1/25/2016. Principles of Securities Trading. Overview. How do we describe trades? FINC-UB.0049, Spring 2016 Prof. Joel Hasbrouck

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1 Principles of Securities Trading FINC-UB.0049, Spring 2016 Prof. Joel Hasbrouck 1 Overview How do we describe a trade? How are markets generally organized? What are the specific trading procedures? How does information affect markets? 2 How do we describe trades? A trade has two sides. Buyer and seller Who bought? Who sold? Trading party and counterparty The side that we re primarily interested in (usually ourselves) is the trading party. The other side is the counterparty. Example: I bought 1,000 shares of Microsoft. I m the buyer and the trading party; the seller is my counterparty. In the trading game, my counterparty is my opponent. 3 1

2 Why do we focus one side of the trade? A news report: Buyers dominated stock trading today, driving prices higher. The traditional economist says, This statement is meaningless, because: For every buyer there is a seller; for every seller there is a buyer. They both had to agree to the price. You can t attribute a price change to one side or the other. 4 The traditional view leaves some things out. In any given situation, the buyer and seller aren t behaving in the same way. One side might shout louder, act with greater urgency, appear more desperate. They will have a greater effect on the price. 5 How are markets organized? Search markets Potential buyers and sellers try to locate counterparties directly By advertising in newspapers, posting to bulletin boards, web boards (Craigslist), etc. There aren t many (any?) securities traded entirely in search markets. But directed search is more common. A broker looking for a buyer of 100,000 shares of XYZ might send an indication of interest (IOI) to investors who already own XYZ, to see if they want to buy more. 6 2

3 Brokered markets A broker is an agent (working on behalf of a buyer or seller) Agent or agency is a legal term that implies certain responsibilities. In a brokered market, most buyers and or sellers use brokers to locate a counterparty. Stock brokers don t normally perform this role, so the stock market is not usually considered a brokered market. Examples: real estate, business brokers. 7 Dealer markets Like a broker, a dealer may assist in a trade. Crucial distinction: a dealer acts as a counterparty to the customer. If I m trying to sell a house, a real estate broker will help me find a buyer, but she won t buy the house herself. If I m trying to sell some Treasury bonds, a treasury bond dealer will buy them from me. Widely used in securities markets (FX, bonds, Over the counter derivatives) 8 Exchange markets An exchange is an organized and centralized trading facility. A floor market has a physical room, pit or other location where buyers and sellers meet. In most present-day exchanges, buyers and sellers meet virtually (on a computer system). Centralized does not mean, there s only one exchange. Microsoft stock trades on multiple exchanges. Exchange trading is widely used for stocks, options and futures. The best known US exchanges are the New York Stock Exchange (NYSE) and Nasdaq. 9 3

4 What are the specific trading procedures (the actual trading mechanisms)? Bilateral (two-sided) bargaining. Buyer and seller negotiate directly. Face-to-face trading on an exchange floor. One-sided auctions. One seller with many potential buyers. One-sided sellers auctions are used for One buyer with many with many potential sellers. One-sided buyers auctions are used for 10 Double-sided auctions. Many buyers; many sellers. Used to open the NYSE and NASDAQ. Continuous double-auction. Buyers and sellers can enter bids and offers at any time. Trades occur when prices match. Continuous trading sessions on NYSE and NASDAQ. 11 Trading, clearing, and settlement A trade is an agreement, a commitment. On Monday at 10 am, I buy 100 shares of Microsoft (ticker symbol MSFT) for $32 per share. Clearing The buyer and seller (or their brokers) confirm the terms of the trade. Settlement The legal transfer of ownership and payment. On Thursday, I actually take possession of the shares. My bank account (or brokerage account) is debited by $3,200. Monday, Tuesday, Wednesday, Thursday. In US equities markets, settlement is T+3 ( Tee plus three ). 12 4

5 Markets respond to information Public information News, accounting statements, market data. Informational efficiency The principle that the value of information can be determined by how much it moves prices. This is a legal as well an economic principle. We ll study some 10b-5 class-action lawsuits. Private information Things not publicly known; judgments formed from analysis and insight. Since private information isn t known, how can it affect prices? When is private information is considered illegal ( inside ) information? We ll study some recent insider trading cases. 13 Securities Trading: Principles and Procedures Chapter 2 Overview of the US equity market 14 Outline Most of what we study in this course is applicable to all markets. We often come back to the US equity market as a specific example. Describing the US equity market requires knowing a bit about Stocks Exchanges Players and their motives Brokers Prices The make or take decision. The buzzwords: liquidity, transparency, and latency Regulation 15 5

