can be for virtually any time period some typical orders are

– day order– open-ended order (good until canceled or GTC)

Example #3

Assume we again want to buy Disney but do not want unless the price hits $31. We would make a limit buy order with a broker

at 31. The broker will transfer the order to the

specialist who enters the order in a limit book. Your order will be filled if the ask price of

Disney falls to or below $31.

Market Mechanics

Types of orders 3. Stop loss order This is an order you put in to insure a limited

loss on a stock. Stop loss orders become a market order once the specified price is reached.

Example #4

Assume we buy Disney at $31 and want to insure we do not lose too much on the stock. We can place a stop loss order at $27 and if

Disney falls to $27 the order will automatically be executed.

In a SLO the stock might be sold at less than $27

Market Mechanics

Types of orders 4. Stop buy order

• Opposite of a stop loss, generally used to cover short positions 5. Stop limit order

• Combination of a stop and limit order.

• The order becomes a limit order as soon as a bid or ask is made at a price equal to or less favorable than the stop price.

• With a stop limit order you must give the broker two prices a stop price and a limit price.

Example #5

Suppose that we bought Disney for 33¾. We want to protect ourselves against losses so we could put a stop limit order with a stop at 30 and a limit at 28. Once the bid price of Disney falls below $30 a

limit order of $28 will be placed.

Market Mechanics

Types of orders 6. Market-if-touched

• The order is executed at the best available price after a trade occurs at a specified price. This differs from a limit order which must be executed at the limit price or a more favorable price.

Market Mechanics

Short sales A short sale is executed when a trader expects

the price of a security to fall Short sales involve borrowing a security and

selling it and then buying the security back at a lower price and returning it to the owner.

Example #6

Assume we think the price of Disney is going to fall. We will sell Disney short in order to benefit from this price decrease

In order to do this we would borrow 1000 shares of Disney and sell it for 33½. We receive $33500 for this transaction.

If Disney falls to a $30 ask price we can buy 1000 shares of Disney for $30000 and return it to its owner.

We make $33500 – $30000 =$3350 less commission and interest on the transaction.

Market Mechanics

Short sales Short sale restrictions

• Short sales can only be made on an up-tick

• The short position owes the owner of the security any dividends paid.

• In order to short a stock you must have a margin account with a broker

Market Mechanics

Margin accounts Margin refers to borrowing part of the cost of a

security when a purchase is made The amount of money that is put up by the

investor is referred to as the margin. Your broker will charge you interest on the

margin. Typical interest rates are 1.5% above the call money rate (which is generally slightly below the prime rate)

Market Mechanics

Margin Accounts Initial margin

• Initial margin is the part of the original transaction value paid for by the investor

• Currently the initial margin requirement on stock is 50% (required by law)

• Broker’s can charge higher initial margins Investor’s equity

• The investor's equity position is the market value of the stock minus the amount borrowed

Actual margin• (investor’s equity)/(market value)

Market Mechanics

Margins accounts Maintenance margin

• Maintenance is the minimum value the actual margin can reach before a margin call is made. Current requirements call for a minimum maintenance margin of 25%.

Margin call• A margin call requires the investor to either put up

enough cash to restore the initial margin requirement of 50% or close the position

Example #7

Assume we want to buy 1000 shares of Disney at $35 using a margin account. The initial margin requirement is 50% and the maintenance margin is 35%

Now assume Disney goes to $45 What is the market value? What is the investors equity? What is the actual margin? What is the return? Return without margin?

Example #7 (cont.)

Now assume Disney falls to $30Now Disney falls to $20

At what price will a margin call occur?

Example #8

Suppose you buy a round lot of Maginn Industries stock on 55% margin when the stock is selling at $20 a share. The broker charges a 10% annual interest rate and commissions are 3% of the total stock value on both purchase and sale. A year after purchase you receive a 50 cent dividend and sell the stock for $27. What is your rate of return on this stock?

Example #9

You decide to sell short 100 shares of Charlotte Horse Farms when it is selling at its yearly high of 56. Your broker tells you that the margin requirement is 45 percent and the commission on the purchase is $155. While you are short the stock, Charlotte pays a $2.50 per share dividend. At the end of one year you buy 100 shares of Charlotte at 45 to close out your position and are charged a commission of $145 and 8% interest on the money borrowed. What is your rate of return on this investment?