Transcript Investor Participation in the Markets

Investor Participation in the Markets
Timothy R. Mayes, Ph.D.
FIN 3600: Chapter 6
Types of Brokerage Firms
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There are three types of brokerage firms:
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Full Service
Discount
Deep Discount
The types of firms differ according to the
following factors:
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Commission
Research
Advice and Services
Full-Service Brokerage Firms
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Full-service brokerage firms provide exactly that, fullservice.
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.
Discount Brokerage Firms
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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 fullservice 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.
Deep Discount Brokerage Firms
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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.
SIPC Insurance
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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.
Price Quotes
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All traded securities have two prices:
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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 – 45.15. The bid is 45 and the ask is
45.15. This is the highest bid price and lowest ask price at the
moment. If you enter a market order to buy you will pay 45.15. 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.
Types of Orders
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In the stock market, there are three generally accepted
types of orders:
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Market orders
Limit orders
Stop orders
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Stop Market
Stop Limit
There are also order modifiers:
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GTC
Day
MOC/LOC
Order Types: Market Orders
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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).
Order Types: Limit Orders
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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.”).
Stop Orders
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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.”
Order Modifiers
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In the stock market, the two most common modifiers are
GTC and Day. These are used only with limit and stop
orders.
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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.
Margin Trading
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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.
Margin Trading (cont.)
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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).
Margin Trading (cont.)
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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:
PM 
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IM %  1
 P0
MM %  1
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.
Margin Trading (cont.)
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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%?
2000
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4000  4000 2857.14
0.30  1
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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)
Short Selling
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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 (http://www.sec.gov/rules/concept/3442037.htm).
Regulation of the Markets
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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:
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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
http://www.sec.gov/about/laws.shtml
The Securities Act of 1933
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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.
The Securities Exchange Act of 1934
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The Securities Exchange Act of 1934 extended regulation
to the secondary markets.
Among other things, it:
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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
The Investment Company Act of 1940
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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.
The Securities Acts Amendments of 1975
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This set of amendments to the major securities
laws was important for several reasons:
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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).
The Securities Investor Protection Act of 1970
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The Securities Investor Protection Act of 1970
created the Securities Investor Protection
Corporation (SIPC) which we’ve discussed
previously
Regulation FD
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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
http://www.sec.gov/rules/final/33-7881.htm
Exchange Self Regulation
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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).