12 Market Microstructure and Strategies

Financial Markets and Institutions
13th Edition
by Jeff Madura
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12 Market Microstructure and Strategies
Chapter Objectives
• Describe the common types of stock transactions.

• Explain how stock transactions are executed.
• Describe high frequency trading.
• Describe the regulation of stock transactions.
• Explain how barriers to international stock
transactions have been reduced.
© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
2
Stock Market Transactions (1 of 9)
Placing an Order — To place an order to buy or sell a

specific stock, an investor contacts a brokerage firm.
• The investor communicates the order to the broker by
specifying (1) the name of the stock, (2) whether to buy or sell
that stock, (3) the number of shares to be bought or sold, and
(4) whether the order is a market or a limit order.
• Broker may provide a bid quote if the investor wants to sell a
stock or an ask quote if the investor wants to buy a stock.
• A Market Order is executed at the best possible price.
• A Limit Order places a limit on the price at which a stock can
be purchased or sold.
3 © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
Placing an Order (Continued)

• Stop-Loss Order — To protect gains or to limit losses
• Investor specifies a selling price that is below the current
market price of the stock.
• When the stock price drops to the specified level, the stop-
loss order becomes a market order.
• Stop-Buy Order
• Investor specifies a purchase price that is above the
current market price.
• When the stock price rises to the specified level, the stop-
buy order becomes a market order.
Placing an Order (Continued)

• Placing an Order Online
• Many Internet brokers accept orders online, provide real-
time quotes, and provide access to information about
stocks.
• Some online brokerage services offer zero-commission
trades. However, investors must maintain a certain amount
of funds in their brokerage accounts.
• Margin Trading
• Investors use cash along with funds borrowed from their
broker to make the purchase.
• The Federal Reserve imposes initial margin requirements,
which represent the minimum proportion of funds that must be
covered with cash (currently 50%).
• Investors must establish an account (called a margin
account) with their broker.
• Over time, the market value of the stock will change. Investors
are subject to a maintenance margin, which is the minimum
proportion of equity that an investor must maintain in the
account as a proportion of the market value of the stock
(currently 25%).
Margin Trading (continued)

• Margin Calls
• A large volume of margin lending exposes the stock
markets to a potential crisis.
• A high volume of margin calls results in more sales, putting
downward pressure on stock prices, leading to additional
margin calls.
Margin Trading (continued)

• Impact on Returns
• The return (R) is affected by the proportion of the
investment that is from borrowed funds.
SP - INV - LOAN + D
R=
INV
Where
SP = selling price of stock
INV = initial investment by investor, not including borrowed funds
LOAN = loan payments on borrowed funds, including principal and
interest
D = dividend payments
Short Selling
• Investors place an order to sell a stock that they do not own.
The investor borrows the stock from another investor and will
return it to the investor from whom they borrowed it.
• If the price of the stock declines by the time the short-sellers
purchase it in the market, the short-sellers earn the difference
between the price at which they initially sold the stock and the
price they paid to obtain the stock.
• The risk of a short sale is that the stock price may increase
over time, forcing the short-seller to pay a higher price for the
stock than the price at which it was initially sold.
Short Selling (Continued)

• Measuring the Short Position of a Stock
• The ratio of the number of shares that are currently sold short
divided by the total number of shares outstanding.
• Short interest ratio — The number of shares that are currently
sold short divided by the average daily trading volume over a
recent period.
• Using a Stop-Buy Order to Offset Short Selling —
Investors commonly use a stop-buy order to limit their losses.
• Concerns about Short Selling — When the credit crisis
intensified in 2008, hedge funds and other investors took large
short positions on many stocks. Some critics argued that the
large short sales placed additional downward pressure on
prices and created paranoia in the stock market.
Short Selling (Continued)

• Restrictions on Short Selling
• In October 2008, the SEC required that short-sellers borrow
and deliver the shares to the buyers within three days. This
rule is important because there were many cases in which
brokerage firms were allowing speculators to engage in
naked shorting, in which they sell a stock short without first
borrowing the stock.
• In 2009, the SEC also reinstated the uptick rule (previously
eliminated in 2007), which prohibits speculators from taking
a short position except after the stock price increases. This
rule is intended to prevent short selling in response to a
stock’s continuous downward price momentum.
How Stock Transactions are Executed (1 of 4)
Floor Brokers
• Floor brokers are situated on the floor of a stock exchange
and fulfill and execute orders.
Market-Makers (Specialists)
• Can serve a broker function by matching up buy and sell
orders on the New York Stock Exchange.
• Making a market implies that they stand ready to buy or sell
certain stocks even if no other investors are willing to
participate.
• Market-makers take positions to capitalize on the discrepancy
between the prevailing stock price and their own valuation of
the stock.
• May take the opposite position to uninformed “noise traders.”
The Spread on Stock Transactions

