Ch 3

HOW SECURITIES ARE TRADED

(only specific topics in chapter 3 are covered)
Outcomes
• Understand different markets
• Know how trade orders are executed
• Know how to make orders to fulfill different strategies
• Understand buy on margin and short selling
Purpose of financial markets
• Without financial markets, you have to find a buyer when you want to
sell your stocks. Financial markets emerge to fulfil the needs of buyers
and sellers.
Types of Markets
• DIRECT SEARCH MARKETS
• Buyers and sellers must seek each other out directly. Such markets are
characterized by random participation and nonstandard goods (e.g. your
private tutoring services).
•
• BROKERED MARKETS
• In markets where trading in a good is active, brokers find it profitable to
offer search services to buyers and sellers. E.g. property market, where
economies of scale in searches for available homes and for prospective
buyers make it worthwhile for participants to pay brokers to conduct the
searches. Brokers in particular markets develop specialized knowledge on
valuing assets traded in that market. You should know how brokers earn
their living.
Types of Markets
• DEALER MARKETS When trading activity in a particular type of asset
increases, dealer markets arise. Dealers specialize in various assets,
purchase these assets for their own accounts, and later sell them for
a profit from their inventory. E.g. 2nd hand car market. Most bonds
trade in over-the-counter dealer markets.

• AUCTION MARKETS All traders converge at one place (either

physically or “electronically”) to buy or sell an asset. The New York
Stock Exchange (NYSE) is an example of an auction market.
•
What is the main advantage of auction markets
over dealer markets
• Answers
• As all participants converge in auction markets, they can arrive at
mutually agreeable prices and save the bid–ask spread (transaction
cost). You can find the best price more easily.
•
Concept check
• Many assets trade in more than one type of market. What types of
markets do the following trade in?
• a. Used cars
• b. Paintings
• c. Rare coins
Types of orders
1. Market order: Execute immediately at the prevailing
price
• For example, an investor check the market price of
Tencent (700) through her internet security account
and the best bid price is $308.60 and the best ask price
is $308.80, meaning that an investor would need to pay
$308.80 to purchase a share and could receive
$308.60 a share if she wished to sell some shares of
Tencent. The bid–ask spread is $0.2

• Bid price: price at which dealer will buy security

• Ask price: price at which dealer will sell security
Limitations
• Posted price quotes actually represent commitments to trade up to a
specified number of shares. If the market order is for more than this
number of shares, the order may be filled at multiple prices.
Concept check
2. If the asked price is good for orders up to 1,000 shares, and the
investor wishes to purchase 1,200 shares, how many shares will be
executed at the asked price?
volume Bid Ask volume

1200 308.6 308.8 1000

1600 308.5 308.9 600
2000 308.4 309.0 1200
4000 308.3 309.1 2000
 Types of orders
2. Price-contingent order: Buy/sell at specified price or better

• Limit order: specifies price at which investor will buy/sell

•A limit buy order will only execute at or lower than the order price
•A limit sell order will only execute at or higher than the order price

• Stop order: not to be executed until price point hit

•A stop buy order will execute once market is at or higher than order price.
•A stop sell order will execute once market is at or lower than the order
price.
Under what conditions would you place the orders mentioned above?
Limit order and Stop-loss order
• Assume you want to buy Tencent at $300( $8 below current market
price).
• You put a limit order of $300.
• You also put a good-until-cancelled stop buy order at 320
• Market rallies next day and Tencent opens at $322, your trade would be
executed at $322
• You do not constantly keep checking the stock price, when you check the
price at 2pm, Tencent is trading at $330, you have benefited from the stop
buy order.
Figure 3.5 Price-Contingent Orders
Concept check
3. What type of trading order might you give to your broker in
each of the following circumstances?
a. You want to buy shares of Intel to diversify your portfolio. You believe the
share price is approximately at the “fair” value, and you want the trade done
quickly and cheaply.
b. You want to buy shares of Intel but believe that the current stock price is too
high given the firm's prospects. If the shares could be obtained at a price 5%
lower than the current value, you would like to purchase shares for your
portfolio.
c. You plan to purchase a condominium sometime in the next month or so and
will sell your shares of Intel to provide the funds for your down payment.
While you believe that Intel share price is going to rise over the next few
weeks, if you are wrong and the share price drops suddenly, you will not be
able to afford the purchase. Therefore, you want to hold on to the shares for
as long as possible but still protect yourself against the risk of a big loss.
 Buying on Margin
• Borrowing money from a broker/bank to purchase stock.
• Try below if you cannot sleep
www.investopedia.com/video/play/buying-margin

