INVESTMENTS
Lecture 3
How Securities Are Traded
Objectives
 Explain brokers’ roles and how brokerage firms
operate
 appreciate the changing nature of the securities
business
 understand how orders to buy and sell securities
work in various marketplaces
 assess the role of regulation in the securities
markets
 understand how margin trading and short selling
contribute to investor opportunities
Investing Your Money
 Where do you go to invest and what type of
account do you want to use?

Where
• Full service broker
• Discount broker
• On-line brokerage service
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What type of account
•
•
•
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Cash account
Margin account
Asset management account
Wrap account
Market Mechanics
 Types of orders

1. Market order
• Order to buy or sell a stock at the best available
price
• Most common order type
• May be issued as a discretionary order, where your
broker has the right to hold the order in order to get
a better price.
Example #1
 Assume we want to buy 1000 shares of Disney.
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We call our broker and enter a market order for Disney.
At the time of the order the quotes on Disney are 33½
bid and 33¾ ask.
This means the highest quote the Disney specialist has
to buy Disney is 33½ and the lowest price anyone will
sell at is 33¾.
Our market order will be filled at 33¾ so our
transaction will cost $33750 plus commissions.
Example #2
 I am aware of some anecdotal evidence
regarding an investor who wanted to
purchase an internet stock.

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A market order was placed for 1000 shares at
$9 (the current price)
The order was filled at $90
The stock closed the next day at $40
Market Mechanics
 Types of orders

2. Limit Order
• A limit order is a buy or sell order that is executed at
a specified price or a more favorable price. The
limit order is given to the specialist who executes
the order when the price is met.
• Limit orders can be for virtually any time period
some typical orders are
– day order
– open-ended order (good until canceled or GTC)
Example #3
 Assume we again want to buy Disney but
do not want unless the price hits $31.
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We would make a limit buy order with a broker
at 31.
The broker will transfer the order to the
specialist who enters the order in a limit book.
Your order will be filled if the ask price of
Disney falls to or below $31.
Market Mechanics
 Types of orders
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3. Stop loss order
This is an order you put in to insure a limited
loss on a stock. Stop loss orders become a
market order once the specified price is
reached.
Example #4
 Assume we buy Disney at $31 and want to
insure we do not lose too much on the
stock.
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We can place a stop loss order at $27 and if
Disney falls to $27 the order will automatically
be executed.
In a SLO the stock might be sold at less than
$27
Market Mechanics
 Types of orders

4. Stop buy order
• Opposite of a stop loss, generally used to cover short positions
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5. Stop limit order
• Combination of a stop and limit order.
• The order becomes a limit order as soon as a bid or ask is made
at a price equal to or less favorable than the stop price.
• With a stop limit order you must give the broker two prices a
stop price and a limit price.
Example #5
 Suppose that we bought Disney for 33¾.
We want to protect ourselves against losses
so we could put a stop limit order with a
stop at 30 and a limit at 28.

Once the bid price of Disney falls below $30 a
limit order of $28 will be placed.
Market Mechanics
 Types of orders

6. Market-if-touched
• The order is executed at the best available price after
a trade occurs at a specified price. This differs from
a limit order which must be executed at the limit
price or a more favorable price.
Market Mechanics
 Short sales
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A short sale is executed when a trader expects
the price of a security to fall
Short sales involve borrowing a security and
selling it and then buying the security back at a
lower price and returning it to the owner.
Example #6
 Assume we think the price of Disney is going to
fall. We will sell Disney short in order to benefit
from this price decrease
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In order to do this we would borrow 1000 shares of
Disney and sell it for 33½. We receive $33500 for this
transaction.
If Disney falls to a $30 ask price we can buy 1000
shares of Disney for $30000 and return it to its owner.
We make
$33500 – $30000 =$3350 less commission and interest
on the transaction.
Market Mechanics
 Short sales

Short sale restrictions
• Short sales can only be made on an up-tick
• The short position owes the owner of the security
any dividends paid.
• In order to short a stock you must have a margin
account with a broker
Market Mechanics
 Margin accounts
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Margin refers to borrowing part of the cost of a
security when a purchase is made
The amount of money that is put up by the
investor is referred to as the margin.
Your broker will charge you interest on the
margin. Typical interest rates are 1.5% above
the call money rate (which is generally slightly
below the prime rate)
Market Mechanics
 Margin Accounts

Initial margin
• Initial margin is the part of the original transaction value paid
for by the investor
• Currently the initial margin requirement on stock is 50%
(required by law)
• Broker’s can charge higher initial margins

Investor’s equity
• The investor's equity position is the market value of the stock
minus the amount borrowed
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Actual margin
• (investor’s equity)/(market value)
Market Mechanics
 Margins accounts
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Maintenance margin
• Maintenance is the minimum value the actual
margin can reach before a margin call is made.
Current requirements call for a minimum
maintenance margin of 25%.
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Margin call
• A margin call requires the investor to either put up
enough cash to restore the initial margin requirement
of 50% or close the position
Example #7
 Assume we want to buy 1000 shares of Disney at
$35 using a margin account. The initial margin
requirement is 50% and the maintenance margin is
35%
 Now assume Disney goes to $45
 What is the market value?
 What is the investors equity?
 What is the actual margin?
 What is the return? Return without margin?
Example #7 (cont.)
 Now assume Disney falls to $30
 Now Disney falls to $20
 At what price will a margin call occur?
Example #8

Suppose you buy a round lot of Maginn
Industries stock on 55% margin when the stock
is selling at $20 a share. The broker charges a
10% annual interest rate and commissions are
3% of the total stock value on both purchase
and sale. A year after purchase you receive a
50 cent dividend and sell the stock for $27.
What is your rate of return on this stock?
Example #9

You decide to sell short 100 shares of Charlotte Horse
Farms when it is selling at its yearly high of 56. Your
broker tells you that the margin requirement is 45
percent and the commission on the purchase is $155.
While you are short the stock, Charlotte pays a $2.50
per share dividend. At the end of one year you buy 100
shares of Charlotte at 45 to close out your position and
are charged a commission of $145 and 8% interest on
the money borrowed. What is your rate of return on
this investment?