CHAPTER THREE

HOW SECURITIES ARE TRADED

CHAPTER OVERVIEW
This chapter discusses how securities are traded on both the primary and secondary markets, with detailed
coverage of both organized exchange and over the counter activities. Margin trading and short selling are
discussed along with detailed examples of margin arrangements. The chapter discusses elements of
regulation and ethics issues associated with security transactions.

LEARNING OBJECTIVES
After studying this chapter the student should have considerable insight as to how securities are traded on
both the primary and secondary markets. The student should understand the mechanics, risk, and
calculations involved in both margin and short trading. The student should begin to understand some of
the implications, ambiguities, and complexities of the regulation of securities markets.

PRESENTATION OF MATERIAL
3.1 How Firms Issue Securities
Chapter 3 begins with a presentation on key characteristics of primary and secondary sales of securities.
The relationship between the primary market terms and subsequent activity in the secondary market
presents a good opportunity for class discussion and relating the material in the investment class to
principles of finance.

Investment banking involves the sale of new issues of securities to investors; Figure 3.1 shows the
relationship between parties involved in an underwritten offering. Shelf registrations allow a firm that is
regularly reporting to sell a limited amount of new stock without going through a registered public
offering. This allows a firm more flexibility in selling additional shares.

Private placements allow a firm to sell securities without going through a registered public offering.
While most stock offerings employ public offerings, many issues of debt are completed using private
placements. It is useful to discuss differences in the markets for equity and bond when discussing this
material. Bond markets are dominated by financial institutions and many of the special characteristics of

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bond issues lend themselves to private placements. In some years the volume of private placements
exceeds public offerings of corporate bond issues.

When a company sells securities to the general investing public for the first time, the transaction is
referred to as an Initial Public Offering (IPO) and uses a prospectus, which is a written registration
statement filed with the SEC that describes the issue and its prospects. The underwriting firms commonly
underprice IPOs leading to significant short-term performance for some investors often with massive
first-day returns, as expressed in Figure 3.2.

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3.2 How Securities Are Traded
This section presents the major types of secondary markets including direct search, brokered, dealer and
auction markets. The discussion of secondary markets should be focused on services rather than
institutional characteristics of our markets. Discussion of different demands for services by different
types of investors can help students understand the recent developments in our markets.
Figure 3.3 demonstrates the average market depth for S&P 500 size companies as well as small Russell
2000 firms; though orders for transactions in securities in auction markets have different priorities.
Market orders are to be executed immediately at current market prices. Price-Contingent Orders place
price as the first priority. Once a target price is reached, a price-contingent order becomes a market order.
Students should be familiar with Figure 3.4 and understand the uses of each of these price-contingent
orders.
The section continues with a discussion on the organization of markets that facilitate trade. In specialists
markets, a dealer is charged to make an orderly market. The specialist is granted a monopoly position
and is highly regulated. Many securities are traded in over the counter markets which utilize dealers and
brokers. A dealer market features competition among dealers to make the market efficient. Electronic
Communication Networks (ECNs) allow electronic interface among traders that bypasses the traditional
dealership function and have mostly replaced specialist systems.
3.3 The Rise of Electronic Trading
This section discusses how the interaction of new technologies and new regulations lead to electronic
trading. In 1975, the NYSE eliminated fixed commissions and National Market System was created in the
attempt to centralize trading across exchange and enhance competition. The new order-handling rules in
1994 on NASDAQ lead to narrower bid-ask spreads; 1997 and 2001 introduced the drop in the minimum
tick size from one-eighth to one-sixteenth, and to 1 cent, respectively. Figure 3.5 illustrated the effect of
minimum tick size on the effective spread. In 2000, NASDAQ Stock Market emerged. In 2006 NYSE
was renamed to NYSE Arca after acquiring the electronic Archipelago Exchange. 2007 marked the
creation of National Market System (NMS) to link exchanges electronically. Overall, the share of
electronic trading in the US rose from 16% to 80% in 2000s.
3.4 U.S. Markets
The domestic securities markets have undergone significant reorganization and restructuring since the
mid-1970s. For example a major component of today’s market includes the NASDAQ market system
that links dealers, organized exchanges and ECNs. Listing requirements on the NYSE and NASDAQ are
significantly different. The NYSE requires much larger market value of shares in the hands of the public
and considerable trading volume. ECNs were originally open to other traders but following the
implementation of Reg NMS, ECNs began listing limit orders on other networks.

