PROBLEMS
4.5 A LTERNATIVE T YPES OF O RDERS A VAILABLE
It is important to understand the different types of orders available to investors irrespective of how the market is organized.
4.5.1 Market Orders
The most frequent type of order is amarket order, an order to buy or sell a stock at the best current price. An investor who enters a market sell order indicates a willingness to sell imme- diately at the highest bid available at the time the order reaches an exchange, a NASDAQ dealer, or an ECN. A market buy order indicates the investor is willing to pay the lowest offer- ing price available at the time on the exchange, the NASDAQ, or an ECN. Market orders pro- videimmediate liquidityfor an investor willing to accept the prevailing market price.
Assume you are interested in General Electric (GE) and you call your broker to find out the current“market”on the stock. The quotation machine indicates that the prevailing best market is 30 bid–30.05 ask. This means that the highest current bid on the books of the specialist or an ECN is 30; that is, $30 is the most that anyone has offered to pay for GE. The lowest offer is 30.05; that is, this is the lowest price anyone is willing to accept to sell the stock. If you placed a market buy order for 100 shares, you would buy 100 shares at $30.05 a share (the lowest ask price) for a total cost of $3,005 plus commission. If you submitted a market sell order for 100 shares, you would sell the shares at $30 each and receive $3,000 less commission.
4.5.2 Limit Orders
The individual placing alimit orderspecifies the buy or sell price. You might submit a limit- order bid to purchase 100 shares of Coca-Cola (KO) stock at $60 a share when the current market is 65 bid–65.10 ask, with the expectation that the stock will decline to $60 in the near future.
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You must also indicate how long the limit order will be outstanding. Alternative time spe- cifications are basically boundless. A limit order can be instantaneous (“fill or kill,” meaning fill the order instantly or cancel it). In the world of algorithmic trading, this is a popular time specification for high-frequency traders. It can also be good for part of a day, a full day, several days, a week, or a month. It can also be open ended, or good until canceled (GTC).
Rather than wait for a given price on a stock, because KO is listed on the NYSE your bro- ker will give the limit order to the specialist, who will put it in a limit-order book and act as the broker’s representative. When and if the market price for KO reaches the limit-order price, the specialist will execute the order and inform your broker. The specialist receives a small part of the commission for rendering this service.
4.5.3 Special Orders
In addition to these general orders, there are several special types of orders. Astop loss orderis a conditional market order whereby the investor directs the sale of a stock if it drops to a given price. Assume you buy a stock at $50 and expect it to go up. If you are wrong, you want to limit your losses. To protect yourself, you could put in a stop loss order at $45. In this case, if the stock dropped to $45, your stop loss order would become a market sell order, and the stock would be sold at the prevailing market price. The stop loss order does not guar- antee that you will get the $45; you can get a little bit more or a little bit less. Because of the possibility of market disruption caused by a large number of stop loss orders, exchanges have, on occasion, canceled all such orders on certain stocks and not allowed brokers to accept fur- ther stop loss orders on those issues.
A related stop loss tactic for an investor who has entered into a short sale is astop buy or- der. Such an investor who wants to minimize his or her loss if the stock begins to increase in value would enter this conditional buy order at a price above the short-sale price. Assume you sold a stock short at $50, expecting it to decline to $40. To protect yourself from an increase, you could put in a stop buy order to purchase the stock using a market buy order if it reached a price of $55. This conditional buy order would hopefully limit any loss on the short sale to approximately $5 a share.
4.5.4 Margin Transactions
When investors buy stock, they can pay for the stock with cash or borrow part of the cost, leveraging the transaction. Leverage is accomplished by buying on margin, which means the investor pays for the stock with some cash and borrows the rest through the broker, putting up the stock for collateral.
The dollar amount of margin credit extended by NYSE members has generally increased over time, but it is a fairly cyclical series that increases during rising markets and declines dur- ing falling markets. The interest rate charged on these loans by the investment firms is typi- cally 1.50 percent above the rate charged by the bank making the loan. The bank rate, referred to as thecall money rate, is generally about 1 percent below the prime rate. For exam- ple, in May 2011 the prime rate was 3.25 percent, and the call money rate was 2.00 percent.
Federal Reserve Board Regulations T and U determine the maximum proportion of any transaction that can be borrowed. Thismargin requirement(the proportion of total transaction value that must be paid in cash) has varied over time from 40 percent (allowing loans of 60 percent of the value) to 100 percent (allowing no borrowing). As of May 2011, the initial mar- gin requirement specified by the Federal Reserve was 50 percent, although individual invest- ment firms can require higher percents.
