1. MARKET MECHANICS CHAPTER SIX Practical Investment Management Robert A. Strong

2. 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

3. 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

4. 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

5. South-Western / Thomson Learning © 2004 6 - 5 Placing Orders: Order Information Flow Individual Investor Broker 1. Places order 4. Confirms trade Stock Exchange Brokerage Firm Accounting Operations 2. Submits order 3. Confirms trade 3. Confirms trade 5. Mails confirmation statement

6. South-Western / Thomson Learning © 2004 6 - 6 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.

7. South-Western / Thomson Learning © 2004 6 - 7 Placing Orders: Types of Orders Insert Figure 6-2 here.

8. South-Western / Thomson Learning © 2004 6 - 8 Placing Orders: Types of Orders BIDVOLASKVOL 90.252590.5050 Last Trade 90.50

9. 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

10. South-Western / Thomson Learning © 2004 6 - 10 Placing Orders: Types of Orders Insert Figure 6-3 here.

11. South-Western / Thomson Learning © 2004 6 - 11 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.

12. 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.

13. South-Western / Thomson Learning © 2004 6 - 13 The Specialist and the Book Insert Figure 6-4 here.

14. South-Western / Thomson Learning © 2004 6 - 14 The Specialist and the Book Insert Figure 6-5 here.

15. South-Western / Thomson Learning © 2004 6 - 15 The Specialist and the Book Insert Figure 6-6 here.

16. South-Western / Thomson Learning © 2004 6 - 16 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.

17. South-Western / Thomson Learning © 2004 6 - 17 The Ticker Tape  Today, the tape is electronic, passing by on a screen.  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

18. South-Western / Thomson Learning © 2004 6 - 18 The Ticker Tape Insert Figure 6-8 here.

19. 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 $23,089.76 500 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

20. 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 $33,792.10 300 INTC 24,000.00 100 RBD 3,000.00 500 OCR 17,437.50 Equity $55,645.40 $89,437.50 $89,437.50

21. South-Western / Thomson Learning © 2004 6 - 21 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.

22. 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.

23. 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.  Buying power can be used to withdraw cash, but the reduction in buying power will be greater than the amount of cash withdrawn.

24. South-Western / Thomson Learning © 2004 6 - 24 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

25. South-Western / Thomson Learning © 2004 6 - 25 Margin Accounts: Withdrawing Cash Figure 6-12 Margin Account Assets Liabilities 500 DE $45,000.00 Margin $53,718.75 300 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

26. 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 $54,939.55 300 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

27. South-Western / Thomson Learning © 2004 6 - 27 Margin Accounts: Margin Calls  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.

28. 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 $57,660.45 300 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

29. 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 $41,150.00 300 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

30. 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.

31. 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.

32. 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.

33. South-Western / Thomson Learning © 2004 6 - 33 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

34. Mechanics of a Short Sale A A buys 100 shares of XYZ B B wants to short 100 shares of XYZ B B returns 100 shares of XYZ to lender D D sells 100 shares of XYZ to B B B buys 100 shares of XYZ B B sells 100 shares of XYZ C C buys 100 shares of XYZ from B Broker borrows shares Shares are held in street name South-Western / Thomson Learning © 2004 6 - 34

35. 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 where the share certificate might be held.  This is a riskless strategy designed to shift a tax liability into the future.

36. 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 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.

37. 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 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

38. 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

39. South-Western / Thomson Learning © 2004 6 - 39 Trading Fees: Current Events Insert Table 6-3 (Broker Production and Compensation) here

40. 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.

41. 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

42. 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

43. 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

44. 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