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Chapter 5
How Securities Are Traded
Learning Objectives
• Explain the role of brokerage firms and
stockbrokers.
• Describe how brokerage firms operate.
• Outline how orders to buy and sell securities are
executed.
• Discuss the regulation of the Canadian securities
industry.
• Explain the importance of margin trading and
short selling to investors.
Brokerage Operations
• Brokerage firms earn commissions on executed
trades, sales charges on mutual funds, profits
from securities sold from inventory, underwriting
fees and administrative account fees
• Full-service brokers offer a full range of services
including order execution, information on markets
and firms, and investment advice
• Full-service brokers in Canada are primarily
owned by large banks (e.g., RBC Dominion
Securities, BMO Nesbitt-Burns, and Scotia
Capital Markets
Brokerage Operations
• Discount brokers concentrate on executing
orders and thus are able to charge lower fees
• Do not offer research reports and
recommendations and/or advice
• Most of the full service brokerage firms have
discount brokerage operations (e.g. Royal Bank
Action Direct Discount Brokerage, TD
Waterhouse, and Bank of Montreal Investor Line
Brokerage Account Types
• Cash account: Investor pays 100% of purchase
price for securities to the broker (the most
common type of brokerage account)
• Margin account: Investor borrows part of the
purchase price from the broker
• Wrap account: A new type of brokerage account
where all costs are wrapped in one fee (for
investors with minimum investments of $100,000)
Fees and Costs
• Brokerage commissions differ by security, broker,
and investor
• The US eliminated fixed commissions requirements
in 1975 and Canada in 1983, now fees are
supposed to be negotiated
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Institutional investors have greatest negotiating
power (Why?)
On-line trading offers significantly lower commission
rates to individual investors
•
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In 1992 E*TRADE became the first brokerage service
to offer on-line trading
E*TRADE now offers banking services as well
Electronic Trading and the Internet
• Individual investors now have three choices
when executing trades:
1- Full-service brokers: e.g., BMO Nesbitt-Burns
2- Large discount brokers: e.g., TD Waterhouse
3- Internet discount brokers: e.g., E*TRADE Canada
Investing without a broker
• Dividend reinvestment plans (DRIPs) permit the
shareholders to reinvest dividends to purchase
additional shares of stock at no additional cost
• Some plans (approximately one third of Canada’s 70)
offer 3 to 5% discount for share purchases
• Therefore, it is possible to invest in the market without
a stockbroker
• A number of companies now sell shares directly to
investors (e.g., Exxon allows investors to open a direct
purchase account to buy its stock)
• Companies selling stock by this method view it as a
way to raise capital without underwriting fees
Orders on Organized Exchanges
• The TSX introduced the world’s first computerassisted trading system (CATS) in 1977
• On April 23, 1997 the TSX closed all floor trading,
and al TSX and TSX Venture Exchange stocks are
now traded electronically
• The NYSE continues to make use of the specialist
system
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Specialists maintain the limit order book
Specialists keep a fair and orderly market by
providing liquidity
Orders in OTC Markets
• Dealers are ready to either buy or sell


Bid price is the highest offer price to buy
Ask price is the lowest price willing to sell
•
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Ask price - Bid price >0 (dealer spread)
Dealer “makes a market” in the security
More than one dealer for each security in overthe-counter markets
Types of Orders
• Investors can buy or sell stocks in “board lots” or
“odd lots,” or a combination of both
• Canadian exchanges define “board lots” as
orders in multiples of 100 shares.
• A trade of less than 100 shares is considered to
be an “odd lot.”
• For example, an order of 356 shares would be
for three board lots and one odd lot.
Types of Orders
• Market order: The most common type of order,
authorizes immediate transaction at best available
price
• Limit order: An order that is executed only if the
buyer (seller) obtains the stated sell (ask) price.
- Limit orders are executed in order of price (e.g., a
limit buy order with a bid of $35 is filled before one with
a bid of $34.5, while a limit sell order with an ask price
of $36 is filled before one with an ask price of $36.5)
- Investors can enter limit orders as day orders or gooduntil-cancelled (GTC) orders which remain in effect
until cancelled or renewed.
Types of Orders
• All or none orders (AON) orders are only executed if
the total number of shares specified in the order can
be bought or sold (“fill or kill” orders). The advantage
of this type of order is that prevents accumulation of
odd lots, which can be more expensive to trade
• Stop order: Specifies a particular market price at
which a market order takes effect (e.g., a stop
order to sell at $50 becomes a market order to
sell as soon as the market price reaches (or
declines to) $50.
• A sell stop order can be used to protect a profit
in the case of a price decline
Difference between limit and stop
orders
• A stop order specifies a certain price at which the
market order takes effect. The exact price
specified in the stop order is not guaranteed and
may not be realized.
• Limit orders are placed on opposite sides of the
current market price of a stock from stop orders.
• For example, while a buy limit order would be
placed below a stock’s current market price, a buy
stop order would be placed above its current
market price.
Clearing Procedures
• The settlement date is the same day for
government T-bills; two business days for other
Government of Canada liabilities
• Settlement dates for stocks are three business
days after the trade date

