Chapter 7: Trading Securities

Margin Deficiency

For example, if the security's price drops to $50 per share, long market value in the customer's margin account also drops to $50 per share. The equity has now dropped from 50% to 40% of the LMV, creating a margin deficiency. A margin deficiency is the amount by which the required margin (50% of LMV) exceeds the equity in the margin account.

What are the steps in a typical securities trade?

1. Investor contacts a broker to buy securities. 2. Broker places the investor's order either by telephoning a trader or by using an electronic trading network. 3. Order is routed. Possibly to an exchange (NYSE or NASDAQ), a market maker, an Electronic Communications Network, or a registered Alternative Trading System or other dark pool, which electronically matches buyers and sellers and does not require the use of an exchange or a market maker. 4. Order is executed. 5. Trade is reported to an exchange or via a Trade Reporting Facility, then to the consolidated tape. 6. Trade is cleared and settled. Clearance is the reconciliation of the information in a trade between the parties. Settlement is the last step when money and securities are exchanged, most often three business days after the order was placed (T + 3). The Depository Trust and Clearing Corporation (DTCC) oversees clearance.

Limit Order

A limit order is an order to buy or sell a security at a specific price or "better"

Special Memorandum Account (SMA)

A restricted account does not require that the margin be replenished until the equity has fallen below 25% of the LMV. This 25% minimum level is called a minimum maintenance requirement.

Stop Order

A stop order, also referred to as a stop-loss order, is an order to buy or sell a stock once the price of the stock reaches a specified price, known as the stop price.

Restricted Account

An account in which the equity falls below 50% of the LMV is called a restricted account. There are very few restrictions on a restricted account, however. Customers are not required to eliminate the margin deficiency. They may continue to buy additional stock, as long as they deposit the required initial margin on each new purchase. However, a customer with a restricted account who sells a security is required to deposit 50% of the proceeds into the margin account to reduce the debit balance and thereby reduce the margin deficiency.

Electronic Communications Networks (ECNs)

Automated trading systems registered with the SEC as broker-dealers that display and execute orders electronically for their private subscribers. ECNs post buy orders against sell orders and automatically complete transactions when they find matches.

What must happen before a security is traded and what is the primary market?

Before a security can be traded, it must be issued to the public through what is called the primary market. Issuers usually do this with the help of an investment bank, also known as an underwriter. The investment bank purchases securities from the issuer and then sells them to investors in a primary offering.

Why are buy limit orders and sell limit orders typically used?

Buy limit orders are typically used when an investor wants to buy at a lower price than the market price and is thus waiting for the market to come down to the limit price. Sell limit orders are typically used when an investor is hoping to sell at a price above the market price, and so the customer is waiting for the market to come up to the limit price.

Buy Limit Order and Sell Limit Order

Buy limit orders mean buy at a specific price or lower (a lower price is better for a buyer); sell limit orders mean sell at a specific price or higher (a higher price is better for a seller).

Sell Stop Order

Investors and traders place sell stop orders below current market prices to protect against a large drop in a stock's price. For example, imagine that an investor buys a stock at $25 hoping for an increase but has reason to believe that the stock's price may drop. The investor could put in a stop order at $22 (sell at $22 stop). If the stock begins to decline and moves below the $22 trigger, the stock will immediately be sold at the best available price, preventing further losses for the investor.

What is the difference in trading hours for NASDAQ and NYSE?

NASDAQ's standard trading hours are 9:30 a.m. to 4:00 p.m., same as the NYSE; however, NASDAQ also offers "pre-market" hours from 4:00 a.m. to 9:30 a.m. and "post-market" hours from 4:00 p.m. to 8:00 p.m. ET.

What rule was put into place to curb naked short selling?

Rule 203 under Regulation SHO was put into place to curb naked short selling. The rule states that before a broker-dealer can execute a short sale, they must locate the securities that will be borrowed to cover the short sale. In this context, locate means: • The securities have already been borrowed or there is a bona fide agreement to borrow the securities. • The broker-dealer has "reasonable grounds" to believe that the security can be borrowed by the settlement date. A broker-dealer has reasonable grounds if the security is on a firm's "Easy to Borrow" list that is less than 24 hours old. The process of "locating" the security must be documented.

Suppose a customer purchases 1,000 shares at $60/share on margin. What is the LMV and how much would Regulation T require the person to owe in the account immediately?