The spread is the difference between the ask price and the bid
price, and is measured as a percentage of the ask price. The
spread is influenced by the following factors:
• Order Costs — Clearing costs and the costs of recording
transactions increase the bid-ask spread.
• Inventory Costs — The cost of maintaining an inventory of a
stock increases the bid-ask spread.
• Competition — Having multiple market-makers promotes
competition and reduces the bid-ask spread.
• Volume — Stocks that are more liquid have a large trading
volume and a lower bid-ask spread.
• Risk — If the firm has risky operations, its stock price is more
volatile, therefore increasing the bid-ask spread.
Electronic Communication Networks

• ECNs are automated systems for disclosing and executing
stock trades. The SEC requires that any quote provided by a
market-maker be made available to all market participants.
• Interaction between Direct Access Brokers and ECNs
• A direct access broker is a trading platform on a computer
website that allows investors to trade stocks without the use of a
broker.
• The website serves as the broker and interacts with ECNs that
can execute the trade. (Exhibit 12.1)
• The advantage of a direct access broker is that investors can
monitor the supply and prices of shares and the demand for
shares on different ECNs.
Exhibit 12.1 Example of an ECN Book at a
Given Point in Time
BID OR ASK? SHARES PRICE
Bid 500 $32.50
Bid 300 $32.50
Bid 400 $32.56
Bid 1,000 $32.60
Bid 400 $32.64
Bid 1,200 $32.64
Bid 300 $32.68
Ask 400 $32.78
Ask 1,000 $32.80
Ask 300 $32.84
Ask 400 $32.84
Ask 6000 $32.88
Electronic Communication Networks (continued)

• Dark Pools
• Platforms that use software to connect buyers and sellers of
stocks.
• Trades are not immediately disclosed to the public, allowing
investors to accumulate large amounts of shares without
public knowledge.
• Also attract high-frequency traders.
• Increasing in popularity and might account for 40% of all
trading of stocks.
High Frequency Trading (1 of 6)
• High frequency trading (HFT) represents the use of

electronic platforms to execute orders based on an
algorithm with programmed instructions.
• HFT is also known as:
• Automated trading
• Algorithmic trading
• Algo trading
• Program Trading
• Program trading represents a computerized response by
institutional investors to either buy or sell a large basket
of stocks in response to movements in a particular stock
index.
• Program trading can be combined with the trading of
stock index futures to create portfolio insurance.
• Bots and Algorithms

• High frequency traders use computerized systems for
accessing stock market information and interpreting that
information.
• Traders develop algorithms that attempt to interpret existing
information about a particular stock’s recent price or volume
movements (or other information) as a signal for its future
price movements.
• The bot is prompted to execute trades as soon as its
algorithms recognize specific information that it is seeking.
• Impact of High Frequency Trading on Stock Volatility

• Flash Crash — On May 6, 2010, stock prices declined
abruptly in what is now referred to as the “flash crash.” It
appears that the flash crash was triggered by HFT.
• Other Breakdowns in Computerized Trading — The
focus on speed to take positions before other investors
can cause panic in the markets even when the public
information disclosed is false.
• Concerns about HFT — Various stock markets have
attempted to impose new guidelines that temporarily
prevent trading when a stock’s price or a market index
declines by a particular level over a short interval (such
as 5 minutes).
• High Frequency Insider Trading

• Some traders with faster trading speed have an advantage
over other traders and take advantage of information that
they receive before other investors.
• High Frequency Front Running
• Other advantages are partially due to the multiple stock
markets in which a particular stock can trade and the
differences in speed at which the traders can access
trading information and submit orders.
• Impact of High Frequency Trading on Spreads

• HFT traders have taken market share from the market
makers because of the large spreads quoted by market
makers in the past.
• The spreads have declined as a result of the participation
by high frequency traders.
Regulation of Stock Trading (1 of 5)
Circuit Breakers
• Restrictions on trading when stock prices or a stock index reaches a
specified threshold level.
Trading Halts
• Stock exchanges may impose trading halts on particular stocks
when they believe market participants need more time to receive and
absorb material information that could affect the stock’s value.
• Trading halts are intended to reduce stock price volatility, as the
market price is adjusted by market forces in response to news.
Taxes Imposed on Stock Transactions

• The tax rate on dividend income from stocks was increased from
15% to 20% in 2013 for investors in high income brackets.
Securities and Exchange Commission

