Stock Trading and
Markets
Chapter 2.3-2.4
Chapter 3
Learning Objectives

Describe key characteristics of different types of
equity securities and equity indexes

Describe how securities are issued and traded

Describe the mechanics and risk of margin trading
and perform relevant calculations

Describe the mechanics and risk of short selling
and perform relevant calculations
2
Before You Get on the Market:
Private Firms

Generally smaller and newer companies
 Also


firms that have fallen on hard times
Kmart, Burger King
Capital comes from:
Credit Cards
2. Friends and Family
3. Angel Investors
1.

4.
Invests own older money
Venture Capital

Limited Partnerships, provide money and experience
3
Going Public: IPO

Initial Public Offering:
 When
a private firm is made public
The general public is now able to invest in the
firm
 Generally happens when a firm needs more
money than it can raise from VC’s

 Or
when the market is “hot”
4
Primary Market: IPOs & SEOs
The firm raises capital from the public by sell
newly issued securities
 Firms use an underwriter (IB) to sell securities

 Firm
receives proceeds from the sale
 Underwriter receives fees
 Investors receive shares

Must file a Prospectus


Description of firm and securities offered
Road Show, Book Building
5
Relationship Between Issuer, Underwriters, & the Public
6
Problems With the Basic IPO

Underpricing
 IPO
shares priced too low
→The firm is “leaving money on the table”

Winner’s Curse
 Because
on underpricing IPO’s are a great S.T. bet
 However, underwriters determine who can invest

Favor Bank: Giving preferential treatment to big customers
if you aren’t a big customer and you get an IPO
allocation, is it likely to be any good?
 So
7
Cost of an IPO

DRK, Inc., has just sold 250,000 shares in an
initial public offering. The underwriter’s
explicit fees were $120,000. The offering price
for the shares was $100, but immediately upon
issue, the share price jumped to $150.
 How
much did the underwriter make?
 How much did the IPO cost DRK?
8
Secondary Market

Investors trade previously issued securities
among themselves
 This

is the market we generally think/talk about
Firm does not receive any of the profits
If the firm is not engaged in these
transactions then does the firm care about
what happens? Why?
9
Types of Equity Securities

Preferred stock: Claim to a perpetual stream of firm’s cash
 No
vote
 Fixed dividends, given priority over common stock, but after
debt

Firms miss this dividend are in Arrears
 Taxed


like common stock (not tax-deductible)
Corporate tax exclusions on 70% of dividends earned
Common stock: represents Ownership of the company
 Common
equity has a claim to any residual cash
 Limited Liability
10
Financial Markets: Goals

Ideally: facilitate low-cost investment
 Provide
liquidity by minimizing time and cost
associated with trading
Bringing buyers and sellers to a single location
 Promoting price continuity
 Reduce information costs associated with investing


Reality: These are publicly traded companies,
so____________
11
Basic Order Type

Market Order: Executed immediately at best price
 Bid:
price at which dealer will buy security
 Ask: price at which dealer will sell security

Price-contingent Order: Buy/sell at specified price or
better
 Limit
buy/sell order: specifies price at which investor will
buy/sell

Will only transact at the specified price
 Stop
order: becomes a market order once a specified price is
reached


Will be filled at best possible price, which maybe above or below the
specified price
What do we know? What is uncertain?
12
Price-Contingent Orders
13
Limit Book Example




Consider the following limit order book for a share of
stock. The last trade in the stock occurred at a price of
$50. Limit Buy Orders
Limit Sell Orders
Price
Shares
Price
Shares
$49.75
500
$50.25
100
$49.50
800
$51.50
100
$49.25
500
$54.75
300
$49.00
200
$58.25
100
$48.50
600
What price will a market buy order (100 shares) be filled?
What price is the next market buy order be filled at?
Does a dealer what to increase or decrease his inventory?
14
Trading Costs
1. Brokerage Commission: fee paid to broker for making trade
2. Spread: Difference between the bid and asked prices
 This is one way to profit from making a market
Bid
 Represents offers to buy
 Investors “sell to the bid.”

Ask
 Represent offers to sell.
 Investors buy at the ask
In an efficient market trades will generally happen
between the bid and ask (mid point)
15
Types of Markets

Direct search
 Buyers
and sellers must search for each other
 No intermediaries

Brokered markets (Housing)
 Brokers

(intermediary) search out buyers and sellers
Dealer markets (NASDAQ)
 Investors
transact with a dealers who has an inventory of
assets from which they buy and sell

Auction markets (NYSE)
 Traders

converge at one place to trade
Electronic communication networks (ECNs)
 Computer
systems that can automatically execute orders
 Play an increasingly important role in our financial system 16
Rise of ECNs



1969: Instinet (first ECN) established
1975: Elimination of fixed commissions (No more easy money)
1994: NASDAQ Scandal (Dealers avoided odd 1/8)
 SEC
instituted new order-handling rules, Include ECN quotes
 ECNs given ability to register as stock exchanges



2000: Emergence of NASDAQ Stock Market
2006: NYSE acquires ECN renamed NYSE Arca
2007: Reg NMS
 All
exchanges linked electronically
 Required to honor quotes from other exchanges
 Broker needs to find best price available
17
BIG U.S. Markets

The New York Stock Exchange
 The
largest U.S. stock exchange as measured by the value
of the stocks listed on the exchange
 Automatic electronic trading runs side-by-side with
traditional broker/specialist system
 Response to 1987 crash

