How Securities Are Traded? - Investment Management by Charles P Jones

Chapter 5- How Securities Are Traded?

Q 5-1: Discuss the advantages and disadvantages of a limit order versus a market order? How does a stop order differ from a limit order?

A market order is placed to buy or sell at the best current price available in the market at the time when the order reaches the trading floor. The advantage of a market order is an ultimate liquidity that it promises. A market order ensures that the transaction would be carried out, however, the disadvantage is that the investor might not be able to ensure a certain level of return, if the current market price of the security is below the desired price of the investor.  Moreover, the price of the security at the time when the order was sent to the broker might differ from the time when the order reaches the trading floor. The price at which the security has been traded would be confirmed only after the security has been traded.

A limit order, on the other hand, is an order to buy or sell at a specified (or better) price. This order specifies a particular price to be met and does not guarantee that the transaction would take place immediately. The advantage of this order is that by placing this order, the customer can obtain a better price than the market order. However, there is a risk that no sale or purchase may occur, since the market price never reached the limit specified in the order. The purchase or sale would occur only if the broker obtains the price or betters it (lower for a purchase or higher for a sale). Due to this fact limit orders may become illiquid for considerable period of time.

A stop order is different from a limit order since these are usually designed either  to protect a customer’s existing profit  or reduce the amount of loss. For instance if a person buys a stock at Rs 35 and the current market price of the stock is 50, the investor may place a sell stop order at Rs 45. Now if the price declines to 45 or below[1] the order would be automatically executed and the shares would be sold, ensuring a profit of about Rs 10 per share. The broker usually does not better the price, he rather tries to meet the limit prescribed in the stop order. The time at which the order takes effect the price may be lower than the order price at 44 or 43 , however the execution of the order would ensure protection of the profit, reducing any further losses in the value of the investor’s portfolio.

Q 5-2: How has the move to quote stock prices in cents on US markets, rather than eighths, helped investors?

For its entire history up to 2001, th4e exchanges and Nasdaq traded stocks based on prices in eighths and sixteenths. This practice provided a comfortable spread between bid price and ask prices of at least one eighth of a point or 12.5 cents, which was captured by the market-makers. Investors benefited from the decimalization of stocks as the spreads narrowed from minimum of 12.5 cents to one cent.

Q 5-3: Explain the margin process, distinguish between the initial and maintenance margin. Who sets these margins?

Accounts are the brokerage houses can either be cash accounts or margin accounts. Opening a margin account requires some deposit of cash or marginable securities. With a margin account the customer can pay part of the total amount due and borrow the remainder from the broker, who typically borrows from a bank to finance the customers. Bank charges the broker at ‘broker call rate’ and the broker, in turn, charges the customer a margin interest rate, which is higher than what the broker pays to the bank. Margin is that part of transaction’s value that a customer has to pay to initiate the transaction, with the other part being borrowed from the broker. The initial margin can be anywhere from 40 to 100 percent, however, the NYSE’s initial margin requirement is 55 percent.

All exchanges and brokers require a maintenance margin below which the actual margin should not fall. NYSE requires 25 percent of the market value of securities while brokers outside NYSE may require 30 percent as maintenance margin. Usually the margin requirement is set by the stock exchange in which the trade is being done.

Q 5-4: What conditions result in account being restricted? What prompts a margin call?

In case the equity level of the investor falls  due to a decrease in the price of marginable securities, the account is said to be restricted. This implies that the investor would not be allowed to make further transactions on margin. A margin call is due when the equity of the investor falls below the maintenance margin requirements.

Q 5-5: How can an investor sell a security that he currently does not own?

An investor can sell a security without actually possessing it by selling it short. In case of short selling, the broker borrows the security from one investor and sells it short in the name of another investor. The investor, in whose name the short sale has been made, would  close his short position by buying the security at a price lower than the one at which the security has been sold short in order to earn a profit. However, if the price rises, the investor sustains a loss.

Q 5-6: What conditions must be met for an investor to sell short?

