Principles of Securities Tradingpeople.stern.nyu.edu/jhasbrou/Teaching/POST 2015... · A news report: “Buyers dominated stock trading today, driving prices higher.” Traditional

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Principles of Securities Trading

FINC-UB.0049, Fall, 2015Prof. Joel Hasbrouck

1Copyright 2015, Joel Hasbrouck, All rights reserved

Overview

How do we describe a trade?

How are markets generally organized?

What are the specific trading procedures?

How does information affect markets?

Copyright 2015, Joel Hasbrouck, All rights reserved 2

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How do we describe trades?

A trade has two sides.

Buyer and seller

Who bought? Who sold?

Trading party and counterparty

The side that we’re primarily interested in (usually ourselves) is the trading party.

The “other” side is the counterparty.

Example: “I bought 1,000 shares of Microsoft.”

I’m the buyer and the trading party; the seller is my counterparty.

If trading is considered a “game,” my counterparty is my opponent.


Why do we focus one side of the trade?

A news report: “Buyers dominated stock trading today, driving prices higher.”

Traditional economics view: this statement is meaningless.

“For every buyer there is a seller; for every seller there is a buyer.”

“They both had to agree to the price. You can’t attribute a price change to one side or the other.”


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The traditional view leaves some things out.

In any given situation the buyer and seller aren’t behaving in the same way.

One side might shout louder, act with greater urgency, appear more desperate.

They will have a greater effect on the price.


How are markets organized?

Search markets

Potential buyers and sellers try to locate counterparties directly …

By advertising in newspapers, posting to bulletin boards, web boards (Craigslist), etc.

Commonly used for …

Who usually advertises?


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Brokered markets

A broker is an agent (working on behalf of a buyer or seller)

“Agent” or “agency” is a legal term that implies certain responsibilities.

In a brokered market, most buyers and or sellers use brokers to locate a counterparty.

Stock brokers don’t normally perform this role, so the stock market is not usually considered a brokered market.

Examples of brokered markets include …


Dealer markets

Like a broker, a dealer may assist in a trade.

Crucial distinction: a dealer acts as a counterparty to the customer.

If I’m trying to sell a house, a real estate broker will help me find a buyer, but she won’t buy the house herself.

If I’m trying to sell some Treasury bonds, a treasury bond dealer will buy them from me.

Widely used in securities markets (FX, bonds, “Over the counter” derivatives)


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Exchange markets An exchange is an organized and centralized trading facility.

A floor market has a physical room, pit or other location where buyers and sellers meet.

In most present-day exchanges, buyers and sellers “meet” virtually (on a computer system).

Centralized does not mean, “there’s only one exchange”. Microsoft stock trades on multiple exchanges.

Exchange trading is widely used for stocks, options and futures. The best known US exchanges are the New York Stock

Exchange (NYSE) and Nasdaq.


What are the specific trading procedures (the actual trading mechanisms)?

Bilateral (two-sided) bargaining.

Buyer and seller negotiate directly.

Face-to-face trading on an exchange floor.

One-sided auctions.

One seller with many potential buyers.

One-sided sellers auctions are used for …

One buyer with many with many potential sellers.

One-sided buyers auctions are used for …


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Double-sided auctions.

Many buyers; many sellers.

Used to open the NYSE and NASDAQ.

Continuous double-auction.

Buyers and sellers can enter bids and offers at any time. Trades occur when prices match.

Continuous trading sessions on NYSE and NASDAQ.


Trading, clearing, and settlement

A trade is an agreement, a commitment. “On Monday at 10 am, I buy 100 shares of Microsoft (ticker symbol

MSFT) for $32 per share.” Clearing

The buyer and seller (or their brokers) confirm the terms of the trade.

Settlement The legal transfer of ownership and payment. “On Thursday, I actually take possession of the shares. My bank

account (or brokerage account) is debited by $3,200.” Monday, Tuesday, Wednesday, Thursday. In US equities markets, settlement is T+3 (“Tee plus three”).


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Markets respond to information

Public information News, accounting statements, market data. Informational efficiency

The principle that the value of information can be determined by how much it moves prices.

This is a legal as well an economic principle: we’ll study some “10b-5” class-action lawsuits.

Private information Things not publicly known; judgments formed from analysis and insight. Since private information isn’t known, how can it affect prices? Why is some private information is considered illegal (“inside”)

information? We’ll study some recent insider trading cases.


Chapter 2Overview of the US equity market


Securities Trading: Principles and Procedures

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Outline

Most of what we study in this course is applicable to all markets.

