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Investor Participation in the Markets

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investor participation in the markets

Investor Participation in the Markets

Timothy R. Mayes, Ph.D.

FIN 3600: Chapter 6

types of brokerage firms
Types of Brokerage Firms
  • There are three types of brokerage firms:
    • Full Service
    • Discount
    • Deep Discount
  • The types of firms differ according to the following factors:
    • Commission
    • Research
    • Advice and Services
full service brokerage firms
Full-Service Brokerage Firms
  • Full-service brokerage firms provide exactly that, full-service.
  • They offer clients professional research reports and advice on what/when to buy and sell. They may also offer the opportunity to participate in IPOs, unit investment trusts, financial planning, and other investment products.
  • Examples of full-service brokers would include Merrill Lynch, Morgan Stanley Dean Witter, Salomon Smith Barney, and many others.
  • Full-service firms charge high commissions and sometimes account maintenance fees to cover the cost of their services.
discount brokerage firms
Discount Brokerage Firms
  • Prior to 1975, brokerage firms charged fixed commission rates. On May 1, 1975 those rates were eliminated and discount brokerage firms arrived on the scene.
  • Discount brokers originally were strictly order takers and charged commissions as much as 80% lower than full-service firms.
  • Today, the discount brokers still function primarily as order takers, but they also offer services such as mutual fund “supermarkets,” and research of other firms. Most do not offer advice.
  • Examples of discount brokers would include Charles Schwab, Quick & Reilly, Scottrade, and many others.
deep discount brokerage firms
Deep Discount Brokerage Firms
  • Deep discount brokerage firms offer commissions much lower than even discount brokers. Some are as low as $5 per trade (Brown & Co). Some “direct access” brokers are as low as $0.01 per share (Interactive Brokers).
  • Deep discounters offer few services and many offer only stock trading (no bonds, mutual funds, etc).
  • Most deep discount firms are Internet-only, offering no local branch offices and little human contact.
  • Examples would include Scottrade, E-Trade, Ameritrade, and many others.
sipc insurance
SIPC Insurance
  • Similar to the FDIC insurance for bank accounts, brokerage firms belong to the Securities Investors Protection Corporation (SIPC).
  • The SIPC, created in 1970, insures accounts up to $500,000 in securities and cash (at most $100,000 cash) in case of brokerage firm failure or unauthorized trades.
  • The SIPC does not insure you against losses, it merely assures that you will get your original stocks, bonds, and cash back up to the limits.
  • Nearly all brokerage firms have additional insurance to cover millions of dollars.
price quotes
Price Quotes
  • All traded securities have two prices:
    • Bid – This is the price that someone is willing to pay at a given point in time.
    • Ask (Offer) – This is the price that someone is offering to sell the security.
  • Normally, when you get a price quote you will be given the best bid and best ask (known as the “inside market”).
  • Assume a stock is trading at 45 – 45.15. The bid is 45 and the ask is 45.15. This is the highest bid price and lowest ask price at the moment. If you enter a market order to buy you will pay 45.15. If you enter a market order to sell the price you will receive is 45.
  • There is usually a long list of lower bids and higher asks for each stock in the limit order book.
types of orders
Types of Orders
  • In the stock market, there are three generally accepted types of orders:
    • Market orders
    • Limit orders
    • Stop orders
      • Stop Market
      • Stop Limit
  • There are also order modifiers:
    • GTC
    • Day
    • MOC/LOC
order types market orders
Order Types: Market Orders
  • A market order is an order to execute a trade at the lowest ask (market order to buy) or highest bid (market order to sell).
  • A market order is executed immediately at the best available price.
  • The advantage is that the order will definitely be filled, and it will be done immediately.
  • The disadvantage is that the price is unknown and could be higher or lower than expected (the market may move against you – this is known as slippage; the opposite is called price improvement).
order types limit orders
Order Types: Limit Orders
  • With a limit order you specify the price at which you wish to buy or sell. Your order will be executed at that price or better.
  • A limit order to buy at 45 will be executed once the ask price moves down to 45. You always place a limit order to buy at or below the current best bid.
  • A limit order to sell at 50 will be executed once the bid rises to 50 or better. Limit orders to sell are placed at above the current best ask.
