Common Stock

• equity security--represents ownership
• entitled to dividends when earnings are distributed
• entitled to assets if company liquidations (AFTER creditors are paid)

• Exchanges
• physical location for trading
• trading done by members who buy a seat on the exchange
• at any given time, a member must be trading for own account OR for another (as a broker) NOT both
• stock traded on the exchange are listed stocks
• New York Stock Exchange (NYSE) or the "Big Board"
• about 2800 U.S. companies listed
• total market value of $18 trillion (3/2004)
• 1366 seats, recent seat price of $1.35 million (October  2003)
• a stock trades at a specific post on the trading floor (20 posts, trading about 100 stocks each)
• specialist processes buy and sell orders at the post
• a specialist is a market maker with an obligation to maintain a fair and orderly market in that stock
• act as buyer or seller as needed (10% of trades)
• match buyers and sellers
• maintain order priority
• 10 firms have 450 specialists (each specialist performing for 5 to 10 stocks)
• process trades coming in from floor brokers (5%) or SuperDot (95%)
• specialist system may be on its way out....
• American Stock Exchange (AMEX) as of 2/02:
• merged with Nasdaq 1998
• specializes more in equity derivative securities than common stock lisitings
• Regional Exchanges
• Pacific Exchange (PCX), Chicago Stock Exchange(CHX), Philadelphia Exchange (PHLX), Boston Exchange (BSE), Cinncinati Exchange
• cheaper seat prices than national exchanges:  as of 1/00 prices ranged from $35,000 to $300,000
• OTC markets
• electronic network of geographically dispersed dealers
• unlisted stocks
• dealers act as market makers BUT
• not obligated & more than one market maker per stock
• Nasdaq
• over 4000 companies listed with a market value of $2 trillion as of 3/03
• over 500 dealers
• listing requirements
• other OTC systems not involving Nasdaq
• Direct trading--Fourth market
• between institutional investors
• avoids commissions and frontrunning
• limited incentive due to the abolishment of fixed commissions in 1975, which means large traders can negotiate cheaper commissions

• Types of orders
• (orders are instructions from investors to brokers who trade on their behalf)
• market order
• buy/sell order to be executed at the best price
• orders of this type are given priority on the trading floor of exchanges
• no guarantee of execution price; i.e. adverse price movements could take place between the time an order is placed to the time the trade actually occurs
• limit order
• buy/sell order where the investor specifies an acceptable price for the trade
• example:  buy at $50 or less; sell at $52 or more
• recorded by specialist in limit order book to await execution
• although the investor sets a reservation price, there is no guarantee that the trade will be executed at all
• stop order
• stop loss order
• order lies dormant and turns into a market order when a certain price (known as the stop) is reached
• example: buy if price rises to $60; sell if price falls to $58
• allows investors to get out of a position at an acceptable price without constantly watching the market BUT a stop order could be triggered prematurely in a volatile market
• stop limit order
• turns into a limit order when the stop is reached
• example:  buy if price rises to $60, but only if execution price is less than $65
• advantages of a limit order and stop order, but the disadvantages of a limit order
• market if touched order
• turns into market order if designated price is reached.
• example: buy if prices falls to $55; sell if price rises to $62
• allows investor to get into a position at an acceptable price without constantly watching the market
• how long is an order good?
• fill or kill order must be executed when reaching trading floor or it is canceled
• open order/good until canceled  is good indefinitely
• order size
• round lots of 100 shares are most commonly traded
• NYSE traded 43 billion round lots in 1998
• odd lots are less than 100 shares and more difficult to trade
• NYSE trade 170 million odd lots in 1998
• block trade is a large trade--either 10,000 shares or $200,000 in value
• Short selling
• sale of securities not owned by the seller, but borrowed from another investor
• why do it?
• a short seller is trying to profit from the belief that the stock is currently overvalued and that its price will fall within a certain period of time
• how is it done?
• borrow stock through a broker (on which interest is paid)
• sell the stock (hopefully at its overvalued price)
• repurchase and return stock later (hopefully at a lower price)
• short selling can be destabilizing because selling could drive down prices; because of this potential, there are tick-test rules to determine if a short sale is allowed:
• short sales are allowed if the previous trade was at an uptick  in price or a zero uptick in price
• i.e. if the price has risen or stayed the same in previous trades
• a price trend of $20 1/8, $20 3/8   OR
• a price trend of $20 1/8, $20 1/8
• so short sellers must believe the stock price is going to fall, that it is going to fall soon, and is not currently falling--and the losses of a short seller, when prices actually rise instead of fall, are potentially unlimited
• Buying on the margin
• this involves the buyer borrowing part of the purchase price for the stock, and putting up the stock as collateral on the loan
• borrows at the call money rate
• since 1934, the Federal Reserve Board of Governors imposed an initial margin requirement. Since 1975 the requirement has been 50%--requiring at least a 50% downpayment for a stock purchase.
• as the stock price falls, the collateral is worth less and less;  if the price falls to a point where the collateral is worth only a little more than the loan (only 25% equity is the minimum maintainance margin on the NASDAQ and NYSE), the stock holder will receive a margin call
• owner must put up additional cash, or stock will be sold
• falling stock prices can prompt many margin calls, which will lead to more sales and a further decline in stock prices
• the purpose of the initial margin requirment is to have margin calls only if there are significant price declines
•  Institutional Trading
• institutional vs. individual (retail) trades
• institutional trades are usually larger, at smaller comissions
• larger orders often require special execution methods to avoid large price movements
• institutional trading makes up over 50% of the share volume on the NYSE
• block trades
• large # of shares (10,000 or $200,000 in value) of  a given stock
• initially executed in "upstairs market" where other firms may directly take other side of trade;  any remaining shares may be executed on NYSE or Nasdaq ("downstairs")
• program trades
• large trade of large number of different stocks (15 stocks, $1 million)
• used to acheive proper asset allocation for mutual funds
• problem:  firm wants to minimize frontrunning,
• brokerage firms trade ahead of program trade in anticipation of the trade causing price movements
• results in firm not getting the best price in their trade
• example:  if broker knows of large buy order for program trade, the broker buys the same stocks to benefit when program trade causes price to rise.  But broker's actions push up the price, so firm with program trade ends up paying more for stock
• agency basis:  brokers bid for program trade by commission
• low commission, but likelihood of frontrunning
• agency incentive arrangement:  broker sets benchmark portfolio value for trade
• if broker gets better price, receives commission + bonus
• higher trading costs, but frontrunning less likely

