principles of securities trading - pages.stern.nyu.edupages.stern.nyu.edu/~jhasbrou/teaching/post...

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Principles of Securities Trading

FINC-UB.0049, Spring 2018Prof. Joel Hasbrouck

MEC 9-88, [email protected]

Course organization and information

Materials: class notes and assigned readings▪ Securities Trading: Principles and Procedures (STPP) draft manuscript.▪ Supplemental articles

Most material will be posted to the NYU Classes website and/or emailed. Deliverables: midterm, final, and trading exercises (simulated trading

situations). The first trading exercise will be scheduled in the second week of classes.

▪ Citadex Kryptonite Exchange▪ Floor market (no computer)

Copyright 2018, Joel Hasbrouck, All rights reserved 3

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Chapter 1Overview


Securities Trading: Principles and Procedures

The language of trading

The two sides of the trade

▪ Buyer and seller

▪ Trading party and counterparty

If I buy 1,000 shares of Microsoft …I’m the buyer and the trading party; the seller is my counterparty.

Sometimes: counterparty = opponent.


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Do buyers or sellers set the price?

Blog post: “Buyers were active in the stock market today, driving prices higher.”

For every buyer there is a seller; for every seller, a buyer.

Both the buyer and the seller agreed on the price.

In any single trade:

▪ Buyer and seller act differently.

▪ One side might be a clear aggressor.(shout louder, act more urgently or desperately).

▪ The aggressor has a greater effect on the price.


Examples

Art auction

▪ Seller offers painting, but buyers set the price.

Procurement auction

▪ NYU wants to buy 1M sheets of copy paper.

▪ Sellers compete to offer the lowest price.

Next: types of markets


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Types of markets: search markets

Buyers and sellers search to find each other …

▪ Advertise on bulletin boards, web sites, etc.

In securities, search notices are narrowly targeted.

▪ A buyer seeking 100,000 shares of XYZ could send an indication of interest (IOI) to current owners of XYZ.


Types of markets: brokered markets

A broker is an agent (working on behalf of a buyer or seller)

In a brokered market, most buyers/sellers use brokers to find a counterparty.

▪ Real estate, business brokers.

Securities brokers do not usually work to find a counterparty.

▪ The stock market is not a brokered market.


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Types of markets: dealer markets

A dealer acts as a counterparty to the buyer or seller.

▪ I’m selling a house.A real estate broker helps me find a buyer, but she doesn’t buy the house herself.

▪ I’m selling some Treasury bonds.A T-bond dealer will buy them from me.

Also called over-the-counter or OTC markets

Widely used for bonds, currency (FX), swaps


Types of markets: exchange markets

An exchange centralizes trading.

▪ A floor market has a physical place (room or pit).

▪ In modern exchanges, the centralization is virtual.

▪ All of an exchange’s orders go to one computer.

Centralized does not mean, “there’s only one exchange”.

▪ Microsoft stock trades on multiple exchanges.

Used for stocks, options and futures.

▪ Examples: New York Stock Exchange (NYSE); Nasdaq; London Stock Exchange; Shanghai Stock Exchange


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Trading procedures

Bargaining: one buyer + one seller. Single-sided auction: One buyer + many sellers (or one seller + many

buyers)▪ US Treasury securities sold by auction.

Double-sided auction: Many buyers + many sellers, one instant.▪ Used to open and close trading sessions at NYSE, NASDAQ.

Continuous double-auction. ▪ Buyers and sellers enter bids and offers at any time. ▪ Match trade▪ Continuous trading sessions on most exchanges.


Trading, clearing, and settlement

A “trade” is a commitment.▪ On Monday at 10 am, I buy 100 shares of Microsoft (ticker symbol MSFT)

for $32 per share. Clearing

▪ Buyer and seller confirm the terms of the trade. Settlement

▪ The irrevocable legal transfer of ownership and payment.▪ “On Wednesday, I actually take possession of the shares.

My bank account (or brokerage account) is debited by $3,200.” Monday, Tuesday, Wednesday.. In US equities markets, settlement is T+2 (“Tee plus two”).

▪ Before September 5, 2017 US stock settlements were T+3


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Chapter 2The elements of a securities market: US equities


Securities Trading: Principles and Procedures

Outline

Most of the course material applies to all markets.▪ Most of the examples are drawn from the US stock market.

Overview▪ Exchanges▪ Traders▪ Brokers▪ Prices▪ “Make or take?”▪ Liquidity, transparency, and latency▪ Regulation


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Stock

Stock shares represent partial ownership of a corporation.

The owner of a share gets:

▪ A slice of corporation’s net income.

▪ A vote in electing the corporation’s directors.

Corporation first sells stock to the public in the initial public offering (IPO).

▪ Additional sales are follow-on or seasoned offerings.

After the offering, most shares trade on exchanges.

▪ The World Federation of Exchanges has over 60 members.


Exchanges

“Marketplaces”

▪ Also: trading venues, market centers

An exchange is a business that provides/produces

▪ Listing services

▪ Trading services

▪ Information

17Copyright 2018, Joel Hasbrouck, All rights reserved

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Listing

“IBM is an NYSE-listed corporation.”

The NYSE (listing exchange) provides

▪ Certification and sponsorship

▪ Monitors the trading process

IBM (the listed firm) must:

▪ Satisfy financial and governance criteria.

▪ Pay a listing fee (depends on size, about $100,000)

A listing is (in practice) necessary for a stock to be traded.


Trading services and facilities

Computer and communication systems

Security, reliability and interoperability are priorities.

▪ Interoperability: many users will be connecting in a variety of ways.

Classic IT cost structure: high fixed costs, low variable costs.

