Lecture 2: Trading

Investment Management
Fall 2023

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Road map for this lecture
• Market types: Primary vs. Secondary Markets, OTC
markets and exchanges
• Order types
• Costs of trading
• Buying on margin
• Short selling

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Primary vs. Secondary
markets
1. The Primary Market
• where firms issue stocks to the public: IPOs
• investment banks
2. The Secondary Market
• where investors trade stocks among themselves
• NYSE, NASDAQ, TSX...
• In this course we focus on equity trading in the
Secondary Market

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How Firms Issue Securities (cont…)
• Publicly Traded Companies
• Public offerings are marketed by underwriters
 Initial Public Offering:
 Seasoned equity offering:
• Registration must be filed with the
 The Ontario Securities Commission (OSC) in
Canada
 Securities and Exchange Commission (SEC) in
the U.S.

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How Firms Issue Securities (cont…)
• Initial Public Offerings
• Road shows to publicize new offering
• Bookbuilding to determine demand
• Degree of investor interest provides valuable
pricing information
• Underwriter bears price risk:
 IPOs are commonly underpriced
o Example: Twitter Inc.
 Some IPOs are well overpriced
o Example: Facebook

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The Primary Market

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IPO underpricing _First day
returns

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IPO long-term performance

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Market types
1. Dealer Market-Over-the-counter (OTC) market is
an informal network of brokers and dealers where
securities can be traded (not a formal exchange)
• Maintains inventory of assets from which they buy and
sell
• Profits from bid-ask spread
2. Brokered
• Arranges transaction between buyer and seller
• Profits from commission
3. Auction: traders converge at one place to trade
(e.g. exchanges such as NYSE)
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Market types
• Historically, two major types of trading environments
1. Over the counter (OTC) market: intermediary dealers
(NASDAQ)
2. Exchange: all traders converge at one place (NYSE);
trading managed by designated market maker
(formerly known as specialists)
• Difference is arguably becoming less and less relevant due
to faster communications and electronic trading.
• ECNs (electronic communication networks-Computer-
operated trading network) that directly link buyers and
sellers have gained in importance at the expense of
exchanges.

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 The Rise of Electronic Trading
• 1975: Elimination of fixed commissions on the
NYSE
• 1994: New order-handling rules on NASDAQ,
leading to narrower bid-ask spreads
• 1997: Reduction of minimum tick size from one-
eighth to one-sixteenth
• 2000s: In the US, the share of electronic trading
rose from 16% to 80% in 2000s
• 2000: Emergence of NASDAQ Stock Market
• 2001: Reduction of minimum tick size from one-
sixteenth to 1 cent

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 The Rise of Electronic Trading
• 2006: NYSE is renamed to NYSE Arca after
acquiring the electronic Archipelago Exchange
• 2007: Creation of National Market System (NMS)
to link exchanges electronically
• Since 2004, the Canadian Securities Exchange has
offered an ECN for Canadian listings in
competition with the TSX and the TSXV
• As of the end of October 2020, 611 companies were
uniquely listed on the CSE from several industries
• In the U.S., ECNs register with the SEC as broker–
dealers and are subject to Regulation ATS (for
Alternative Trading System).

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The Effective Spread Fell Dramatically
as the Minimum Tick Size Fell

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Canadian Securities Markets
• The Toronto Stock Exchange (TSX)
• trading platform for senior companies
• The TSX Venture Exchange
• trading platform for emerging companies
• Canadian National Stock Exchange (CNSX)
• alternative electronic trading platform
• Derivative Markets
• Canadian Derivatives Exchange or the Montréal
Exchange
 options and futures on financial instruments
• ICE Futures Canada formerly Winnipeg
Commodity Exchange
 Commodity futures for agricultural products
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New Trading Strategies
• Algorithmic trading is the use of computer
programs to make trading decisions
• High-frequency trading is a subset of
algorithmic trading that relies on computer
programs to make extremely rapid decisions
• Dark pools are private trading systems in
which participants can buy or sell large blocks
of securities without showing their hand

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Consolidation of Stock Markets
• Widespread alliances and mergers

• NYSE merged with European Euronext

• NASDAQ merged with OMX (Stockholm) to
form NASDAQ OMX Group
• Chicago Mercantile Exchange acquired Chicago
Board of Trade and New York Mercantile
Exchange
• Eurex took over the International Securities
Exchange (ISE)

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Trading Equity: Order
Types
• Market Orders
Execute order immediately at market price

