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How Securities are Traded

How Securities are Traded. Chapter 3. Agenda. Organization of secondary markets Trading and execution Margin trading Costs and regulation. A. Primary vs. Secondary Markets. Primary market New issues Issuer receives the proceeds from the sale Secondary market

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How Securities are Traded

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  1. How Securities are Traded Chapter 3

  2. Agenda • Organization of secondary markets • Trading and execution • Margin trading • Costs and regulation

  3. A. Primary vs. Secondary Markets • Primary market • New issues • Issuer receives the proceeds from the sale • Secondary market • Trading of securities among investors • Issuer does not receive proceeds and is not directly involved (except for repurchases, exercising options….etc.)

  4. Secondary Market Two major arrangements: • Auction market - Trading is centralized: no need to search for best price from different dealers • Over-the-Counter (OTC) market - Network of dealers / market makers

  5. Auction Market • Organized exchanges with centralized order flow • Before: trading pits/open outcry • Mid-1980’s - now: computerized • One specialist (US) / registered trader (Canada) per stock • Assigned by the Exchange • Securities: stocks, futures contracts, options, and to a lesser extent, bonds • Examples: Toronto Stock Exchange, New York Stock Exchange, Chicago Board Options Exchange

  6. Toronto Stock Exchange • 1852: Toronto Stock Exchange officially founded on October 25, 1852. The trading list consisted of 18 securities • 1977: Toronto Stock Exchange launched the world's first Computer Assisted Trading System. The TSE 300 Composite Index also launched • 1997: Toronto Stock Exchange trading floor closed and the exchange became the largest stock exchange in North America to choose a floorless, virtual trading environment

  7. Last Day of floor trade

  8. OTC Market • Dealers market: no centralized (buy and sell) order flow • Can have >1 dealer / market maker per stock, depending on demand and volume • NASDAQ: largest organized stock market for OTC trading • Most secondary bonds transactions are OTC, as are precious metals (e.g., London Bullion Market)

  9. Other Secondary Markets • Direct trading among investors through a computer network, rather than on an exchange or an OTC market • Electronic communication networks (ECNs) • computerized trading systems, available to subscribers • Active in the 1990’s; many have since been acquired by exchanges • Instinet, now part of NASDAQ • Archipelago, now NYSE Arca • Upstairs market/dark pools • Large block trades off organized exchanges • Dark: little pre-trade transparency • Largest 2: Credit Suisse Crossfinder, Goldman Sachs Sigma X

  10. Types of Orders • Instructions to broker on how to complete the order. Most common are: • Market orders • Limit orders • Stop (loss) orders • Stocktrak also allows: trailing stop orders ($ or %) • If market price = $50, and set trailing stop = $5 • becomes a market order if price falls to $45 • If price goes up to $60, new stop price is $55 • Allows investors to set a limit on loss, but no limit on gain

  11. C. Trading with Margin • An investment strategy using borrowed funds or securities (in margin account) • Margin purchases • Short sales • Margin requirement • Collateral • Requirements vary across securities • Set by regulatory body (Canada: Reg.100) • Margin call • When value of collateral  • Broker calls for more funds to back the trade

  12. Margin Purchase ExampleInitial Conditions X Corp $70 50% Initial margin 25% Maintenance margin in U.S. (NYSE/FINRA) 1000 Shares purchased Initial Position Stock $70,000 Borrowed $35,000 Equity $35,000

  13. Margin Purchase Margin Stock price falls to $60 per share New Position Stock $60,000 Borrowed $35,000 Equity $25,000 Margin (as a %) = $25,000/$60,000 = 41.67%

  14. Leveraging effect of margin purchases • Impact on rate of return • Buy 200 shares of XYZ at $100, 30% appreciation of the stock in one year: • Margin: 50% • Financed by a 9% loan for one year • Net return: 51% • A 30% drop in price  net return = -69% • Leads to bigger swings in returns: leverage effect

  15. Short Sales • Purpose: to profit from a decline in the price of a security Mechanics • Borrow security from broker • Sell and deposit proceeds and margin in account • Dividends; voting rights • Close out/cover the position: buy the security back and return to broker TSX Short position reports

  16. Short Sale ExampleInitial Conditions Z Corp 100 shares 50% Initial margin 25% Maintenance margin (U.S.) $100 Initial price Sale Proceeds $10,000 Margin (50%) +$ 5,000 Stock owed - $10,000 Equity $ 5,000 (In Canada – this margin is expressed as 150%)

  17. Short Sale Margin Stock price rises to $110 Sale proceeds $10,000 Initial margin +$ 5,000 Stock owed - $11,000 Equity $ 4,000 Margin as a % (4,000/11,000) = 36%

  18. Risks(From FINRA website) • You can lose more funds than you deposit in the margin account • A decline in the value of securities that are purchased on margin may require you to provide additional funds to the firm that has made the loan to avoid the forced sale of those securities or other securities in your account. • Broker can force the sale of securities in your account • If the equity in your account falls below the maintenance margin requirements under the law—or the firm’s higher "house" requirements—the firm can sell the securities in your account to cover the margin deficiency. You will also be responsible for any short fall in the account after such a sale. • Broker can sell your securities without contacting you • Some investors mistakenly believe that a firm must contact them for a margin call to be valid, and that the firm cannot liquidate securities in their accounts to meet the call unless the firm has contacted them first. This is not the case. As a matter of good customer relations, most firms will attempt to notify their customers of margin calls, but they are not required to do so. • You are not entitled to an extension of time on a margin call • While an extension of time to meet initial margin requirements may be available to customers under certain conditions, a customer does not have a right to the extension. In addition, a customer does not have a right to an extension of time to meet a maintenance margin call.

  19. D. Costs of Trading • Direct costs: commission • Fee paid to broker • Full service broker vs. discount broker • Indirect costs: bid-ask spread • Traded securities have bid and ask prices • Bid: price dealer will buy the security at • Ask: price dealer will sell the security at • Bid-ask spread: ask minus bid

  20. Costs of trading (cont’d) • Amount lost if simultaneous buy and sell • Why is there a spread? • To compensate dealers for the risk they take in keeping the market liquid • In the absence of this compensation, you would be buying (selling) at a lower (higher) price • Liquidity and bid-ask spread

  21. Regulation of Securities Markets • Government regulation • Provincial regulation in Canada, e.g., OSC in Ontario, BCSC in British Columbia…etc. • Likely to see a national body in the future • SEC in the U.S. • Self-regulatory bodies (investment industry) • FINRA in U.S., IIROC in Canada • Circuit breakers • Insider trading laws

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