▪ Once we have a system in place, the cost of an additional message, order or trade is low.


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Information (market data)

Especially

▪ Last sale prices

▪ Current bid and ask prices.

▪ Real-time order-book data.

Market data generates substantial revenues.

▪ In order to trade effectively, we need current information.


Ownership and governance of exchanges

Historically, exchanges were member-owned cooperatives.

▪ A membership (“seat”) gave ownership rights and trading rights.

Nowadays most exchanges are for-profit, publicly-held corporations.

▪ They have stockholders and (trading) members.

Most exchanges are units of larger holding companies

▪ Intercontinental Exchange (“ICE”) owns 11 exchanges, including New York Stock Exchange (NYSE).

▪ Euronext owns and operates the Paris, Lisbon, Brussels, Amsterdam Exchanges

▪ Nasdaq-OMX runs The Nasdaq Stock Market, OMX Nordic, etc.


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Stock brokers

Trading members of an exchange have direct access to trading facilities.

Most other investors gain access through brokers.

▪ Individuals use retail brokers.

Discount brokers (Scott Trade, Interactive Brokers, …) provide trading services.

Full service brokers (Charles Schwab, Merrill Lynch, …) also provide research and advice.

▪ Institutions (mutual and hedge funds) use prime brokers.

Larger trades, more securities, more markets.

Specialized services (for margin trading and short selling).


Traders (investors): holding periods

Long- (ten years or more) and medium-term (business cycle, five to ten years) investors trade infrequently.

Short term (minutes to days) traders buy and sell frequently.

High-frequency (seconds) traders.

▪ Frequent trading, high turnover, usually try to end the day “flat” (with no net position).


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Traders’ motives (Why do we trade?)

Liquidity traders are reacting to changes in their own situation.

▪ Inflows are invested by buying securities; outflows are funded by selling.

▪ Liquidity needs are specific to the trader, not the security being traded.

▪ Trading style: liquidity traders are often patient.


Hedgers are exposed to some risk.

▪ They will buy or sell to offset this risk.

▪ Hedging needs are usually individual-specific.

▪ Trading style: hedgers are often impatient traders.

Risk reduction can be an urgent need.


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Information traders know something.

▪ Illegal inside information

▪ Advance knowledge of public information.

▪ Superior analysis of public information.

▪ Trading style: Informed traders are often impatient.

They need to trade before their information or insight becomes public.

Who is our counterparty?

▪ Liquidity trader or hedger: okay.

▪ Informed: we lose.


“What is the price?”

Last sale price

▪ AAPL last traded at $572.05.

▪ Represents an actual trade, but might be stale.

Bid and ask (offer) quotes

▪ The market for AAPL is

“$572.10 bid for 1,000 shares, with 500 shares offered at $572.14.”

▪ Current, but inexact.

Which price is “correct” (the bid or the offer)?


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MSFT (Yahoo Finance, 16 January 2018)

How’s MSFT?

“89.59 bid, offered at 89.60”

“89.59 bid for 800 shares;100 shares offered at 89.60”

▪ The 800 and 100 shares are the size of the market.

Also: 8 × 1 (“8 by 1”)


MSFT (CBOE, 16 January 2018)

Copyright 2018, Joel Hasbrouck, All rights reserved29

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Immediate trades

To sell immediately, we agree to receive the bid price.

▪ “Hit the bid”

To buy immediately, we need pay the ask price.

▪ “Lift the ask” or “lift the offer”

Avoid: “hit the ask”


The basic trading decision: make or take?

The lowest ask price in the market is $20.50.

If we want to buy, we can …

▪ Take the ask (buy immediately), or

▪ Make our own bid

For example, $20.40.

What are the pros and cons?


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Terms of art

Liquidity = Ease of trading

▪ In a liquid market, you can buy or sell in large size, quickly, without moving the price very much.

Transparency = Visibility

▪ How much can we observe about the trading process? All bids? All offers? Last sale prices?

Latency = Delay

▪ When we try to trade, what slows us down?


Regulation

Modern securities trading crosses national boundaries.

Most securities regulation is national (federal).

▪ Some rules are made and enforced by the exchanges.

▪ In the US, some states also regulate securities.


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US regulators

Securities and Exchange Commission (SEC) regulates “securities”

▪ Corporate stock, bonds, stock options, state and local government bonds

▪ Not: US govt bonds, forward contracts, futures contracts, currency (foreign exchange).

US Commodities Futures Trading Commission (CFTC) regulates trading in forwards and futures.


US: some special cases

Currency (foreign exchange, FX) is regulated indirectly.

▪ The largest participants are banks (which are regulated by the Federal Reserve (“Fed”) and the Office of the Controller of the Currency (OCC).

▪ Because FX is the “underlying” for many forwards, futures and swaps, the CFTC has some jurisdiction.

US Treasury bond markets are regulated by the Fed and the Department of the Treasury.


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US: Industry regulation

The US Financial Regulatory Authority (FINRA)

▪ A not-for-profit corporation that regulates many aspects of trading and broker/customer interactions.

▪ If you work for a securities firm and have any dealings with customers, you’ll take FINRA’s “Series 7” exam.

▪ FINRA arbitrates broker-customer disputes.


Canada

▪ Provincial securities authorities

▪ Investment Industry Regulatory Organization of Canada (IIROC)

European Commission

▪ Internal Market and Services Directorate General

Directorate G – Financial Markets. ▪ Markets in Financial Services Directives 2 (“MiFID 2”).

▪ Some market regulation is delegated to the home country.

China

▪ China Securities Regulatory Commission (CSRC)

▪ Authorized and supervised by the State Council.


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China

China Securities Regulatory Commission (CSRC)

Authorized and supervised by the State Council.


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