1. Investor Participation in the Markets
Timothy R. Mayes, Ph.D.
FIN 3600: Chapter 6

2. Types of Brokerage Firms
There are three types of brokerage firms:
Full Service
Discount
Deep Discount
The types of firms differ according to the following factors:
Commission
Research
Advice and Services

3. Full-Service Brokerage Firms
Full-service brokerage firms provide exactly that, full-service.
They offer clients professional research reports and advice on what/when to buy and sell. They may also offer the opportunity to participate in IPOs, unit investment trusts, financial planning, and other investment products.
Examples of full-service brokers would include Merrill Lynch, Morgan Stanley Dean Witter, Salomon Smith Barney, and many others.
Full-service firms charge high commissions and sometimes account maintenance fees to cover the cost of their services.

4. Discount Brokerage Firms
Prior to 1975, brokerage firms charged fixed commission rates. On May 1, 1975 those rates were eliminated and discount brokerage firms arrived on the scene.
Discount brokers originally were strictly order takers and charged commissions as much as 80% lower than full-service firms.
Today, the discount brokers still function primarily as order takers, but they also offer services such as mutual fund “supermarkets,” and research of other firms. Most do not offer advice.
Examples of discount brokers would include Charles Schwab, Quick & Reilly, Scottrade, and many others.
The fixed commission rates were set by the NYSE with approval by the SEC. The SEC issued a rule ending these fixed rates under pressure from congress, the Justice Department and the courts.

5. Deep Discount Brokerage Firms
Deep discount brokerage firms offer commissions much lower than even discount brokers. Some are as low as $5 per trade (Brown & Co). Some “direct access” brokers are as low as $0.01 per share (Interactive Brokers).
Deep discounters offer few services and many offer only stock trading (no bonds, mutual funds, etc).
Most deep discount firms are Internet-only, offering no local branch offices and little human contact.
Examples would include Scottrade, E-Trade, Ameritrade, and many others.

6. Source: The Wall Street Journal, 11 July 2006 page D1.
I have deleted two companies from the graphic in order to make it fit.

7. SIPC Insurance
Similar to the FDIC insurance for bank accounts, brokerage firms belong to the Securities Investors Protection Corporation (SIPC).
The SIPC, created in 1970, insures accounts up to $500,000 in securities and cash (at most $100,000 cash) in case of brokerage firm failure or unauthorized trades.
The SIPC does not insure you against losses, it merely assures that you will get your original stocks, bonds, and cash back up to the limits.
Nearly all brokerage firms have additional insurance to cover millions of dollars.
Technically, the SIPC insurance covers insolvency of only clearing firms. In some cases, two firms are involved: the introducing broker (which employs the broker who deals directly with the customer) and the clearing firm (which actually maintains the account and executes the trades). Larger firms typically clear their own trades.

8. Price Quotes All traded securities have two prices:
Bid – This is the price that someone is willing to pay at a given point in time.
Ask (Offer) – This is the price that someone is offering to sell the security.
Normally, when you get a price quote you will be given the best bid and best ask (known as the “inside market”).
Assume a stock is trading at 45 – The bid is 45 and the ask is This is the highest bid price and lowest ask price at the moment. If you enter a market order to buy you will pay If you enter a market order to sell the price you will receive is 45.
There is usually a long list of lower bids and higher asks for each stock in the limit order book.
Note that this bid/ask spread is a cost of your trade just as much as the commission is. Suppose that you purchased the above stock at If you then turn around and sell it immediately, you will get a price of 45. In other words, you lose $0.15 per share, which is $15 per 100 shares. That’s more than the commission that many deep discount brokerage firms would charge. Even if you don’t sell immediately, you’ll always be selling at the best bid which is lower than the best ask. Therefore, you’ll always have to bear this cost, no matter when you sell.

9. Types of Orders
In the stock market, there are three generally accepted types of orders:
Market orders
Limit orders
Stop orders
Stop Market
Stop Limit
There are also order modifiers:
GTC
Day
MOC/LOC

10. Order Types: Market Orders
A market order is an order to execute a trade at the lowest ask (market order to buy) or highest bid (market order to sell).
A market order is executed immediately at the best available price.
The advantage is that the order will definitely be filled, and it will be done immediately.
The disadvantage is that the price is unknown and could be higher or lower than expected (the market may move against you – this is known as slippage; the opposite is called price improvement).

11. Order Types: Limit Orders
With a limit order you specify the price at which you wish to buy or sell. Your order will be executed at that price or better.
A limit order to buy at 45 will be executed once the ask price moves down to 45. You always place a limit order to buy at or below the current best bid.
A limit order to sell at 50 will be executed once the bid rises to 50 or better. Limit orders to sell are placed at above the current best ask.
The advantage of a limit order is that you know the price you will pay.
The disadvantage is that your order may never get executed if your limit price is not touched. (Remember: “That last penny can be the most expensive of all.”).

