Equity Market Structure and Margin Trading

EQUITY MARKET STRUCTURE

  • Quote-Driven Markets (Dealer Markets)

    • Customers trade with dealers who quote prices.
    • Also known as price-driven or over-the-counter (OTC) markets.
    • Dealers maintain inventories and profit from bid-ask spreads.
    • Trades occur via proprietary networks, phone, or messaging systems.

  • Order-Driven Markets

    • Utilize order matching systems (e.g., exchanges, brokers, ATS).
    • Orders are matched based on predefined rules.
    • Commonly found in most exchanges and automated systems.

SECONDARY TRADING MARKET ORGANIZATION

  • Call Market

    • Trades executed at specific times when the market is "called."
    • Orders collected and executed at a single price.

  • Continuous Trading Market

    • Trades may occur anytime during market hours.
    • Orders matched and executed as they arrive.

ORDER PROCEDURE RULES

  1. Price Priority

    • Orders with better prices executed first.
    • Higher bid prices take priority in buying; lower ask prices take priority in selling.

  2. Time Priority

    • For orders at the same price, the earliest order is filled first.
    • Ensures fairness with multiple orders at identical prices.

TRADE PRICING RULES

  • Uniform Pricing Rule

    • All trades execute at the same price.
    • Price chosen to maximize the number of shares traded.
    • Common in call markets and opening auctions.

  • Discriminatory Pricing Rule

    • Trades execute at the price of existing limit orders.
    • Prices may vary among trades.
    • Common in continuous trading markets.

BID AND ASK CONVENTIONS

  • Bid Price

    • Highest price a buyer is willing to pay.
    • If selling, this is the received amount.

  • Ask (Offer) Price

    • Lowest price a seller will accept.
    • If buying, this is the paid amount.

  • Bid-Ask Spread

    • The difference between bid and ask prices.
    • Indicates liquidity and constitutes dealer profit.

  • Liquidity

    • Ease of trading a security without impacting its price.
    • High liquidity implies quick transactions with minimal price effects.

BEST BID/OFFER

  • Best Bid/Offer (BBO)

    • The highest bid and lowest offer on a single exchange.

  • National Best Bid/Offer (NBBO)

    • Best available bid/offer across all U.S. exchanges.
    • Brokers must execute trades at prices at least as favorable as NBBO, per Regulation NMS.

ORDER TYPES

  • Market Order

    • Buy/sell immediately at the best available price.

  • Limit Order

    • Specific price for buying/selling.
    • Buy only at/below the limit; sell only at/above.

  • Stop Order (Stop Loss)

    • Becomes a market order at a certain triggering price.

  • Stop-Limit Order

    • Turns into a limit order once the stop price is triggered.

  • Market-if-Touched (MIT)

    • Executes a market order upon reaching a specified price.

  • Market-not-Held Order

    • Gives broker discretion over timing and pricing of execution.

  • Day Order

    • Expires at end of trading day if not executed.

  • Good Till Canceled (GTC)

    • Active until filled or canceled by the trader.

  • Fill or Kill (FOK)

    • Must be executed fully immediately, otherwise canceled.

  • All-or-None (AON)

    • Requires full execution or none at all; can stay active longer than FOK.

ELECTRONIC TRADING

  • Electronic Trading

    • Conducted via computer systems and digital platforms.
    • Orders transmitted and matched electronically.

  • Automated Trading

    • Employs algorithms for ordering decisions.
    • A subset of electronic trading.

  • High-Frequency Trading (HFT)

    • Utilizes high-speed computers and algorithms for rapid trading.
    • Focuses on speed, minimal profits per trade, and high volume.

INTERNALIZATION

  • Internalization
    • Broker fills client orders from its inventory or another customer’s order.
    • Bypasses public exchanges, speeding up execution but raising conflict-of-interest concerns.

NATIONAL MARKET SYSTEM (NMS) AND REGULATION NMS

  • National Market System (NMS)

    • Connects major U.S. exchanges, allowing stocks to be traded across platforms.
    • Enables Unlisted Trading Privileges (UTP).

  • Regulation NMS

    • SEC rules aimed at improving market efficiency and competition.
    • Key Rules:
    1. Order Protection Rule: Must execute at the best price across venues.
    2. Access Rule: Guarantees fair access to available quotes, limiting access fees.
    3. Sub-Penny Rule: Prevents price increments smaller than $0.01 (for most stocks).
    4. Market Data Rules: Ensures broad access to trading data.

TICK CONVENTIONS

  • Tick

    • Smallest permissible price movement in a security.

  • Tick Size

    • Dollar value of a tick (e.g., $0.01 for most U.S. stocks).
    • Once quoted in fractions before the 2001 decimalization.

  • Decimalization

    • Shift from fractional to decimal pricing in 2001.
    • Resulted in tighter spreads and improved price transparency.

  • Tick Size Pilot Program

    • A temporary program (2016–2018) exploring larger tick sizes for better liquidity in small-cap stocks.

MAKER-TAKER MODEL

  • Taker

    • Removes liquidity by placing marketable orders.
    • Subject to a fee by the exchange.

  • Maker

    • Provides liquidity via non-marketable limit orders.
    • Receives a rebate for providing liquidity.

  • Exchange Profit

    • Derived from the difference between takers’ fees and makers’ rebates.

  • Pros

    • Increased liquidity which can aid retail investors.

  • Cons

    • May cause brokers to prioritize payments over best execution; raises conflict-of-interest issues.

PAYMENT FOR ORDER FLOW

  • Payment for Order Flow
    • Brokers compensated for routing orders to specific dealers rather than exchanges.
    • Dealers promise slight improvements over the NBBO execution.
    • Brokers satisfy "best execution" while profiting from routing.