Short sellers must have a margin account to sell short and must put up margin if their short position goes long. Short sales a permitted only on rising prices, i.e. a short seller can sell short at the last trade price only if that price exceeds the last price before it. Even if the order has been placed, it will not be executed unless an up-tick occurs.

There is no time limit on a short sale. Short sellers can remain short indefinitely until the lenders of the securities sold short want them back. In such cases brokers borrow from elsewhere, but for tightly held or thinly capitalised stock, it may not be possible to arrange the stocks from anywhere and the investor would have to pay in cash to close his short position. The net proceeds from the short sale, plus the required margins are held by the brokers, thus the short seller receives no immediate funds. If the price of the stock rises instead of falling, the investor is likely to receive a margin call.

Q 5-7: Explain the difference, relatively to the current market price of the stock, between a sell limit order, buy limit order, sell stop order and buy stop order?

In a sell limit order, the investor prescribes a price to the broker at which the securities need to be sold. For instance, if the current market price of a stock of IBM is at $23.40, an investor who expects the price to be rising, may order to sell it at $27.00. If the price reaches $27 or more, the broker would execute the order.

In a buy limit order, the investor specifies a price at which particular shares need to be bought. If the IBM stock starts falling from 27.00, the investor may ask the broker to buy the stock at $24.00 or lower. If the price reaches $24.00 or below, the order would be executed.

A sell stop order could be used to protect a profit in case the price declines. For instance, the IBM stock bought at $24.00 now sells at $39.00. the investor might not wish to limit additional gains by selling the stock at this price, however, he may wish to protect his gains against a price decline and for that he may place a stop order to sell the shares at $36.00.

A buy stop order could be used to protect a profit from a short sale. If the investor short sells the IBM stock at $39.00 and the current market price reaches $27.00, the investor may place a stop order to buy shares at $29.00.

Q 5-8: What is the margin requirement of US government securities?

US government securities and GNMA’s securities require an initial margin of 8-15 percent, whereas treasury bills may require only one percent of market value. For treasury securities it can be greater of 10% of market value or 6% of principal as the initial margin.

Q 5-9: What is a Wrap Account? How does it involve a change in the traditional role of the broker?

Under a Wrap Account all costs—including the cost of broker consultancy and money management, all transaction costs, custody fees, and the cost of detailed performance reports—are wrapped in one fee. The traditional role of the broker was to act as a middleman among investors who want to buy and sell shares. However, with a change in the traditional role, the brokers act as middlemen, the client chooses an outside money manager from a list provided by the broker.

Q 5-10: Distinguish between a large discount broker such as Fidelity and an Online discount broker?

A large discount broker can offer multiple services, along with the facility of online trading. Such discount brokers offer touch-tone phone system for receiving information and placing trades. The ordinary online brokers only offer online trading with no ancillary services.

Q 5-11: How can investors invest without a broker?

Investors can invest without hiring the services of a broker by investing in a Dividend Reinvestment Plan (DRIP). DRIP is a plan offered by a company whereby stockholders can reinvest dividends  in additional shares of stocks at no cost. In order to be in a company’s dividend reinvestment plan, investors usually have to buy the stock through the brokers, although some companies might directly sell stocks to individuals the advantage is dollar cost averaging, whereby more shares are repurchased when the stock price is low than when it is high. Charles Schwab, a large discount brokerage firm, offers dividend reinvestment services allowing them to reinvest dividends on any US stock automatically. A number of companies also offer no load stock purchase programme to first time investors, which is a direct stock purchase plan. Through such programmes, the investors make their initial purchase of the stock directly from the company for purchasing fee ranging from zero to about 7 cents a share. The price paid is typically based on the closing price of the stock on designated dates. Such programmes are also useful for the companies as they raise additional capital without underwriting fees and also as a way to build goodwill with the investors.

Q 5-13: Explain the role of a specialist on the NYSE? How do specialists act as both brokers and dealers?

Specialists are critical to auction process. They are responsible for maintaining a fair and orderly market in securities assigned to them. They manage auction process, providing a conduit of information—electronically quoting and recording current bid and asked prices of the assigned stocks.

