Stock Trading Basics

5. Stock Trading Basics Before we move on to investment banking and stock markets to nish up the survey of nancial institutions, it is a good idea that we understand how stocks are traded rst. 5.1 Stock Quote 1. Bid, ask, and last prices Buyers and sellers look at di¤erent prices. a) Does a small bid-ask spread indicate an active market? b) The market can be seen as a gigantic order book for now. 2. Volume Volume alone transmits very little information. 3. Settlement An order executed must be settled within 3 working days (T+3 Rule). 18 5. Stock Trading Basics 5.2 Order Types 1. Market orders Market orders are buy or sell orders that are to be executed immediately

at current market prices. 2. Price-contingent orders Investors also may place orders specifying prices at which they are willing to buy or sell a security. a) Limit orders A limit buy order is to buy shares at or below a stipulated price. b) Stop orders (stop market orders) A stop order is similar to a limit order, but once the stipulated price is reached, the order will turn into a market order for immediate execution. 5.3 Stock Trading Costs Trading stocks costs investors. Some of the costs are obvious and explicit, while others are not that straightforward. 1. Explicit costs a) Broker’s commission b) Bid-ask spread 2. Implicit costs a) Impact costs It takes time and price concessions for the market to absorb large orders. b) Timing costs Execution speed makes or kills a trade. The speed depends on the privilege level and technology. c) Opportunity costs "You’ll know that to lose your position is something nobody can a¤ord; not even John D. Rockefeller." 5.4 Leveraging Your Bets: Margin Trading 19 5.4 Leveraging Your Bets: Margin Trading There are many reasons why investors want to leverage their bets. For some, a strong belief in a certain stock’s direction calls for doubling down bets. For others, leveraging is the price (or the bene t, depending on the angle the investors look) of hedging. Leveraging through derivatives, such as options and futures, is not covered in this principles class. Buying stocks on margin means investing in stocks with borrowed money. We will use the balance sheet of an investor’s brokerage account to explain how margin trading is conducted. 1. Before stock purchase: 2. After stock purchase: 20 5. Stock Trading Basics 3. Calculation of margin (Note that margin can be either the dollar amount or the percentage. Pay attention to the context.) Margin = EquityValue of Stock a) The initial margin Set by the Fed to be 50%. b) The maintenance margin Set by the broker. If the percentage margin falls below this level, the broker will issue a margin call. c) A margin call Additional assets (cash or other securities) are required to be added to the account. Otherwise, the broker will liquidate stocks in the account to restore the percentage margin. 4. An example You purchased 100 shares of IBM stock on margin (50% initial margin). IBM’s stock price is $100 per share at the time you purchase. Suppose your...

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