We often come back to the US equity market as a specific example.

Describing the US equity market requires knowing a bit about

Stocks

Exchanges

Players and their motives

Brokers

Prices

The make or take decision.

The buzzwords: liquidity, transparency, and latency

Regulation15

Stock

Stock shares represent partial ownership of a corporation.

The owner of a share is entitled to:

A share of the corporation’s net income.

A vote in electing the corporation’s directors or other major decisions.

The first public sale of stock is called the initial public offering(IPO).

Additional sales are considered to be seasoned offerings.

After the offering, most shares trade in exchange markets.


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The largest stock exchanges (Table 2-1)

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Domestic equity

market cap

(end of year, $T)

Trading Volume

(annual, $T)

Annual

Turnover

NYSE 11.796 18.027 153%

NASDAQ OMX 3.845 12.724 331%

Tokyo SE Group 3.325 3.972 119%

London SE Group 3.266 2.837 87%

Euronext 2.447 2.134 87%

Shanghai SE 2.357 3.658 155%

Total global equity capitalization ≈ $31Trillion

Copyright 2015, Joel Hasbrouck, All rights reserved

Exchanges

“Marketplaces” Also: trading venues, market centers

Examples New York Stock Exchange (NYSE) Nasdaq (from “National Association of Securities Dealers

Automated Quotations”) An exchange’s products and services usually cover: Listing Trading Information


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Listing

“IBM is an NYSE-listed corporation.”

The NYSE (listing exchange) provides

Certification and sponsorship

Monitors the trading process

IBM (“listed firm”) must:

Meet financial and governance conditions.

Pay a listing fee (depends on size, about $100,000)

A listing is (in practice) necessary for a stock to be traded.


Trading services and facilities

Computer and communication systems

Fee structures are complex.

Members have high fixed costs, but lower costs per message, per order, per trade, etc.

Speed is priced.


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Information (market data)

Especially

Last sale prices

Current bid and ask prices.

Real-time order-book data.

Market data generates substantial revenues.


Most exchanges are owned by holding companies.

Intercontinental Exchange (“ICE”) owns 11 exchanges, including New York Stock Exchange (NYSE).

Euronext owns and operates the Paris, Lisbon, Brussels, Amsterdam Exchanges

Nasdaq-OMX runs The Nasdaq Stock Market, OMX Nordic, etc. Historically, exchanges were member-owned cooperatives. A membership (“seat”) gave ownership rights and trading

rights. Currently most exchanges are for-profit, publicly-held

corporations. They have stockholders and (trading) members.


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Stock brokers

Trading members of an exchange have direct access to trading facilities. Most customers go through brokers. (Recall: a broker generally acts as agent

for the customer). Retail brokers service individuals.

Discount brokers (Scott Trade, Interactive Brokers) provide services related to trading

Full service brokers (Charles Schwab, Merrill Lynch) also provide research and advice.

Prime brokers service institutions (like mutual funds and hedge funds). Larger trades, more securities, more markets. Specialized services (for margin trading and short selling).

Customers pay commissions to the brokers.


Investing in and trading stocks

Many individuals and institutions hold and trade stock.

Strategies and motives vary widely.

We often differentiate stock traders by

Holding period (horizon)

Whether their trades are motivated by information, hedging or liquidity.


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Traders differ by holding period or horizon

Long term (ten years or more)

Individuals saving for education or retirement or universities and charities with endowments.

Trade infrequently, low turnover.

Medium term (business cycle, five to ten years)

Attempt to profit by timing the market to current economic conditions.

Trade infrequently, low turnover.


Short term (minutes to months)

Follow momentum strategies, technical (statistical) trading rules.

Frequent trading, high turnover.

High-frequency (seconds and shorter horizons)

Profit from short-term trends and reversals in price movements

Frequent trading, high turnover, usually try to end the day “flat” (with no net position).


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Traders differ by motive

Liquidity

Our non-financial incomes and expenses aren’t smooth.

Unexpected inflows need to be invested; unexpected expenses need to be met by selling.

Liquidity motives are specific to the trader, and are external to the security.

Trading style: liquidity traders are often patient.


Hedging

Someone who is exposed to financial or non-financial risk will …

Try to sell a security that is positively correlated with the risk or buy a security that is negatively correlated with the risk.

Hedging needs are usually specific to the trader.

Trading style: hedgers are often impatient traders. Risk reduction can be an urgent need.


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Information

An informed trader possesses a real advantage.

Illegal inside information

Advance knowledge of public information.

Superior analysis of public information.