The long market value (LMV) of the stock is $60,000. Regulation T requires the customer to put down at least 50% of this amount ($30,000) to buy the securities. • LMV = the current market value of the stock (the market price of the stock times the number of shares) • Debit balance = the money the customer borrows from the broker-dealer • Equity = the value of the stock the customer owns

Over-the-Counter Bulletin Board (OTCBB)

The over-the-counter bulletin board (OTCBB) is an electronic trading service provided by the National Association of Securities Dealers (NASD) that offers traders and investors up-to-the-minute quotes, last-sale prices and volume information for equity securities traded over the counter (OTC). All companies listed on this exchange must file current financial statements with the Securities and Exchange Commission (SEC) or a regulator. Different from listings on the Nasdaq and New York Stock Exchange (NYSE), there are no listing requirements for companies listing stocks on the OTCBB.

The Market

Third market refers to the negotiated sale of an exchange-listed security off the exchange. This over-the-counter (off-exchange) trading of securities between broker-dealers is done by computer and telephone. Historically, this option was chosen by institutional investors such as mutual funds, insurance companies, and pension funds seeking lower trading costs and greater flexibility.

Trade Reporting Facility (TRF) and Automated Confirmation Transaction Service (ACT)

Third market trades must be reported to the consolidated tape within 10 seconds of execution. Typically, these OTC trades are reported to the FINRA Trade Reporting Facility (TRF). The TRF provides automated trade reporting through the Automated Confirmation Transaction Service (ACT) platform. From the TRF, the transactions are displayed on the consolidated tape.

Agency Transactions

Transactions where a firm is acting as a broker are called agency transactions, since the firm is acting as an agent for the buyer and seller

Broker/Agent

When a firm acts as a broker, the firm serves as an agent, or matchmaker, for the buyer and the seller. The broker gets paid for the service by charging a commission.

Market Order

A market order is an order to buy or sell a security immediately at the best available price. A market order to buy will be filled at the lowest ask price; a market order to sell will be filled at the highest bid price. A market order is usually filled quickly, and the order is good for that day only (such orders are called day orders).

Dark Pool

A private trading system that allows participants to make transactions without displaying quotes to the public. Despite their anonymous nature, dark pool transactions must still be reported to the consolidated tape.

Quote

A quote will consist of the highest bid and the lowest offer price. An order becomes a quote when the DMM or floor broker communicates the order to the crowd. As auctioneers, the DMMs must promptly report quote information for the securities they manage, and they must ensure that trades occur at prices no worse than the disseminated quotes. Orders reported electronically must be reported as soon as practicable following their receipt.

Buying Power

A restricted account does not require that the margin be replenished until the equity has fallen below 25% of the LMV. This 25% minimum level is called a minimum maintenance requirement.

Minimum Maintenance Requirement

A restricted account does not require that the margin be replenished until the equity has fallen below 25% of the LMV. This 25% minimum level is called a minimum maintenance requirement.

Selling Short

An investor who thinks the price of a security will drop in the future can try to profit from this belief by selling short. To sell short, an investor borrows securities, sells them, and then repurchases the securities in the future (the investor hopes at a lower price) to return to the lender. If successful, the short seller pockets the difference minus any trading costs.

Sell Stop-limit Order

An investor would use a sell stop-limit order when he wants to protect against a downward trend in a long position but wants to put a limit on how low he is willing to sell his stock for. If the stock passes the trigger price and the next available price is below the limit price, the order will not be executed.

Long Position

An order is a request to buy or sell a security. An investor who buys a security becomes the owner of the security. This is also called having a long position in a security.

Dealer/Principal

When the firm acts as a dealer, in contrast, it is putting its own money at risk, buying or selling securities out of its own inventory. Rather than brokering a deal for another party, the dealer is a principal to the trade, since the transaction is adding to or depleting the dealer's own account.

Buy Stop Orders

Conversely, investors and traders place buy stop orders above current market prices to protect from short sale losses. A short sale opens the investor up to unlimited losses if the price of the stock increases rather than decreases. Placing a buy stop order can curb losses by placing an order to buy the shorted shares if the price goes above a certain trigger. If the stock declines as hoped, the short seller can place a new stop order at a lower price to protect the profits that were gained.

Buy limit orders are typically used when an investor wants to buy at a lower price than the market price and is thus waiting for the market to come down to the limit price. Sell limit orders are typically used when an investor is hoping to sell at a price above the market price, and so the customer is waiting for the market to come up to the limit price. What does this mean?

If the bid price rises to $45, Peter's shares will be sold at $45 minus any commission or markup.

