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CHAPTER SIX
MARKET MECHANICS
Practical Investment Management
Robert A. Strong
South-Western College Publishing ©1998 2
Outline
Placing Orders Order Information Flow Types of Orders Settlement Procedures
The Specialist and the Book The Specialist and the Spread Adjusting Limit and Stop Prices for Dividends
The Ticker Tape Format Accuracy Other Ticker Tape Information
South-Western College Publishing ©1998 3
Outline
Types of Accounts Cash Account Margin Account Other Types of Accounts
Selling Short Rationale Criticisms Mechanics of a Short Sale Selling Short Against the Box
South-Western College Publishing ©1998 4
Outline
Brokers and Commissions The Commission Structure Full-Service Brokers Discount Brokers Electronic Brokers Current Events
South-Western College Publishing ©1998 5
Placing Orders: Order Information Flow
Individual Investor
Broker1. Places order
4. Confirms trade
Stock Exchange
Brokerage FirmAccounting Operations
2. Submits order3. Confirms
trade
3. Confirms trade
5. Mails confirmation statement
South-Western College Publishing ©1998 6
Placing Orders: Types of Orders
Market orders are to be executed as soon aspossible after reaching the exchange floor.
Limit orders must specify a price and a timelimit, e.g. “Buy 500 at $90, good till canceled.”
A stop order differs from a limit order in thatthe order is only executed if the specified price, called the stop price, is touched.Stop orders become market orders when the stop price is reached.
South-Western College Publishing ©1998 7
Placing Orders: Types of Orders
The most important use of a stop order is to protect a profit. Moving a stop up behind a rising stock is called using a crawling stop order.
Other orders:- one cancels the other- all or none- fill or kill- stop limit
South-Western College Publishing ©1998 8
Placing Orders: Settlement Procedures
The activities surrounding the transfer ofownership are called settlement procedures.
In the United States, stock and bondtransactions settle three business days after the trade date.
A number of market speculators engage in a practice known as a day trade, which involves buying and selling securities on the same day.
The Specialist and the Book
Specialists help maintain a fair and orderlymarket.
To tighten the spread in the market...
South-Western College Publishing ©1998 9
BID ASK
Price Size Firm Price Size Firm
90 10 Specialist 90 10 Specialist 90 50 Paine Webber 90 5 DLJ 90 20 Merrill 90 10 AG Edwards 90 100 Kidder 91 35 Josephthal
83
41
41
81
85
43
43
South-Western College Publishing ©1998 10
The Specialist and the Book
Unless a customer indicates a contrarywish, limit and stop orders are automatically adjusted downward for the payment of a cash dividend.
South-Western College Publishing ©1998 11
The Ticker Tape
Today the tape is electronic, passing by on ascreen.
To accommodate the human eye, an upper speed limit is set for the tape. So on heavy trading days, trade data can get backlogged.
Notices like data corrections, omissions, and news may also appear on the tape.
DE HRD PEP ASN C DIS 90 1/4 6s25 3/4 10,000s37 2s55 8 6s55.2s 1/8
Types of Accounts
In a cash account, an investor must have or deposit cash equal to the full value of the securities purchased.
South-Western College Publishing ©1998 12
Cash Account
Assets Liabilities
Cash $23,089.76500 DE 45,000.00300 LOTS 24,000.00100 RBD 3,000.00500 OCR 17,437.50 Equity $112,527.26
$112,527.26 $112,527.26
Types of Accounts
A margin account permits an investor to borrow part of the cost of investments from a brokerage firm.
South-Western College Publishing ©1998 13
Margin Account
Assets Liabilities
500 DE $45,000.00 Margin $33,792.10300 LOTS 24,000.00100 RBD 3,000.00500 OCR 17,437.50 Equity $55,645.40
$89,437.50 $89,437.50
South-Western College Publishing ©1998 14
Margin Accounts: The Nature of the Debt
An investor must pay interest on amargin loan until the debt is repaid from the eventual sale of the securities.
