chapter 12
High Frequency Trading (3 of 6)
¡Bots and Algorithms ¡High frequency traders use computerized systems for accessing stock market information and interpreting that information. ¡Traders develop algorithms that attempt to interpret existing information about a particular stock's recent price or volume movements (or other information) as a signal for its future price movements. ¡The bot is prompted to execute trades as soon as its algorithms recognize specific information that it is seeking.
High Frequency Trading (1 of 6)
¡High frequency trading (HFT) represents the use of electronic platforms to execute orders based on an algorithm with programmed instructions. ¡HFT is also known as: ¡Automated trading ¡Algorithmic trading ¡Algo trading
High Frequency Trading (6 of 6)
¡Impact of High Frequency Trading on Spreads ¡HFT traders have taken market share from the market makers because of the large spreads quoted by market makers in the past. ¡The spreads have declined as a result of the participation by high frequency traders.
High Frequency Trading (4 of 6)
¡Impact of High Frequency Trading on Stock Volatility ¡Flash Crash — On May 6, 2010, stock prices declined abruptly in what is now referred to as the "flash crash." It appears that the flash crash was triggered by HFT. ¡Other Breakdowns in Computerized Trading — The focus on speed to take positions before other investors can cause panic in the markets even when the public information disclosed is false. ¡Concerns about HFT — Various stock markets have attempted to impose new guidelines that temporarily prevent trading when a stock's price or a market index declines by a particular level over a short interval (such as 5 minutes).
Stock Market Transactions (5 of 9)
¡Margin Calls ¡A large volume of margin lending exposes the stock markets to a potential crisis. ¡A high volume of margin calls results in more sales, putting downward pressure on stock prices, leading to additional margin calls.
Stock Market Transactions (4 of 9)
¡Margin Trading ¡Investors use cash along with funds borrowed from their broker to make the purchase. ¡The Federal Reserve imposes initial margin requirements, which represent the minimum proportion of funds that must be covered with cash (currently 50%). ¡Investors must establish an account (called a margin account) with their broker. ¡Over time, the market value of the stock will change. Investors are subject to a maintenance margin, which is the minimum proportion of equity that an investor must maintain in the account as a proportion of the market value of the stock (currently 25%).
The Nasdaq market does not impose circuit breakers. a. True b. False
b
Specialists and market-makers both enhance the stock market's liquidity by making a market for stocks. a. True b. False
a
How Stock Transactions are Executed (3 of 4)
Electronic Communication Networks ¡ECNs are automated systems for disclosing and executing stock trades. The SEC requires that any quote provided by a market-maker be made available to all market participants. ¡Interaction between Direct Access Brokers and ECNs ¡A direct access broker is a trading platform on a computer website that allows investors to trade stocks without the use of a broker. ¡The website serves as the broker and interacts with ECNs that can execute the trade. (Exhibit 12.1) ¡The advantage of a direct access broker is that investors can monitor the supply and prices of shares and the demand for shares on different ECNs.
How Stock Transactions are Executed (4 of 4)
Electronic Communication Networks (cont.) ¡Dark Pools ¡Platforms that use software to connect buyers and sellers of stocks. ¡Trades are not immediately disclosed to the public, allowing investors to accumulate large amounts of shares without public knowledge. ¡Also attract high-frequency traders. ¡Increasing in popularity and might account for 40% of all trading of stocks.
How Stock Transactions are Executed (1 of 4)
Floor Brokers ¡Floor brokers are situated on the floor of a stock exchange and fulfill and execute orders. Market-Makers (Specialists) ¡Can serve a broker function by matching up buy and sell orders on the New York Stock Exchange. ¡Making a market implies that they stand ready to buy or sell certain stocks even if no other investors are willing to participate. ¡Market-makers take positions to capitalize on the discrepancy between the prevailing stock price and their own valuation of the stock. ¡May take the opposite position to uninformed "noise traders."
Stock Market Transactions (6 of 9)
Margin Trading (cont.) ¡Impact on Returns The return (R) is affected by the proportion of the investment that is from borrowed funds
Stock Market Transactions (2 of 9)
Placing an Order (Cont.) ¡Stop-Loss Order — To protect gains or to limit losses ¡Investor specifies a selling price that is below the current market price of the stock. ¡When the stock price drops to the specified level, the stop-loss order becomes a market order. ¡Stop-Buy Order ¡Investor specifies a purchase price that is above the current market price. ¡When the stock price rises to the specified level, the stop-buy order becomes a market order.
Stock Market Transactions (1 of 9)
Placing an Order — To place an order to buy or sell a specific stock, an investor contacts a brokerage firm. ¡The investor communicates the order to the broker by specifying (1) the name of the stock, (2) whether to buy or sell that stock, (3) the number of shares to be bought or sold, and (4) whether the order is a market or a limit order. ¡Broker may provide a bid quote if the investor wants to sell a stock or an ask quote if the investor wants to buy a stock. ¡A Market Order is executed at the best possible price. ¡A Limit Order places a limit on the price at which a stock can be purchased or sold.
