CHAPTER SIX MARKET MECHANICS Practical Investment Management Robert A Strong Outline Placing Orders Order Information Flow Types of Orders Settlement Procedures The Specialist and the Book The Specialist and the Spread Adjusting Limit and Stop Prices for Dividends The Ticker Tape Format Accuracy Other Ticker Tape Information South-Western / Thomson Learning © 2004 6-2 Outline Types of Accounts Cash Account Margin Account Other Types of Accounts Selling Short Rationale Criticisms Mechanics of a Short Sale Selling Short Against the Box South-Western / Thomson Learning © 2004 6-3 Outline Trading Fees The Costs of Trading The Commission Structure Full-Service Brokers Discount Brokers Electronic Brokers Current Events South-Western / Thomson Learning © 2004 6-4 Placing Orders: Order Information Flow Confirms trade Stock Exchange Confirms trade Submits order Confirms trade Places order Broker Brokerage Firm Accounting Operations Mails confirmation statement Individual Investor South-Western / Thomson Learning © 2004 6-5 Placing Orders: Types of Orders Market orders are to be executed as soon as possible after reaching the exchange floor Limit orders must specify a price and a time limit, e.g “Buy 500 at $90, good till canceled.” A stop order differs from a limit order in that the order is only executed if the specified price, called the stop price, is touched Stop orders become market orders when the stop price is reached South-Western / Thomson Learning © 2004 6-6 Placing Orders: Types of Orders Insert Figure 6-2 here South-Western / Thomson Learning © 2004 6-7 Placing Orders: Types of Orders BID VOL ASK VOL 90.25 25 90.50 50 Last Trade 90.50 South-Western / Thomson Learning © 2004 6-8 Placing Orders: Types of Orders The most important use of a stop order is to protect a profit Moving a stop up behind a rising stock is called using a crawling stop order Other orders: - once cancels the other - all or none - fill or kill - stop limit South-Western / Thomson Learning © 2004 6-9 Placing Orders: Types of Orders Insert Figure 6-3 here South-Western / Thomson Learning © 2004 - 10 Margin Accounts: Variations Some brokerage firms offer products that are similar to a traditional margin account, but offer additional flexibility to the customer Paine Webber, for instance, offers an account that allows a customer to borrow against the securities in their account for education, home improvement, or other similar uses South-Western / Thomson Learning © 2004 - 30 Margin and Speculation Some market observers view the level of margin debt as a precursor of things to come with the market averages As margin debt as increased, so has the level of stock prices, and vice versa South-Western / Thomson Learning © 2004 - 31 Other Types of Accounts Bonds and income-producing securities can be in a separate account called an income account Convertible bonds may be segregated into their own account, as may government bonds or short positions South-Western / Thomson Learning © 2004 - 32 Selling Short Short selling involves selling borrowed shares Rationale: Short sellers sell first and buy later Criticisms: pros - market exists - short selling helps offset inflationary margin buying cons - short selling has a checkered heritage - downward pressure on price runs counter to public interest South-Western / Thomson Learning © 2004 - 33 Mechanics of a Short Sale A buys 100 shares of XYZ Shares are held in street name B wants to short 100 shares of XYZ Broker borrows shares South-Western / Thomson Learning © 2004 B returns 100 shares of XYZ to lender B sells 100 shares of XYZ B buys 100 shares of XYZ C buys 100 shares of XYZ from B D sells 100 shares of XYZ to B - 34 Selling Short against the Box In a short sale against the box, the investor sells short shares that are simultaneously owned The box refers to the safe deposit box where the share certificate might be held This is a riskless strategy designed to shift a tax liability into the future South-Western / Thomson Learning © 2004 - 35 Trading Fees: The Costs of Trading Explicit Costs These are the direct cost of trading and include brokerage fees and taxes Implicit Costs These costs are especially important to institutional traders because of the size of the trades they typically make Such costs include the bid-ask spread, the price impact of the trade, and the opportunity cost of being unable to execute the trade when you want to South-Western / Thomson Learning © 2004 - 36 Trading Fees: The Commission Structure Commissions are usually a function of the dollar amount involved, the number of shares in the trade, and a minimum figure A limit order that is filled over several days is charged a separate commission for each day that a trade was made Brokers can discount their commission Such a discount comes from the broker’s share of the commission South-Western / Thomson Learning © 2004 - 37 Trading Fees: Broker Types Full-service brokers provide personalized service to their clients e.g Merrill Lynch, UBS PaineWebber Discount brokers execute trades for their clients, and little else e.g Charles Schwab Electronic brokers allow their clients to trade via the Internet e.g E*TRADE, Datek, Ameritrade South-Western / Thomson Learning © 2004 - 38 Trading Fees: Current Events Insert Table 6-3 (Broker Production and Compensation) here South-Western / Thomson Learning © 2004 - 39 Trading Fees: Current Events Superstar brokers naturally pull up the average annual compensation, making it appear that the typical stockbroker is doing better than he or she actually is The official SEC position seems to be that a commission structure in which “more trades mean more commissions” tends to encourage active trading and may lead to account churning South-Western / Thomson Learning © 2004 - 40 Trading Fees: Current Events In the post-Enron/accounting scandal era, investors are likely to pay more attention to their investments and to perform a higher level of “due diligence” than in the past South-Western / Thomson Learning © 2004 - 41 Review Placing Orders Order Information Flow Types of Orders Settlement Procedures The Specialist and the Book The Specialist and the Spread Adjusting Limit and Stop Prices for Dividends The Ticker Tape Format Accuracy Other Ticker Tape Information South-Western / Thomson Learning © 2004 - 42 Review Types of Accounts Cash Account Margin Account Other Types of Accounts Selling Short Rationale Criticisms Mechanics of a Short Sale Selling Short Against the Box South-Western / Thomson Learning © 2004 - 43 Review Trading Fees The Costs of Trading The Commission Structure Full-Service Brokers Discount Brokers Electronic Brokers Current Events South-Western / Thomson Learning © 2004 - 44 ... transactions settle three business days after the trade date A number of market speculators engage in a practice known as a day trade, which involves buying and selling securities on the same day South-Western... $112,527.26 - 19 Types of Accounts A margin account permits an investor to borrow part of the cost of investments from a brokerage firm Margin Account 500 300 100 500 Assets DE $45,000.00 INTC 24,000.00