5. Stock Trading Basics

Before we move on to investment banking and stock markets to nish upthe survey of nancial institutions, it is a good idea that we understand howstocks are traded rst.

5.1 Stock Quote

1. Bid, ask, and last pricesBuyers and sellers look at dierent prices.a) Does a small bid-ask spread indicate an active market?b) The market can be seen as a gigantic order book for now.

2. VolumeVolume alone transmits very little information.

3. SettlementAn order executed must be settled within 3 working days (T+3 Rule).

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5.2 Order Types

1. Market ordersMarket orders are buy or sell orders that are to be executed immediatelyat current market prices.

2. Price-contingent ordersInvestors also may place orders specifying prices at which they are willingto buy or sell a security.a) Limit ordersA limit buy order is to buy shares at or below a stipulated price.

b) Stop orders (stop market orders)A stop order is similar to a limit order, but once the stipulated priceis reached, the order will turn into a market order for immediateexecution.

5.3 Stock Trading Costs

Trading stocks costs investors. Some of the costs are obvious and explicit,while others are not that straightforward.

1. Explicit costsa) Brokers commissionb) Bid-ask spread

2. Implicit costsa) Impact costsIt takes time and price concessions for the market to absorb largeorders.

b) Timing costsExecution speed makes or kills a trade. The speed depends on theprivilege level and technology.

c) Opportunity costs"Youll know that to lose your position is something nobody canaord; not even John D. Rockefeller."

5.4 Leveraging Your Bets: Margin Trading 19

5.4 Leveraging Your Bets: Margin Trading

There are many reasons why investors want to leverage their bets. For some,a strong belief in a certain stocks direction calls for doubling down bets. Forothers, leveraging is the price (or the benet, depending on the angle theinvestors look) of hedging. Leveraging through derivatives, such as optionsand futures, is not covered in this principles class. Buying stocks on marginmeans investing in stocks with borrowed money. We will use the balancesheet of an investors brokerage account to explain how margin trading isconducted.

1. Before stock purchase:

2. After stock purchase:

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3. Calculation of margin (Note that margin can be either the dollar amountor the percentage. Pay attention to the context.)Margin = EquityValue of Stocka) The initial marginSet by the Fed to be 50%.

b) The maintenance marginSet by the broker. If the percentage margin falls below this level, thebroker will issue a margin call.

c) A margin callAdditional assets (cash or other securities) are required to be addedto the account. Otherwise, the broker will liquidate stocks in theaccount to restore the percentage margin.

4. An exampleYou purchased 100 shares of IBM stock on margin (50% initial margin).IBMs stock price is $100 per share at the time you purchase. Supposeyour brokers maintenance margin is 30%. When will you receive a margincall from your broker?

5.5 Short Selling

Buying stocks on margin is a long bet, while short selling is a short bet, inwhich the investors wish the stock price to decline.The short-seller completes the following steps for a short sale.

Step 1 Present margin (cash collateral) to brokerStep 2 Broker lends the shares to youStep 3 Broker helps you sell the sharesStep 4 You keep the proceeds but owe sharesStep 5 You order to buy shares to pay back debtsStep 6 Settle the transaction with your proceeds (possibly with money out

of your pocket, if the stock is on the rise)

5.6 Balance Sheet 21

5.6 Balance Sheet

What happens to the share that is borrowed and sold?

Street name securities: shares held electronically in the account of a stockbroker. The real shareholder is referred to as the benecial owner.

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5.7 Short Sale Details

1. Margin calculationMargin = EquityValue of Stock Owed

a) An example: You short sell 100 shares of IBM stock at $100 pershare. Your broker required 50% margin. How much is required inyour account for you to be able to short sell IBM? If IBMs sharesdrop to $80 per share and you immediately close your position, whatis your prot?

2. The short-seller owes dividends3. Proceeds must be kept in the account and are not generating any income.Large, institutional investors are exceptions.

5.8 Short Squeeze and Regulation

1. Unlimited losses for short sellersShort sellers are recommended to cover short positions with stop orders.

2. Short ratioIt is the percentage of oating shares being shorted.

3. Short squeezeStocks might be cornered if too many shares have already been shorted.At the rst sight of a potential price spike, the short sellers rush to reexit.

4. Bans on short salesMany policy makers believe short sellers are to blame for stock plungesbecause they induce downward pressure on share prices. During marketstresses, short sale bans are commonplace. The blame, however, is mis-placed. There is no evidence that short sales exacerbate plunges. Shortsellers bet with their own money, absorb the risk, and help discover theprice faster.

5. Un-American"Cheering for a short seller goes against the American spirit", said RichKarlgaard, Publisher of Forbes.