After the initial purchase, changes in the market price of the stock will cause changes in the investor’s equity, which is equal to the market value of the collateral stock minus the amount borrowed. Obviously, if the stock price increases, the investor’s equity as a proportion of the
total market value of the stock increases; that is, the investor’s margin will exceed the initial margin requirement.
Assume you acquired 200 shares of a $50 stock for a total cost of $10,000. A 50 percent initial margin requirement allowed you to borrow $5,000, making your initial equity $5,000.
If the stock price increases by 20 percent to $60 a share, the total market value of your posi- tion is $12,000, and your equity is now $7,000 ($12,000 − $5,000), or 58 percent ($7,000/
$12,000). In contrast, if the stock price declines by 20 percent to $40 a share, the total market value would be $8,000, and your investor’s equity would be $3,000 ($8,000−$5,000), or 37.5 percent ($3,000/$8,000).
This example demonstrates that buying on margin provides all the advantages and the dis- advantages of leverage. Lower margin requirements allow you to borrow more, increasing the percentage of gain or loss on your investment when the stock price increases or decreases. The leverage factor equals 1/percent margin. Thus, as in the example, if the margin is 50 percent, the leverage factor is 2, that is, 1/0.50. Therefore, when the rate of return on the stock is plus or minus 10 percent, the return on yourequity is plus or minus 20 percent. If the margin re- quirement declines to 33 percent, you can borrow more (67 percent), and the leverage factor is 3(1/0.33). As discussed by Ip (2000), when you acquire stock or other investments on margin, you are increasing the financial risk of the investment beyond the risk inherent in the security itself. Therefore, you should increase your required rate of return accordingly.
The following example shows how borrowing by using margin affects the distribution of your returnsbefore commissions and intereston the loan. If the stock increased by 20 percent, your return on the investment would be as follows:
1. The market value of the stock is $12,000, which leaves you with $7,000 after you pay off the loan.
2. The return on your $5,000 investment is 7,000
5,000−1=1:40−1
=0:40=40%
In contrast, if the stock declined by 20 percent to $40 a share, your return would be as follows:
1. The market value of the stock is $8,000, which leaves you with $3,000 after you pay off the loan.
2. The negative return on your $5,000 investment is 3,000
5,000−1=1:60−1
=−0:40=−40%
Notably, this symmetrical increase in gains and losses is only true prior to commissions and interest. For example, if we assume a 4 percent interest on the borrowed funds (which would be $5,000 × 0.04 = $200) and a $100 commission on the transaction, the results would indicate a lower positive return and a larger negative return as follows:
20% increase :$12,000−$5,000−$200−$100
5,000 −1=6,700
5,000−1=0:34=34%
20% decline :$8,000−$5,000−$200−$100
5,000 −1=2,700
5,000−1=−0:54=−54%
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In addition to the initial margin requirement, another important concept is the maintenance margin, which is the required proportion of your equity to the total value of the stock after the initial transaction; the maintenance margin protects the broker if the stock price declines. At present, the minimum maintenance margin specified by the Federal Reserve is 25 percent, but, again, individual brokerage firms can dictate higher margins for their custo- mers. If the stock price declines to the point where your investor’s equity drops below 25 per- cent of the total value of the position, the account is considered undermargined, and you will receive amargin callto provide more equity. If you do not respond with the required funds in time, the stock will be sold to pay off the loan. The time allowed to meet a margin call varies between investment firms and is affected by market conditions. Under volatile conditions, the time allowed to respond to a margin call can be shortened drastically (e.g., one day).
Given a maintenance margin of 25 percent, when you buy on margin you must consider how far the stock price can fall before you receive a margin call. The computation for our example is as follows: If the price of the stock isPand you own 200 shares, the value of your position is 200P and the equity in your account is (200P−$5,000). The percentage margin is (200P−5,000)/200P.
To determine the price,P, that is equal to 25 percent (0.25), we use the following equation:
200P−5,000 200P =0:25 200P−$5,000=50P
150P =$5,000 P =$33:33
Therefore, when the stock is at $33.33, the equity value is exactly 25 percent; so if the stock declines from $50 to below $33.33, you will receive a margin call.
To continue the previous example, if the stock declines to $30 a share, its total market value would be $6,000 and your equity would be $1,000, which is only about 17 percent of the total value ($1,000/$6,000). You would receive a margin call for approximately $667, which would give you equity of $1,667, or 25 percent of the total value of the account ($1,667/$6,667). If the stock declines further, you would receive additional margin calls.
4.5.5 Short Sales
Most investors purchase stock (“go long”) expecting to derive their return from an increase in value. If you believe that a stock is overpriced, however, and want to take advantage of an ex- pected decline in the price, you can sell the stock short. Ashort sale is the sale of stock that you do not own with the intent of purchasing it back later at a lower price. Specifically, you would borrowthe stock from another investor through your broker and sell it in the market.