Specialists act as agents, executing orders entrusted to them by a floor broker—orders are to be executed if and when the stock reaches a price specified by customer. In instances, when there is a temporary shortage of buyers or sellers, specialists will buy and sell from their own accounts against the trend of the market. As dealers specialists buy and sell shares of the assigned stock to maintain an orderly market. Since the orders do not arrive at the same time so that they could be matched, the specialists would buy from the commission brokers with orders to sell and sell to those with orders to buy, hoping to profit from a favourable spread from the two transactions.

Q 5-14: What is the difference between a day order and an open order?

A day order is a type of limit order, which is effective only for one day. An open or good-till-cancelled order remains in effect for six months unless cancelled or renewed.

Q 5-14: What is the role of the SEC in the regulations of the securities markets?

The Securities & Exchange Commission (SEC) is a federal government agency established by the Securities Exchange Act of 1934 to protect the investors. Being a quasi-judicial agency its mission is to administer laws in the securities field and to protect investors and public in securities transactions. The commission consists of five members appointed by the president for a five-year term. SEC staff consists of lawyers, accountants, security analysts and others. Every company that offers securities for public sale for the first time or trading on national exchange is registered with the commission. The registration of securities does not ensure that investors purchasing them will not lose money, it only means that the issuer of securities has made adequate disclosure. In recent times, the issue of ‘insider trading’ has emerged as a big challenge before the commission. Insiders (officers and directors of the corporations) are prohibited from using corporate information that is not generally available to the public and are required to file reports with the SEC showing their equity holdings.

Q 5-15: Who regulates brokers and dealers? What type of actions can be taken against firms and individuals?

Brokers and dealers are regulated by Securities & Exchange Commission, Stock exchanges and National Association of Securities Dealers, to protect the investors. The individuals and firms that are not abiding by the rules of trading can be penalised to the extent of million of dollars and cancellation of their trading license.

Q 5-16: Why are investors interested in having margin accounts? What risk do such accounts involve?

Accounts at the brokerage houses can either be cash or margin accounts. Opening a margin account requires some deposit of cash or marginable securities. With the margin account a customer can pay part of the total amount due and borrow the remainder from the broker, who typically borrows from the bank to finance the customers. The bank charges ‘broker call rate’, and the broker in turn charges the customer a ‘margin interest rate’, which is usually higher than what the brokers pays to the bank.

A margin account has following attractions to an investor.

1.      They can purchase additional securities by leveraging the value of eligible shares to buy more.

2.      They can borrow from a brokerage account for personal purposes, which may cost more interest.

3.      They are provided with overdraft  protection in amounts up to the loan value of the marginable securities for checks written.

Another benefit of using a margin account is that the returns are magnified, but there is a risk that the losses may also magnify. The magnification can be calculated by the reciprocal of the margin percentage.

Q 5-17: How popular are short sales, relative to all reported sales?

In year 2000, roughly 29 billion shares were sold short on the NYSE, which was about 11 percent of the total reported volume traded in the exchange. NYSE members accounted for 66 percent of the total short sales and public did the rest. Out of the total short selling by the members, 40 percent was done by the specialists to keep an orderly market.

Q 5-18: Explain the basis of regulating mutual funds? How successful has this regulation been?

The mutual funds are regulated under the Investment Company Act of 1940, which requires of the investment companies to register with the SEC and provide a regulatory framework within which they must operate. Investment companies are required to disclose considerable information and to follow procedures designed to protect their shareholders. Although this industry is heavily regulated, in the recent times the number of investment companies increased to 3,500 and while more companies are coming into the business. SEC would find it difficult to regulate this growing industry.

Q 5-19: What assurance does the Investment Advisors Act of 1940 provides to investors in dealing with people who offer investment advice?

The investment advisor act of 1940 requires individuals and firms who sell advice about investments to register with the SEC. Registration connotes only compliance with the law, it does not provide assurances. Almost anyone can become an investment advisor since the SEC cannot deny anyone the right to sell investment advice unless it can demonstrate dishonesty or fraud. However, through registration investment advisors can be directly monitored by the SEC. In case of any fraudulent activity from a firm or individual, its registration may be cancelled by the SEC denying him of the right to continue with the business.