Cash Account

In a cash account, the investor must pay the full amount for the securities it purchases. Securities traders must pay for purchased securities by the regular way settlement date (which usually means three business days after the trade date) and the securities cannot be sold again until the payment has been made.

What are the minimum deposit requirements for the first margin transactions?

Margin accounts have minimum deposit requirements for the first transaction. For a long market account, a purchase of less than $2,000 requires 100% of the value of the purchase. For purchases between $2,000 and $4,000, the customer must deposit at least $2,000. For purchases over $4,000, the customer must deposit at least 50%.

NASDAQ

NASDAQ, the second largest stock exchange in the world by market capitalization, is a hybrid market that trades in both listed and OTC stocks. NASDAQ stands for National Association of Securities Dealers Automated Quotation System. It operates as a negotiated market but is registered as an exchange; its network of computers substitutes for a centralized trading floor. To be traded on the NASDAQ, an issuer must meet listing requirements, including SEC registration, and there must be at least three market makers for that security. NASDAQ market makers must agree to offer a firm bid and ask for the securities they are making a market in.

Regulation T

A federal regulation that lays out a set of initial margin requirements and describes how a margin account is to be maintained. For registered securities bought on margin, Regulation T sets the initial margin requirement at 50%. This means that the customer must put down at least 50% of the price of the stock in a margin account, and the broker-dealer will extend the customer credit for the rest of the price.

Secondary market

After the primary offering, securities may be bought and sold by investors. This trading between investors takes place in the secondary market. If there is an appreciation in the value of the security, this appreciation goes to the investor of the security, not the issuer of the security. To use an analogy, buying a security in the primary market is like buying a new car. Buying a security in the secondary market is like buying a used car.

Market 1: WMT: 54.08, 54.10, 54.09, 54.10, 54.11, 54.13, 54.10 Market 2: WMT: 54.08, 54.10, 54.15, 54.12, 54.16, 54.12, 54.20 Which is a more orderly market?

Above, the first market is an example of a fairer and more orderly market, because there is less variation in the price of the security (WMT is the ticker symbol for Walmart). As the market makers on the exchange, DMMs often buy and sell for their own accounts to maintain price continuity and minimize price volatility. The DMMs are also the ones who fill orders for prices that cannot be executed immediately. The DMM, acting as an agent for the floor broker, will execute the trade when market conditions allow and will receive a fee for the service out of the broker's commission.

Buy Stop-limit Order

Buy stop-limit orders are used to protect short sell gains, and they also protect the investor from ending up purchasing the stock at a high price if there is a sharp increase in the stock price.

Ray goes long 200 shares of XYZ @ 35. What is the maximum gain and loss?

His maximum loss is the amount that he has invested, $7,000. His maximum gain is unlimited.

Hidden Profit

Charging a commission in addition to a markup or markdown on the same transaction. This is prohibited.

How do ECNs make their money?

ECNs make their money by charging subscription fees. The latest development in the fourth market is so-called dark pools of liquidity, which are non-public trading venues where large blocks of shares can be traded with a high degree of anonymity. Despite their anonymous nature, dark pool transactions must still be reported to the consolidated tape.

Give me an example of a market maker / dealer...

Example: A market maker is a dealer that offers a bid (buy) and ask (sell) quote for a security. A market maker posts the following bid for Microsoft, 32.43 - 32.47. This "two-sided market" guarantees that there will always be a buyer and seller for a particular security. The bid price is the highest price at which a buyer is willing to buy, and the ask price is the lowest price at which a seller is willing to sell. In the above example, the market maker is willing to buy Microsoft at 32.43 and sell Microsoft at 32.47. A customer who puts in a buy order that is filled by the market maker will get the market maker's ask price or 32.47. A customer who puts in a sell order will receive the MM's bid price of 32.43. The difference between the bid and ask price is known as the spread; the market maker earns this spread for taking the risk of making a market in a security. Generally, the more market makers there are for a security, the smaller the spread. In addition, thinly traded securities have lower spreads than more actively traded securities.

20s WMT 54.08 What does this mean?

For example: 20s WMT 54.08 would mean the last transaction was 20 round lots (20 x 100), or 2,000 shares, of Walmart sold for $54.08 per share. When there is no number ahead of the ticker symbol, you can assume that a round lot of 100 shares was sold. Trades over 10,000 shares and stocks trading at a price greater than $175 show the number of shares, not the number of round lots.

Principal Transactions

For this reason, dealer transactions are often referred to as principal transactions.