Subsequently you would replace it by buying at a price lower (you hope) than the price at which you sold it (this is referred to as covering your short position). Although a short sale has no time limit, the lender of the shares can decide to sell the shares, in which case your broker must find another investor willing to lend the shares. For discussions of both good and bad experiences with short-selling, see Power (1993), Loomis (1996), Weiss (1996), Beard (2001), and McKay (2005).
Two technical points affect short sales.11The first technical point concerns dividends. The short seller must pay any dividends due to the investor who lent the stock. The purchaser of the short-sale stock that you borrowed receives the dividend from the corporation, so the short seller must pay a similar dividend to the person who lent the stock.
11Prior to June 2007 there was a rule that short sales of individual stocks could only be made on“upticks,”meaning the price of the short sale had to be higher than the last trade price. As discussed in Jakab (2007), this rule was elimi- nated in 2007 by the SEC.
Secondly, short sellers must post the same margin as an investor who had acquired stock.
This margin can be in cash or any unrestricted securities owned by the short seller.
To illustrate this technique and demonstrate these technical points, consider the following example using Cara Corporation stock that is currently selling for $80 a share. You believe that the stock is overpriced and decide to sell 1,000 shares short at $80. Your broker borrows the Cara Corporation stock on your behalf, sells it at $80, and deposits the $80,000 (less com- missions that we will ignore in this example) in your account. Although the $80,000 is in your account, you cannot withdraw it. In addition, you must post 50 percent margin ($40,000) as collateral. Your percent margin equals:
Percent Margin=Value of Your Equity Value of Stock Owed
The value of your equity equals: the cash from the sale of stock ($80,000), plus the required margin deposited ($40,000), minus the value of the stock owed (1,000P). Therefore, the per- cent margin at the initiation is
Percent Margin=$80,000+$40,000−$80,000
$80,000
=$40,000
$80,000 =0:50
Similar to the discussion under margin transactions, it is necessary to continue to compare the percent margin over time to the maintenance margin (assumed to be 25 percent). Notably, in the case of a short sale, a price decline is a positive event related to the percent margin. For example, if we assume that the price of Cara Corporation stock declines to $70, the percent margin would increase as follows:
Your Equity
Value of Stock Owed=$80,000+$40,000−$70,000
$70,000
=$50,000
$70,000=0:71
Alternatively, if the stock price increases to $90 a share, the percent margin would experi- ence a decline as follows:
Your Equity
Value of Stock Owed=$80,000+$40,000−$90,000
$90,000
=$30,000
$90,000=0:33
As before, it is important to determine the stock price that would trigger a margin call, which is computed as follows:
Your Equity
Value of Stock Owed=$120,000−1,000P 1,000P =0:25
=$120,000−1,000P =250P
=1,250P =120,000 P =$96
Therefore, if the stock price moves against your short sale andincreasesabove $96, you will receive a margin call. Given this unlimited upside potential (which is a negative event for the short seller), it is easy to understand why many short-sellers consistently enter stop-gain
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orders along with selling a stock short to limit this loss and possibly avoid a margin call—that is, they would put in a stop-gain order at some price below 96.
4.5.6 Exchange Market-Makers
Earlier we discussed exchange “brokers”who bring buyers and sellers together to transact but never own the asset involved (real estate brokers are a popular example). We also discussed
“dealers”who expedite transactions by buying and selling for their own account and make a living based on the bid-ask spread (the difference between what they paid for the asset [their bid price] and what they sell it for [the asking price]). As we will discuss subsequently, the NASDAQ market is composed of competing dealers who trade the stocks on that system. In contrast, the major market-makers on the U.S. listed exchanges (NYSE and AMEX) are re- ferred to as“specialists”or“designated market makers (DMM).”
The specialist (DMM) is a member of the exchange who applies to the exchange to be as- signed stocks to handle (generally 10–15). These DMMs have two major functions. First, they serve asbrokersto match buy and sell orders and to handle special limit orders placed with other brokers—they transact when the market price reaches the limit price. The second major func- tion is to act as adealerto maintain a fair and orderly market by providing liquidity when the natural flow of orders is not adequate. As noted, as a dealer he or she must buy or sell for his or her own account when public supply or demand is not enough for a continuous liquid market.
4.5.7 New Trading Systems
As daily trading volume has gone from about 5 million shares to over 2 billion shares on both the NYSE and NASDAQ, it has become necessary to introduce new technology into the trad- ing process. Following are some technological innovations that assist in the trading process.
