How Securities are Traded (ElementsOfInvestments) Flashcards
4 Types of Markets for trading securities
- Direct search markets (like a Wallapop)
- Brokered markets (broker as intermediary, real estate)
- Dealer markets or quote-driven markets (dealer posts quote, trader posts price willing to buy or sell)
- Auction markets or order-driven: stock exchanges are the premier example of this market
In a dealer (quote-driven) market, dealers set the prices at which they are willing to buy and sell securities by posting two-way quotes:
Bid price → The price at which the dealer is willing to buy the security.
Ask (offer) price → The price at which the dealer is willing to sell the security.
The spread (difference between bid and ask prices) is how the dealer makes a profit.
2 Types of Orders and their 4 subtypes
- Market Orders: executed immediately at current market prices.
- Price-contingent orders: investors place orders at specified pricing levels
- We have market sell order (total execution) or market buy order (would trade at bid side)
- Price contingent orders include limit buy and limit sell:
* In a limit buy order the investor instructs the broker to buy a number of shares at, or below a stipulated price.
* In a limit sell order the investor instructs the broker to sell a number of shares at, or above a specified limit.
For example, with Microsoft quoted 238.95/239, a ** market buy order** for 100 shares would be executed at —. A sell market order would trade ——-.
market buy order: 239
market sell order: would trade at the bid side, 238.95.
TRADING MECHANISMS
Investors willing to buy or sell securities will place an order with a ——- firm.
brokerage firm
The broker charges a commission for executing the trade. The trade can be executed through several means. Most equities now trade on electronic platforms, but even the large exchanges use a variety of trading procedures
TYPES OF TRADING SYSTEMS
Most securities, especially fixed income securities (bonds), are traded in —– markets, which means they do not trade on a centralized exchange mechanism like the NYSE or NASDAQ.
Over-the-Counter (OTC) markets
listed on Pink Sheets!
What are Pink Sheets?
listings (originally printed in pink paper) for stocks that trade OTC, rather than on a major exchange.
Most pink sheet stocks are low-priced stocks (penny stocks), and are considered highly speculative as many of these companies have little regulation, low liquidity, and limited financial disclosures.
What is an ECN?
Electronic Communication Networks
computerized system that automatically matches buy and sell orders
Most orders are limit orders, meaning traders set a maximum or minimum price they are willing to buy or sell at. The system automatically matches buyers and sellers without the need for a market maker or dealer. Execution is fast and cost-efficient, with fees typically less than a penny per share.
What is a Specialist or Designated Market Maker (DMM)?
Many Global exchanges like the NYSE were originally specialist or market maker-based markets.
type of trader responsible for maintaining an orderly market in specific stocks on an exchange
A designated market maker or “specialist” accepts the obligation to provide firm quotes on
a number of designated stocks, committing its own capital to maintain an orderly market (as the DMM use their own money to buy and sell stocks to ensure that prices are stable).
What side of trades are DMMs expected to take? Weak or strong?
Weak
meaning they buy when there are excess sell orders and sell when there are excess buy orders, to maintain market balance and stability.
How does a Designated Market Maker (DMM) provide liquidity to the market?
- using its own inventory to trade securities, thereby tightening the bid-offer (ask) spreads
- ensuring a minimum level of market depth (ensuring that there are enough trades for buying and selling)
Does the NYSE use fixed commissions?
No, they were eliminated
Regulation NMS
National Market System
integrated electronic market. REG NMS required exchanges to honor quotes from other exchanges if they
could be executed automatically.
An exchange that could not handle a quote electronically was labeled a —- and could be ignored by other participants.
“slow market”
US MARKETS
The NASDAQ stock market has about ????? listed firms. Its electronic platform, ?????? handles the
majority of its trades. NASDAQ merged in 2007 with OMX- a Swedish-Finnish company that controlled seven
Nordic/Baltic exchanges to form ?????. The company also operates an options and futures exchange in
the US.
3,000
NASDAQ Market Center
NASDAQ OMX Group
US MARKETS
Does NASDAQ operate an options and futures exchange?
Yes
US MARKETS
What are the 3 levels of NASDAQ subscribers?
Level 3: registered market makers
Level 2: can see all bid and ask quotes, but cannot enter their own quotes
Level 1: receive only the inside quotes (the inside market, the best, highest bid and the best, lower offer), but cannot see the volume on either side.