12. Stop Orders
A stop order is one that becomes active once the specified “stop” price is touched.
Most stop orders are stop market orders that are executed as market orders once the stop price is touched.
A stop limit order has two prices (the stop price and the limit price) and becomes a limit order once the stop price is touched.
The most common stop order is a “stop loss.” This is an order to sell out a long position at the market when the stock falls to a specified level. Technically, this is a stop market order to sell.
Stop losses can be dangerous if a stock gaps down. You will be sold out at a very low price and may miss out on a chance to get out at a higher price if the stock bounces up.
On the other hand, stop losses can protect you from yourself. Stop loss orders placed at the time of a purchase can keep you from saying, “It’ll come back. It’ll come back.”

13. Order Modifiers
In the stock market, the two most common modifiers are GTC and Day. These are used only with limit and stop orders.
GTC – Good ‘Till Canceled. These orders remain in effect until they are executed or you cancel them. Most brokers actually require that they be renewed monthly or quarterly, or they will be automatically canceled.
Day – A day order is good until it is executed, or until the end of the trading day. If it is not executed by the end of trading, it will be canceled. Some brokers will allow day orders to extend into the “after hours” session if so instructed.
MOC/LOC – These are orders that are executed at or near the close of the market. MOC is market on close, and LOC is limit on close.

14. Margin Trading
Approved customers (those with margin accounts, as opposed to cash accounts) are allowed to buy stocks “on margin,” that is, on credit.
Margin is the amount of money that you put up (collateral), the balance of the cost of the position constitutes your margin loan
The Federal Reserve Board’s Regulation T requires that your initial margin is 50% of the value of the trade. So a trade of $5,000 would require at least $2,500 in equity (cash or marginable securities).
The Fed does not regulate maintenance margin, but the NYSE and NASD require maintenance margin of at least 25%, though many brokerage firms require more. The NYSE (Rule 431) also requires that customers opening margin accounts must deposit at least $2,000.
Note: The margin I am discussing here is not the same as margin in the futures markets. Futures market margins are good faith deposits, they do not in any way represent collateral for a loan.

15. Margin Trading (cont.)
Since 1934, the initial margin requirement has never been below 40% (it was 100% in 1946), but before 1934 it was set by brokerage firms and was sometimes as low as 10%. It has been 50% since 1974.
During 1999, many brokers began requiring 100% margin on certain very volatile stocks, especially Internet stocks. Brokerage firms can set margin requirements higher than those required by Reg T or the NYSE.
You cannot borrow against stocks trading for less than $4 per share.
In 2001, the NASD and NYSE approved new rules for “Pattern Day Traders.” A person who makes 4 or more day trades in 5 days is now called a pattern day trader. These investors are required to have minimum account equity of $25,000 (which must be maintained at all times).
Notes:
Pattern Day Traders are defined in NASD Rule 2520 which went into effect on 28 September In addition to having 4 day trades in 5 days, those trades must amount to more than 6% of trading activity in those 5 days. Day-trading buying power is limited to four (4) times maintenance margin excess.

16. Margin Trading (cont.)
If your account equity falls below the maintenance requirement, you will receive a “margin call” requiring you to deposit funds to bring your account into compliance.
You will normally have at least three trading days to meet a margin call, but some brokers (especially deep discounters) will sell you out if you don’t wire funds immediately.
To determine the minimum amount of equity that you may have before receiving a margin call, use the following formula:
Where PM is the price that will trigger a margin call, P0 is the initial price of the stock, IM% is the initial margin as a percentage of portfolio value, and MM% is the maintenance margin requirement.
Derivation of margin call formula:
Definitions:
P0 = Value of portfolio at the time borrowed funds are initially used
E0 = Portfolio equity at time period 0
P1 = Value of portfolio at time period 1 (some arbitrary amount of time in the future)
E1 = Portfolio equity at time period 1
PM = Value of portfolio that will trigger a margin call
EM = Portfolio equity when a margin call is made
IM% = The amount of equity at time period 0 divided by P0
MM% = The required minimum equity as a percent of the portfolio value
Note that at time period 0 your equity (dollars) is given by:
E0 = IM% x P0
and, if the portfolio value has fallen, then your equity has fallen by:
Loss = P0 – P1
So that your equity at period 1 is:
E1 = IM% x P0 – (P0 – P1)
Now, a margin call will be triggered when E1 falls to EM, and your equity as a percentage of portfolio value is:
CM% = E1/P1
If we set CM% equal to MM%, we will know what your equity (in dollars) will be when a margin call is made:
MM% = EM/PM
Now, substituting in for EM, we find that:
MM% = [IM% x P0 – (P0 – PM)]/PM
Solve for PM:
MM% x PM = IM% x P0 – P0 + PM
MM% x PM = P0(IM% - 1) + PM
MM% x PM - PM = P0(IM% - 1)
PM(MM% - 1) = P0(IM% - 1)
PM = (IM% - 1)/(MM% - 1) P0
QED.

