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

2. South-Western College Publishing ©1998 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 College Publishing ©1998 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 College Publishing ©1998 4 Outline  Brokers and Commissions  The Commission Structure  Full-Service Brokers  Discount Brokers  Electronic Brokers  Current Events

5. South-Western College Publishing ©1998 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 College Publishing ©1998 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 College Publishing ©1998 7 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: - one cancels the other - all or none - fill or kill - stop limit

8. South-Western College Publishing ©1998 8 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.

9. The Specialist and the Book  Specialists help maintain a fair and orderly market.  To tighten the spread in the market... South-Western College Publishing ©1998 9 BID ASK Price Size Firm 90 10 Specialist 90 10 Specialist 90 50 Paine Webber 90 5 DLJ 90 20 Merrill 90 10 AG Edwards 90 100 Kidder 91 35 Josephthal

10. South-Western College Publishing ©1998 10 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.

11. South-Western College Publishing ©1998 11 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

12. Types of Accounts In a cash account, an investor must have or deposit cash equal to the full value of the securities purchased. South-Western College Publishing ©1998 12 Cash Account Assets Liabilities Cash $23,089.76 500 DE 45,000.00 300 LOTS 24,000.00 100 RBD 3,000.00 500 OCR 17,437.50 Equity $112,527.26 $112,527.26 $112,527.26

13. Types of Accounts A margin account permits an investor to borrow part of the cost of investments from a brokerage firm. South-Western College Publishing ©1998 13 Margin Account Assets Liabilities 500 DE $45,000.00 Margin $33,792.10 300 LOTS 24,000.00 100 RBD 3,000.00 500 OCR 17,437.50 Equity $55,645.40 $89,437.50 $89,437.50

14. South-Western College Publishing ©1998 14 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.

15. South-Western College Publishing ©1998 15 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.

16. South-Western College Publishing ©1998 16 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.

17. South-Western College Publishing ©1998 17 Margin Accounts: Margin Calls  The investor can deposit more assets (usually cash) into the account, 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.

18. South-Western College Publishing ©1998 18 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.

19. South-Western College Publishing ©1998 19 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

20. Mechanics of a Short Sale South-Western College Publishing ©1998 20 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

21. South-Western College Publishing ©1998 21 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.

22. South-Western College Publishing ©1998 22 Brokers & Commissions: The Commission Structure  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.

23. South-Western College Publishing ©1998 23 Brokers & Commissions: Broker Types  Full-service brokers provide personalized service to their clients. e.g. Merrill Lynch, PaineWebber  Discount brokers execute trades for their clients, and little else. e.g. Charles Schwab  Electronic brokers allow their clients to place orders via the Internet. e.g. AccuTrade, E-Trade

24. South-Western College Publishing ©1998 24 Brokers & Commissions: Current Events  The median annual broker compensation has nearly doubled in a decade.  A higher commission share may encourage brokers to trade via the NASDAQ system, but spreads are sometimes wider in the OTC market.  The official SEC position seems to be that “more trades mean more commissions” tends to encourage active trading and may lead to account churning.

25. South-Western College Publishing ©1998 25 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

26. South-Western College Publishing ©1998 26 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

27. South-Western College Publishing ©1998 27 Review  Brokers and Commissions  The Commission Structure  Full-Service Brokers  Discount Brokers  Electronic Brokers  Current Events