NASDAQ
 Lists
about 3,000 firms
 Originally, a dealer market with a price quotation system
 Now offers a sophisticated electronic trading platform with
automatic trade execution
18
New Trading Strategies: Quants

Algorithmic Trading
 Devise
complicated models with the goal of predicting price
movements and identifying mis-pricings
 Program these models into computers which then make trades

Models are guarded like nuclear launch codes
“Always trust the machine”
 More than 50% of all trades are thought to be computer initiated
 Motto

Trades are based on a proprietary model, which they
hope represents reality
 However,
NO model can full encompass the complexity of the
real world
 If model misses something → Big Issues
19
New Trading Strategies: HFT



High-Frequency Traders: Special class of algorithmic trading
HTF claims to uses computer programs to make very
rapid trading decisions (with very short order execution
time) in order to compete for very small profits
Alternative: NMS requires brokers to look for the best
prices available across multiple markets
 HFT
set small orders in all markets, looking for big orders
 Once they detect a large order they rush to the other exchanges,
Front Running the larger order
 Transact with the large order initiator at a profit

Rely heavily on speed, has led to colocation, and
private fiber optic lines
20
Widespread trends:

Market Globalization
 Alliances
& Mergers
NYSE acquired Archipelago (ECN), American Stock
Exchange, and merged with Euronext
 NASDAQ acquired Instinet/INET (ECN), Boston Stock
Exchange, and merged with OMX to form NASDAQ
OMX Group

 Moving

to automated electronic trading
Current trends will eventually result in 24-hour global
markets
21
Buying on Margin

Borrowing part of the total purchase price of a
position using a loan from a broker
 Investor
contributes the remaining portion
Margin refers to the percentage or amount
contributed by the investor
 You are leveraging your position

22
Margin Terminology

Initial Margin Requirement (IMR)
 Amount

Equity
 Position

that investor must put up set by Fed (50%)
value – Borrowing + Additional cash
Maintenance Margin Requirement
 Fed
says 25%, but brokers generally set at 30%
 Margin Call triggered when equity hits MMR

Margin Call
 Notification
is liquidated
from broker: put up more cash or position
23
Margin Call Math

Margin call triggered when:
Equity/ Market Value  MMR
 (Market

value – Borrowed) / Market Value  MMR
A margin call will occur when:
 Market
value = Borrowed/(1 − MMR)
24
Margin Call Example

We want to purchase 1,000 shares of X Corp,
which is currently trading at $70 on Margin
 IMR
is ___ %
 We have a conservative broker so MMR is 40%
 What is the market value of our position?
 How much can we borrow?
 What is our equity position?
25
Margin Call Example Continued

If the stock price falls to $60 per share what is
our equity position?
 What
is our margin %?
 Will we face a margin call?
 If not then what price will trigger a margin call?
26
Margin Example 2

Steve opens a brokerage account and purchases
100 shares of IBM at $40 per share. His broker
requires a margin of 50%. The interest rate on the
loan is 8%.
 What
is Steve’s initial equity position (margin)?
Loan?
 If the price rises to $45 at year end what is his
margin?

Hint: Don’t forget about interest
 What
was the return on the investment?
27
Short Sales

Sale of shares not owned by investor but borrowed
through broker with intention to replace later
 Purpose:
To profit from a decline in the price of a
stock or security

Mechanics
 Borrow
 Sell

stock through a dealer
it and deposit proceeds and margin in an account
Must also deposit funds out of pocket (Margin)
 Closing
out the position: Buy the stock and return to
the party from which it was borrowed
28
Steps in a Short Sale

You short 100 shares of Ford at $60 per share
 Broker
requires you deposit the $6,000 proceeds
with them in the margin account
 Plus you have to put up a 50% margin

 In

6,000 * 0.5 = 3,000
total you provide $9,000 to short the 100 shares
Only $3,000 is out of pocket
 Short
sale equity = Total margin account – Market
value

3,000 = 9,000 – 6,000
29
Short Sale Math

Maintenance margin for short sale of stock with price >
$16.75 is 30% market value

30% x $6,000 = $1,800
 You

have $1,200 excess margin
What price triggers a margin call?
When equity = (.30 x Market value)
 Total margin account – MV = (MMR * MV)
 MV = Total Margin Account / (1+MMR)
 Hint:
30
Short Example
Bill opened an account to short-sell 1,000
shares of Ford at $40 per share. The initial
margin requirement was 50%. A year later, the
price of Ford has risen from $40 to $50, and
the stock has paid a dividend of $2 per share.
 How much margin remains in the account?
 What is the short margin %?
 What is his rate of return?

31
Long & Short Cash Flows
Purchase of Stock
Time
Action
Cash Flow*
0
Buy share
− Initial price
1
Receive dividend, sell share
Ending price + Dividend
Profit = (Ending price + Dividend) – Initial price
Short Sale of Stock
Time
Action
Cash Flow*
0
Borrow share; sell it
+ Initial price
1
Repay dividend and buy share to replace − (Ending price + Dividend)
share originally borrowed
Profit = Initial price – (Ending price + Dividend)
*Note: A negative cash flow implies a cash outflow.
32
Margin Example 3
Sara opens a brokerage account and purchases
300 shares of Google for $50/share. She
borrows $5,000 from her broker for the
purchase. The interest rate on the loan is 10%.
 What is Sara’s initial margin?
 If at the end of the year the price has fallen to
$40 what is her margin? Hint: What does she owe the broker?
 What is her rate of return?

33