• Initial Margin Requirement (IMR)

• an investor needs to deposit a certain amount of cash as
collateral
• E.g. for equity securities, the initial margin requirement is 50%.
• You buy 10 shares at $100/share, you need to 50% of $1000
in your account
 Buying on Margin
• 1 − IMR = Maximum % amount investor can borrow
• Maintenance margin
• minimum amount of equity that must be maintained in a margin account
• Equity: Position value (market value) – Borrowing + Additional cash
• Previous example: you borrow $500: 1000- 500 +0=500 (your equity
value), equity/position value =500/1000=50%,
• Share price drops to $90, equity=900-500=400, margin=400/900= 44%
• Margin Call
• Notification (Calls) from broker that you must put up additional
funds or have position liquidated
Buying on Margin
• Maintenance Margin Requirement (MMR)
• Minimum amount equity can be before
additional funds must be put into account
• Previous example, your margin drops to 44%, if
MMR=50%, you will receive margin call. If
MMR=40%, you will not receive margin call
Buying on Margin

• If Equity / Market value  MMR, then

margin call occurs
Market Value - Borrowed
 MMR
Market Value
• Solve for market value
• A margin call will occur when:

Borrowed
Market Value 
1  MMR
Buying on Margin
• Margin Trading: Initial Conditions
• X Corp: Stock price = $70

• 50%: Initial margin

• 40%: Maintenance margin

• 1000 shares purchased

Initial Position
Stock $70,000 Borrowed $35,000
Equity $35,000
Buying on Margin
• Stock price falls to $60 per share
• Position value – Borrowing + Additional cash

• Margin %: $25,000/$60,000 = 41.67%

New Position
Stock $60,000 Borrowed $35,000
Equity $25,000

• How far can price fall before margin call?

• Market value = $35,000/(1 – 0.40) = $58,333
Buying on Margin

• With 1,000 shares, stock price for margin

call is $58,333/1,000 = $58.333
• Margin % = $23,333/$58,333 = 40%
• To restore initial margin requirement, equity = ½
x $58,333 = $29,167

New Position
Stock $58,333(corrected) Borrowed $35,000
Equity $23,333
Short Sales
• Sale of shares not owned by investor but
borrowed through broker and later purchased
to replace loan
• Mechanics
• Borrow stock from broker; must post margin
• Broker sells stock, and deposits proceeds/margin
in margin account (you cannot withdraw proceeds
until you “cover”)
• Covering or closing out position: Buy stock; broker
returns title to party from which it was borrowed
 Short Sales: Example
• Sell 100 short shares of stock at $60 per share

• $6,000 must be pledged to broker

• Pledge 50% margin, or $3,000

• Now there is $9,000 in margin account

• Short sale equity = Total margin account – Market value

= 9000 – 6000 = 3000
Short Sales
• Example
• If the maintenance margin for short sale of
stock is 30% market value
• 30% x $6,000 = $1,800

• You have $1,200 excess margin (3000 – 1800)

• What price for margin call?

 Short Sales: Example, Margin Call
• When equity  (MMR x Market value) ---(1)

• Equity = Total margin account – Market value ---(2)

• With equation (1) and (2) above, we have equation (3)

• When Market value  Total margin account / (1 + MMR) ----(3)

• Market value  $9,000/(1 + 0.30) = $6,923, we will have margin

call
• Price for margin call: $6,923/100 shares = $69.23 or above
Short Sales: Example, Continued

• If this occurs:

• Equity = $9,000 − $6,923 = $2,077

• Equity as % market value = $2,077/$6,923 =

30%
• To restore 50% initial margin, you have to
deposit:
• ($6,923/2) − $2,077 = $1,384.50