Investor Participation in the Markets

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Investor Participation in the Markets

• Timothy R. Mayes, Ph.D.
• FIN 3600 Chapter 6

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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

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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.

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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.

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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.

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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.

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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.

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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

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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).

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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.).

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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,
  Itll come back. Itll come back.

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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.

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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 Boards 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.

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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).

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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 dont 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.

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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 (youve lost 11.43 per
  share, or 1143) which is 30 of the total value
  of the position (2,857)

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Short Selling

• Short selling is the process of selling
  securities that you dont 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
  (http//www.sec.gov/rules/concept/34-42037.htm).

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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
  http//www.sec.gov/about/laws.shtml

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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.

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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

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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.

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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).

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The Securities Investor Protection Act of 1970

• The Securities Investor Protection Act of 1970
  created the Securities Investor Protection
  Corporation (SIPC) which weve discussed
  previously

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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
  http//www.sec.gov/rules/final/33-7881.htm

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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).