Level 3 firms profit from the bid-ask spread, trading at their own risk. They have the advantage of faster execution.
Level 2 tend to be brokerage firms that execute riskless trades for clients.
Level 1 is normally used by institutional investors who just want information on current prices
US MARKETS
What is the NYSE
largest US exchange measured by the market value of its listed companies
What is the DOT system and when was it introduced at the NYSE?
The DOT (Designated Order Turnaround) system, introduced in 1976, was the NYSE’s first step towards electronic trading, primarily used to electronically route orders to the trading floor.
NYSE
What is the SuperDOT system and how did it expand upon the original DOT system?
SuperDOT was an enhancement of the original DOT system, offering more efficient electronic order processing capabilities and handling larger order volumes.
What is Direct+, and what were its key features when launched?
Direct+ was an NYSE electronic trading system capable of automatically crossing small trades (up to 1,099 shares). In 2004, it eliminated size restrictions, allowing for the automatic processing of larger trades as well.
What is the NYSE Hybrid Market and what flexibility does it offer?
Introduced in 2006, the NYSE Hybrid Market combines electronic trading with the traditional specialist system, allowing orders to be either sent for electronic execution or directed to specialists for potential price improvement.
What is NYSE Arca and how does it function?
ECN of the NYSE
a fully electronic order matching system that facilitates direct trading among market participants without the need for traditional market makers.
ECNs use cross platform links, what is a trading system that has risen due to this?
High Frequency and Algorithmic (or Algo) trading
What is Algo trading?
Algo trading is the use of computer programs to make trading decisions. Currently, more than half of all equity volume in the US is believed to be initiated by computer algorithms.
what are algorithms that try to benefit from short term differences in the normal price relationships between
stocks or groups of stocks?
“pairs trading” algorithms
Pairs trading involves buying the underperforming stock (Apple) and selling short the overperforming stock (Microsoft) to profit from their prices realigning to their historical correlation.
What is the main trouble behind the huge rise in algorithmic and high frequency
trading?
the sudden collapse in liquidity
that algos can generate when abandoning the market in periods of turbulence
What is High frequency trading
subset of algo trading that relies on computer programs to make extremely rapid decisions
“Today, block trading has largely moved to “Dark Pools” “
What does this mean?
ECNs where participants can
anonymously buy or sell blocks.
Traders need anonymity so their decisions don’t move prices against them
the vast majority of bond trading is
OTC
What is the main cost of trading a security?
the broker’s comission
What are the 2 types of brokers?
- Full service brokers are normally referred to as account executives, financial consultants or financial advisors (FAs).
- Discount brokers only provide the basic services.
What are the basic brokerage services?
- Trade execution and settlement
- Holding securities for safekeeping (so having custoty of the securities)
- Facilitating short selling: you borrow shares from a broker and sell them at current market price, hoping to buy them back at a lower price
- Extending margin loans : you can borrow money from brokers to invest
What is Margin?
Margin is the buying and selling of securities using borrowed funds or securities.
Margin (taking leverage or leveraging a position) increases both the potential profit and the potential percentage loss of holding securities.
Equity formulas (2)
Equity = market value of the securities - borrowed amount
Equity = (initial value + margin) - market value
Margin formula
Margin = equity / market value of the securities
What is initial margin?
minimum percentage of the purchase price of a security that must be covered with the investor’s own money when buying on margin
According to the Fed’s Regulation T, this minimum is set at 50%
This means if you want to buy $10,000 worth of stock on margin, you must provide at least $5,000 in cash, and you can borrow the remaining $5,000 from your broker.
What is Maintenance Margin, and what happens if it falls below the required level?
minimum amount of equity that must be maintained in a margin account after a stock purchase is made.
FINRA sets this minimum at 25%, but brokers often require a higher %
If the margin falls below the maintenance level,
invertors will be subject to a margin call, they will be asked to deposit extra money or securities.
Margin Account Value formula
Margin Account Value =
Initial margin loan /
(1-Maintenance Margin)
What does it mean to sell a security short?
borrowing shares that you do not own, selling them at the current market price, and aiming to buy them back later at a lower price to make a profit.
What are the responsibilities of a short seller regarding distributions?
A short seller is responsible for covering any distributions such as dividends or bond coupons that occur while the securities are borrowed and sold short.