Q 5-20: Given the lower brokerage costs changed by discount brokers and deep-discount brokers, why might an investor choose to use a full service broker?

Full service brokers offer a variety of services to investors, particularly information and advice. They offer information on economy, industrial sectors, individual companies and the market situation. Due to these additional services and professional advice, investors choose to go to a full service brokerage firm, although choosing for a full service may cost as much as 8 times more than what they would have to pay in case they choose a deep-discount broker.

Q 5-21: What assurances as to the success of a company does the SEC provide to the investor when an initial public offering (IPO) is made?

Under the securities act of 1933, the SEC ensures that the new securities being offered for public sale are registered with the commission. The registration of the securities does not ensure that the investor purchasing them will not lose money. Registration only means that the issuer of the security has made enough disclosure.

Q 5-22: Contrast the specialist system used on the NYSE and AMEX with the dealer system associated with the OTC market?

A typical order in NYSE can be handled as follows. The investor phones the broker and asks him about the performance of the company, he intends to purchase. The broker looks for the best price  on which the shares of that particular company are traded, the turnover, and high and low prices for the day. If the investor is interested in purchasing the shares of stock at the market rate or a price close to that, he can instruct the broker to buy some volume of shares of that particular company.

This order would be transmitted to the broker’s office at the exchange. The representative of the broker on the floor will go to the trading post, where the specialist handling the particular company’s stocks would be asked about its price.

The specialist knows the current quotes of the company because he keeps the limit order of the stock. If there is no other member party there to sell the shares, the specialist would quote a current bid and asked price. The representative confirms that there is a purchase order to be filled at the asking price. A confirmation is relayed back to the broker, who notifies the investor. The role of the specialist is critical on an auction market. Specialists are expected to maintain a fair an orderly market in stocks assigned to them.

Traditionally, dealers in the OTC market arrive at the prices of securities by both negotiating with customers specifically and by making competitive bids. They match the forces of demand and supply with each dealer dealing in certain securities. They do this by standing ready to purchase a particular security from the seller or sell it to the buyer. The dealers quote bid and asked price for each security; the bid price is the price at which the specialist or dealer offers to buy shares. The asked price is the price at which the specialist or dealer offers to sell shares. The dealer profits from the spread between the two prices. The dealers also share profits with the brokerage firms for supplying the order. This is called payment of the order flow.

Q 5-23: Explain the difference between the initial margin requirement and the maintenance margin requirement?

The initial margin requirement implies the amount required to be invested to open a margin account and initiate a transaction. If the actual margin falls below the initial margin the account becomes restricted. However, the maintenance margin requirement implies that amount of equity which should be there at all times in order to keep the margin account functioning. If the actual margin falls below the margin account, the investor receives a margin call, which means that no transaction can take place without the investor’s placing more money in the account to replenish the account at least at the maintenance margin level.

Q 5-24: What is meant by having margin accounts “marked to market” daily?

By having margin accounts marked to market daily it means that actual margin of the investor’s account is calculated on a daily basis. This actual margin may be influenced by the changes in security prices in which the investor has invested using margin facility.

Q 5-25: Is there any link between margin account and short selling?

The link between margin account and short selling is such that without having a margin account an investor cannot short sell.

Q 5-26: Why do people say “The potential losses from short selling are unlimited”?

An investor sells short with the hope that the price of a stock will fall in future. If the price reaches minimum the investor will like to buy the share to close his short position. If the price of the stock increases instead, the investor can have losses. The minimum price that a stock can reach is zero, which means that there is a limit to which the profit off a short seller can increase. However, if the stock price starts increasing there is no limit to which the price may go and hence the potential losses for the short seller can be unlimited.

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[1] Unlike a limit order, where the broker tries to better the price, a stop order is used to hedge losses and therefore a price below the one mentioned in the order is acceptable to the investor. However, another kind of order is a stop-limit order, which combines the feature of a limit order and a stop-order, which is used to hedge losses in the same way as an ordinary stop order, however, the order is executed only if the investor’s mentioned price is met or bettered, otherwise no sale takes place, i.e., if the price has fallen below the limit the order would not be executed.