• Limit Orders
– limit buy: executed when price falls to target

– limit sell: executed when price increases to target

• Stop Orders
– stop loss: sell stock when price falls to target-for long positions
– stop buy: buy stock when price increases to target-for short positions

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The Market Maker
In a stock exchange, the market maker (or specialist)
plays different roles:
– Broker role
• maintain book of limit orders
• execute limit orders at market prices (crossing)
• use highest outstanding limit buy and lowest outstanding limit sell to fill
market orders
– Dealer role
• must maintain an “orderly” market: provide liquidity
• quotes bid (price at which dealer buys) and asked prices (at which
dealer sells)
• trades on his own account

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Limit order book example

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Example
Consider the following limit-order book of a market-maker. The last trade in the stock took
place at a price of $50.
limit-buy orders limit-sell orders
price shares price shares
49.75 500 50.25 100
49.50 800 51.50 100
49.25 500 54.75 300
49.00 200 58.25 100
48.50 600
a. If a market-buy order for 100 shares comes in, at which price will it be filled?
b. At what price would the next market-buy order be filled?
c. If you were the specialist, would you desire to increase or decrease your inventory of this
stock?

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Over the counter markets (OTC)

• OTC market characteristics

o no “centralized” marketplace
o different dealers may offer different bid and ask prices

• NASDAQ: has become more like an exchange over time

o About 3,000 firms listed
o Network of dealers
o In 1971, NASDAQ: computer system, first only used for displaying
price quotes
o Now includes electronic trading platform

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Recent Developments

• Traditional differences between exchanges and OTC markets have

diminished because of computer technology and automated trading
• Technology makes “flash trading” possible (orders execution speed
measured in microseconds!)
• Globalization and consolidation among exchanges (e.g. NYSE-
Euronext-AMEX-Archipelago (ECN))
• Exchanges have switched from organizations to businesses that
compete with each other

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The Costs of Trading
• Brokerage commissions: the only cost (with mutual fund
expenses) that is clearly apparent to investors, has been
going down
• Bid-ask spread
• Price impact
• Taxes
• Not a glamorous topic, but important:
• More likely to make a difference across investors than e.g., choice
of stocks
• Even seemingly small costs make a big difference in the long run
(compounding)
• Costs should be compared to the average return of the market
(7%/yr.?) Easy to lose 50% or more of profits…
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Bid-Ask Spreads
• Orders to buy/sell executed at different price
• Dealers buy at price lower than price at which they sell
• Bid: dealer buys < Asked: dealer sells
• Difference = “spread” = dealer’s profit = cost to investors.
• Spread compensates dealer/market makers for inventory and
operating costs, and for the risk of trading against informed
investors
• Can be much larger than commissions
• Small for largest stocks (a few cents on average on the
NYSE)
• Much larger for small, illiquid stocks (risky for the dealer to
hold): about 6.5% for smallest 10%

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Spreads vary over time
Bid-ask spread for large US companies around
financial (subprimes) crisis

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Price Impact
• Large orders move prices (always in unfavorable direction)
• Limited market depth at quoted bid/asked prices
• Causes: Imperfect liquidity (not enough trading)
• Informational issues: when a large “sell” order comes, people
suspect someone knows something bad about the stock => price
goes down
• Much larger for smaller stocks
• Large investors are often at a disadvantage (cf. mutual
funds: the more successful they are => the more money
they attract => the larger they become =>the worse they
do; they may become “closet indexers”)

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Price Impact

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Managing price impact
• Large “block” trades avoid regular exchanges and
go through specialized brokers (block houses) or
(increasingly) “dark pools”
• Split up trade into many small orders and trade
these over time
• In OTC markets, sometimes it may be optimal to do
the opposite: a small order may take the dealer as
much time as a large one, so if your order isn’t big
enough, the dealer won’t give you a good deal =>
trade in chunks that are worth the dealer’s time.

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Costs of active
management
Typical annualized costs for mutual funds, according to
William J. Bernstein.
• This is only an approximation. In particular, costs depend on
turnover rate (100% per year typical for active stock funds)
• Does not include impact of taxes

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Taxes
• Different investment strategies are more or less affected by taxes
• In some cases, tax code allows you to postpone paying taxes
• Tax-sheltered accounts (mostly for retirement)
• Capital gains taxed only when they are “realized” (i.e., asset sold)
• In general, better to postpone paying taxes to as late as possible.
Example: asset pays 7%/year, all in capital gains, taxed at 30%. How
much does $100 yield (after-tax) if gains realized at the end of 30
years? What if gains realized every year?
• Different strategies for taxable and tax-exempt investors (e.g. pension
funds), taxable and tax-sheltered accounts (for example, where do you
want to put high dividend stocks? Keep in mind dividends are taxed
more highly than capital gains.)
• Watch out for mutual funds with high turnover (capital gains passed on
to investors => tax inefficient)