  • The advantage of a limit order is that you know the price you will pay.
  • The disadvantage is that your order may never get executed if your limit price is not touched. (Remember: “That last penny can be the most expensive of all.”).
stop orders
Stop Orders
  • A stop order is one that becomes active once the specified “stop” price is touched.
  • Most stop orders are stop market orders that are executed as market orders once the stop price is touched.
  • A stop limit order has two prices (the stop price and the limit price) and becomes a limit order once the stop price is touched.
  • The most common stop order is a “stop loss.” This is an order to sell out a long position at the market when the stock falls to a specified level. Technically, this is a stop market order to sell.
  • Stop losses can be dangerous if a stock gaps down. You will be sold out at a very low price and may miss out on a chance to get out at a higher price if the stock bounces up.
  • On the other hand, stop losses can protect you from yourself. Stop loss orders placed at the time of a purchase can keep you from saying, “It’ll come back. It’ll come back.”
order modifiers
Order Modifiers
  • In the stock market, the two most common modifiers are GTC and Day. These are used only with limit and stop orders.
    • GTC – Good ‘Till Canceled. These orders remain in effect until they are executed or you cancel them. Most brokers actually require that they be renewed monthly or quarterly, or they will be automatically canceled.
    • Day – A day order is good until it is executed, or until the end of the trading day. If it is not executed by the end of trading, it will be canceled. Some brokers will allow day orders to extend into the “after hours” session if so instructed.
    • MOC/LOC – These are orders that are executed at or near the close of the market. MOC is market on close, and LOC is limit on close.
margin trading
Margin Trading
  • Approved customers (those with margin accounts, as opposed to cash accounts) are allowed to buy stocks “on margin,” that is, on credit.
  • Margin is the amount of money that you put up (collateral), the balance of the cost of the position constitutes your margin loan
  • The Federal Reserve Board’s Regulation T requires that your initial margin is 50% of the value of the trade. So a trade of $5,000 would require at least $2,500 in equity (cash or marginable securities).
  • The Fed does not regulate maintenance margin, but the NYSE and NASD require maintenance margin of at least 25%, though many brokerage firms require more. The NYSE (Rule 431) also requires that customers opening margin accounts must deposit at least $2,000.
margin trading cont
Margin Trading (cont.)
  • Since 1934, the initial margin requirement has never been below 40% (it was 100% in 1946), but before 1934 it was set by brokerage firms and was sometimes as low as 10%. It has been 50% since 1974.
  • During 1999, many brokers began requiring 100% margin on certain very volatile stocks, especially Internet stocks. Brokerage firms can set margin requirements higher than those required by Reg T or the NYSE.
  • You cannot borrow against stocks trading for less than $4 per share.
  • In 2001, the NASD and NYSE approved new rules for “Pattern Day Traders.” A person who makes 4 or more day trades in 5 days is now called a pattern day trader. These investors are required to have minimum account equity of $25,000 (which must be maintained at all times).
margin trading cont16
Margin Trading (cont.)
  • If your account equity falls below the maintenance requirement, you will receive a “margin call” requiring you to deposit funds to bring your account into compliance.
  • You will normally have at least three trading days to meet a margin call, but some brokers (especially deep discounters) will sell you out if you don’t wire funds immediately.
  • To determine the minimum amount of equity that you may have before receiving a margin call, use the following formula:
  • Where PM is the price that will trigger a margin call, P0 is the initial price of the stock, IM% is the initial margin as a percentage of portfolio value, and MM% is the maintenance margin requirement.
margin trading cont17
Margin Trading (cont.)
  • As an example, suppose that you open a margin account with $2,000 (the required minimum). You buy 100 shares of a $40 stock. What price will trigger a margin call if the maintenance margin is set at 30%?
  • Note that if the stock falls to $28.57, your equity will be $857 (you’ve lost $11.43 per share, or $1143) which is 30% of the total value of the position ($2,857)
short selling
Short Selling
  • Short selling is the process of selling securities that you don’t own (hoping they decline in value).
