Unit 8 - Trading Securities in the secondary markets

Purpose of secondary markets

• where investors can easily buy and sell securities

• for a fair price

• if very few people buy stocks, then it would be more difficult for corporations to raise capital by issuing securities

• no secondary market = little to no primary market

• trading is regulated under the Securities Exchange Act of 1934

  • created the SEC and gave it the authority to regulate securities exchanges and the OTC market

• market center → location when buyers and sellers connect to trade securities…4 in the US

  • exchanges, OTC market, third market, and fourth market

  • all of these make up the secondary market

• primary market → issuer is the seller

• secondary market → investors buy and sell securities

Exchanges - process for transactions

• New York Stock Exchange (NYSE) → model for an exchange

• Most exchanges maintain a physical location called the trading floor or just floor.

  • There are exceptions to this so don't get too stuck on this point.

  • Most of the trading happening on an exchange happens electronically and never goes to the floor.

• Trading on an exchange is done between the members of the exchange.

  • The exchanges do have employees: administrative staff, information technology staff, and others who support the exchange but are not actually doing trades.

• Exchange member firms have employees, called floor brokers, who execute trades for their firm and its customers.

• An exchange will also have members called designated market makers (DMMs). Each DMM is assigned a group of stocks (often several hundred).

  • The DMM maintains an inventory in their assigned securities, facilitates trades, and is expected to maintain a fair and orderly market in their assigned securities.

  • The DMM will buy into and sell from their inventory in order to keep markets balanced.

• Exchanges may be referred to as an auction market or a double-auction market.

  • During trading hours, floor brokers are continually placing bids on securities in order to find the best price.

• There are other exchange members, like floor traders and two-dollar brokers, who help keep trading on the exchange moving smoothly.

• Stocks that trade on an exchange are called listed stock.

OTC Markets

• Market center for smaller companies

• securities that trade OTC are called non-listed or unlisted securities

  • most debt securities trade OTC

• There is no floor. The OTC is a decentralized market.

• Trades in the OTC are between specialized broker-dealers called market makers.

• There are multiple market makers for a given stock. The market makers compete for business.

• Market makers maintain an inventory of the securities they make a market in.

  • provide liquidity for customers

• Market makers post their prices (quotes) in an electronic system so investors can see them.

• When an investor buys an OTC security, they are buying from a market maker.

• When an investor sells an OTC security, they are selling to a market maker.

• A broker-dealer may assist a customer in a trade by identifying a market maker that will be able to provide the trade the customer needs.

• A broker-dealer that assists the customer is acting as an agent, representing the customer in the trade. They will charge a commission for this service.

• A market maker makes a profit on the difference between what they pay to buy the security and what they sell it for. This is called the spread; it may also be referred to as a markup or markdown.

• A broker-dealer may not act as both the agent and a market maker on the same trade.

**Nasdaq is a registered exchange but it operates as part of the OTC market

• listed stocks but they trade through the dealer network like the OTC market

Third Market (Nasdaq Intermarket)

• OTC market makers may make a market in exchange-listed stocks

• when exchange-listed securities are traded OTC → in the third market

• securities listed on the regional exchanges are eligible for OTC trading in the third market

Fourth Market (The ECNs)

• market for institutional investors in which large blocks of stock trade, with other institutional investors and without the assistance of BDs

• take place through electronic communication networks (ECNs)

  • are open 24 hours a day

  • protects the institutional investors from revealing their trades

  • protects the market from orders that might be disruptive b/c they’re so large

• orders aren’t made public under after the trade is complete

  • happens during the dark pool

  • trades are less transparent than exchange or OTC trades

Investors

buy and sell the meet their needs and objectives

• wants to generate cash to do something else with it

• it is the seller thats the investor in the secondary market

Facilitators

assist investors in completing those trades

Retail Investors

• normal people who invest their own money to accomplish their own objective

• rules are designed to help these investors

Day trader

• trades rapidly in and out of positions

• trades throughout the day

• end the day flat (with no positions in their account)

Accredited Investors

identify as wealthier or more sophisticated retail investors

Institutional Investors

• large investor

• investment decisions for these are made by a professional (investment adviser) who is paid by the institution to manage the institution’s portfolio

Fiduciaries

• manages assets for another person

• have legal and moral obligation to perform their duties in the best interest of the beneficiary

  • the beneficiary’s interest before their own

• Custodians are those who manage a minor's account under the Uniform Transfers to Minors Act (UTMA). Custodian may also refer to a firm that holds assets in a qualified retirement account such as an IRA.

• Trustees are fiduciaries that oversee a trust. This might be a living trust, a pension trust, or any other sort of trust. If there is a trust, there will be a trustee.