On the NYSE:
• Super Dot.Super Dot is an electronic order-routing system through which member firms transmit market and limit orders in NYSE-listed securities directly to the posts where se- curities are traded or to the member firm’s booth. After the order has been executed, a report of execution is returned directly to the member firm office over the same electronic circuit, and the execution is submitted directly to the comparison systems. Member firms can enter market orders up to 2,099 shares and limit orders in round or odd lots up to 30,099 shares. An estimated 85 percent of all market orders enter the NYSE through the Super Dot system.
• The Display Book.The Display Book is an electronic workstation that keeps track of all limit orders and incoming market orders. This includes incoming Super Dot limit orders.
• Opening Automated Report Service (OARS).OARS, the opening feature of the Super Dot system, accepts member firms’preopening market orders up to 30,099 shares. OARS auto- matically and continuously pairs buy and sell orders and presents the imbalance to the spe- cialist prior to the opening of a stock. This system helps the specialist determine the opening price and the potential need for a preopening call market, as discussed earlier.
• Market-Order Processing. Super Dot’s postopening market-order system is designed to accept member firms’ postopening market orders up to 30,099 shares. The system pro- vides rapid execution and reporting of market orders. During 2010, 94.5 percent of market orders were executed and reported in less than 20 seconds.
• Limit-Order Processing. The limit-order processing system electronically files orders to be executed when and if a specific price is reached. The system accepts limit orders up to 99,999 shares and electronically updates the Specialists’ Display Book. Good-until- canceled orders that are not executed on the day of submission are automatically stored until executed or canceled.
On the NASDAQ:
• Small-Order Execution System (SOES). Market makers receiving SOES orders must honor their bids for automatic executions up to 1,000 shares. SOES was introduced in 1984 and became compulsory following the October 1987 crash.
• SelectNet.SelectNet is an order-routing and execution service for institutional investors that allows brokers and dealers to communicate through NASDAQ terminals instead of the phone. Once two parties agree to a trade on SelectNet, the execution is automatic.
4.5.8 Exchange Merger Mania
While the basic purpose of security markets has not changed, and the alternative orders em- ployed by investors and traders have been quite constant, a relatively recent phenomenon has been numerous mergers among exchanges both within countries and between countries.
Equally important, it is envisioned that this phenomenon will continue into the future.
Why Merger Mania? There are two major reasons why exchange merger mania started and will continue. The first reason is caused by the trend suggested in Chapter 2—the trend toward portfolios that are diversified both between countries (globally) and among asset classes. Given this dual diversification, exchanges want to be able to service individual investors, but mainly institutional investors as they buy and sell different assets (e.g., stocks, bonds, and derivatives) in global markets. (The point is, the exchanges want to provide global one-stop investing).
The second reason is the economics of high-technology trading. Earlier we discussed the trend toward electronic (computerized) trading venues that employ very sophisticated compu- ters and highly trained personnel to develop the advanced algorithms that provide fast, effi- cient trading. Two facts dominate: (1) this equipment and the personnel to operate it is very expensive, and (2) there are significant economies of scale in the operation of these systems.
This combination of high cost and required scale leads to the need for mergers within a coun- try and across countries and asset classes so the exchange can afford the equipment andthe staff as well as attain the scale required to have a profitable operation.
Some Past Mergers Following the creation of a number of ECNs in the 1990s, there were mergers of these entities into something like Archipelago (a registered stock exchange), which then acquired PCX Holdings, an electronic trader of options. In early 2006 the NYSE acquired Archipelago Holdings Co., a public company, and became a publicly traded entity, the NYSE Group, Inc. This was followed by a major merger in 2007 with Euronext NV, which itself was the product of several earlier mergers of Lisbon and Oporto, Amsterdam, Brussels, and the Paris stock exchanges and Liffe, a derivatives exchange.
During this time, NASDAQ acquired the Instinet Group, an ECN, and became a public company that acquired the Philadelphia Stock Exchange and OMX, an ECN.
In the derivatives area, the Chicago Mercantile Exchange (CME) Holding went public in 2006, and subsequently the Chicago Board of Trade (CBT) also went public. In late 2007 these two exchanges merged to create the largest derivatives exchange, and were subsequently joined by the New York Mercantile Exchange in 2008.
Another active participant has been the London Stock Exchange that rejected several offers to be acquired and, in turn, acquired the Borsa Italiana in 2007. Subsequently it attempted a merger with the Toronto Exchange (TMX Group) but this was abandoned in June, 2011.
The Present and Future It seems clear that the future financial market landscape will be made up of a relatively few large holding companies that own global exchanges for stocks, bonds, and derivatives. A major step toward such an entity was announced in February 2011 when the German Stock Exchange (Deutsche Borse) and the NYSE announced a potential merger that would create a dominant U.S.-European stock and derivatives group.12 Shortly
12For details and discussion of the proposal, see Browning, Bunge and Lucchetti (February 10, 2011).
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