How Securities Are Traded



How Securities Are Traded

Brokerage Firms

• Types:

• Full Service

• Discount

• Income

• Only 15% come from commission paid by investors

Brokers Income

▪ Less than 50% customer commissions

▪ Selling mutual funds owned by their firm

• Load funds-commission

▪ Principal transactions

• Public buy recommendation

• Or

• Being compensated to sell this security

▪ Sale of new issues of securities

▪ Administrative fees on

• Inactive accounts

• Transfers

• Maintenance fees

Types of Brokerage Accounts

1. Cash Account

• Pays cash no later than settlement + 2 business days

• Reg T Extension

• Granted by exchange on which the security trades and gives the customer another 3 business days

• Failure to pay on time ---brokerage firm obligated to sell out the position

2. Margin Account

• Buy sec or sell short as long as Reg T initial margin is met

• If Reg T doesn't apply then meet the exchange's maintenance margin

(Exempted securities: US Govt, Agencies, Muni, & Commercial Paper)

• Initial Margins set by Fed. Res. Reg T

Long Positions Short Positions

Stock=50% Stock =50%

Convertible Sec.=50% Convertible Sec.=50%

U.S. Govt = na U.S. Govt = na

Muni=na Muni=na

Corp bond = na Corp bond = na

Stock Options= 100% of Premium

Broad Based Index Option = 100% of Premium

Int. Rate/Foreign Currency Option=100% of Premium

• Minimum Margins:

• Exchanges require a min. margin be maintained after the Reg T requirement has been met

• Usually less than the initial

• Maintenance Calls

• Must bring up to the min maintenance margin within 3 bus. days

• NYSE margins

$2000 for both long/short positions

long-$2000 equity or price of security if less than $2000

short---$2000 equity at any time

• NYSE Min. Maintenance

Long Short

Stock=25% Stock=30%

Convert. Sec.=25% Convert. Sec.=30%

Corp Debt = Same

Greater of 20% of market value

Or 7% of face value

Muni = Same

Greater of 15% of market value

Or 7% of face value

All Options=100% of Premiums

• Example:

Investor's Equity ---Long Position

Buy 200 shares @ $100

Long MV - Debit(Loan) = Equity Margin

(Reg. T)

20000 - 10000 = 10,000 50%

market value drops to $90

18000 - 10000 = 8000 8000/18000=44%

• Actual Margin=(MV of Sec - Amt borrowed)/MV of Sec

Market value drops to $65

13,000 - 10,000 = 3000 3000/13000 =23%

Maintenance call to bring account up to 25% (set by NYSE)

25% (13000)=3250 ----- call for $250

• MV at Maintenance Call:

MV-Loan =.25 MV

Loan/.75= MV

Ie. 10000/.75 = 13,333

• Per Share value at maintenance Call:

Loan / (number of shares (1-maintenance percentage))

• Example:

Investor's Equity-----Short Margin

Sell short 200 sahres @ $50

Sell Short

10,000---Sale Price

5,000---Reg T--initial margin

15,000 Investor's brokerage accont

Initial Short Sell @ $50

Credit - Short MV = Equity Margin

15,000 - 10,000 = 5,000 50%

market value increase to $60

Credit - Short MV = Equity Margin

15000 - 12000 = 3000 3000/12000=25%

Maintenance Call (margin 30%)

30% (12000) =3600---have 3000, call for 600

▪ MV at Maintenance Call

Credit Acct- Short MV = .3 Short MV

Credit Account/ 1.3 = Short MV

• Restricted Accounts:

• Account's equity is less than 50% of Market value

• 50% of proceeds from sale of any security in account must be retained to increase the equity

• Margin On Options:

• Long---100% of option price

• Puts or Naked Calls

o Initial Margin = 20% of the underlying security's market

o Minimum Margin = 10% of the underlying security's market value

3. Asset Management Accounts

• Requires min. balance to open

• Pymt of annual fee

• Bank cards & checks

• Loans

4. Wrap Account

• All accounts are wrapped in one fee

• Broker matches clients with independent money managers

• Typical fee 3% of assets managed

Commissions

NYSE required its members to charge a fixed (and minimum) commission

Securities Act Amendment 1975

Eliminated all fixed fees

Fees--negotiated

Large variation

Internet trading effect

Fidelity Investments

Schwab

E-Trade

DRIPS

▪ Dividends are reinvested into company shares

▪ Typically no brokerage or administrative fees are involved

▪ Advantage: dollar cost averaging

▪ Outgrowth--

• no load stock purchases programs (DSP) offered to first time-investors

▪ Treasury Direct Program

• publicdebt.

