CHAPTER FIVE

How Securities Are Traded

CHAPTER FIVE

How Securities Are Traded

Cleary / Jones

Investments: Analysis and Management

Learning ObjectivesLearning ObjectivesLearning 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 To outline how orders to buy and sell securities are executedare executed

To discuss the regulation of the Canadian To discuss the regulation of the Canadian securities industrysecurities industry

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

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

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 TypesAccount 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 costs with outside money managers; all costs are wrapped in one feeare wrapped in one fee

Fees and CostsFees and CostsFees 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

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 MarketsOrders 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 OrdersTypes 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 ProceduresClearing 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 between exchange members facilitated by a clearinghouse: The facilitated by a clearinghouse: The Canadian Depository for Securities Canadian Depository for Securities (CDS)(CDS)

Canadian Regulatory Canadian Regulatory EnvironmentEnvironment

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 industryassociation for the investment industry

Margin AccountsMargin AccountsMargin 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 SellingShort 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