The base rate for these loans is called the broker’s call money rate.
The smaller the loan, the higher the interest rate.
South-Western College Publishing ©1998 15
Margin Accounts: Fed Regulation T
Margin trading is governed by Regulation T of the Federal Reserve Board.
The initial margin requirement is the percentage an investor must pay toward new purchases.
The maintenance margin requirement determines how badly a position can deteriorate before the investor must deposit more money into the account portfolio.
South-Western College Publishing ©1998 16
Margin Accounts: Buying Power Buying power is a measure of how much
more can be spent for securities without having to put up any additional cash.
balance
debit equity
t requiremen
margin initial
power
buying
11
Buying power can be used to withdraw cash,
but the reduction in buying power will be greater than the amount of cash withdrawn.
South-Western College Publishing ©1998 17
Margin Accounts: Margin Calls
margin emaintenanc
balancedebit value portfolio minimum
1
The investor can deposit more assets (usually cash) into the account, or some security position(s) can be closed out to reduce the amount of margin debt.
A margin call is a requirement to depositadditional equity into a brokerage account because the account equity fell below the maintenance margin limit.
South-Western College Publishing ©1998 18
Other Types of Accounts
Bonds and income-producing securities can be in a separate account called an income account.
Convertible bonds may be segregated into their own account, as may government bonds or short positions.
South-Western College Publishing ©1998 19
Selling Short
Short selling involves selling borrowedshares.
Rationale: Short sellers sell first and buy later.
Criticisms: pros - market exists - short selling helps offset inflationary margin buyingcons - short selling has a checkered heritage - downward pressure on price runs counter to public interest
Mechanics of a Short Sale
South-Western College Publishing ©1998 20
A buys 100 shares of
XYZ
B wants to short 100 shares of
XYZ
B returns 100 shares of XYZ to
lender
D sells 100 shares of XYZ to B
B buys 100 shares of
XYZ
B sells 100 shares of
XYZ
C buys 100 shares of
XYZ from B
Broker borrows shares
Shares are held in
street name
South-Western College Publishing ©1998 21
Selling Short against the Box
In a short sale against the box, the investor sells short shares that are simultaneously owned.
The box refers to the safe deposit box wherethe share certificate might be held.
This is a riskless strategy designed to shift a tax liability into the future.
South-Western College Publishing ©1998 22
Brokers & Commissions: The Commission Structure
Commissions are usually a function of the dollar amount involved, the number of shares in the trade, and a minimum figure.
A limit order that is filled over several days ischarged a separate commission for each day that a trade was made.
Brokers can discount their commission. Such a discount comes from the broker’s share of the commission.
South-Western College Publishing ©1998 23
Brokers & Commissions: Broker Types
Full-service brokers provide personalized service to their clients.e.g. Merrill Lynch, PaineWebber
Discount brokers execute trades for their clients, and little else.e.g. Charles Schwab
Electronic brokers allow their clients to place
orders via the Internet.e.g. AccuTrade, E-Trade
South-Western College Publishing ©1998 24
Brokers & Commissions: Current Events
The median annual broker compensation has nearly doubled in a decade.
A higher commission share may encourage brokers to trade via the NASDAQ system, but spreads are sometimes wider in the OTC market.
The official SEC position seems to be that “more trades mean more commissions” tends to encourage active trading and may lead to account churning.
South-Western College Publishing ©1998 25
Review
Placing Orders Order Information Flow Types of Orders Settlement Procedures
The Specialist and the Book The Specialist and the Spread Adjusting Limit and Stop Prices for Dividends
The Ticker Tape Format Accuracy Other Ticker Tape Information
South-Western College Publishing ©1998 26
Review
Types of Accounts Cash Account Margin Account Other Types of Accounts
Selling Short Rationale Criticisms Mechanics of a Short Sale Selling Short Against the Box
South-Western College Publishing ©1998 27
Review
Brokers and Commissions The Commission Structure Full-Service Brokers Discount Brokers Electronic Brokers Current Events
