Market Microstructure & Strategies

Market
Microstructure &
Strategies
Physical location stock
exchanges vs. Electronic dealer-
based markets
• Auction market vs. Dealer
market (Exchanges vs. OTC)
• NYSE vs. Nasdaq
• Differences are narrowing
Stock Market Transactions
• Placing an order
• Full service broker: advice, research and analyze
• Discount broker
• Online broker: online trading platforms, web based, usually the cheapest and you take
control of your funds and trading
• Combination brokers: a combination of trade execution and some limited services.
Who to chose?
Depending on prior experience, your available time, how confident are you making your
own calls?
1. Market Order: A market order is an order to buy or sell a stock at the
market's current best available price.
2. Limit Order: set the maximum or minimum price at which you are
willing to complete the transaction, whether it be a buy or sell.
• It enables an investor to obtain the stock at a lower price
• But there is no guarantee the market price will ever reach the limit
price established by the investor
3. Stop-Loss Order: An advance order to sell an asset when it reaches a
particular price point. It is used to limit loss or gain in a trade.
• A stop-loss order is basically a tool used for short-term investment
planning.
• It is used when the investor doesn’t want the pressure of monitoring
a security on a day-to-day basis.
• The trade gets triggered automatically and the limits are decided in
advance.
• This can be very helpful for small investors.
4. Stop-Buy Order
• A buy stop order is an order to purchase a security only once the price
of the security reaches the specified stop price.
• The stop price is entered at a level, or strike, set above the current
market price.
• It is a strategy to profit from an upward movement in a stock’s price
by placing an order in advance.
Margin Trading
• In the stock market, margin trading refers to the process whereby individual
investors buy more stocks than they can afford to.
• The broker would lend the money to buy shares and keep them as collateral.
• Initial margin: The initial deposit of cash
• Maintenance margin: Minimum proportion of equity that an investor must
maintain in the account as a proportion of the market value of the stock.
• Margin call: The reminder call from the broker to the investor to provide more
collateral or sell the stock, when an investor’s equity position falls below the
maintenance margin.
• 100 shares @$60, IM: 50%, MM: 30%, Borrowing:50%
• Market price: $50, equity 40% (2000/5000)
• Market Price: $ 40, equity 25% (1000/4000)
Impact on Return
R = SP – INV – Loan + D
INV
SP= Selling price of stock
INV= initial investment by investor, not including borrowed funds
Loan = loan payments on borrowed funds, including both principal and
interest
D = Dividend Payments
Example
• Market price = $40
• Annual Dividend = $1
• Investment by investor= $20 per share
a. Borrowing from the brokerage firm =$ 20 @ 10%p.a. Return on stock
if after 1 year stock is sold for $60?
b. Returns if the investor had used only personal funds rather than
borrowing funds?
c. Returns if the stock is sold at a price of $30 per share for both the
cases narrated above?
5. Margin Calls: When an investor’s equity position falls below the
maintenance margin, the investor receives a margin call from the
broker, which means that the investor will have to provide more
collateral or sell the stock.
• A major downturn in the market could result in many margin calls,
some of which may force investors to sell their stock holdings, putting
additional downward pressure.
• During favorable conditions margin lending reaches its peak.
6. Short Sell: One way to make money on stocks for which the price is
falling is called short selling (or going short). Short selling is a fairly simple
concept—an investor borrows a stock, sells the stock, and then buys the
stock back to return it to the lender.
• If the stock does drop after selling, the short seller buys it back at a
lower price and returns it to the lender. The difference between the sell
price and the buy price is the profit.
• Transaction cost: Risk, tax, interest and brokerage commission
• Investor use a stop-buy order to offset short selling if the market price
goes against their expectation. Then stop buy order automatically
becomes a market order.
• One measure of the degree of short position is the ratio of the
number of shares that are currently sold short divided by the total
number of shares outstanding.
• High percentage shows relatively large number of investors expects
the stock price to decline and investor believe that the stock is
currently overvalued.
• investor who have established a short position commonly request a
stop buy order to limit their losses.
Short sales of 200 shares of ABC co. @$70 per share. Current price $80,
investor believe that stock price will drop below $70. He is unwilling to
accept a loss more then $15 so he places a stop buy order with the
purchase price $85 per share for 200 shares. Stop buy order will
become market order if the prices increases to $85. stop buy order will
never be executed if share prices will not increase to $85.
How Trades Are Executed
1. Floor Brokers: Floor brokers are situated on the floor of a stock exchange.
• Floor broker may or may not be an employee of the brokerage firm with which
investor is having an account.
• There are 20 trading posts on the NYSE and a different set of stocks is traded
at each trading post.
2. Specialists: the floor brokers purchase securities from a person called
specialist.
• They assigned to the posts on trading floor where they make a market in one
or more stocks assigned to them by the exchange.
• They act both as broker and dealer in the stock assigned to them
• Bid ask spread
• They incur risk when they take positions on any given day but at the
end they earn profits
• They have access to the book of limit orders on the buy side and sell
side involving in a poker game.
3. Making a Market: specialists are required to make a market if no
other investor is willing to participate.
• It does not mean that specialists are offering all orders by taking the
opposite side of every transaction.
• It does not mean that specialists must prevent a stock price from
falling.

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