practical investment management by robert.a.strong slides ch06
TRANSCRIPT
MARKET MECHANICS
CHAPTER SIX
Practical Investment Management
Robert A. Strong
South-Western / Thomson Learning © 2004 6 - 2
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 - 3
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 - 4
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 - 5
Placing Orders: Order Information Flow
Individual Investor
Broker1. Places order
4. Confirms trade
Stock Exchange
Brokerage FirmAccounting Operations
2. Submits order3. Confirms
trade
3. Confirms trade
5. Mails confirmation statement
South-Western / Thomson Learning © 2004 6 - 6
Placing Orders: Types of Orders
Market orders are to be executed as soon aspossible after reaching the exchange floor.
Limit orders must specify a price and a timelimit, e.g. “Buy 500 at $90, good till canceled.”
A stop order differs from a limit order in thatthe 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 - 7
Placing Orders: Types of Orders
Insert Figure 6-2 here.
South-Western / Thomson Learning © 2004 6 - 8
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 - 9
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 - 10
Placing Orders: Types of Orders
Insert Figure 6-3 here.
South-Western / Thomson Learning © 2004 6 - 11
Placing Orders: Settlement Procedures
The activities surrounding the transfer ofownership are called settlement procedures.
In the United States, stock and bondtransactions 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 / Thomson Learning © 2004 6 - 12
The Specialist and the Book
Specialists help maintain a fair and orderly market.
To tighten the spread in the market, specialists may actively participate in the market.
South-Western / Thomson Learning © 2004 6 - 13
The Specialist and the Book
Insert Figure 6-4 here.
South-Western / Thomson Learning © 2004 6 - 14
The Specialist and the Book
Insert Figure 6-5 here.
South-Western / Thomson Learning © 2004 6 - 15
The Specialist and the Book
Insert Figure 6-6 here.
South-Western / Thomson Learning © 2004 6 - 16
The Specialist and the Book
Unless a customer indicates a contrarywish, limit and stop orders are automatically adjusted downward for the payment of a cash dividend.
South-Western / Thomson Learning © 2004 6 - 17
The Ticker Tape
Today, the tape is electronic , passing by on ascreen.
To accommodate the human eye, an upper speed limit is set for the tape. So, on heavy trading days, trade data can get backlogged.
Notices like data corrections, omissions, and news may also appear on the tape.
DE HRD PEP ASN C DIS 90 1/4 6s25 3/4 10,000s37 2s55 8 6s55.2s 1/8
South-Western / Thomson Learning © 2004 6 - 18
The Ticker Tape
Insert Figure 6-8 here.
South-Western / Thomson Learning © 2004 6 - 19
Types of Accounts
In a cash account, an investor must come up with cash equal to the full value of the securities purchased.
Cash Account
Assets Liabilities
Cash $23,089.76500 DE 45,000.00300 INTC 24,000.00100 RBD 3,000.00500 OCR 17,437.50 Equity $112,527.26
$112,527.26 $112,527.26
South-Western / Thomson Learning © 2004 6 - 20
Types of Accounts
A margin account permits an investor to borrow part of the cost of investments from a brokerage firm.
Margin Account
Assets Liabilities
500 DE $45,000.00 Margin $33,792.10300 INTC 24,000.00100 RBD 3,000.00500 OCR 17,437.50 Equity $55,645.40
$89,437.50 $89,437.50
South-Western / Thomson Learning © 2004 6 - 21
Margin Accounts: The Nature of the Debt
An investor must pay interest on amargin loan, until the debt is repaid from the eventual sale of the securities.
The base rate for these loans is called the broker’s call money rate.
The smaller the loan, the higher the interest rate.
South-Western / Thomson Learning © 2004 6 - 22
Margin Accounts: Fed Regulation T
Margin trading is governed by Regulation T of the Federal Reserve Board.
The initial margin requirement is the percentage an investor must pay toward new purchases.
The maintenance margin requirement determines how badly a position can deteriorate before the investor must deposit more money into the account portfolio.
South-Western / Thomson Learning © 2004 6 - 23
Margin Accounts: Buying Power Buying power is a measure of how much
more can be spent for securities without having to put up any additional cash.
balance
debit equity
t requiremen
margin initial
power
buying
11
Buying power can be used to withdraw cash,
but the reduction in buying power will be greater than the amount of cash withdrawn.
