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Understanding Securities Trading: Mechanisms, Markets, and Margin Trading Dynamics

This chapter provides a comprehensive overview of the mechanics of investing in securities, detailing how firms issue securities and the structure of secondary markets. It distinguishes between primary and secondary security sales, explaining underwritten versus best efforts arrangements. The chapter covers public offerings, private placements, and types of markets such as organized exchanges and OTC markets. Additionally, it delves into margin trading, the execution of trades, and various types of orders. Gain insights into the institutional details essential for successful investing.

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Understanding Securities Trading: Mechanisms, Markets, and Margin Trading Dynamics

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Presentation Transcript

  1. Chapter 3 How Securities are Traded

  2. Chapter Summary • Objective: To explain the institutional details and mechanics of investing in securities. • How firms issue securities • Organization of secondary markets • Trading and execution • Margin trading • Costs and regulation

  3. Primary vs. Secondary Security Sales • Primary • New issue • Key factor: issuer receives the proceeds from the sale • Secondary • Existing owner sells to another party • Issuing firm doesn’t receive proceeds and is not directly involved

  4. Investment Banking Arrangements • Underwritten vs. “Best Efforts” • Underwritten: firm commitment on proceeds to the issuing firm • Best Efforts: no firm commitment • Negotiated vs. Competitive Bid • Negotiated: issuing firm negotiates terms with investment banker • Competitive bid: issuer structures the offering and secures bids

  5. Public Offerings • Public offerings: registered with the OSC (Ontario - SEC in USA) and sale is made to the investing public • Red herring • Prompt offering prospectus • Initial Public Offerings (IPOs) • Evidence of underpricing • Performance

  6. Private Placements • Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration • Dominated by institutions • Very active market for debt securities • Not active for stock offerings

  7. Summary Reminder • Objective: To explain the institutional details and mechanics of investing in securities. • How firms issue securities • Organization of secondary markets • Trading and execution • Margin trading • Costs and regulation

  8. Types of Markets • Direct search markets • Brokered markets Block transactions • Dealer markets OTC market • Auction markets Major exchanges

  9. Organization of Secondary Markets • Organized exchanges • OTC market • Third market • Fourth market

  10. Organized Exchanges • Auction markets with centralized order flow • Dealership function: can be competitive or assigned by the exchange (specialists or registered traders) • Securities: stock, futures contracts, options, and to a lesser extent, bonds • Examples: TSE, ME, VSE, NYSE, AMEX, Regionals, CBOE

  11. OTC Market • Dealer market without centralized order flow • NASDAQ: largest organized stock market for OTC trading; information system for individuals, brokers and dealers • Levels of interaction: users, market-makers • Securities: stocks, bonds and derivatives • Most secondary bonds transactions

  12. Third Market • Trading of listed securities away from the exchange • Institutional market: to facilitate trades of larger blocks of securities • Involves services of dealers and brokers

  13. Fourth Market • Institutions trading directly with institutions • No middleman involved in the transaction • Organized information and trading systems • INSTINET • POSIT • ECN development

  14. International Market Structures • London Stock Exchange • Dealer market similar to NASDAQ • Stock Exchange Automated Quotation • Greater Anonymity • Tokyo Stock Exchange • No market making service • Sartori provides bookkeeping service • Feature a floor and electronic trading • Global market alliances

  15. Summary Reminder • Objective: To explain the institutional details and mechanics of investing in securities. • How firms issue securities • Organization of secondary markets • Trading and execution • Margin trading • Costs and regulation

  16. The execution of trades • Registered trader (market-maker) functions • Maintaining a “book” • Maintain a “fair and orderly market” • Execute “stabilizing” trades • Registered traders possess valuable inside information about the future direction of the market

  17. Types of Orders • Instructions to the brokers on how to complete the order • Market • Limit • Stop loss

  18. Summary Reminder • Objective: To explain the institutional details and mechanics of investing in securities. • How firms issue securities • Organization of secondary markets • Trading and execution • Margin trading • Costs and regulation

  19. Margin Trading • Using only a portion of the proceeds for an investment • Borrow remaining component • Margin arrangements differ for stocks and futures

  20. Stock Margin Trading • Greatest margin • Currently 30% • Set by the securities commissions • Minimum margin • Minimum level the equity margin can be (called “maintenance” in USA) • Margin call • Call for more equity funds

  21. Margin Trading - Initial Conditions X Corp $70 50% Initial Margin 30% Minimum Margin 1000 Shares Purchased Initial Position Stock $70,000 Borrowed $35,000 Equity $35,000

  22. Margin Trading - Minimum Margin Stock price falls to $60 per share New Position Stock $60,000 Borrowed $35,000 Equity $25,000 Margin% = $25,000/$60,000 = 41.67%

  23. Margin Trading - Margin Call • How far can the stock price fall before a margin call? Therefore, P = $50 Note: 1,000xP – Amount Borrowed = Equity

  24. Leveraging effect of margin purchases • You buy 200 shares of XYZ at $100, expecting a 30% appreciation of the stock in one year: • Initial margin: 50% • Financed by a 9% loan for one year • Expected net return: 51% • A 30% drop in the price, though, brings a negative rate of return of -69%.

  25. Short Sales • Purpose: to profit from a decline in the price of a stock or security Mechanics • Borrow stock through a dealer • Sell it and deposit proceeds and margin in an account • Close out the position: buy the stock and return it to the owner

  26. Short Sale - Initial Conditions Z Corp 100 Shares 50% Initial Margin 30% Minimum Margin $100 Initial Price Sale Proceeds $10,000 Margin & Equity $ 5,000 Stock Owed $10,000

  27. Short Sale - Minimum Margin Stock Price Rises to $110 Sale Proceeds $10,000 Initial Margin $ 5,000 Stock Owed $11,000 Net Equity $ 4,000 Margin % (4,000/11,000) = 36%

  28. Short Sale - Margin Call • How much can the stock price rise before a margin call? So, P = $115.38 Note: $15,000 = Initial margin + sale proceeds

  29. Summary Reminder • Objective: To explain the institutional details and mechanics of investing in securities. • How firms issue securities • Organization of secondary markets • Trading and execution • Margin trading • Costs and regulation

  30. Costs of Trading • Commission: fee paid to broker for making the transaction • Full service broker • Discount broker • Spread: cost of trading with dealer • Bid: price dealer will buy from you • Ask: price dealer will sell to you • Spread: ask - bid • Execution: better price obtained

  31. Internet Trading • On-line brokers (discount or full-service) • ECNs – electronic communication networks • Pre- and post-market trading (lack of integration, thin trading)

  32. Regulation of Securities Markets • Government Regulation • Self-Regulation in the Industry • Circuit Breakers • Insider Trading

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