6 Stock Stock shares represent partial ownership of a corporation. The owner of a share is entitled to: A share of the corporation s net income. A vote in electing the corporation s directors or other major decisions. The first public sale of stock is called the initial public offering (IPO). Additional sales are considered to be seasoned offerings. After the offering, most shares trade in exchange markets. 16 The largest stock exchanges (Table 2-1) Domestic Market Value of EOB Trading Capitalization (Millions, Millions, End of Year, 2015) Calendar Year 2015 Turnover Currency Nasdaq - US 7,280,752 12,515, USD NYSE 17,786,787 17,477, USD Japan Exchange Group 589,788, ,342, JPY Shanghai Stock Exchange 29,519, ,741, CNY Euronext 3,025,561 1,882, EUR NASDAQ OMX Nordic Exchange 1,160, , EUR 17 Exchanges Marketplaces Also: trading venues, market centers Examples New York Stock Exchange (NYSE) Nasdaq (from National Association of Securities Dealers Automated Quotations ) An exchange s products and services usually cover: Listing Trading Information 18 6

7 Listing IBM is an NYSE-listed corporation. The NYSE (listing exchange) provides Certification and sponsorship Monitors the trading process IBM ( listed firm ) must: Meet financial and governance conditions. Pay a listing fee (depends on size, about $100,000) A listing is (in practice) necessary for a stock to be traded. 19 Trading services and facilities Computer and communication systems Fee structures are complex. Members have high fixed costs, but lower costs per message, per order, per trade, etc. Speed is priced. 20 Information (market data) Especially Last sale prices Current bid and ask prices. Real-time order-book data. Market data generates substantial revenues. 21 7

8 Most exchanges are owned by holding companies. Intercontinental Exchange ( ICE ) owns 11 exchanges, including New York Stock Exchange (NYSE). Euronext owns and operates the Paris, Lisbon, Brussels, Amsterdam Exchanges Nasdaq-OMX runs The Nasdaq Stock Market, OMX Nordic, etc. Historically, exchanges were member-owned cooperatives. A membership ( seat ) gave ownership rights and trading rights. Currently most exchanges are for-profit, publicly-held corporations. They have stockholders and (trading) members. 22 Stock brokers Trading members of an exchange have direct access to trading facilities. Most customers go through brokers. (Recall: a broker generally acts as agent for the customer). Retail brokers service individuals. Discount brokers (Scott Trade, Interactive Brokers) provide services related to trading Full service brokers (Charles Schwab, Merrill Lynch) also provide research and advice. Prime brokers service institutions (like mutual funds and hedge funds). Larger trades, more securities, more markets. Specialized services (for margin trading and short selling). Customers pay commissions to the brokers. 23 Investing in and trading stocks Many individuals and institutions hold and trade stock. Strategies and motives vary widely. We often differentiate stock traders by Holding period (horizon) Whether their trades are motivated by information, hedging or liquidity. 24 8

9 Traders differ by holding period or horizon Long term (ten years or more) Individuals saving for education or retirement or universities and charities with endowments. Trade infrequently, low turnover. Medium term (business cycle, five to ten years) Attempt to profit by timing the market to current economic conditions. Trade infrequently, low turnover. 25 Short term (minutes to months) Follow momentum strategies, technical (statistical) trading rules. Frequent trading, high turnover. High-frequency (seconds and shorter horizons) Profit from short-term trends and reversals in price movements Frequent trading, high turnover, usually try to end the day flat (with no net position). 26 Traders differ by motive Liquidity Our non-financial incomes and expenses aren t smooth. Unexpected inflows need to be invested; unexpected expenses need to be met by selling. Liquidity motives are specific to the trader, and are external to the security. Trading style: liquidity traders are often patient. 27 9