• Guardians are normally court-appointed custodians over a minor or an incapacitated adult.

• Executors are custodians of estates (all the money and property owned by a particular person at death).

Investment Advisors (IAs)

• anyone who

  • (1) gives investment advice

  • (2) provides this advice as a regular part of their business; and

  • (3) does so for compensation must register as an investment adviser under the Investment Advisers Act of 1940 (federal registration) or the Uniform Securities Act (state registration)

• BDs who provide advice for a fee are subject to registration under these acts

• act as a fiduciary for a customer

Broker-Dealers (BDs)

• perform securities transactions for their own accounts or for their customers

• primary source of revenue → transaction fees (commissions or loads)

• each member firm BD operates under a membership agreement with FINRA and other self-regulatory organizations (SROs)

  • membership agreement explains what lines of business the BD undertakes

  • firms may never state that they are endorsed, approved, or recommended by a regulator

• some offer all types of investment products

• others limit the products they offer

• can incorporate proprietary trading (trading the firm’s own capital)

  • these firms stand ready to buy and sell specific securities, hoping they can profit from price swings

• other firms publish quotes to buy and sell securities (these are market makers)

• types of BDs: carrying firms, fully disclosed firms, and prime brokers

Carrying/Clearing Firms

• carries customer accounts and accepts funds and securities from customers

• capability to do trade executions, clear and settle transactions, take custody of customer funds and securities, and handle all back-office tasks

• must segregate customer funds and securities

  • can’t combine the firm’s assets with client assets

Fully Disclosed Firms

• introducing BD

• introduced its customers to a clearing firm

• the clearing firm holds the funds and securities of the introducing firm’s customers and performs related functions

• clearing firm acts as the introducing firm’s back office

• take orders from customers and pass them to a clearing firm for execution

• has the ability to execute trades but the settlement falls to the clearing firm

Prime Brokers

• prime account: allows a customer to select one member firm (the prime broker) to provide custody and other services, while calling on other firms, called executing brokers, to handle certain trades placed by the customer

• often execute some of their customers’ transactions but they have the option to send a trade to an executing broker

• to open a prime brokerage account for a customer, a member (the PB) must sign an agreement w/ the customer that spells out the terms of the business relationship and names all executing brokers the customer has contracted with

  • PB will enter in written agreements w/ each EB

• customer receives trade confirmations and account statements from the PB, who does the clearance and settlement of the trades

• key advantage → provides a client with the ability to trade with multiple brokerage houses while maintaining a centralized master account with all of the client’s cash and securities

  • includes a list of specialized services

Transfer Agents

• maintains a count of the total number of shares of a company that are authorized and outstanding

• ensuring that the company's securities are issued in the correct owner's name;

• canceling old and issuing new certificates;

• maintaining records of ownership;

• handling problems relating to lost, stolen, or destroyed certificates; and

• ensuring that shares are properly registered.

Registrars

• separate from the issuer and transfer agent

• licensed by the states and provide audit and oversight services for the transfer agents

Clearing Agencies and Depositories

• clearing agency → intermediary between the buy and sell side of a transaction

  • ensure that trades are settled correctly and that securities are properly transferred from one owner to the next

  • receives and delivers payments on behalf of both parties

  • like a bank clears checks between two parties

• Depository Trust and Clearing Corporation (DTCC) → provides custody services for virtually all securities except those subject to transfer or ownership restriction (restricted securities)

  • largest securities depository

• Options Clearing Corporation (OCC) → clearing agent for listed options contracts

Bull vs Bear

• Bull → a person believes that the market overall or a specific stock is likely to go UP in value

  • long a stock

• Bear → a person believes that the market overall or a specific stock is likely to go DOWN in value

  • short a stock

Bid, Ask, Spread

• Bid → highest amount someone is currently willing to pay for a security

  • bid price is the price a seller receives

• Ask → lowest amount someone is currently willing to sell the security

  • ask price is the price a buyer pays

• size is in round lots (each lot is 100 shares)

• quote → BCO Bid 42 Ask 42.5 size 10 × 12

• bid is always less than the ask

• spread → difference between the bid and ask prices

Quotes for Listed Stocks

• listed in an order book

• all the open limit orders for the assigned stock

• highest buy limit and lowest sell limit

Number of Shares	Sell Limit Orders	Buy Limit Orders
200	43
100	42.75
400	42.5
800	42.5
The spread, which we cover shortly.
1,000		42
300		41.75
1,500		41.5
100		41.25

• customer placing a market order to buy would pay $42.50; a market order to sell would execute at $42.