High Frequency Trading (HFT)

High-frequency trading (HFT) is a strategy that uses algorithms and specialized trading systems to determine whether to buy or sell securities. The algorithms are mathematical formulas and computerized instruction sets that allow traders to execute a trade in a very short amount of time—we are talking nanoseconds or a billionth of a second. Computers that are close to exchanges or ECNs have an advantage over computers that are farther away because information takes time to travel. For this reason, high-frequency traders try to get as close as possible to the rest of the market, sometimes by having their computers "co-located" in an exchange.

Sam shorts 200 shares of XYZ @ 35. What is the maximum gain and loss?

His maximum loss is infinite. His maximum gain occurs if the price of XYZ goes to zero, where he will earn $7,000.

Naked Short Selling

Naked short selling is where a short seller does not borrow or arrange to borrow the securities in advance of selling them. When sellers do not deliver the sold securities to buyers within the three-day settlement period, it is called a "failure to deliver." When many sellers choose to naked short sell, the result can be many, many "failures to deliver," which could potentially drive down the price of the stock.

Supplemental Liquidity Provider (SLP)

One of three key market participants on the New York Stock Exchange (NYSE). Supplemental Liquidity Providers (SLPs) are market participants that use sophisticated high-speed computers and algorithms to create high volume on exchanges in order to add liquidity to the markets. As an incentive for providing liquidity, the exchange pays the SLP a rebate or fee, which was 0.15 cents as of 2009.

Round Lots, Odd Lots, and Mixed Lots

Orders can be taken in two different kinds of sizes—round lots or odd lots. Round lots are the standard unit size, either 100 shares or some multiple of 100. Odd lots are smaller than 100. It is possible to make an order that is a combination of a round lot and an odd lot, and this is known as a mixed lot. A mixed lot order would be an order such as 315 shares, which can be divided into a round lot of 300 shares and an odd lot of 15 shares. Orders can be no larger than 999,999 shares. Orders that exceed this maximum can be broken up into multiple orders to meet this size requirement.

Holding Period Return

Perhaps the simplest type of return is a holding period return. A holding period return measures the return on an investment over the time period that the investment was held. The time period may be less than a year or more than a year. The important fact to remember is that a holding period return is not annualized, so the investor must be careful when comparing holding period returns.

What are the positives and negatives of high frequency trading?

Proponents of HFT say that it provides more liquidity to the market, narrows bid-ask spreads, and lowers volatility. Researchers have found that the increase in HFT has lowered transaction costs for retail investors. Critics of HFT say it exacerbates anomalies in the market. In fact, many have blamed HFT for the Flash Crash that occurred in 2010. HFT has also been criticized because many orders sent out by high-frequency traders are eventually cancelled. Critics of HFT also point out that the exchanges encourage HFT by paying HFT firms for order flow. This can be a significant source of revenue for an HFT firm.

Stop-limit Order

Stop-limit orders are orders that become limit orders after the market passes the trigger price. Thus, a stop-limit order involves two prices, the trigger price and the limit price.

New York Stock Exchange (NYSE)

The New York Stock Exchange (NYSE) is the largest and best-known first market exchange. The NYSE bills itself as a hybrid market offering floor and electronic trading in equities (stocks), futures, options, fixed-income (bonds), and exchange-traded products such as ETFs. Although there is still a trading floor with live humans, the majority of trading on the NYSE takes place via electronic networks.

Non-NASDAQ OTC Securities

The OTC Link (Pink Sheets) is an electronic quotation system whose securities do not have to be registered with the SEC, but several are. Securities that trade OTC are typically offered by smaller issuers who cannot or do not wish to comply with an exchange's listing requirements. They are often thinly traded (that is, traded in low volumes). Most U.S. government and municipal securities trade OTC (over-the-counter or "off exchange") between bond brokers and dealers and institutional investors.

National Market System

The Securities Acts Amendments of 1975 authorized the establishment of a National Market System (NMS). The goal of the National Market System was to consolidate the trading rules across all the exchanges and to encourage competition among them. This legislation authorized an electronic linkage across the U.S. exchanges, created the consolidated tape and the consolidated quotation system, and eliminated fixed commissions. Regulation NMS is a set of regulations that apply to securities that are listed on exchanges, including the NASDAQ. Under the National Market System, all trading of exchange-listed securities (NMS securities) is required to take place within this system, and the Regulation NMS rules apply to all transactions in these securities, even when they are traded over-the-counter in the third market.