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Taxes

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Trading Costs
• All of these costs (including taxes) affect “active” portfolio
strategies more
• Many of these costs affect smaller stocks more
• When people try to “sell” you a portfolio strategy by
showing you past performance:
• Check to see if all costs have been taken into account – most likely,
they haven’t
• Be suspicious of any strategy that involves disproportionate trading
in smaller stocks (e.g., buying the “losers” from last year, small firm
over performance)

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 Buying on Margin
To get leverage, borrow part of purchase price. This gives you more
exposure to a stock when you think it will go up.
Margin = value of the stock position net of the loan = your contribution
to the account
Equity in acct Value of stock - loan
Margin = =
Value of stock Value of stock
– margin requirements: initial margin vs. maintenance margin (lower
than initial), trigger margin call if violated; ensure you have enough in
your account to repay the loan
– example: pay $6000 towards 100 shares @ $100 , Loan=4000
» initial margin= (10000-4000)/10000 = 0.6
» if stock price declines to $70;
» New margin= (7000-4000)/7000 = 0.43

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Margin Trading: Maintenance Margin
• How far can the stock price fall before a
margin call? Let maintenance margin = 30%
• Equity = 100P - $4000
• Percentage margin
(100P - $4,000)/100P =0.30
Solve to find:
P = $57.14

We can use following tailor-made formula to find the price to receive margin call.
Let P* denotes the price to receive margin call, then
P* = Purchase price x (1-initial margin)/(1-maintenance margin)
= $100 x 0.4 /0.7 = $57.14

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 Buying on Margin
You borrow $20,000 on margin to buy shares in Disney, which is
now selling at $80 per share. Your account starts at the initial
margin requirement of 50%. The maintenance margin is 35%. Two
days later, the stock price falls to $75 per share.

(a) Will you receive a margin call?

(b) How low can the price of Disney shares fall before you receive
a margin call?

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Another example
Dee Trader opens a brokerage account and purchases
300 shares at $40 / share. She borrows $4,000 from
her broker to help pay for the purchase. The interest
rate on the loan is 8%.
a. What is the margin in Dee’s account when she first
purchases the stock?
b. If the price falls to $30 / share by the end of the year,
what is the remaining margin in her account. If the
maintenance margin requirement is 30%, will she
receive a margin call?
c. What is the rate of return on her investment?
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Buying on margin: risk and
return

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Short selling
Short Sale
– to profit from expected price drop
– borrow shares from investor/broker and sell
– buy back later at (hopefully) lower price
– losses are potentially unlimited
– leave sale proceeds with broker + additional collateral to meet margin
requirements

Equity value MV of assets - value of stk owed

Margin Ratio = =
Value of stk owed Value of stk owed

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Example
You are bearish on BCE stock and decide to sell short 100 shares at the
current market price of $50 / share.
a. How much in cash/securities must you put into your brokerage account
if the broker’s initial margin requirement is 50% of the value of the short
position?
b. How high can the price of the stock go before you get a margin call if
the minimum margin is 30% of the value of the short position?

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 Practice Example on
Shorting
• You are bearish on Canopy Growth stock and
decide to sell short 100 shares at the current
market price of $25 per share.
• a. How much in cash or securities must you put
into your brokerage account if the broker's initial
margin requirement is 50% of the value of the
short position?
• b. How high can the price of the stock go before
you get a margin call if the minimum margin is
30% of the value of the short position?
More on shorting
Some hedge funds focus on short selling. Some ideas:
look for companies
• With over-stated earnings: aggressive accounting
methods, incomprehensible statements in SEC filings,
engaged in fraud
• With flawed business plan: e.g. based on technology
becoming obsolete (Blackberry after launch of iPhone)
• With low return on capital but high growth
• Loudest “alarm bell”: sudden, unexplained departure of
the CEO