▪ Directory of Dividend Reinvestment Plans by S&P

▪

▪

Trading

Specialists

• Expected to maintain a fair and orderly market in those stocks assigned to them

• Act as both dealers and brokers

o Brokers--limit book

o Dealers--buy/sell shares of their assigned stock(s) to maintain an orderly market

▪ Buy from commission brokers who have orders to sell

▪ Sell to Commission brokers with orders to buy

▪ Min. required amount of capital

Automation of NYSE

▪ Electronic system

▪ Super Dot

▪ Super Dot's Opening Automated Report Service (OARs)

▪ Postopening market order system (2,099 shares)

▪ Specialist's Electronic Book

▪ Large trades can avoid the floor trading by the "clean-cross" rule

OTC

▪ Market makers

▪ Dealers in the over-the-counter market make markets in stocks, buying from investors and selling to them from their inventory. Thus, they have a vested interest in each transaction and in the spread between the bid and asked price.

• Bid prices

• Asked prices

▪ On NASDAQ-- stocks traded average about 11 market makers per sec.

TYPES OF ORDERS

1. Market Orders

• Order to be filled immediately at the prevailing market price

• No price specified on the order

• Market Order--Not Held

• Market Order

2. Limit Order

• Specify a price at which to buy or sell

Ie. Buy 100 GM @ 42--the price is the limit

• A limit order is to be filled at that price or better (lower)

• Alimit order to sell is to be filled at that price or better (higher)

• Entered as:

▪ Day orders

• Day orders are cancelled at the end of the day if order is not filled

▪ Good-til Cancelled

• Order sits with exchange until it is cancelled by customer (Max. 6 mon)

▪ All or None (AOL)

• Either the entire order is filled or the order is not executed

▪ Fill or Kill (FOK)

• Either the entire order is filled on the first try or the order is cancelled

▪ Immediate or Cancel (IOC)

• Either part or all of the order is filled on the first try and the balance is cancelled

3. Stop Orders

• Used to buy and sell after a stock reaches a certain price level

• A Stop on the order tells the trader that this order cannot be executed until the market reaches the specified price

• Sell Stop Order

• Once the specified price is reached (or lower), the order is triggered and turns into a market order

• Order is then filled on the next trade

• Used to limit losses on long stock positions in falling markets

• Buy Stop Order

• Once the specified price is reached (or higher), this order is triggered and turns into a market order

• Order filled on the next trade

• Used to limit losses on short stock positions in rising markets

• Stop-Limit Order

• If a stop order is triggered, it becomes a market order to be filled on the next trade

• If a stop-limit order, when the stop price is hit, the order is triggered as a limit order and is filled at the limit price or better

Example:

Sell 100 ABC @ 30 stop Limit 28

When price falls to 30, the order is triggered. It turns into a limit order to sell for 28 or higher.

Clearing Procedures

• Regular Way

▪ Occurs 3 business days after the trade date

SUN MON TU WED TH FRI SAT

10* 11 12

13 14 15**

• *Trade date

• ** Settlement date--customer becomes the legal owner of any securities bought or gives the security up if sold

• Street Name

▪ Brokerage firm safeguards clients securities--hold in street name

• Clearinghouses

• Net out all transactions made by its members during a day

• Depository Trust Co. (DTC)

Investor Protection Regulation

1. Federal Level

• Great Depression

• SEC (1934)

• Independent quasi-judicial agency of the US govt

• 5 members appointed by Pres for 5 year terms

• enforces the Securities Act 1933 and the 1934 extension

• Maloney Act 1936

• Extend the SEC control to the OTC market

• Self-regulation of the OTC dealers

• Investment Co Act 1940/ Investment Advisor Act 1940

• Investment co's and investment advisors must register with the Sec and disclose certain information

• Securities Investor Protection Act 1970

• Insurance co protecting investors from brokerage firms that fail

• Securities Act Amendment 1975

• Called for SEC to move toward establishment of a nat'l markt

2. Self-Regulation

• Stock exchanges regulate and monitor trading for the benefit of investors and the protection of the financial system

• NYSE

• Rules are self-imposed and approved by SEC

• Circuit Breakers

• Sidecar

• Rule 80A

• Index arbitrage orders in stocks comprising the S&P 500 Index subject to tick test if DJIA moves 50 points or more from the previous day's close in down (up) market sells (buy) orders can be executed only on a plus or zero-plus (minus or zero-minus) tick

Prices: 10 11 11 10 10

Start plus zero-plus minus minus-zero

NASD

▪ Trade assoc established to enhance the self-regulation of the security industries

▪ Virtually all brokerage firms are members

▪ Regulates brokers and dealers

▪ All brokers must register with NASD to trade

▪ Keep records of disciplinary actions

Insured Brokerage Accounts

SIPC

Arbitration

Binding arbitration before the NASD

Short Sales

• Sale of a stock not owned in order to take advantage of an expected decline in the price of the stock

• Seller borrows the stock from the broker by borrowing from those held in street-name margin accounts and lending it to the short-seller

• Sell borrowed security on the open market

• Dividend declared on any stock must be covered by the short seller

• Must have a margin account to sell short

▪ 50% initial margin

▪ 50% maintenance margin

• Net proceeds from a short sale plus the required margin are held by the broker

▪ Account is marked to market

• Short sales are permitted only on rising prices

▪ Uptick or zero-plus

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