Announcements

Equity valuation pitches due Thursday

Come to class on Thursday!

Exam next week

Practice exam will be uploaded to t-square

Trading Securities

The Process of Placing a Trade

How do we (or our broker) find a counter-party and complete the trade?
Different financial assets are traded in different types of markets

Do I want to buy or sell (or go short) the security?

Should I borrow capital to make the purchase (buying on margin)?

Should the order be contingent on a certain price?

Multiple types of orders we can place

What will the process cost?

Explicit and implicit trading costs

Types of Markets

Primary vs. Secondary Markets

Primary Market

Market for newly issued securities

Examples: Initial public offerings of
stock, initial sales of treasury
securities

Secondary Market

Market for existing securities

U.S. IPOs
Number and
First-day returns

Source: Jay Ritter (U. of Florida)

OTC vs. Exchange

Exchange markets:

Market information and clearing is centralized, contracts

are standardized

OTC markets are a network of trading relationships

Price of asset need not be uniform

Mostly for bonds, derivatives and specialized financial assets
Benefits of OTC: customization and innovation
Costs of OTC: lack of transparency, non-uniform prices, lack of
liquidity, greater search costs, greater counter-party risk
Post crisis: OTC derivative trades under scrutiny

Types of Markets

Direct search markets

Buyers and sellers seek

each other

Dealers have inventories of

assets from which they buy
and sell

Examples: Craigslist, newspaper

ads

Example: Corporate bond markets,

foreign exchange spot and forwards
contracts, NASDAQ stocks

Brokered markets

Brokers search out buyers

and sellers

Examples: real estate, IPOs

(investment bankers act as brokers)

Dealer markets

Auction markets

Traders converge at one

place to trade
Example: NYSE

Trading Mechanisms

Dealer markets: dealers quote prices at which they are

willing to buy or sell securities. Most dealer markets are
over-the-counter markets.
Ex: corporate bond market

Specialist markets: the exchange assigns responsibility

for trading in stocks to a specialist
Ex: NYSE

Electronic Communication Networks (ECN):

participants post orders over the internet. Can see the
limit-order book.
Ex: Direct Edge, BATS, NYSE ARCA

Bond Trading

Most bond trading takes place in the OTC market

among bond dealers

NYSE Bonds is the largest centralized bond

market of any U.S. exchange

Market for many bond issues is thin and is

subject to liquidity risk

NYSE and NASDAQ

Combined they make up approximately 40% of world stock market capitalization
Both mainly rely on electronic trading now

NYSE

Auction market with

specialists

Specialists are almost all HFT

firms

NASDAQ

Dealer market with multiple

market makers
On average, 10 market makers
per stock

Competition

Growth in exchanges (mainly ECNs) in recent years

SEC approved a new exchange (Investors Exchange) in June 2016

The same stock will trade in multiple markets

Arbitrageurs will monitor and trade on any discrepancies across

markets
Brokers are required to find the best execution

Total Notional Value by Exchange (2015)

Source: BATS
Grand Total
NYSE MKT (A)
NYSE Arca (P)
NYSE (N)
NYSE (DN)
NASDAQ PSX (X)
NASDAQ BX (B)
NASDAQ (Q)
NASDAQ (DQ)
EDGX (K)
EDGA (J)
CHX (M)
BATS BZX (Z)
BATS BYX (Y)
0.00

10000.00

20000.00

30000.00

40000.00

50000.00

60000.00

70000.00

80000.00

Competition

Seems to have improved outcomes for investors

Transaction costs have been falling

Could be due to increase in high frequency traders as
well

Trading can move if there are issues with one exchange

The Next Market Shutdown Could Be Much Worse WSJ, August 16, 2015

Source: NY Times

Short Sales

The Process of Placing a Trade

How do we (or our broker) find a counter-party and complete the trade?
Different financial assets are traded in different types of markets

Do I want to buy or sell (or go short) the security?

Should I borrow capital to make the purchase (buying on margin)?

Should the order be contingent on a certain price?

Multiple types of orders we can place

What will the process cost?

Explicit and implicit trading costs

Activist Short Sellers

Short Sales
Purpose:

to profit from security price decline

Mechanics:
Sell high (hopefully)

Borrow shares from your broker

Sell the shares and deposit proceeds and margin in an
account

Buy low (hopefully)

Close out: buy the number of shares borrowed and return

them to the broker

Short Sales
Your

position will be limited by how much

your net position

Assets

Liabilities

(1) Proceeds from sale (# shares x initial price)

+ (2) Capital Invested (margin capital)
-(3) Commission on sales and purchases

(1) Current Value of Shares (# shares x current

price)
+ (2) Hard-to-borrow fees (amount borrowed x
annual interest rate x [days position is open / 360])
+ (3) Dividend paid (Dividend/share x # shares)

Short Sale Example

If you short 100 shares of AAPL today at $117, how much capital must you
invest initially?

Your initial margin is 80% and maintenance margin is 50% (of the value of
the short position)

No hard-to-borrow fee, commission or dividends paid

Short Sale Example

(1) How much capital must you invest initially?

(2) What is your total assets after initiating the short sale?

(3) What is your total liabilities?

Short Sale Example

How high can the price go before you get a margin call (maintenance margin
is 50%)?

Buying on Margin

The Process of Placing a Trade

How do we (or our broker) find a counter-party and complete the trade?
Different financial assets are traded in different types of markets

Do I want to buy or sell (or go short) the security?

Should I borrow capital to make the purchase (buying on margin)?

Should the order be contingent on a certain price?

Multiple types of orders we can place

What will the process cost?