Quotes for OTC Stocks and Bonds

• highest bid from a market market and the ask is the lowest ask from a market maker

• sell to the dealer at the bid or buy from the dealer at the ask

Market Maker A	Bid 15	Ask 15.25	Size 15 × 20
Market Maker B	Bid 15.2	Ask 15.27	Size 5 × 8
Market Maker C	Bid 15.15	Ask 15.22	Size 5 × 12

quote → ABCD stock is Bid 15.2 Ask 15.22 size 5 × 12

• bonds will be quotes as a percentage of par

• stocks are priced in dollars and cents

  • inside quote → highest big and lowest ask

Market Order

• an order to buy or sell “at the market”

• want the trade done at the best available price when the order reaches the market

• There is no price restriction on a market order.

• It may be filled at any price.

• The customer won't know the price until the order is filled.

• A market order has priority over orders that have a restriction.

• Market orders are filled in the order they are received.

• If no restriction is stated when the order is entered, it is a market order.

• Market orders will normally fill at or very near the current quote, but there is no guarantee of that.

Limit Order

• specify a price that is acceptable to them

• guaranteed the limit price or better but not guaranteed a trade

• expire at the end of the trading day if not executed,

• are processed in the order received at a given price level,

• that are a buy limit orders mean that "or better" is a lower price,

• that are a sell limit orders mean that "or better" is a higher price

Stop Orders

• a trigger price that creates an order

• “if the price moves to or past this value, enter an order to do this”

• A stop order becomes a market order when the current market value of the stock moves to or through the trigger price. This is the stop price or trigger price.

• Another way to say that the trigger price was reached is to say that the order was elected.

• A sell stop is used to sell a stock if it begins to move down.

  • A sell stop will have a trigger that is below the market price when the order is entered.

  • Once triggered it becomes a market order to sell.

• A buy stop is used to buy a stock that is starting to move up.

  • A buy stop will have a trigger that is above the market price when the order is entered.

  • Once triggered it becomes a market order to buy the stock.

  • Buy stops are used by traders that want to buy a stock if it begins to move up rapidly.

• Stop orders may also be used to trigger limit orders (instead of market orders).

  • A sell stop limit order is entered with a trigger price below the market price.

  • A buy stop limit order is entered with a trigger price above the market price.

  • The trigger price and the limit price may be different values (and they usually are different).

• Stop orders are not entered until triggered. They have no place in the line (no priority) until they are triggered. The time of order entry is based on when they are triggered, not when the stop order was originally placed.

Time restrictions

• Day order. A day order is valid until the close of trading on the day it is entered. If the order has not been filled, it is canceled at the close of the day's trading. Because market orders should be filled immediately, this time limit is of more importance with limit orders. If the order is partially filled, then any unexecuted portion of the order is canceled at the end of the trading day. An order is a day order unless specified otherwise.

• Good-til-canceled (GTC) order. GTC orders are valid until executed or canceled. Broker-dealers will impose limits on how long a GTC order may remain open before being canceled. This is usually a set period from entry, and the order will stand for a period of a few months. Because this varies between BDs, the time limit is not tested.

Fill Restrictions

• Fill-or-kill (FOK) order. A FOK order is an instruction to fill the entire order immediately or kill (cancel) the order completely.

  • With a FOK order, there can't be a partial execution.

• Immediate-or-cancel (IOC) order. IOC orders are like FOK orders except that a partial execution is acceptable.

  • If only a portion of the order can be filled, it is, and the remaining unexecuted portion is canceled.

• All-or-none (AON) order. AON orders must be executed in their entirety or not at all.

  • AON orders can be day orders or GTC orders.

  • They differ from the FOKs in that they do not have to be filled immediately. They can be entered GTC.

Comparing the Roles of a BD

Broker (Agent, Agency)	Dealer (Principal, Market Maker)
Trades on behalf of customers	Trades with customers from their own inventory
Charges a commission	Maintains an inventory
	Profits on the markup (spread)

can’t be both on the same trade

Settlement Requirements

• ensures that both parties to a transaction receive what they are supposed to receive

• money to the seller and securities to a buyer

• completed in a timely manner

Regular Way Settlement

• next business day after the trade date

• T+1

Cash Settlement

• same-day settlement

• requires delivery on the same day the trade is executed

• both parties must agree

Good Delivery of Physical Certificates

• it must be

  • endorsed (signed) by all owners whose name appears on the face of the certificate and

  • signed exactly as the name appears.

• could sign a separate document called a stock power

  • common when certificates will be mailed

  • in different envelope than the certificate

Good Delivery of Book Entry Securities

• non-physical securities

• ownership records are kept at a central agency

• changes are entered on the books or electronic files

• held in street name → security is held in electronic form by a BD