Stock Market Transactions (7 of 9)
Short Selling ¡Investors place an order to sell a stock that they do not own. The investor borrows the stock from another investor and will return it to the investor from whom they borrowed it. ¡If the price of the stock declines by the time the short-sellers purchase it in the market, the short-sellers earn the difference between the price at which they initially sold the stock and the price they paid to obtain the stock. ¡The risk of a short sale is that the stock price may increase over time, forcing the short-seller to pay a higher price for the stock than the price at which it was initially sold.
Stock Market Transactions (8 of 9)
Short Selling (Cont.) ¡Measuring the Short Position of a Stock ¡The ratio of the number of shares that are currently sold short divided by the total number of shares outstanding. ¡Short interest ratio — The number of shares that are currently sold short divided by the average daily trading volume over a recent period. ¡Using a Stop-Buy Order to Offset Short Selling — Investors commonly use a stop-buy order to limit their losses. ¡Concerns about Short Selling — When the credit crisis intensified in 2008, hedge funds and other investors took large short positions on many stocks. Some critics argued that the large short sales placed additional downward pressure on prices and created paranoia in the stock market.
Program trading is commonly cited as the reason for a decline or rise in the stock market, and the underlying reason for a large amount of program trading is that institutional investors believe that numerous stocks are over- or undervalued. a. True b. False
a
Stock Market Transactions (9 of 9)
Short Selling (Cont.) ¡Restrictions on Short Selling ¡In October 2008, the SEC required that short-sellers borrow and deliver the shares to the buyers within three days. This rule is important because there were many cases in which brokerage firms were allowing speculators to engage in naked shorting, in which they sell a stock short without first borrowing the stock. In 2009, the SEC also reinstated the uptick rule (previously eliminated in 2007), which prohibits speculators from taking a short position except after the stock price increases. This rule is intended to prevent short selling in response to a stock's continuous downward price momentum
How Stock Transactions are Executed (2 of 4)
The Spread on Stock Transactions The spread is the difference between the ask price and the bid price, and is measured as a percentage of the ask price. The spread is influenced by the following factors: ¡Order Costs — Clearing costs and the costs of recording transactions increase the bid-ask spread. ¡Inventory Costs — The cost of maintaining an inventory of a stock increases the bid-ask spread. ¡Competition — Having multiple market-makers promotes competition and reduces the bid-ask spread. ¡Volume — Stocks that are more liquid have a large trading volume and a lower bid-ask spread. ¡Risk — If the firm has risky operations, its stock price is more volatile, therefore increasing the bid-ask spread.
A market order is an order to buy or sell a stock at the best possible price. a. True b. False
a
A stop-loss order is a particular type of limit order whereby the investor specifies a selling price that is below the current market price of the stock. a. True b. False
a
A(n) ________ from a broker requires the investor to put up additional collateral. a. margin call b. maintenance margin c. initial margin d. None of these choices are correct.
a
The short-interest ratio is the shares sold short divided by the a. average daily trading volume over a recent period. b. average daily trading volume on other stocks from the same industry. c. interest rate paid on the short sale. d. average shares purchased over a recent period. e. None of these choices are correct.
a
When investors place a limit order, they can place it for the day only. a. True b. False
a
Which of the following statements is incorrect with respect to Regulation Fair Disclosure (FD)? a. It prohibits firms from communicating with analysts after a news announcement is made to all investors. b. It restricts firms from providing analysts with information that they could use before the market is aware of the information. c. It required firms to disclose relevant information broadly to investors at the same time. d. It requires firms to announce a change in expected earnings to all investors and other interested parties at the same time. e. All of these choices are correct with respect to Regulation FD.
a
______________ represents the use of electronic platforms to execute orders based on an algorithm with programmed instructions. a. High frequency trading b. Mechanical analysis c. Liquidity trading d. Technical analysis
a
A ____ order to buy a stock means to execute the transaction at the best possible price but pay no more than a specified maximum price. a. market b. limit c. stop-loss d. stop-buy
b
An investor sold a stock short a year ago for $50 per share. The stock's price is currently $52 per share. If the investor is unwilling to accept a loss of more than $5 per share on the short sale transaction, she could place a a. stop-loss order with a specified selling price of $55 per share. b. stop-buy order with a specified purchase price of $55 per share. c. stop-loss order with a specified selling price of $45 per share. d. stop-buy order with a specified purchase price of $45 per share.
b
Kevin Mostner, a private investor, would like to purchase a stock priced at $70. The stock is not expected to pay any dividends in the coming year. Mr. Mostner can either put up the entire amount and purchase the stock or borrow $35 from his brokerage firm at an annual interest rate of 12 percent and put up the remainder. Mr. Mostner thinks he can sell the stock for $100 after one year. If Mr. Mostner does not borrow any money from his brokerage firm, what is the estimated return on the stock? a. -30.00 percent b. 42.86 percent c. -42.86 percent d. 30.00 percent e. None of these choices are correct.
