MARKET MECHANICS
CHAPTER SIX
Practical Investment Management
Robert A,Strong
6 - 2Strong C6 – Market Mechanics
Placing Orders,Order Information Flow
Individual Investor
Broker1,Places
order
4,Confirms
trade
Stock Exchange
Brokerage Firm
Accounting Operations
2,Submits
order3,Confirms
trade
3,Confirms trade
5,Mails
confirmation
statement
6 - 3Strong C6 – Market Mechanics
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.
6 - 4Strong C6 – Market Mechanics
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
6 - 5Strong C6 – Market Mechanics
Placing Orders,Types of Orders
Insert Figure 6-3 here.
6 - 6Strong C6 – Market Mechanics
Placing Orders,Settlement Procedures
? The activities surrounding the transfer of
ownership are called settlement procedures.
? In the United States,stock and bond
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.
6 - 7Strong C6 – Market Mechanics
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.
6 - 8Strong C6 – Market Mechanics
The Specialist and the Book
? Unless a customer indicates a contrary
wish,limit and stop orders are
automatically adjusted
downward for the payment of
a cash dividend.
6 - 9Strong C6 – Market Mechanics
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 $23,089.76
500 DE 45,000.00
300 INTC 24,000.00
100 RBD 3,000.00
500 OCR 17,437.50 Equity $112,527.26
$112,527.26 $112,527.26
6 - 10Strong C6 – Market Mechanics
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 $33,792.10
300 INTC 24,000.00
100 RBD 3,000.00
500 OCR 17,437.50
Equity $55,645.40
$89,437.50 $89,437.50
6 - 11Strong C6 – Market Mechanics
Margin Accounts,The Nature of the Debt
? An investor must pay interest on a
margin 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.
6 - 12Strong C6 – Market Mechanics
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.
6 - 13Strong C6 – Market Mechanics
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.
b al an c e
d eb i t
eq u i ty
t r eq u i r e men
ma r g i n i n i ti al
p o wer
b u yi n g
??
??
?
?
?
?
?
??
?
?
?
?
?
?? 1
1
? Buying power can be used to withdraw cash,
but the reduction in buying power will be
greater than the amount of cash
withdrawn.
6 - 14Strong C6 – Market Mechanics
Margin Accounts,Buying Power
Margin Account
Assets Liabilities
500 DE $45,000.00 Margin $51,792.10
300 INTC 24,000.00
100 RBD 3,000.00
500 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
6 - 15Strong C6 – Market Mechanics
Margin Accounts,Withdrawing Cash
Figure 6-12
Margin Account
Assets Liabilities
500 DE $45,000.00 Margin $53,718.75
300 INTC 24,000.00
100 RBD 3,000.00
500 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
6 - 16Strong C6 – Market Mechanics
Margin Accounts,Withdrawing Cash
Insert Figure 6-13 here.
Margin Account
Assets Liabilities
500 DE $45,250.00 Margin $54,939.55
300 INTC 28,500.00
100 RBD 3,100.00
500 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
6 - 17Strong C6 – Market Mechanics
Margin Accounts,Margin Calls
m a r g i n em a i n t e n a n c
b a l a n c ed e b i t v a l u e p o r t f o l i o m i n i m u m
?? 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 deposit
additional equity into a brokerage account
because the account equity fell below the
maintenance margin limit.
6 - 18Strong C6 – Market Mechanics
Margin Accounts,After Stock
Value Decrease
Figure 6-14
Margin Account
Assets Liabilities
500 DE $35,500.00 Margin $57,660.45
300 INTC 22,700.00
100 RBD 3,100.00
500 OCR 18,000.00
3000 BAD 3,000.00 Equity $24,639.55
$82,300.00 $82,300.00
6 - 19Strong C6 – Market Mechanics
Margin Accounts,After Meeting
Margin Call
Figure 6-15
Margin Account
Assets Liabilities
500 DE $35,500.00 Margin $41,150.00
300 INTC 22,700.00
100 RBD 3,100.00
500 OCR 18,000.00
3000 BAD 3,000.00 Equity $41,150.00
$82,300.00 $82,300.00
6 - 20Strong C6 – Market Mechanics
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.
6 - 21Strong C6 – Market Mechanics
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.
6 - 22Strong C6 – Market Mechanics
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.
6 - 23Strong C6 – Market Mechanics
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
Mechanics of a Short Sale
A buys 100
shares of
XYZ
B wants to
short 100
shares of
XYZ
B returns
100 shares
of XYZ to
lender
D sells 100
shares of
XYZ to B
B buys 100
shares of
XYZ
B sells 100
shares of
XYZ
C buys 100
shares of
XYZ from B
Broker
borrows
shares
Shares are
held in
street name
South-Western / Thomson Learning ? 2004 6 - 24
6 - 25Strong C6 – Market Mechanics
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.
6 - 26Strong C6 – Market Mechanics
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.
6 - 27Strong C6 – Market Mechanics
? 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.
Trading Fees,The Commission Structure
6 - 28Strong C6 – Market Mechanics
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
6 - 29Strong C6 – Market Mechanics
Trading Fees,Current Events
Insert Table 6-3 (Broker Production and
Compensation) here
6 - 30Strong C6 – Market Mechanics
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.
6 - 31Strong C6 – Market Mechanics
? 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