10 Hedging Someone who is exposed to financial or non-financial risk will Try to sell a security that is positively correlated with the risk or buy a security that is negatively correlated with the risk. Hedging needs are usually specific to the trader. Trading style: hedgers are often impatient traders. Risk reduction can be an urgent need. 28 Information An informed trader possesses a real advantage. Illegal inside information Advance knowledge of public information. Superior analysis of public information. Informed traders are often impatient because they need to trade before their information or insight becomes public. Who is the counterparty to our trade? If liquidity trader or hedger, okay. If informed, we generally lose. 29 The trading process: what do we mean by the price? Last sale price AAPL last traded at $ Real (represented an actual trade) but might be stale. Bid and ask (offer) quotes The market for AAPL is $ bid for 1,000 shares, 500 shares offered at $ Current, but hypothetical. The bid and ask might depend on how much we re buying or selling, and who we are

11 Immediate trades To sell immediately, we agree to receive the bid price. Hit the bid To buy immediately, we need pay the ask price. Lift the ask or lift the offer Avoid the usage hit the ask 31 The basic trading decision: make or take? Suppose that the lowest ask price in the market is $ If we want to buy, we can Take the ask (buy immediately), or Make our own bid For example, $ What are the pros and cons? 32 The trading process in action Security markets are dynamic Bids and asks are entered, modified, canceled. Trades (executions) occur when someone hits a bid or ask. Example: Figure 2 1. Trading activity in AACC on April 25, The bid (National Best Bid) is a blue solid line; the offer (ask) price (National Best Offer) is a dashed red line; black dots represent trades. Source: NYSE daily TAQ

12 34 Terms: Liquidity Ease of trading In a liquid market, you can buy or sell in large size, quickly, without moving the price very much. Sometimes liquidity = immediacy + breadth + depth + resiliency. Immediacy: How quickly can we trade? Sooner is better. Breadth: How wide is the bid-ask spread? Narrower is better. Depth: What quantities are sought at the bid or offered at the ask? More is better. Resiliency: Following a large trade that moves the price, how quickly do the bid or offer bounce back? Faster is better. 35 Liquidity as a network externality Network: relating to connectivity Externality: a cost or benefit that is not directly associated with the purchase or sale. With liquidity The value of a market increases as more people participate in the market. More people provide more trading opportunities and competition. Liquidity begets liquidity

13 Terms: Transparency How much can we observe about the trading process? Pre-trade transparency Prices and volumes of recent trades; indicative prices for small and large trades; what does the limit order book (or books) look like? Post-trade Who is my counterparty? 37 Terms: Latency (delay) Acted upon by market Information generated by market (e.g., a trade) Received by user Most exchanges claim that the time from receipt of an order through transmission of an outcome is about 100 microseconds. Transmit to the market Analysis, strategic response 38 Regulation Modern securities trading is trans-national. Most securities regulation is based at the national level. But some rule-making and enforcement is delegated to the exchanges. Exchange rules often predate Federal regulation 39 13

14 US Securities and Exchange Commission (SEC) Regulates trading in securities Corporate stock, bonds, stock options, state and local bonds Securities Act applies to primary markets. The initial sale of a security, from issuer to investor Securities Act applies to secondary markets. Trading after the initial issue. 40 US Commodities Futures Trading Commission (CFTC) Regulates trading in forward and futures contracts (including financial futures) Regulates swaps (in partnership with the SEC) Historically, futures contracts were dominated by agricultural commodities. Markets regulated by the CFTC look different from those regulated by the SEC 41 And some special cases Currency (foreign exchange, FX) is regulated indirectly. The largest participants are banks (which are regulated by the Federal Reserve ( Fed ) and the Office of the Controller of the Currency (OCC). Because FX is the underlying for many forwards, futures and swaps, the CFTC has some jurisdiction. US Treasury markets are regulated by the Fed and the Department of the Treasury

15 Industry Regulation The US Financial Regulatory Authority (FINRA) is a not-forprofit corporation that regulates many aspects of trading and broker/customer interactions. If you work for a securities firm and have any dealings with customers, you ll take FINRA s Series 7 exam. FINRA oversees arbitrations of broker-customer disputes. 43 European Union European Commission Internal Market and Services Directorate General Directorate G Financial Markets. The overarching regulation is the Markets in Financial Services Directives 2 ( MiFID 2 ). Much regulation of trading is delegated to the home country (where the exchange is based)