• is a measure of average price performance of a group of stocks
• different indexes are highly correlated over the long run, but they are different with respect to
• what stocks are included in the index
• arithmetic vs. geometric averages of price
• weighting of stocks in the index--equal, price, or value weighted
• stock exchange index
• tracks performance of all stockes traded on the exchange
• NYSE Composite Index
• NASDAQ Composite Index
• subjectively selected index
• organization selects what stocks are included
• Dow Jones Industrial Average (DJIA)
• price weighted average of 30 large blue chip companies; leaders in a cross section of industries in U.S. economy
• most followed index, but narrowest in what it measures
• recently changed in 1997 and 1999 to reflect changes in the composition of U.S. economy (growing importance of technology and service sectors; decline of manufacturing sector) and changes in industry leaders
• DJIA changes may halt trading on NYSE
• 10% drop   1 hour halt
• 20% drop   2 hour halt
• 30% drop   trading halted for rest of the day
• Standard and Poor's 500 (S&P 500)
• 500 large blue chip companies
• most popular benchmark for index funds
• objectively selected index
• numerical criteria determines if stock is included; usually based on market capitalization (the total value of shares outstanding)
• Wilshire 5000
• all publicly traded stocks, over 6500
• total market index--the broadest index available
• Russell 2000
• take 3000 publicly traded companies with largest market capitalization, then take smallest 2000 of those
• consider the benchmark for performance of small company stocks

• What information is reflected in current stock prices?  What implications does this have for chosing stocks?
• This is a HUGE and unresolved debate.  Keep in mind, though, that practitioners have a vested interest in markets being inefficient, since it would justify their services.
• In general, the greater the price efficiency of a market implies
• the greater the amount of information reflected in current asset prices AND
• the more difficult it is to exploit information to earn above-averages returns in that market
• positive abnormal returns
• Some great outside reading about the evidence for and against an efficient U.S. stock market:
• A Random Walk Down Wall Street by Burton G. Malkiel (in its 8th edition)
• the book looks at the ongoing debate among both academics and practioners about whether stock prices are predictable or not (a random walk).  The first book is very readable (and cheap--less than $15) but the second is quite technical.
• 3 levels of Price Efficiency
• Weak form efficiency
• holds if current stock prices reflect information about past prices and trading history
• if a market is weak form efficient then using past prices and trading history to predict future stock prices will not work
• technical analysis will fail to beat the market, consistently and in the long run
• Is the U.S. stock market weak form efficient?  YES
• after adjusting for transactions costs, technical analysts methods do not outperform market indexes
• Semi-strong form efficiency
• holds if current stock prices reflect all relevant publicly available information
• if a market is semi-strong form effcient then using public information about companies and the economy in order to predict future stock prices will not work
• fundamental analysis will fail to beat the market, consistently and in the long run
• Is the U.S. stock market semi-strong form efficient?  EVIDENCE IS MIXED
• YES.  Professionally managed portfolios (such as mutual funds) do not perform better than portfolios of randomly selected stocks over long horizons
• 1974-94 only 30% of professional money managers outperformed the S&P 500
• NO.  Pricing anomalies, such as the size effect or the January effect, do exist for long periods of time.
• Strong form efficiency
• holds if current stock prices reflect all information, both public and private
• if a market is strong form efficient, then predicting future stock prices is impossible
• Is the U.S. stock market strong form efficient? NO
• corporate insiders' portfolios consistently outperform market benchmarks
• note:  this does not necessarily indicate illegal insider trading
• the fact the professional money managers do not as a group outperform the market suggests that as a group they do not have superior information
• Implications for trading
• those that believe there are substantial inefficiencies in stock pricing would choose an active strategy
• buy/sell stocks in portfolio based on methods from technical and/or fundamental analysts
• examples of actively managed portfolios include growth, value, sector funds
• heavy trading increases costs, incurs tax consequences, and pulls down the return of the portfolio
• looking at past price data suggests the odds of such strategies working are low
• those that believe the stock market is fairly efficient would choose a passive strategy
• buy and hold a portfolio, seeking to match the long term gains of the market
• examples of passively managed portfolios include index funds and unit trusts
• expenses are low due to less trading, capital gains taxes are deferred
• index funds have outperformed most of the actively managed funds in the past 10 years