Informed traders are often impatient because they need to trade before their information or insight becomes public.

Who is the counterparty to our trade?

If liquidity trader or hedger, okay.

If informed, we generally lose.


The trading process: what do we mean by “the price?”

Last sale price

“AAPL last traded at $572.05.”

Real (represented an actual trade) but might be stale.

Bid and ask (offer) quotes

The market for AAPL is $572.10 bid for 1,000 shares, 500 shares offered at $572.14.”

Current, but hypothetical.

The bid and ask might depend on how much we’re buying or selling, and who we are.


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Immediate trades

To sell immediately, we agree to receive the bid price.

“Hit the bid”

To buy immediately, we need pay the ask price.

“Lift the ask” or “lift the offer”

Avoid the usage “hit the ask”


The basic trading decision: make or take?

Suppose that the lowest ask price in the market is $20.50.

If we want to buy, we can …

Take the ask (buy immediately), or

Make our own bid

For example, $20.40.

What are the pros and cons?


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The trading process in action

Security markets are dynamic

Bids and asks are entered, modified, canceled.

Trades (executions) occur when someone hits a bid or ask.

Example: Figure 2 1. Trading activity in AACC on April 25, 2011.

The bid (National Best Bid) is a blue solid line; the offer (ask) price (National Best Offer) is a dashed red line; black dots represent trades. Source: NYSE daily TAQ.


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Terms: Liquidity

“Ease of trading” In a liquid market, you can buy or sell in large size, quickly,

without moving the price very much. Sometimes liquidity = immediacy + breadth + depth + resiliency. Immediacy: How quickly can we trade? Sooner is better. Breadth: How wide is the bid-ask spread? Narrower is better. Depth: What quantities are sought at the bid or offered at the

ask? More is better. Resiliency: Following a large trade that moves the price, how

quickly do the bid or offer “bounce back”? Faster is better.


Liquidity as a “network externality”

Network: relating to connectivity

Externality: a cost or benefit that is not directly associated with the purchase or sale.

With liquidity

The value of a market increases as more people participate in the market.

More people provide more trading opportunities and competition.

Liquidity begets liquidity.


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Terms: Transparency

How much can we observe about the trading process?

Pre-trade transparency

Prices and volumes of recent trades; indicative prices for small and large trades; what does the limit order book (or books) look like?

Post-trade

Who is my counterparty?


Terms: Latency (delay)

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Information generated by market (e.g.,

a trade)

Received by user

Analysis, strategic response

Transmit to the market

Acted upon by market

Copyright 2015, Joel Hasbrouck, All rights reserved

Most exchanges claim that the time from receipt of an order through transmission of an outcome is about 100 microseconds.

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Regulation

Modern securities trading is trans-national.

Most securities regulation is based at the national level.

But some rule-making and enforcement is delegated to the exchanges.

Exchange rules often predate Federal regulation


US Securities and Exchange Commission (SEC)

Regulates trading in “securities”

Corporate stock, bonds, stock options, state and local bonds.

1933 Securities Act applies to primary markets.

The initial sale of a security, from issuer to investor.

1934 Securities Act applies to secondary markets.

Trading after the initial issue.


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US Commodities Futures Trading Commission (CFTC)

Regulates trading in forward and futures contracts (including financial futures)

Regulates swaps (in partnership with the SEC)

Historically, futures contracts were dominated by agricultural commodities.

Markets regulated by the CFTC look different from those regulated by the SEC


And some special cases

Currency (foreign exchange, FX) is regulated indirectly.

The largest participants are banks (which are regulated by the Federal Reserve (“Fed”) and the Office of the Controller of the Currency (OCC).

Because FX is the “underlying” for many forwards, futures and swaps, the CFTC has some jurisdiction.

US Treasury markets are regulated by the Fed and the Department of the Treasury.


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Industry Regulation

The US Financial Regulatory Authority (FINRA) is a not-for-profit corporation that regulates many aspects of trading and broker/customer interactions.

If you work for a securities firm and have any dealings with customers, you’ll take FINRA’s “Series 7” exam.

FINRA oversees arbitrations of broker-customer disputes.


European Union

European Commission

Internal Market and Services Directorate General

Directorate G – Financial Markets. The overarching regulation is the Markets in Financial Services

Directives 2 (“MiFID 2”).

Much regulation of trading is delegated to the home country (where the exchange is based).


Documents

Principles of Securities Tradingpeople.stern.nyu.edu/jhasbrou/Teaching/POST 2015... · A news report: “Buyers dominated stock trading today, driving prices higher.” Traditional