Consolidated Tape

The consolidated tape, introduced in 1975, provides continuous, real-time data on trading volume and price for exchange-traded securities. Round lot exchange-listed equity security trades, but not odd-lot sales, are reported on the consolidated tape. It is called the "consolidated" tape because it consolidates trade information of listed securities from every exchange in the country. The place where the trade took place is not indicated on the tape. Securities that are listed on the NYSE or a regional exchange are reported to the consolidated tape, while NASDAQ securities are reported to a tape called Tape C.

Underwriting Spread

The difference between the price at which the investment bank purchases the securities from the issuer and the price at which it sells the securities to investors is called the "underwriting spread."

Auction Market

The first market is an auction market, where securities are traded on an exchange floor. It is an auction market because brokers gather around a trading post where a Designated Market Maker (DMM), formerly known as a specialist, acts as auctioneer and allows supply and demand to determine the price of the security.

Designated Market Maker (DMM)

The first market is an auction market, where securities are traded on an exchange floor. It is an auction market because brokers gather around a trading post where a Designated Market Maker (DMM), formerly known as a specialist, acts as auctioneer and allows supply and demand to determine the price of the security. The DMM is responsible for making sure trading moves in a fair and orderly fashion. Fair means that no individual or organization is favored. Orderly means there is a continuous market (active buyers and sellers) for their designated security. A fair and orderly market also means there are not large variations in the price of a security from one transaction to the next.

The Fourth Market

The fourth market is a negotiated market where institutional investors and other big money players trade listed and unlisted securities directly with each other via Electronic Communications Networks (ECNs).

The Inside Market

The inside market is the highest bid and the lowest ask offered on the NASDAQ system. The inside market represents the best prices that NASDAQ has to offer for clients on a specific security. The inside market is sometimes known as the inside quote and the best bid and offer (BBO). The inside market does not include the markup or markdown that a market maker may charge.

Short Market Value (SMV)

The market value of a security borrowed or sold short in a margin account at the close of the last business day.

Long Market Value (LMV)

The market value of a security held in a cash or margin account at the close of the last business day.

Second/Negotiated Market

The second market (not to be confused with the "secondary" market) refers to the decentralized buying and selling of securities without one central market maker. This type of market, with no "auctioneer" like the Designated Market Maker on the floor of the NYSE, is referred to as a negotiated market. The second market includes both over-the-counter securities and the NASDAQ. This is an important and highly testable point. Instead of a physical place with a single market maker, the second market consists of electronic systems connecting multiple market makers who post competing bid and ask prices online. Orders are filled either automatically, with the computer matching the best quotes first, or by private negotiation. The second market is composed of exchange-listed securities that trade on the NASDAQ stock exchange and securities that trade on over-the-counter markets, such as the Over-the-Counter Bulletin Board (OTCBB) and the Pink Sheets (now called OTC Link).

What happens if the price increases and you have short sold?

Unlike for long market accounts, the minimum maintenance requirement for short accounts is 30% in addition to the current market value of the securities. To find the value at which a short market account will get a margin call, divide the credit balance by 1.3, or 130% (SMV + 30% of SMV). A margin call is a demand that an investor deposit additional money or stock into the margin account to bring it up to the minimum maintenance requirement. In our example above, Candy shorted 1,000 shares at $30. Her credit balance was $45,000. If the SMV went up to $34,615 ($45,000 / 1.3 = $34,615), Candy's account would get a minimum maintenance call, which is a type of margin call related to changes in security values. In other words, if XYZ increases from $30 to $34.62, Candy's account will get a minimum maintenance call. The minimum maintenance call would demand that Candy deposit more funds to bring the equity back up to the minimum maintenance requirement.

Consolidated Quotation Service (CQS)

Users of the third market typically use the Consolidated Quotation Service (CQS) to access quotes. The CQS provides quotations for securities listed on the NYSE, Amex, certain regional exchanges, and the NASDAQ, providing a convenient platform for third market makers to post their quotes.

Selling Long and Selling Short

When an investor sells a security, he can sell long, which means to sell securities that he already owns. Or he can sell short, which means to sell securities that have been or will be borrowed. An investor sells short when he expects the price of the security to drop in the future. His goal is to sell at a high price and buy the shares back in the future at a lower price, profiting from the difference. Because a short seller will have to buy back the shares sometime in the future, and during that time the price of the shares could hypothetically rise infinitely, the short seller's risk is infinite. A short seller's gains are capped by the price of the security going to zero. In other words, a short seller earns his maximum profits when the price of the security goes to zero.