5.

Stock Trading Basics

Before we move on to investment banking and stock markets to nish up

the survey of nancial institutions, it is a good idea that we understand how
stocks are traded rst.

5.1 Stock Quote

1. Bid, ask, and last prices

Buyers and sellers look at dierent prices.
a) Does a small bid-ask spread indicate an active market?
b) The market can be seen as a gigantic order book for now.

2. Volume
Volume alone transmits very little information.
3. Settlement
An order executed must be settled within 3 working days (T+3 Rule).

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5. Stock Trading Basics

5.2 Order Types

1. Market orders
Market orders are buy or sell orders that are to be executed immediately
at current market prices.
2. Price-contingent orders
Investors also may place orders specifying prices at which they are willing
to buy or sell a security.
a) Limit orders
A limit buy order is to buy shares at or below a stipulated price.
b) Stop orders (stop market orders)
A stop order is similar to a limit order, but once the stipulated price
is reached, the order will turn into a market order for immediate
execution.

5.3 Stock Trading Costs

Trading stocks costs investors. Some of the costs are obvious and explicit,
while others are not that straightforward.
1. Explicit costs
a) Brokers commission
b) Bid-ask spread
2. Implicit costs
a) Impact costs
It takes time and price concessions for the market to absorb large
orders.
b) Timing costs
Execution speed makes or kills a trade. The speed depends on the
privilege level and technology.
c) Opportunity costs
"Youll know that to lose your position is something nobody can
aord; not even John D. Rockefeller."

5.4 Leveraging Your Bets: Margin Trading

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5.4 Leveraging Your Bets: Margin Trading

There are many reasons why investors want to leverage their bets. For some,
a strong belief in a certain stocks direction calls for doubling down bets. For
others, leveraging is the price (or the benet, depending on the angle the
investors look) of hedging. Leveraging through derivatives, such as options
and futures, is not covered in this principles class. Buying stocks on margin
means investing in stocks with borrowed money. We will use the balance
sheet of an investors brokerage account to explain how margin trading is
conducted.

1. Before stock purchase:

2. After stock purchase:

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5. Stock Trading Basics

3. Calculation of margin (Note that margin can be either the dollar amount
or the percentage. Pay attention to the context.)
Equity
Margin = Value
of Sto ck
a) The initial margin
Set by the Fed to be 50%.
b) The maintenance margin
Set by the broker. If the percentage margin falls below this level, the
broker will issue a margin call.
c) A margin call
Additional assets (cash or other securities) are required to be added
to the account. Otherwise, the broker will liquidate stocks in the
account to restore the percentage margin.
4. An example
You purchased 100 shares of IBM stock on margin (50% initial margin).
IBMs stock price is $100 per share at the time you purchase. Suppose
your brokers maintenance margin is 30%. When will you receive a margin
call from your broker?

5.5 Short Selling

Buying stocks on margin is a long bet, while short selling is a short bet, in
which the investors wish the stock price to decline.
The short-seller completes the following steps for a short sale.
Step 1 Present margin (cash collateral) to broker
Step 2 Broker lends the shares to you
Step 3 Broker helps you sell the shares
Step 4 You keep the proceeds but owe shares
Step 5 You order to buy shares to pay back debts
Step 6 Settle the transaction with your proceeds (possibly with money out
of your pocket, if the stock is on the rise)

5.6 Balance Sheet

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5.6 Balance Sheet

What happens to the share that is borrowed and sold?

Street name securities: shares held electronically in the account of a stock

broker. The real shareholder is referred to as the benecial owner.

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5. Stock Trading Basics

5.7 Short Sale Details

1. Margin calculation
Margin = Value ofEquity
Sto ck

Owed

a) An example: You short sell 100 shares of IBM stock at $100 per
share. Your broker required 50% margin. How much is required in
your account for you to be able to short sell IBM? If IBMs shares
drop to $80 per share and you immediately close your position, what
is your prot?
2. The short-seller owes dividends
3. Proceeds must be kept in the account and are not generating any income.
Large, institutional investors are exceptions.

5.8 Short Squeeze and Regulation

1. Unlimited losses for short sellers
Short sellers are recommended to cover short positions with stop orders.
2. Short ratio
It is the percentage of oating shares being shorted.
3. Short squeeze
Stocks might be cornered if too many shares have already been shorted.
At the rst sight of a potential price spike, the short sellers rush to re
exit.
4. Bans on short sales
Many policy makers believe short sellers are to blame for stock plunges
because they induce downward pressure on share prices. During market
stresses, short sale bans are commonplace. The blame, however, is misplaced. There is no evidence that short sales exacerbate plunges. Short
sellers bet with their own money, absorb the risk, and help discover the
price faster.
5. Un-American
"Cheering for a short seller goes against the American spirit", said Rich
Karlgaard, Publisher of Forbes.