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3.5 New Trading Strategies
This section presents new trading strategies that came into play after the development of the electronic
trading. Algorithmic Trading uses computer programs to make trading decisions. High-Frequency
Trading employs special class of algorithmic with very short order execution time. Dark Pools are the
trading venues that preserve anonymity, mainly relevant in block trading. In 2006 the NYSE gained
approval to expand bond-trading systems to include debt issues of NYSE-listed firms. Most bond trading
occurs in the OTC market among bond dealers.
3.6 Globalization of Stock Markets
Figure 3.7 demonstrates the biggest stock markets in the world by domestic market
capitalization, with NYSE-Euronext being by far the largest equity market. The section a wave
of mergers in the last two decades, the industry now has a few giant security exchanges: ICE
(Intercontinental Exchange, operating NYSE-Euronext, and several commodity futures and
options markets), NASDAQ, the LSE (London Stock Exchange Group), Deutsche Boerse, the
CME Group (largely options and futures trading), TSE (Tokyo Stock Exchange), and HKEX
(Hong Kong Stock Exchange).

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3.7 Trading Costs
On some trades, only a commission is paid; on others, only a portion of the spread is paid; and many
trades require both a commission and a portion of the spread are paid. This point can be made by
contrasting orders on both listed and OTC stocks. While the payment of a portion of the spread is not
actually reported, the concept is important when considering the total cost of trading.
3.8 Buying on Margin
This section introduces margin trading. The use of actual borrowing of funds contrasts with margin
arrangement in futures. While both futures and stock trading have maintenance margins and margin calls
which are similar, the costs of borrowed funds must be factored into analysis of the returns of stock
margin trading. The degree of leverage available in equities is set by the Federal Reserve Board and is far
less than is available in futures.
A sample margin trade is used to develop the concepts of margin call and maintenance margin. The
student’s understanding of the concept is helped by explicit treatment of the accounting for the problem
using assets = liabilities + equity. The initial position shows a 60% initial margin on a 100 share purchase
of a stock that is selling for $100 per share. If the stock drops to $70 as depicted in the example, the
equity falls to $3,000. The margin call price is then developed. Table 3.1 illustrates some potential
returns from buying stock on margin. An optional exercise on buying on a margin is presented on p. 77
and can be analyzed using an Excel spreadsheet.
3.9 Short Sales
With the background developed in margin trading, the concept of short selling is then covered. A brief
description of the mechanics of a short sale is shown here. While stock is generally available for short
sellers, sometimes short sellers are not able to find additional stock to borrow when stock is called back
from loan. If the short seller is not able to find other stock to borrow in that situation, he may be forced to
close out her position. Table 3.2 illustrates cash flows from purchasing versus short-selling shares of
stock.

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of McGraw-Hill Education.
A sample calculation of margin, maintenance margin and margin calls is developed for a short sale. The
short sale involves 1000 shares of a stock that has an initial price of $100 with the maintenance margin of
30%. The example works through calculation of the margin position when the stock price rises to $110.
The amount borrowed and owed is no longer constant with a short sale. The amount owed is actually
equal to number of shares shorted time the current price. The amount owed is subtracted from the
original sale proceeds plus the customer’s margin to determine the equity. With a 30% maintenance
margin, the short seller will receive a margin call if the stock price rises above $115.38. Examples 3.3 and
3.4 demonstrate the mechanics of short sales and margin calls on short positions. An optional exercise on
a short sale is presented on p. 81 and can be analyzed using an Excel spreadsheet.
3.10 Regulation of Securities Markets
Recent scandals have rocked the securities markets. This is an area that has received and continues to
receive enormous amounts of coverage in the press. Numerous proposals for additional regulation have
appeared even before the costs and efficiency of Sarbanes-Oxley can be assessed. The financial crisis of
2008 has launched a new round of financial regulation legislation while insider trading remains a major
problem in the financial world. The SEC has multiple ways to monitor for insider trading and there is
considerable evidence to support the idea that it occurs.
Excel Applications
Two Excel models are available for margin trading (on p. 77) and short sales (on p. 81). These models
allow the student to examine the impact of margining combined with stock price volatility. Excel models
that cover material in this chapter are available on the Online Learning Center (www.mhhe.com/bkm).

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of McGraw-Hill Education.