CHAPTER FIVE

How Securities Are Traded

Cleary / Jones Investments: Analysis and

Management

Learning ObjectivesLearning Objectives To explain the role of brokerage firms and To explain the role of brokerage firms and

stockbrokersstockbrokers To describe how brokerage firms operateTo describe how brokerage firms operate To outline how orders to buy and sell securities are To outline how orders to buy and sell securities are

executedexecuted To discuss the regulation of the Canadian securities To discuss the regulation of the Canadian securities

industryindustry To explain the importance of margin trading and To explain the importance of margin trading and

short selling to investorsshort selling to investors

Brokerage OperationsBrokerage Operations Brokerage firms earn commissions on executed Brokerage firms earn commissions on executed

trades, sales loads on mutual funds, profits from trades, sales loads on mutual funds, profits from securities sold from inventory, underwriting fees securities sold from inventory, underwriting fees and administrative account feesand administrative account fees

Full-service brokers offer order execution, Full-service brokers offer order execution, information on markets and firms, and information on markets and firms, and investment adviceinvestment advice

Discount brokers offer order executionDiscount brokers offer order execution

Account TypesAccount Types Cash account:Cash account: Investor pays 100% of Investor pays 100% of

purchase price for securitiespurchase price for securities

Margin account:Margin account: Investor borrows part Investor borrows part of the purchase price from the brokerof the purchase price from the broker

Wrap account:Wrap account: Brokers match investors Brokers match investors with outside money managers; all with outside money managers; all costs are wrapped in one feecosts are wrapped in one fee

Fees and CostsFees and Costs Brokerage commissions differ by Brokerage commissions differ by

security, broker, and investorsecurity, broker, and investor– Institutional investors have greatest Institutional investors have greatest

negotiating powernegotiating power– On-line trading offers significantly lower On-line trading offers significantly lower

commission rates to individual investorscommission rates to individual investors Dividend reinvestment plans (DRIPs) Dividend reinvestment plans (DRIPs)

permit reinvestment of dividends in permit reinvestment of dividends in additional stockadditional stock

Orders on Organized Orders on Organized ExchangesExchanges

The TSE introduced the world’s first The TSE introduced the world’s first computer-assisted trading system computer-assisted trading system (CATS) in 1977(CATS) in 1977

The NYSE continues to make use of The NYSE continues to make use of the specialist system the specialist system – Specialists maintain the limit order bookSpecialists maintain the limit order book– Specialists keep a fair and orderly Specialists keep a fair and orderly

market by providing liquiditymarket by providing liquidity

Orders in OTC MarketsOrders in OTC Markets Dealers are ready to either buy or sellDealers are ready to either buy or sell

– Bid price is highest offer price to buyBid price is highest offer price to buy

– Ask price is lowest price willing to sellAsk price is lowest price willing to sell Ask price - Bid price >0 (dealer spread)Ask price - Bid price >0 (dealer spread)

– Dealer “makes a market” in the securityDealer “makes a market” in the security

– More than one dealer for each security in More than one dealer for each security in over-the-counter marketsover-the-counter markets

Types of OrdersTypes of Orders Market order:Market order: Authorizes immediate Authorizes immediate

transaction at best available pricetransaction at best available price Limit order:Limit order: Specifies a particular Specifies a particular

market price before a transaction is market price before a transaction is authorizedauthorized

Stop order:Stop order: Specifies a particular Specifies a particular market price at which a market order is market price at which a market order is authorizedauthorized

Clearing ProceduresClearing Procedures Settlement dates for stocks are three Settlement dates for stocks are three

business days after the trade datebusiness days after the trade date– Legal ownership transferred and financial Legal ownership transferred and financial

arrangements settled with brokerage firmarrangements settled with brokerage firm

Transfer of securities and funds Transfer of securities and funds between exchange members facilitated between exchange members facilitated by a clearinghouse: The Canadian by a clearinghouse: The Canadian Depository for Securities (CDS)Depository for Securities (CDS)

Canadian Regulatory Canadian Regulatory EnvironmentEnvironment

Self-Regulatory Organizations (SROs) Self-Regulatory Organizations (SROs) regulate their own activitiesregulate their own activities

Canadian Investor Protection Fund Canadian Investor Protection Fund (CIPF) established to protect investors(CIPF) established to protect investors

Investment Dealers Association of Investment Dealers Association of Canada (IDA) is the national trade Canada (IDA) is the national trade association for the investment association for the investment industryindustry

Margin AccountsMargin Accounts Exchanges set Exchanges set minimumminimum required required

deposits of cash or securitiesdeposits of cash or securities Investor pays part of investment cost, Investor pays part of investment cost,

borrows remainder from brokerborrows remainder from broker– Margin is percent of total value that cannot Margin is percent of total value that cannot

be borrowed from brokerbe borrowed from broker Margin call occurs when the actual Margin call occurs when the actual

margin declines below the margin margin declines below the margin requirementrequirement

Short SellingShort Selling Investor borrows stock from a third Investor borrows stock from a third

partyparty Borrowed security sold in open Borrowed security sold in open

market, to be repurchased later at an market, to be repurchased later at an expected price lower than sale priceexpected price lower than sale price– Investor liable for declared dividendsInvestor liable for declared dividends– Short sale proceeds held by brokerShort sale proceeds held by broker– Investor responsible for borrowed sharesInvestor responsible for borrowed shares