How Securities are Traded

1
How Securities are Traded

• Chapter 3

2
Agenda

• Organization of secondary markets
• Trading and execution
• Margin trading
• Costs and regulation

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A. Primary vs. Secondary Markets

• Primary market
• New issues
• Issuer receives the proceeds from the sale
• Secondary market
• Trading of securities among investors
• Issuer does not receive proceeds and is not
  directly involved (except for repurchases,
  exercising options.etc.)

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Secondary Market

• Two major arrangements
• Auction market
• - Trading is centralized no need to search for
  best price from different dealers
• Over-the-Counter (OTC) market
• - Network of dealers / market makers

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Auction Market

• Organized exchanges with centralized order flow
• Before trading pits/open outcry
• Mid-1980s - now computerized
• One specialist (US) / registered trader (Canada)
  per stock
• Assigned by the Exchange
• Securities stocks, futures contracts, options,
  and to a lesser extent, bonds
• Examples Toronto Stock Exchange, New York Stock
  Exchange, Chicago Board Options Exchange

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Toronto Stock Exchange

• 1852 Toronto Stock Exchange officially founded
  on October 25, 1852. The trading list consisted
  of 18 securities
• 1977 Toronto Stock Exchange launched the world's
  first Computer Assisted Trading System. The TSE
  300 Composite Index also launched
• 1997 Toronto Stock Exchange trading floor closed
  and the exchange became the largest stock
  exchange in North America to choose a floorless,
  virtual trading environment

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Last Day of floor trade
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OTC Market

• Dealers market no centralized (buy and sell)
  order flow
• Can have gt1 dealer / market maker per stock,
  depending on demand and volume
• NASDAQ largest organized stock market for OTC
  trading
• Most secondary bonds transactions are OTC, as are
  precious metals (e.g., London Bullion Market)

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Other Secondary Markets

• Direct trading among investors through a computer
  network, rather than on an exchange or an OTC
  market
• Electronic communication networks (ECNs)
• computerized trading systems, available to
  subscribers
• Active in the 1990s many have since been
  acquired by exchanges
• Instinet, now part of NASDAQ
• Archipelago, now NYSE Arca
• Upstairs market/dark pools
• Large block trades off organized exchanges
• Dark little pre-trade transparency
• Largest 2 Credit Suisse Crossfinder, Goldman
  Sachs Sigma X

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Types of Orders

• Instructions to broker on how to complete the
  order. Most common are
• Market orders
• Limit orders
• Stop (loss) orders
• Stocktrak also allows trailing stop orders ( or
  )
• If market price 50, and set trailing stop 5
• becomes a market order if price falls to 45
• If price goes up to 60, new stop price is 55
• Allows investors to set a limit on loss, but no
  limit on gain

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C. Trading with Margin

• An investment strategy using borrowed funds or
  securities (in margin account)
• Margin purchases
• Short sales
• Margin requirement
• Collateral
• Requirements vary across securities
• Set by regulatory body (Canada Reg.100)
• Margin call
• When value of collateral ?
• Broker calls for more funds to back the trade

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Margin Purchase Example Initial Conditions

• X Corp 70
• 50 Initial margin
• 25 Maintenance margin in U.S. (NYSE/FINRA)
• 1000 Shares purchased
• Initial Position
• Stock 70,000 Borrowed 35,000
• Equity 35,000

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Margin Purchase Margin

• Stock price falls to 60 per share
• New Position
• Stock 60,000 Borrowed 35,000
• Equity 25,000
• Margin (as a ) 25,000/60,000 41.67

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Leveraging effect of margin purchases

• Impact on rate of return
• Buy 200 shares of XYZ at 100, 30 appreciation
  of the stock in one year
• Margin 50
• Financed by a 9 loan for one year
• Net return 51
• A 30 drop in price ? net return -69
• Leads to bigger swings in returns leverage effect

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Short Sales

• Purpose to profit from a decline in the price of
  a security
• Mechanics
• Borrow security from broker
• Sell and deposit proceeds and margin in account
• Dividends voting rights
• Close out/cover the position buy the security
  back and return to broker
• TSX Short position reports

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Short Sale ExampleInitial Conditions

• Z Corp 100 shares
• 50 Initial margin
• 25 Maintenance margin (U.S.)
• 100 Initial price
• Sale Proceeds 10,000
• Margin (50) 5,000
• Stock owed - 10,000
• Equity 5,000
• (In Canada this margin is expressed as 150)

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Short Sale Margin

• Stock price rises to 110
• Sale proceeds 10,000
• Initial margin 5,000
• Stock owed - 11,000
• Equity 4,000
• Margin as a (4,000/11,000) 36

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Risks(From FINRA website)

• You can lose more funds than you deposit in the
  margin account
• A decline in the value of securities that are
  purchased on margin may require you to provide
  additional funds to the firm that has made the
  loan to avoid the forced sale of those securities
  or other securities in your account.
• Broker can force the sale of securities in your
  account
• If the equity in your account falls below the
  maintenance margin requirements under the lawor
  the firms higher "house" requirementsthe firm
  can sell the securities in your account to cover
  the margin deficiency. You will also be
  responsible for any short fall in the account
  after such a sale.
• Broker can sell your securities without
  contacting you
• Some investors mistakenly believe that a firm
  must contact them for a margin call to be valid,
  and that the firm cannot liquidate securities in
  their accounts to meet the call unless the firm
  has contacted them first. This is not the case.
  As a matter of good customer relations, most
  firms will attempt to notify their customers of
  margin calls, but they are not required to do so.
  
• You are not entitled to an extension of time on a
  margin call
• While an extension of time to meet initial margin
  requirements may be available to customers under
  certain conditions, a customer does not have a
  right to the extension. In addition, a customer
  does not have a right to an extension of time to
  meet a maintenance margin call.

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D. Costs of Trading

• Direct costs commission
• Fee paid to broker
• Full service broker vs. discount broker
• Indirect costs bid-ask spread
• Traded securities have bid and ask prices
• Bid price dealer will buy the security at
• Ask price dealer will sell the security at
• Bid-ask spread ask minus bid

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Costs of trading (contd)

• Amount lost if simultaneous buy and sell
• Why is there a spread?
• To compensate dealers for the risk they take in
  keeping the market liquid
• In the absence of this compensation, you would be
  buying (selling) at a lower (higher) price
• Liquidity and bid-ask spread

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Regulation of Securities Markets

• Government regulation
• Provincial regulation in Canada, e.g., OSC in
  Ontario, BCSC in British Columbiaetc.
• Likely to see a national body in the future
• SEC in the U.S.
• Self-regulatory bodies (investment industry)
• FINRA in U.S., IIROC in Canada
• Circuit breakers
• Insider trading laws