Explicit and implicit trading costs

Margin

Borrowing money from your broker to purchase

stock
Increases return and risk

The amount of initial margin is the portion of the

purchase price contributed by the investor

Example
Buy $100 worth of stock by borrowing $20 and
investing $80 of your own capital. No fee
(interest).
Total value: $100
Debt: $20
Equity: $80

Margin

Stock margin limited by Fed

Initial Margin limited to 50%

Maintenance margin limited to 25%

Minimum equity that must be kept in the margin account

If value of securities falls too much: margin call

Stock Margin Example

Purchase

10 shares of a stock for a $100/share

Take position with an initial margin of 75%.

Assume no fees

How

much (in dollars) will you borrow from

the broker?
Initial position (total value):

Initial equity (amount invested by investor):

Borrowed (amount contributed by brokerage):

Stock Margin Example

At what price will you hit a 50% maintenance

margin requirement?

Costs

Interest (margin fees) are calculated based on the number of days in the
holding period

Typically, brokers borrow money from banks at the call money rate, charge
investor an interest rate of call rate + fee
Call rate is usually 1% above the short-term T-bills rate
Banks can demand the funds be paid back immediately (hence, the "call)

Any commissions

Charles Schwab Margin Rates

Margin Example With Fees

Buy 500 shares at $200/share

Initial margin: 80%

Margin fee rate (aka margin interest rate) is 12%

What will be the dollar amount of fees after one month

(30 days)?
Stock:
$100,000
Initial equity:
=80% x $100,000 = $80,000
Initial debt (borrowed from brokerage):
= $100,000 - $80,000 = $20,000
Fees = $20,000 x 12% x (30 days / 360 days) = $200

Margin Example

Stock price falls to $50 in one month, will there be

a margin call? Maintenance margin: 40%

Value of stock:

Debt:

Equity:

Margin%:

Margin Example Continued

How

far can the stock price fall in one month

before a margin call?

Margin % = (Equity)/Total Value

How does the return on margin capital compare to the stocks return?

Types of Orders

The Process of Placing a Trade

How do we (or our broker) find a counter-party and complete the trade?
Different financial assets are traded in different types of markets

Do I want to buy or sell (or go short) the security?

Should I borrow capital to make the purchase (buying on margin)?

Should the order be contingent on a certain price?

Multiple types of orders we can place

What will the process cost?

Explicit and implicit trading costs

Types of Orders

Market orders

Executed as soon as
possible at the current
market price

Price-contingent orders
Limit orders (limit buy or
limit sell)
Stop orders (stop-loss or
stop-buy)

For a stop order:

once the trigger price
is hit, it becomes a
market order

For a limit order:

Trade is completed at
the limit price or better

What kind of trade would you make if you bought a security at $20
and want to sell if it reaches $30?

Limit orders are recorded in

limit order book
In the limit order
book, the bids
(asks) are buy
(sell) limit orders
that havent been
executed

Limit order book for Google

(Source: Data.nasdaq.com)

Trades are processed

when there is a
mutually beneficial
trade
Trades are typically
processed on a pricetime priority basis

Trading Costs

The Process of Placing a Trade

How do we (or our broker) find a counter-party and complete the trade?
Different financial assets are traded in different types of markets

Do I want to buy or sell (or go short) the security?

Should I borrow capital to make the purchase (buying on margin)?

Should the order be contingent on a certain price?

Multiple types of orders we can place

What will the process cost?

Explicit and implicit trading costs

Trading Costs

Direct cost: brokerage commission

Indirect costs:

Bid-ask spreads
Price impact of large trades

Market depth: may have to move up/down the order book to find counter
parties
Other investors will learn from the trade and update their orders

Strategies: break up trades into small pieces, trade on dark pools

Liquidity
The speed and cost with which you can sell/buy a security
Trade-off between the price you can receive and the speed with which you can sell

Bid-Ask Spreads

Ask price: price at which an investor can buy a

share

Bid price: price at which an investor can sell a

share

Ask > Bid. Difference is the bid-ask spread.

How dealers, specialists make money

Innovations in Trading

http://www.cnbc.com

Computer Trading

Algorithmic trading: computers make the

trading decision according to an algorithm
Makes up more than half of trading volume

High Frequency Trading - rapid algo trading

Strategies:

Exploit short-term trends, new information

Pairs trading
Stock price vs. futures price
Feel out bid-ask, profit on spread before prices move
Price discrepancies across markets

Computer Trading

Speed matters

Arms race for the fastest speeds

Co-locating near exchanges

http://www.wsj.com/articles/satellite-startup-leosat-secures-customer-for-high-speed-trading-1473145382

Downsides to computer trading

Computers make mistakes. Like using old news stories as trading

signals

HFT not obligated to make markets

Abandon market during turbulent periods
Flash Crash: May 6, 2010

Other Innovations/Changes

Dark pools

Private trading systems in which participants can trade large blocks of shares
without showing their hand
There is no visible order book
Mainly used by institutional investors

New exchange (IEX) plans to place speed bumps on trades to limit the
advantage of HFT over slower traders

Exchange consolidation:
NYSE:

Merged with Archipelago ECN in 2006, acquired American Stock Exchange in 2008

NASDAQ:

Acquired Instinet in 2005, Boston Stock Exchange in 2007

International:

Germanys Deutsche Brse tried to merge with the NYSE Euronext in 2011/12
Now, London Stock Exchange trying to merge with Deutsche Brse

Summary

Different types of markets, orders and trades

Markets constantly evolving with regulation,

technology, rest of the economy

Next Class

Equity valuation stock pitch presentations