Post on 22-Oct-2014
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The Common Stock Market
Types of markets Trading mechanics Stock market indexes Pricing efficiency
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Common stock
equity security ownership entitled to distributed earnings entitled to share of assets
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I. Type of Markets
exchanges OTC trading of
unlisted stocks & listed stocks direct trading
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Exchanges
physical location for trading trading by members
own a seat on the exchange
stock traded on exchange are listed stocks
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NYSE
the “Big Board” about 2800 listed U.S. companies
& 450 non-U.S. companies
$18 trillion market value (2/04) 1366 seats (fixed)
seat price $2 million 2002 10/2003 $1.35 million
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stocks trade at post on the trading floor 20 posts, trading about 100 stocks
each stock has one specialist 10 specialist firms, 470 specialists each specialist has 5-10 stocks process trades from floor brokers (5%) and
electronically (95%)
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role of the specialist
MUST maintain a fair and orderly market for stock
act as buyer or seller as needed (10% of trades) match buyers and sellers maintain order priority
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the future of the specialist
may be phased on with next 5-10 years recent SEC fines for improper trading for
several major firms
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AMEX
merged w/ Nasdaq 1998 specializes in equity derivative securities and
closed-end funds
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Regional exchanges
stocks may be listed on both NYSE and regional exchange
5 regional exchanges cheaper seat prices
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OTC markets
electronic network of dealers all over the world
ECNs electronic communication networks
more than one dealer per stock not obligated to make a market
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Nasdaq
not the only OTC system, but the largest over 4000 companies listed
mkt. value $2 trillion (2/28/03)
leader in daily share volume over 500 dealers listing requirements
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II. Trading Mechanics
types of orders short selling buying on the margin institutional trading
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Types of orders
instructions from investors to brokers market order
buy/sell order to be executed at best price
-- get lowest price for buy order
-- get highest price for sell order
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market order (cont.) market orders given priority in trading no guarantee of execution price
-- price could rise/fall from time order is placed to time it is executed
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limit order buy/sell order where investor specifies price range “buy at $50 or less” “sell at $52 or more” specialist records orders in
limit order book
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investor sets reservation price
BUT no guarantee that limit order will be executed
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stop order order lies dormant turns into market order when certain price (“the
stop”) is reached “buy if price rises to $60” “sell if price falls to $58”
-- stop loss order
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investor does not have to watch market but in a volatile market stop could be triggered
prematurely
-- end up trading unnecessarily
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stop limit order turns into limit order when stop is reached “buy if price rises to $60, but only is executed at
$65 or less”
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market if touched order turns into market order if certain price is reached “buy if price falls to $55” “sell if price rises to $62”
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how long is an order good?
fill or kill order executed when reaches trading floor, or canceled
good until canceled/open order is good indefinitely
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order size
round lots lots of 100 shares
odd lots less than 100 shares more difficult to trade
block trades 10,000 shares or $200,000 value
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short selling
sale of borrowed stock profit from belief that stock price is too high
will fall soon how?
borrow stock through broker sell stock buy and return later
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short selling could further destabilize falling prices tick test rules on exchange
short sales allowed if uptick or zero uptick in price for previous trades: $20.75, $21 (uptick) $20.75, $20.75 (zero upick) $20.75, $20 (downtick)
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so short sellers believe price will fall and SOON but price not currently falling face unlimited losses if price rises
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Buying on the margin
buyer borrows part of purchase price of stock, using stock as collateral borrow at call money rate
Fed sets initial margin requirement minimum cash payment 50% since 1975
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if stock price falls collateral worth less if collateral worth only 125% of loan
(maintenance margin)
-- margin call
-- owner must put up more cash or sell stock margin calls can worsen stock crash
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example
1000 shares, $20 per share $20,000 cost $10,000 cash, borrow $10,000
leverage gains/losses on $20,000 capital but tied up only $10,000 capital
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if prices falls to $12, value of stock $12,000 below 125% of $10,000 loan get a margin call
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Institutional trading
vs. retail trades institutional trades are larger special execution over 50% of NYSE share volume
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block trades
large # shares in one stock executed in “upstairs” market
other firms directly take other side of trade
remainder executed on trading floor or Nasdaq (downstairs)
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program trades
large # shares, different stocks used by mutual funds for asset allocation want
low commissions prevent frontrunning
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what is frontrunning?
brokers trade ahead of program trade to benefit from anticipated price movements due to large trade
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example
broker buys ahead of large buy order broker buys first large buy order pushes up price broker’s holdings increase in value
result frontrunning starts to push up price, so firm does
not get best price
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agency basis
brokers bid for trade by commission low commission, but frontrunning likely
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agency incentive agreement
set benchmark value for trade based on last day’s prices
if broker does better gets commission + bonus
higher commission, but frontrunning less likely
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III. Stock market indicators
measure average performance of a group of stocks
different indexes are highly correlated: DJIA & S&P 500 .991 (1990s) DJIA & NYSE .95
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indexes differ due to
stocks included in the index weighting of stocks
equal, price, value
average arithmetic geometric
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stock exchange index
includes all stocks listed on exchange NYSE Composite Nasdaq Composite (both value weighted)
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subjectively selected index
organization picks group of stocks to measure Dow Jones Industrial average S&P 500
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DJIA
price weighted 30 large blue chip companies
cross section of industries leaders
large movements in DJIA may halt trading on NYSE
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S&P 500
500 large blue chip companies value weighted most popular benchmark for index funds
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objectively selected index
inclusion of stock based on objective criteria market value
Wilshire 5000 all publicly traded stocks
Russell 2000 largest 3000 companies, then take
smallest 2000 of those
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IV. Pricing Efficiency of the Stock Market
what information is reflected in current stock prices? what implications does this have for active vs.
passive investment strategies?
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3 levels of price efficiency
what are they? implication? evidence for U.S. stock markets?
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Weak form efficiency
current stock prices reflect information about past prices and trading history
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implication
if markets are weak-form efficient using past price/trading pattern to predict future
stock prices will not work so, technical analysis will fail to beat the market
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evidence
U.S. stock market is weak-form efficient technical analysts do not beat the market
especially after trading costs
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Semi strong form efficiency
current stock prices reflect all publicly available information
relevant to stock
-- economic data
-- financial statements
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implication
using public info to predict future stock prices will not work fundamental analysis will fail to beat market
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evidence
mixed Yes
most actively managed portfolios do not outperform randomly selected portfolios
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No. certain pricing anomalies persist for long periods
of time January effect size effect
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Strong form efficiency
current stock prices reflect all information public and private
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implication
impossible to predict future stock prices stock prices are a random walk
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evidence
U.S. stock market is not strong form efficient why?
corporate insiders consistently outperform market & they have access to private info
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active strategy
using fundamental or technical analysis to select stocks to buy/sell
growth, sector, value funds trading on this info increases
trading costs tax consequences
odds of working are low
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passive strategy
believe market is efficient, just capture long-run returns of market
buy-and-hold diversified portfolio index funds
lower expenses, defer taxes index funds outperform most actively
managed funds