  • In order to short a stock, you must have a margin account and your broker must be able to borrow shares from another broker and lend them to you.
  • Obviously, you will eventually need to buy back the shares. You will profit if the shares are repurchased at a lower price.
  • Note that stocks may only be shorted on an “uptick,” though some other types of securities (ETFs and futures for example) may be shorted at any time. The uptick rule (10a-1 of the Securities Exchange Act of 1934) is currently under review by the SEC and may be eliminated (
regulation of the markets
Regulation of the Markets
  • Prior to 1933 there was very little regulation of the securities markets and the market manipulators often engaged in “bull raids” and “bear raids” on stocks. These and other tactics were used to take advantage of other investors.
  • After the great crash of 1929, congress began to look seriously at regulating the markets and eventually passed several major laws.
  • The most important of these are:
    • The Securities Act of 1933
    • The Securities Exchange Act of 1934
    • The Investment Company Act of 1940
    • The Securities Investor Protection Act of 1970
    • The Securities Acts Amendments of 1975
  • A summary of these and other laws is available at
the securities act of 1933
The Securities Act of 1933
  • The Securities Act of 1933 required that all new securities sold to the public be registered with the federal government.
  • The act requires that a registration statement (usually Form S-1) be filed with the government at least 20 days before the securities are sold, and that the securities cannot be sold until the statement is approved.
  • The Act also allows distribution of the preliminary prospectus (“Red Herring”), and publication of a “tombstone” ad. The final prospectus must be sent to all purchasers of the new security.
  • The Act allows for criminal penalties, and for investors to sue, in the event of fraud or misrepresentation in the prospectus.
the securities exchange act of 1934
The Securities Exchange Act of 1934
  • The Securities Exchange Act of 1934 extended regulation to the secondary markets.
  • Among other things, it:
    • Created the SEC (Securities Exchange Commission) and gave it the power to regulate securities markets and establish trading policies for the exchanges and self-regulatory organizations (such as the NASD)
    • Requires firms to file an annual report (Form 10-K), quarterly reports (Form 10-Q), and various other reports such as 8-K which disclose material events
    • Prohibits “insider trading”
    • Requires disclosure of tender offers for 5% or more of the outstanding shares of a public corporation
the investment company act of 1940
The Investment Company Act of 1940
  • The Investment Company Act of 1940 and the Investment Advisor Act of 1940 regulate mutual funds and other investment advisors.
  • The Investment Company Act requires that mutual funds register with the SEC and disclose their financial condition and investment policies to their investors annually.
  • The Investment Advisor Act requires that investment advisors managing more than $25 million must register with the SEC.
the securities acts amendments of 1975
The Securities Acts Amendments of 1975
  • This set of amendments to the major securities laws was important for several reasons:
    • It eliminated the fixed commissions set by the NYSE.
    • Created the national market system.
    • Allowed shelf registration of securities so that they could be issued much more quickly when needed.
    • Gave the SEC final say over any regulations proposed by self-regulatory organizations (e.g., the NYSE and NASD).
the securities investor protection act of 1970
The Securities Investor Protection Act of 1970
  • The Securities Investor Protection Act of 1970 created the Securities Investor Protection Corporation (SIPC) which we’ve discussed previously
regulation fd
Regulation FD
  • Effective 23 October 2000, Regulation FD (Fair Disclosure) requires that when companies disclose material, non-public information to certain parties (generally analysts or shareholders who may profit from the information) they must immediately disclose the same information to the public.
  • Usually, the disclosure takes the form of a press release and Form 8-K.
  • Previously, information was frequently given to analysts but not to the public which created an unfair advantage.
  • More detail on Regulation FD may be found at
exchange self regulation
Exchange Self Regulation
  • All U.S. exchanges and the NASD maintain an extensive set of rules that the exchanges, members, and listed companies must follow.
  • In addition, all exchanges conduct surveillance operations throughout the trading day to watch for suspicious trading patterns that may be evidence of manipulation.
  • They also maintain time and sales data that allows them to catch those trading illegally (such as insider trading).