17. Margin Trading (cont.)
As an example, suppose that you open a margin account with $2,000 (the required minimum). You buy 100 shares of a $40 stock. What price will trigger a margin call if the maintenance margin is set at 30%?
Note that if the stock falls to $28.57, your equity will be $857 (you’ve lost $11.43 per share, or $1143) which is 30% of the total value of the position ($2,857)

18. Short Selling
Short selling is the process of selling securities that you don’t own (hoping they decline in value).
In order to short a stock, you must have a margin account and your broker must be able to borrow shares from another broker and lend them to you.
Obviously, you will eventually need to buy back the shares. You will profit if the shares are repurchased at a lower price.
Note that stocks may only be shorted on an “uptick,” though some other types of securities (ETFs and futures for example) may be shorted at any time. The uptick rule (10a-1 of the Securities Exchange Act of 1934) is currently under review by the SEC and may be eliminated (
When you open a margin account, among the forms you will have to sign is one called a “Hypothecation” agreement. This allows your broker to lend any shares held in your margin account. If you don’t wish you shares to be loaned out, you must either hold the shares in a separate cash account, or have the certificates in your possession.

19. Regulation of the Markets
Prior to 1933 there was very little regulation of the securities markets and the market manipulators often engaged in “bull raids” and “bear raids” on stocks. These and other tactics were used to take advantage of other investors.
After the great crash of 1929, congress began to look seriously at regulating the markets and eventually passed several major laws.
The most important of these are:
The Securities Act of 1933
The Securities Exchange Act of 1934
The Investment Company Act of 1940
The Securities Investor Protection Act of 1970
The Securities Acts Amendments of 1975
A summary of these and other laws is available at

20. The Securities Act of 1933
The Securities Act of 1933 required that all new securities sold to the public be registered with the federal government.
The act requires that a registration statement (usually Form S-1) be filed with the government at least 20 days before the securities are sold, and that the securities cannot be sold until the statement is approved.
The Act also allows distribution of the preliminary prospectus (“Red Herring”), and publication of a “tombstone” ad. The final prospectus must be sent to all purchasers of the new security.
The Act allows for criminal penalties, and for investors to sue, in the event of fraud or misrepresentation in the prospectus.

21. The Securities Exchange Act of 1934
The Securities Exchange Act of 1934 extended regulation to the secondary markets.
Among other things, it:
Created the SEC (Securities Exchange Commission) and gave it the power to regulate securities markets and establish trading policies for the exchanges and self-regulatory organizations (such as the NASD)
Requires firms to file an annual report (Form 10-K), quarterly reports (Form 10-Q), and various other reports such as 8-K which disclose material events
Prohibits “insider trading”
Requires disclosure of tender offers for 5% or more of the outstanding shares of a public corporation

22. The Investment Company Act of 1940
The Investment Company Act of 1940 and the Investment Advisor Act of 1940 regulate mutual funds and other investment advisors.
The Investment Company Act requires that mutual funds register with the SEC and disclose their financial condition and investment policies to their investors annually.
The Investment Advisor Act requires that investment advisors managing more than $25 million must register with the SEC.

23. The Securities Acts Amendments of 1975
This set of amendments to the major securities laws was important for several reasons:
It eliminated the fixed commissions set by the NYSE.
Created the national market system.
Allowed shelf registration of securities so that they could be issued much more quickly when needed.
Gave the SEC final say over any regulations proposed by self-regulatory organizations (e.g., the NYSE and NASD).

24. The Securities Investor Protection Act of 1970
The Securities Investor Protection Act of 1970 created the Securities Investor Protection Corporation (SIPC) which we’ve discussed previously

25. Regulation FD
Effective 23 October 2000, Regulation FD (Fair Disclosure) requires that when companies disclose material, non-public information to certain parties (generally analysts or shareholders who may profit from the information) they must immediately disclose the same information to the public.
Usually, the disclosure takes the form of a press release and Form 8-K.
Previously, information was frequently given to analysts but not to the public which created an unfair advantage.
More detail on Regulation FD may be found at

26. Exchange Self Regulation
All U.S. exchanges and the NASD maintain an extensive set of rules that the exchanges, members, and listed companies must follow.
In addition, all exchanges conduct surveillance operations throughout the trading day to watch for suspicious trading patterns that may be evidence of manipulation.
They also maintain time and sales data that allows them to catch those trading illegally (such as insider trading).
Here’s a quote from the NYSE Web site about market surveillance (
Sophisticated technology and pattern recognition systems are used by the staff to detect and investigate activity that may violate Exchange rules or federal securities laws.   Such activity may involve:
1) insider trading
2) market manipulation
3) breaches of fiduciary duties
4) violation of agency responsibility and investor protection rules
5) failure by specialists to maintain fair and orderly markets in listed securities and products, and
6) violation of rules governing members’ on-Floor trading and auction market procedures.
When Market Surveillance detects possible insider trading that involves corporate employees, officers or directors of a listed company, or members of the public, it refers these cases to the SEC.   If cases are prosecuted by the SEC or the U.S. Attorney's office, Market Surveillance staff provides expertise, trading data and may even serve as expert witnesses.