South-Western / Thomson Learning © 2004 6 - 24
Margin Accounts: Buying Power
Margin Account
Assets Liabilities
500 DE $45,000.00 Margin $51,792.10300 INTC 24,000.00100 RBD 3,000.00500 OCR 17,437.50
3000 BAD 18,000.00 Equity $55,645.40
$107,437.50 $107,437.50
Buying Power: $55,645.50 - $51, 792.10 = $3,853.30
Figure 6-11
South-Western / Thomson Learning © 2004 6 - 25
Margin Accounts: Withdrawing Cash
Figure 6-12
Margin Account
Assets Liabilities
500 DE $45,000.00 Margin $53,718.75300 INTC 24,000.00100 RBD 3,000.00500 OCR 17,437.50
3000 BAD 18,000.00 Equity $53,718.75
$107,437.50 $107,437.50
Buying Power: $53,718.75 - $53,718.75 =$0
South-Western / Thomson Learning © 2004 6 - 26
Margin Accounts: Withdrawing Cash
Insert Figure 6-13 here.
Margin Account
Assets Liabilities
500 DE $45,250.00 Margin $54,939.55300 INTC 28,500.00100 RBD 3,100.00500 OCR 18,000.00
3000 BAD 17,250.00 Equity $57,160.45
$112,100.00 $112,100.00
Buying Power: $57,160.45 - $54,939.55 =$2,220.90
South-Western / Thomson Learning © 2004 6 - 27
Margin Accounts: Margin Calls
margin emaintenanc
balancedebit value portfolio minimum
1
The investor can deposit more assets (usually cash or cash equivalents), or some security position(s) can be closed out to reduce the amount of margin debt.
A margin call is a requirement to depositadditional equity into a brokerage account because the account equity fell below the maintenance margin limit.
South-Western / Thomson Learning © 2004 6 - 28
Margin Accounts: After Stock Value Decrease
Figure 6-14
Margin Account
Assets Liabilities
500 DE $35,500.00 Margin $57,660.45300 INTC 22,700.00100 RBD 3,100.00500 OCR 18,000.00
3000 BAD 3,000.00 Equity $24,639.55
$82,300.00 $82,300.00
South-Western / Thomson Learning © 2004 6 - 29
Margin Accounts: After Meeting Margin Call
Figure 6-15
Margin Account
Assets Liabilities
500 DE $35,500.00 Margin $41,150.00300 INTC 22,700.00100 RBD 3,100.00500 OCR 18,000.00
3000 BAD 3,000.00 Equity $41,150.00
$82,300.00 $82,300.00
South-Western / Thomson Learning © 2004 6 - 30
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 6 - 31
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 6 - 32
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 6 - 33
Selling Short
Short selling involves selling borrowedshares.
Rationale: Short sellers sell first and buy later.
Criticisms: pros - market exists - short selling helps offset inflationary margin buyingcons - short selling has a checkered heritage - downward pressure on price runs counter to public interest
Mechanics of a Short Sale
AA buys 100 shares of
XYZ
BB wants to short 100 shares of
XYZ
BB returns 100 shares of XYZ to
lender
DD sells 100 shares of XYZ to B
BB buys 100 shares of
XYZ
BB sells 100 shares of
XYZ
CC buys 100 shares of
XYZ from B
Broker borrows shares
Shares are held in
street name
South-Western / Thomson Learning © 2004 6 - 34
South-Western / Thomson Learning © 2004 6 - 35
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 wherethe share certificate might be held.
This is a riskless strategy designed to shift a tax liability into the future.
South-Western / Thomson Learning © 2004 6 - 36
Trading Fees: The Costs of Trading
Explicit Costs These are the direct cost of trading and include brokerage fees and taxes.
Implicit CostsThese 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 6 - 37
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 ischarged 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.
Trading Fees: The Commission Structure
South-Western / Thomson Learning © 2004 6 - 38
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 6 - 39
Trading Fees: Current Events
Insert Table 6-3 (Broker Production and Compensation) here
South-Western / Thomson Learning © 2004 6 - 40
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 6 - 41
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.
Trading Fees: Current Events
South-Western / Thomson Learning © 2004 6 - 42
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 6 - 43
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 6 - 44
Review
Trading Fees The Costs of Trading The Commission Structure Full-Service Brokers Discount Brokers Electronic Brokers Current Events