Page 65 - DCOM507_STOCK_MARKET_OPERATIONS

Stock Market Operations

Notes stock exchange. There are two main mechanisms for achieving liquidity – the quote-driven and
the order-driven. In the quote-driven markets, dealers announce a ‘bid’ price at which they stand
ready to buy up to some maximum quantity and an ‘ask’ (or offer) price at which they are
prepared to sell. They then meet orders out of their inventory, adjusting prices accordingly.
In order-driven markets, dealers (known as intermediaries) submit limit orders on a continuous
basis to the stock exchange computer. A limit order is an instruction to buy (or sell) shares up to
specified maximum at a price equal or below (or above) the specified level. These orders are
‘crossed’ or executed against existing limit orders if possible, but otherwise added to the order
book, which forms the price schedule for the market. Similarly, clients can submit limit orders.
They can also submit market orders, which are unconditional as to price, and are immediately
matched against the most favourable limit order price, on the computer. An individual wishing
to buy or sell a security would contact salesperson at a brokerage firm and place an order. The
order must specify the name of the issuer of the security, types of security, whether order is for
purchase or sale, the order size, type of order, and the price and length of time the order is to be
outstanding. Under type of order, market, limit, short sale, stop orders are to be specified.

Order size trading on the stock markets, is usually carried out in round lots. A round lot for most
common stocks is considered to be hundred shares. An odd lot is a quantity different from
hundred shares. Orders can be for both, round or odd lots. Generally, odd lots have higher
transaction costs. For securities other than common stock or ordinary shares, there is no
differential categorization by order size, but there may be a minimum order size.
Market orders are the most common type of orders placed by an individual investor. A market
order is an order to buy (or sell) at the least (or highest) price currently available. The purchase
or sale price can differ from the bid or ask. First, consider a market buy order. Other investors
could simultaneously be placing market orders to sell, and the shares could be traded inside the
bid-ask price. Second, the bid-asks spread could change, between the time the order is placed
and the time it is executed, because of other preceding trades or because new information caused
a change in the bid-ask spread. Thus, an investor using a market order is insuring execution with
some uncertainty as to price.

Limit orders are orders to buy or sell at a minimum or maximum price. Limit orders control the
price paid or received, but the investor has no way of knowing, when and if the order will be
filled. A limit order may be utilized by an investor, who observes the price to be varying within
a range and tries to sell or buy the stock at a favourable price within the range, and is willing to
bear the risk of not filling the order.
Short sale investors can sell shares they do not own. This type of trade is referred to, as a short
sale. When an investor short sells a security, the security is physically sold. Since the investor
does not own the security, the brokerage firm borrows it from another investor or lends it to the
investor. The securities borrowed normally come from the securities held, at the brokerage
firm, for other investors. Securities, kept at a brokerage firm by investors, are referred to as
securities registered ‘in street name’. If the firm does not possess the shares they desire to sell,
they would borrow the shares from someone else, often another broker. The investor, whose
shares were borrowed and sold, normally would not know that the transaction had occurred
and would definitely not know who had borrowed the shares. Since the shares are physically
sold, the company would not pay dividend to the investor whose shares were borrowed, but
instead pay the purchaser of the shares. For the investor, whose shares are borrowed, not to be
hurt by the short sale, he or she must receive the dividends. The person, who sold the shares
short, is responsible for supplying the funds, so that the person, whose shares were borrowed,
can receive any dividend paid on the stock that was sold short. At a future time, the short seller
repurchases the shares, and replaces the shares that were borrowed.

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