b
Marziano Co. stock is quoted by a broker as bid $21.20, ask $21.40. The bid-ask spread is ____ percent. a. 0.94 b. 0.93 c. 0.20 d. none of the above
b
Marziano Co. stock is quoted by a broker as bid $21.20, ask $21.40. The bid-ask spread is ________ percent. a. 0.94 b. 0.93 c. 0.20 d. None of these choices are correct
b
Program trading a. may involve the purchase of stocks that become "underpriced." b. is commonly used to reduce the susceptibility of a stock portfolio to stock market movements. c. may involve the sale of stocks that become "overpriced." d. can be combined with the trading of individual bonds to create portfolio insurance. e. None of these choices are correct.
b
The SEC's Division of Market Regulation assesses possible violations of the SEC's regulations and can take action against individuals or firms. a. True b. False
b
The initial margin is the minimum amount of margin that investors must maintain as a percentage of the stock's value without receiving a margin call. a. True b. False
b
The most well-known electronic communications network (ECN) is the Nasdaq. a. True b. False
b
The short interest ratio is the shares sold short divided by the a. average shares purchased over a recent period. b. average daily trading volume over a recent period. c. interest rate paid on the short sale. d. average daily trading volume on other stocks from the same industry.
b
When investors sell short, they are essentially lending the stock to another investor and will ultimately receive that stock back from the investor to whom they lent it. a. True b. False
b
Which of the following statements is not true with respect to electronic communication networks (ECNs)? a. They are automated systems for disclosing and sometimes executing stock orders. b. The SEC allows ECNs limited access to orders placed in the Nasdaq market. c. They were adapted to facilitate the execution or orders and normally service institutional rather than individual investors. d. ECNs are appealing to investors because they do not require traders to execute the transaction.
b
_______ offer advice to customers on stocks to buy or sell. a. Floor brokers b. Full-service brokers c. Discount brokers d. Market-makers e. Specialists
b
Maggie Hawthorne, a private investor, just purchased a stock costing $33 on margin, paying $23 and borrowing the remainder from a brokerage firm at 15 percent annual interest. The stock pays an annual dividend of $2. If Ms. Hawthorne sells the stock after one year at a price of $50, what is her return? a. 27.60 percent b. 82.61 percent c. 76.09 percent d. 58.70 percent e. None of these choices are correct.
c
Which of the following statements is incorrect with respect to the structure of the SEC? a. Commissioners meet to assess whether existing regulations are successfully preventing abuses and to revise the regulations as needed. b. The president selects one commissioner to chair the commission. c. It is composed of seven commissioners appointed by the president of the United States d. Each commissioner serves a five-year term. e. Commissioners' terms are staggered.
c
Which of the following statements is incorrect? a. Market makers take positions to capitalize on the discrepancy between the prevailing stock price and their own valuation of a stock. b. Market makers may take the opposite position of uninformed investors and therefore stand to benefit if their expectations are correct. c. Market makers are required to purchase the stocks they are assigned for a price existing when the market opened on any given day. d. The spread quoted for a given stock may vary among market makers
c
An advantage of trading in dark pools is that a. the bid or ask prices offered can be more favorable than those available in the public stock exchanges. b. an investor can accumulate a large number of shares of a particular stock without putting excessive upward pressure on the stock price. c. they are convenient for high frequency traders using computer algorithms to catch price discrepancies. d. all of the above
d
Expert networks consisting of managers or executives of a publicly traded company who are hired as consultants ("experts") by a hedge fund to provide insight about the company a. are illegal under Regulation FD. b. are legitimate if the consultants divulge only information that is already public. c. have raised concerns that the consultants provide inside information. d. B and C
d
Kevin Mostner, a private investor, would like to purchase a stock priced at $70. The stock is not expected to pay any dividends in the coming year. Mr. Mostner can either put up the entire amount and purchase the stock or borrow $35 from his brokerage firm at an annual interest rate of 12 percent and put up the remainder. Mr. Mostner thinks he can sell the stock for $100 after one year. If Mr. Mostner borrows from his brokerage firm, his estimated return on the stock would be ________ percent. a. 42.86 b. 30.00 c. 85.71 d. 73.71
d
The flash crash was attributed to a. the use of inside information. b. faulty circuit breakers. c. the default of a major financial institution. d. high frequency trading.
d
Which of the following barriers to the international trading of stocks has been reduced recently? a. transaction costs b. exchange rate risk c. information costs d. All of these choices are correct.
d
________ are required to maintain a fair and orderly market in the securities assigned to them on the New York Stock Exchange. a. Dealers b. Market-makers c. Floor brokers d. Specialists e. None of these choices are correct.
d
Maggie Hawthorne, a private investor, just purchased a stock costing $33 on margin, paying $23 and borrowing the remainder from a brokerage firm at 15 percent annual interest. The stock pays an annual dividend of $2. If Maggie Hawthorne had not used any borrowed funds when purchasing the stock for $33, her return after one year would be ________ percent. a. 76.09 b. 82.61 c. 27.60 d. 57.58 e. None of these choices are correct.
e
Trading halts
¡Stock exchanges may impose trading halts on particular stocks when they believe market participants need more time to receive and absorb material information that could affect the stock's value. ¡Usually happens around major news announcements when information is being revealed. ¡Happens when market and economic uncertainty is high. ¡Focus is to reduce volatility within stocks.