Legal ownership transferred and financial
arrangements settled with brokerage firm
• Transfer of securities and funds between
exchange members facilitated by a clearinghouse:
The Canadian Depository for Securities (CDS)
Canadian Regulatory Environment
• Self-Regulatory Organizations (SROs) regulate
their own activities
• Canadian Investor Protection Fund (CIPF) was
established to protect investors
• Investment Dealers Association of Canada (IDA)
is the national trade association for the
investment industry
• Canadian Securities Institute (CSI) is the national
education body of the Canadian securities
industry
Margin Accounts
• Exchanges set minimum required deposits of
cash or securities
• Investor pays part of investment cost,
borrows remainder from broker

Margin is the percent of total value that cannot
be borrowed from broker
• Margin call occurs when the actual margin
declines below the margin requirement
• Actual margin= (Market value of securities – Amount borrowed)
Market value of securities
Margin Accounts
• Cash has 100% loan value, which means that
$100,000 in cash deposits constitutes a $100,000
margin
• Stocks have 50% (or lower) loan value because of
potential fluctuations in their market value (i.e., an
investor may have to deposit $200,000 worth of stocks
to satisfy a $100,000 margin requirement
• Margin requirements for stocks traded in Canada range
from 30% to 100%, depending on the stock’s price
(Table 5.1 pg 141)
• The margin requirements increase as the stock price
decreases, reflecting the additional risk associated with
lower-priced stocks.
Margin Accounts
What are the advantages and disadvantages of
margin accounts?
• Margin accounts allow for the magnification of
gains (but also losses).
• With a margin requirement of 50%, percentage
gains are doubled (ignoring transaction costs and
interest costs), because the investor only has 50%
of the value of the transaction at stake
• The risks are obvious, if the transaction goes
against the investor, the percentage losses are
doubled
Margin Accounts
• Example 1
If the margin requirement is 30% on a $10,000
transaction (100 shares at $100 per share).
How much money must the investor come up
with? How much will the investor borrow from
the broker?
Margin Accounts
• Example 2
Assume that the margin requirement is 30% and
that the price of 100 shares of stock declines
from $100 to $95.
Calculate the new actual margin.
How much will the investor have to contribute in
order to restore the margin requirement of 30%
Margin Accounts
• Example 3
An investor purchases common shares of two
companies on margin. The first share (A) has a
margin requirement of 70% and is presently trading
for $10, while the second share (B) has a margin of
50% and is trading at $2.
a- What is the total margin requirement if the investor
purchases 1,000 shares of A and 1,000 shares of B?
b- If the price of A immediately increases to $11 and the
price of B falls to $1.5, how much is the required
deposit on the margin account?
Short Sales
• The sale of a stock not owned by the investor but
borrowed from a third party in order to take
advantage of an expected decline in the price of the
stock
• Borrowed security sold in open market, to be
repurchased later at an expected price lower than
sale price
• The investor profits from the difference between the
price at which the borrowed stock was sold and the
price at which it was purchased
Short Sales
• The securities could be borrowed from another
broker
• Individuals sometimes agree to lend securities to
short sellers in exchange for interest-free loans
equal to the value of the securities sold short
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Investor (short seller) liable for declared dividends
Short sale proceeds held by broker, no funds are
immediately received by the short seller
There is no limit on short sales. Short sellers can
remain short indefinitely until the lender wants the
securities back
Short sales are permitted only on rising prices or an
uptick
Short sellers must have a margin account to sell short
Risks associated with short selling
• The threat of being required to purchase shares
at undesirable prices if the margin is not
maintained and/or if originally borrowed stock is
called by its owners and cannot be replaced
• The possibility of volatile prices if a rush to cover
short positions occurs
• Unlimited potential loss
Short Sales
• Example 1
Molson requires a margin of 130%. If Helen short
sells 100 shares for $36 each, How much will she
have to deposit to bring the margin account up to
130%?
If the price of Molson rises to $42, how much will
Helen have to deposit in order to restore the
margin?
If the Price of Molson fell to $30, how much will
Helen be able to withdraw from the margin?
Short Sales
• Example 2
What amount must an investor put into a margin
account, if the margin requirement is 130% and
the investors short sells 1,000 shares at $10?
What will happen if the price of the shares
increase to $12?
Appendix 5-A: Trading on the NYSE
• Centralized continuous
auction market
• Exchange participants:

single specialist
 commission brokers
 independent floor
brokers
 registered traders
• SuperDot
• Major roles of NYSE
specialist
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Dealer
 Agent
 Catalyst
 Auctioneer
• Commissions
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deregulated in 1975
Appendix 5-B: U.S. Securities Regulation
• The Securities and Exchange Commission (SEC)
was created by the US Congress in 1934

An independent and quasi-judicial agency of the US
government
• SEC is required to investigate complaints of
violations in securities transactions
• Investment advisor and companies must register
with the SEC and disclose certain information
• The National Association of Securities Dealers
(NASD) is a trade association established to
enhance the self-regulation of the securities industry