2010 FLASH CRASH

  • Summary

    • May 6, 2010: U.S. stock markets experienced a sharp drop, then rebounded rapidly.
    • Some trades occurred at extreme prices, later canceled under "clearly erroneous" regulations.

  • Key Findings (SEC/CFTC Report)

    • A large mutual fund used a sell algorithm to rapidly dump 75,000 E-mini contracts (~$4.1 billion).
    • The algorithm lacked price/time consideration, enabling rapid execution.
    • Coupled with low liquidity and spoofing, this triggered the crash.

  • Stub Quotes

    • Extremely high or low limit orders without intent to execute.
    • Can skew market perceptions, particularly in illiquid environments.

MARKET MANIPULATION

  • Spoofing

    • Creating fake large orders to mislead traders, subsequently canceling before execution.

  • Layering

    • Placing multiple spoofed orders at varied price levels to deceive regarding market depth.

  • Painting the Tape

    • Coordinated trades among participants creating a false sense of activity.

  • Wash Trading

    • Buying/selling a security back to oneself to misrepresent volume or manipulate taxes.

MARGIN TRADING

  • Margin

    • Amount an investor must deposit with a broker to borrow for purchasing securities.
    • Represents the investor's equity in their position.

  • Buying on Margin

    • Borrowing a portion of the purchase price from a broker to buy more securities than they could with available funds.

  • Collateral

    • Securities bought on margin serve as collateral for the broker’s loan.

  • Street Name

    • Securities acquired on margin are registered in the broker's name, not the investor's, for administrative purposes.

  • Broker’s Call Loan

    • Loan by a broker to the investor for margin purchasing.
    • Broker borrows from a bank at the call money rate, then lends to investor.

  • Call Money Rate

    • Interest rate for broker borrowing from banks for margin lending.

  • Initial Margin

    • Minimum percentage of total purchase price that an investor must pay.
    • Typical requirement is 50% (established under Regulation T).

  • Margin Account

    • Specific account type allowing investors to borrow from the broker for purchasing securities.
    • Requires a minimum deposit of at least $2,000.

  • Minimum Initial Margin

    • Set by the Federal Reserve, typically 50% of security purchase price.

  • Percentage Margin

    • Ratio of investor's equity to total securities value in margin account.
    • Calculated as: PercentageMargin=EquityinAccountTotalValueofSecuritiesPercentage Margin = \frac{Equity in Account}{Total Value of Securities}

  • Maintenance Margin

    • Minimum equity level that must be preserved in a margin account.
    • Failure to maintain leads to a margin call.

  • Margin Call

    • Broker requests additional funds/securities to meet the maintenance margin.
    • If unmet, broker may liquidate holdings to cover the loan.

MARGIN TRADING EXAMPLES

  • Example 1: Stock Price Causes Margin Call

    • Stock XYZ ($10/share, 1,000 shares) with initial margin 60% and maintenance margin 40%.
    • Investor borrows $4,000, investing $6,000.
    • If stock drops to $8/share (total value = $8,000), equity: $4,000.
    • Percentage margin: 50% (equity / stock value) - no margin call.
    • If drops to $6/share (total value = $6,000), equity: $2,000, percentage margin: 33.33% (below maintenance margin) - margin call issued.

  • Example 2: Price Causing Margin Call Calculation

    • For Stock XYZ ($10/share, 1,000 shares, 60% initial & 40% maintenance).
    • To trigger a margin call:
    • Equity=(1,000×P)−4,000Equity = (1,000 \times P) - 4,000
    • PercentageMargin=(1,000×P−4,000)1,000×P=0.40Percentage Margin = \frac{(1,000 \times P - 4,000)}{1,000 \times P} = 0.40
    • Solving for P gives $6.67 - below this price triggers a margin call.

  • Using Margin for Leverage

    • Allows control over more shares than solely using personal funds.

  • Example 1: Margin Investment Return

    • If XYZ rises 30% from $10 to $13, value increases by $3,000 on a $10,000 investment (30% return).

  • Example 2: Margin vs. Loss

    • With margin to buy 2,000 shares (borrowing $10,000), 30% rise gives 50% return.
    • Conversely, a 30% decline causes a 70% loss.

SHORT SALES TERMINOLOGY

  • Short Sale

    • Selling securities not owned, planning to buy back lower in price.
    • Shares are borrowed from a broker and sold.

  • Covering / Buying to Cover

    • Buying back to return borrowed shares.

  • Margin Requirements

    • Investor must maintain margin account and deposit funds against potential short sale losses.

  • Stock Loan Fee

    • Charge for borrowing shares to short sell.

  • Short-Interest Rebate

    • Rebate from stock lender to borrower for borrowing shares.

  • Regulation SHO

    • SEC rule mandating locating shares before short sale execution.

  • Naked Short Sales

    • Selling short without borrowing shares—illegal and could distort market.

  • Selling Short Against the Box

    • Holding a long position while simultaneously shorting the same security to hedge or lock profits.

  • Short Sale Restrictions

    • Alternative Uptick Rule: Short sales must be executed above last price or last uptick.
    • Old Uptick Rule: Allowed short sales only when the last trade exceeded prior price.

  • Short Squeeze

    • Surge in price forcing short sellers to buy back at higher rates, pushing prices higher.

  • Fails

    • Occurs when a short seller doesn't borrow or deliver stock when necessary.

SHORT SALE EXAMPLES

  • Example: Short Sale Profit

    • Sell 1,000 shares XYZ at $100/share (50% initial margin, 30% maintenance margin).
    • If price drops to $70, buy back at $70, yielding $30,000 profit.

  • Example: Short Sale Margin Call

    • If XYZ price rises instead, margin call risk emerges.
    • If rises to $115.38/share, additional funds are needed to meet maintenance margin.