Investments 3720

Deck 1: Market Structure and Exchanges

Brokers and Dealers

To understand the structure of many securities markets, it is helpful to understand the

difference between brokers and dealers:

Brokers
• Act on behalf of others (are agents)
• Make money by charging a commission

Dealers
• Act on their own behalf (are principals)
• Make money by charging a markup, or spread
• Maintain their own inventory
Stock Markets

The New York Stock Exchange (NYSE) was originally conceived as a brokerage market where
brokers would gather to execute trades on behalf of their clients. It was considered prestigious
for a company to have its shares traded on the exchange, due to the rigorous listing
requirements.

Shares traded off exchange, or over the counter (OTC), were therefore thought to be of lower
quality. The market for these shares were made by dealers, who trade these issues directly with
members of the investing public. With the rise of electronic trading, the National Association of
Securities Dealers introduced its Automatic Quotations System (NASDAQ). Today, while shares
traded on the NASDAQ are still technically traded over the counter, NASDAQ now also has
strict listing requirements, meaning the advantages between trading in one market or the other
are highly technically, and are typically of little interest to the retail trader.

Today both NYSE and the NASDAQ function as hybrid markets, obscuring the distinction
between brokers and dealers.
Order Types

Market Order – an order to buy, or sell, a given amount shares at whatever price the seller, or
buyer, is offering.

Limit Order (Buy) – an order to buy a given amount shares, at a specified price or lower.

Limit Order (Sell) – an order to sell a given amount shares, at a specified price or higher.

Stop Loss Order (Sell) – an order to sell a given amount shares, if the price falls below a
specified level.

Stop Loss Order (Buy) – an order to buy a given amount shares, if the price rises above a
specified level.
Short Selling

While the first four types of orders are pretty self-explanatory, the unitality of a stop-loss buy
order may not be immediately obvious – that is, an order to buy shares after its price goes up to
a specified level.

To understand why such orders are useful, consider what happens when we short sell a stock.
Here we borrow shares from a broker, sell those shares on the market, and then buy them back
at a later date. If the price we sell them for is greater than the price at which we buy them back,
the difference is out profit. In general, shorting a stock provides a way for us to profit on our
belief that the stock is expected to fall.

If the price rises after we sell the shares, we will have to buy them back at a loss. A stop-loss
buy order, therefore serves to limit our losses when we are short.
The Limit Order Book

The state of the market is recoded in a limit order book that shows how much shares are
available to buy and sell a specified prices. The book is divided between bids – the price at
which participants are willing to buy – and asks – the price at which participants are willing to
sell. The difference between the best bid (the highest buying price) and the best ask (the lowest
selling price) is called the bid-ask spread.

Different venues maintain their own order books. The best bid and the best offer across all
venues is called the National Best Bid and Offer (NBBO). By law, brokers are required to
execute trades at the best price.
The Limit Order Book
Bid Ask
2000
1800
1600
1400
1200
1000
600
800 1600
600
600 200
400 700
600 200 600
200 400
200
0
10.02 10.03 10.04 10.05 10.06 10.07 10.08 10.09 10.1

Here, each rectangle represents a different limit order.

The Limit Order Book
Bid Ask
2000
1800
1600
1400
1200
1000
600
800 1600
600
600 200
400 700
600 200 600
200 400
200
0
10.02 10.03 10.04 10.05 10.06 10.07 10.08 10.09 10.1

The the best bid and ask columns represent Top of Book, or Level One data.
The Limit Order Book
Bid Ask
2000
1800
1600
1400
1200
1000
600
800 1600
600
600 200
400 700
600 200 600
200 400
200
0
10.02 10.03 10.04 10.05 10.06 10.07 10.08 10.09 10.1

Access to the whole book, which is much more expensive, is known as Depth of Book, or
Level Two data.
Market Indices

If we want to get a sense of what the market as a whole is doing, we can look a market indices. The two most
widely known indices are the Down Jones Industrial Average (DJIA) and the S&P 500.

Dow

The Dow is a price weighted index composed of 30 large, well-known companies. Imagine you had a portfolio
consisting of one share of each stock. If you take the average their prices the result would give you the level of
the index. (It’s a bit more complicated than that, since the Dow must account for stock splits and so forth, but
that’s the basic idea.

S&P 500

The S&P 500 is a market weighted index composed of 500 of the largest companies. Imagine you take the
market capitalization (number of shares times the price per share) of each of the 500 companies and add them
up. The weight of each company is given by its own market cap divided by this total.