The Securities Act of 1933 and the Securities Exchange Act
of 1934 gave the SEC authority to monitor exchanges and
required listed companies to file a registration statement and
financial reports with the SEC and the exchanges.
• Some SEC regulations involve the following requirements:
• Firms must publicly disclose all information about themselves
that could affect the value of their securities.
• Employees of firms may take positions in their own firm’s
securities only during periods when they do not know of inside
information.
• Participants in security markets who facilitate trades must work
in a fair and orderly manner.
Securities and Exchange Commission (continued)

• Structure of the SEC
• Consists of five commissioners appointed by the President
of the United States and confirmed by the Senate.
• Each commissioner serves a 5-year term. The terms are
staggered so that, each year, one commissioner’s term
ends and a new appointee is added.
• The president also selects one of the five commissioners to
chair the commission.

• Key Divisions of the SEC
• The Division of Corporate Finance reviews the
registration statement filed when a firm goes public,
corporate filings for annual and quarterly reports, and proxy
statements.
• The Division of Market Regulation requires the orderly
disclosure of securities trades.
• The Division of Enforcement assesses possible violations
of the SEC’s regulations and can take action against
individuals or firms.

• SEC Oversight of Corporate Disclosure
• In October 2000, the SEC issued Regulation Fair
Disclosure (FD), which requires firms to disclose relevant
information broadly to investors at the same time.
• SEC Oversight of Insider Trading
• Insiders of a publicly traded company often have
information that would allow them to take favorable
positions in a stock before the general public. This type of
trading is illegal.
• The SEC attempts to prevent investors from trading based
on inside information.
Trading International Stocks
Reduction in Transaction Costs

• In recent years, countries have consolidated their
exchanges, increasing efficiency and reducing
transaction costs.
• Many international stock exchanges are now fully
computerized.
Reduction in Information Costs
• Information about foreign stocks is now available on the
Internet, enabling investors to make more informed
decisions without having to purchase information about
these stocks.
SUMMARY (1 of 4)
• Investors engage in various types of stock transactions.

They can place an order by phone or online. They can
request that a transaction be executed at the prevailing
price or only if the stock price reaches a specified level.
They can finance a portion of their stock purchase with
borrowed funds as a means of increasing the potential
return on their investment. They can also sell stocks
short.
SUMMARY (2 of 4)
• Organized stock exchanges such as the NYSE and the

Nasdaq market facilitate secondary stock market
transactions. Members of the exchanges trade stock for
their own accounts or for their clients. The exchanges are
served by floor brokers and market makers, who execute
transactions. An over-the-counter exchange also exists,
where stock transactions are executed through a
telecommunications network. Electronic communication
networks (ECNs) facilitate the execution of orders. ECNs
can interact with a trading platform on a website that
allows investors to trade stocks without the use of a
broker.
SUMMARY (3 of 4)
• High frequency trading (HFT) is the use of electronic

platforms to execute orders based on an algorithm with
programmed instructions. High frequency traders take
large positions in stock and typically close them out on
the same day. Bots and algorithms enable orders to be
placed or canceled in less than a second in response to
information such as recent stock price movements.
Although some critics argue that HFT has increased
market volatility, it now accounts for more than half of the
trading volume in the United States.
SUMMARY (4 of 4)
• Stock markets are regulated to ensure that investors are

treated fairly. Stock trading is regulated by the individual
exchanges and by the SEC. Many of the regulations are
intended to prevent unfair or unethical trading practices
on the security exchanges. The stock exchanges and the
SEC attempt to prevent the use of inside information by
investors.
• As various stock markets have removed their barriers to
foreign investors, they have become more globally
integrated. Transaction costs, information costs, and
exchange rate risk have all been reduced, making it
easier for investors to engage in international stock
trading.

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Financial Markets and Institutions

• Describe the common types of stock transactions.

Placing an Order — To place an order to buy or sell a

Placing an Order (Continued)

Placing an Order (Continued)

Margin Trading (continued)

Margin Trading (continued)

Short Selling (Continued)

Short Selling (Continued)

The Spread on Stock Transactions

Electronic Communication Networks

Electronic Communication Networks (continued)

• High frequency trading (HFT) represents the use of

• Bots and Algorithms

• Impact of High Frequency Trading on Stock Volatility

• High Frequency Insider Trading

• Impact of High Frequency Trading on Spreads

Taxes Imposed on Stock Transactions

Securities and Exchange Commission

Securities and Exchange Commission (continued)

Securities and Exchange Commission (continued)

Securities and Exchange Commission (continued)

Reduction in Transaction Costs

• Investors engage in various types of stock transactions.

• Organized stock exchanges such as the NYSE and the

• High frequency trading (HFT) is the use of electronic

• Stock markets are regulated to ensure that investors are

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