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Difficulties with short
selling
• Short selling requires that you can borrow the security
• Not always possible
• You must pay a lending fee, small for liquid stocks (0.1 to 0.2% annualized), a lot
larger for smaller stocks
• Risk that security is re-called
• Short squeeze
• Companies sometimes fight short sellers
• Suing them
• Take actions to make shorting difficult such as trying to coordinate with
shareholders to withdraw shares from the stock lending market:
• in 1996, Solv-Ex sent fax to shareholders: “To help you control the value of your investment…
we suggest that you request delivery of the Solv-Ex certificates from your broker as soon as
possible.”
• Later hired private investigators to find short sellers, and subsequently filed suit against a
well-known short seller
• Company went bankrupt in 1997, later ruled to be a fraud.
• Stocks go up more often than not: odds not in your favor
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More difficulties
• Policy makers and the general public seem to believe short selling is
“wrong”:
• Morally wrong (Proverbs 24:17: "Do not rejoice when your enemy falls, and
do not let your heart be glad when he stumbles.")
• In 1989 Congress held hearings about short selling:
• During the hearings, Congressman Dennis Hastert (later speaker of the US House of
Representatives), described short selling as “blatant thuggery”
• SEC official testified that “many of the complaints we receive about alleged illegal
short selling come from companies and corporate officers who are themselves under
investigation by the Commission or others for possible violations of the securities or
other laws.”
• Testimony from three supposedly victimized firms. Subsequent to this testimony, the
presidents of two of these three firms were prosecuted for fraud (for the third firm,
the SEC determined the company had made materially false and misleading
statements, but that the evidence was insufficient to prosecute).
• During the global financial crisis 2008 and in 2011 many countries
banned shorting of financial companies
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Evidence on short selling
• Stocks that are expensive to sell short earn low subsequent
returns: suggests they’re overpriced => shorting would have
helped make the price more reasonable
• Short interest rises around negative fundamental events:
Evidence indicates that short sellers are able to anticipate
identify manipulation/fraud
• “In the financial markets the sharks protect the sheep from the
wolves”: Short sellers help make sure the public is getting
assets worth what they pay. According to James Chanos of
Kynikos Associates:
“Of the major financial frauds of the past 25 years, almost every single one
of them has been uncovered by an internal whistle blower, a journalist, or a
short seller. Not outside auditors. Not outside counsel. Not law enforcement”

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Example: Enron
Jim Chanos’ shorting of Enron made his
firm, Kynikos (the largest exclusive short
selling investment firm in the World),
famous. What piqued his interest?
• aggressive “gain-­on-­sale” accounting
• mismatch of cost of capital and return on
investment
• cryptic disclosure re. “related party
transactions”
• large amount of selling by senior executives
• analysts at Wall Street firms: “trust me”
story

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 Trailing Stop Loss
• A trailing stop is an order type designed to lock in profits
or limit losses as a trade moves favorably.
• Trailing stops only move if the price moves favorably.
• A trailing stop can be set at a defined percentage or
dollar amount away from a security's current market
price. For a long position, an investor places a trailing
stop loss below the current market price. For a short
position, an investor places the trailing stop above the
current market price.
• A trailing stop is designed to protect gains by enabling a
trade to remain open and continue to profit as long as
the price is moving in the investor’s favor. The order
closes the trade if the price changes direction by a
specified percentage or dollar amount.
• A trailing stop is typically placed at the same time the
initial trade is placed, although it may also be placed
after the trade.

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 Trailing Stop Loss-An Example
• Assume you bought Alphabet Inc. (GOOG) at $1,000. By looking at prior
advances in the stock you see that the price will often experience a
pullback of 5% to 8% before moving higher again. These prior
movements can help establish the percentage level to use for a trailing
stop.
• Choosing 3%, or even 5%, may be too tight. Even minor pullbacks tend
to move more than this, which means the trade is likely to be
stopped out by the trailing stop before the price has a chance to move
higher.
• Choosing a 20% trailing stop is excessive. Based on the recent trends,
the average pullback is about 6%, with bigger ones near 8%.
• A better trailing stop loss would be 10% to 12%. This gives the trade
room to move but also gets the trader out quickly if the price drops by
more than 12%. A 10% to 12% drop is larger than a typical pullback
which means something more significant could be going on—mainly,
this could be a trend reversal instead of just a pullback.
• Using a 10% trailing stop, your broker will execute a sell order if the
price drops 10% below your purchase price. This is $900. If the price
never moves above $1,000 after you buy, your stop loss will stay at
$900. If the price reaches $1,010, your stop loss will move up to $909,
which is 10% below $1,010. If the stock moves up to $1250, your
broker will execute an order to sell if the price falls to $1,125. If the
price starts falling from $1,250 and does not go back up, your trailing
stop order stays at $1,125, and if the price drops to that price the 51
broker will enter a sell order on your behalf.