Week 3: Trading Locations & Practices

trading locations

Week 3: Trading Locations & Practices

“Overview for the Week … Stock Exchanges … Technology in Trading … How Margin Works … Advanced Margin Considerations … Short Selling – Basics … Short Selling – Games and Strategies … Setting the Valuation Stage … Economic Analysis: Measurement Issues”
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Summaries

  • Week 3: TRADING LOCATIONS AND PRACTICES > Stock Exchanges > Lecture: Stock Exchanges
  • Week 3: TRADING LOCATIONS AND PRACTICES > Technology in Trading > Lecture: Technology in Trading
  • Week 3: TRADING LOCATIONS AND PRACTICES > How Margin Works > Lecture: How Margin Works
  • Week 3: TRADING LOCATIONS AND PRACTICES > Advanced Margin Considerations > Lecture: Advanced Margin Considerations
  • Week 3: TRADING LOCATIONS AND PRACTICES > Short Selling - Basics > Lecture: Short Selling - Basics
  • Week 3: TRADING LOCATIONS AND PRACTICES > Short Selling - Games and Strategies > Lecture: Short Selling - Games and Strategies
  • Week 3: TRADING LOCATIONS AND PRACTICES > Setting the Valuation Stage > Lecture: Setting the Valuation Stage
  • Week 3: TRADING LOCATIONS AND PRACTICES > Economic Analysis: Measurement Issues > Lecture: Economic Analysis - Measurement Issues
  • Week 3: TRADING LOCATIONS AND PRACTICES > Economic Analysis: Policy Issues > Lecture: Economic Analysis - Policy Issues

Week 3: TRADING LOCATIONS AND PRACTICES > Stock Exchanges > Lecture: Stock Exchanges

  • Let’s talk finally about stock exchanges for this segment of our class today.
  • How do companies get listed on exchanges? Again, I’m using the example of the New York and the NASDAQ, which are exchanges that I’m the most intimately familiar with.
  • There are multiple trading systems around it, but there are multiple levels of subscribers: There are market makers, there are people who do order executions, and then, there are investors- level 1, 2, and 3.
  • Different levels of market participants can see some or all of those quotations.
  • The specialists are kind of uber market makers in this place.
  • They are the guy, the go-to person for that particular security in which they make market.
  • Their job is more than just buying and selling stuff for profit.
  • They are charged with having to maintain a fair and orderly market.
  • They have to execute orders for other brokers on the floor.
  • That’s the supply and demand equilibrium in this market place above and below current market prices, and it’s those quotations that are visible to only the specialists on the New York Stock Exchange.
  • Here, in India, you would be surprised, some of you would be surprised to hear that this limit order book is central and it’s open and everybody can see this; everybody can be a limit order, a market maker if they wanted to be.
  • There is actually a level of transparency in Indian equity markets that doesn’t seem to exist yet, at least, on the floors of New York Stock Exchange, although they are getting that way pretty soon.

Week 3: TRADING LOCATIONS AND PRACTICES > Technology in Trading > Lecture: Technology in Trading

  • So it became, that’s when those were the kinds of things that started the practice of looking through large masses of numbers to try and find patterns in prices.
  • By the way, the Medallion Fund that I alluded to, a few seconds ago, had something like 40% rates of return annually over the first 10 plus decades of its existence.
  • So they were clearly returns to be made from this kind of short term trading.
  • More recently, in the last few years, short term trading has come under a different name, it’s called High Frequency Trading now.
  • People not just are exploiting price differences, in terms of different securities at different points in times, people are even playing games in terms of how they place orders.
  • You might find people putting in orders to kind of test out, and suss out, feel out, what are the supply and demand characteristics there are in the marketplace and then kick in programs to go out and do thing.
  • If you go out and look at or are fortunate enough to look at what high frequency trading shops, offices look like, there is really nothing going on, there is just silence, there are just these huge banks of computers and screens where transactions are going faster than the eye can see.
  • Trades are being executed, hundreds of thousands of trades a minute, a second, even, sometimes now.
  • There is no hurry and burry and flurry like you might have been used to seeing on the floors of registered stock exchanges like New York or any other places that you are familiar with.
  • Recent estimates tell you that something like 40% plus of all equity trading in the US is high frequency or related.
  • One peculiar aspect of the high frequency story that I want to highlight for you, again just to put in perspective, how these markets have evolved from the time that even I started in this business There is a notion of something called colocation.
  • Colocation has to do with the physical location of your trading terminal to that of the market maker, who’s the final arbiter of buy-and-sell orders that are coming through.
  • A few weeks ago, we had a speaker coming here from Australia, who had done a study of the Australian high-frequency exchange.
  • What he told us was that there was this big room with lots of computers, the markets maker’s desk was in the middle and around him were banks of traders’ terminals.
  • The exchange had mandated that the distance between the market maker’s terminal and that of each of those trading terminals was to be exactly 65 feet.
  • If one terminal happened to be physically closer than 65 feet, then the wires connecting them to the market makers would be twisted so that his distance would be 65 feet exactly.
  • You start wondering, why does an inch or two matter here.
  • It does, when you have trades going through in milliseconds, thousandth of a second, microseconds, even nanoseconds.
  • In a world like this, where trading is so frequent, and so rapid, and so popular; you have to ask yourselves as investors wanting to enter this marketplace, “What is the role for me? Is there even a role for me to play in this thing?” And that’s the topic that we will talk about next.

Week 3: TRADING LOCATIONS AND PRACTICES > How Margin Works > Lecture: How Margin Works

  • What if I wanted to buy more shares with it? I have borrowing capacity now that the equity has given me.
  • ” Remember the initial margin was 50%. So, if you have 15,000 in equity to commit now; you can support twice as much- $30,000 in market value.
  • You only have 25,000 in market value at the moment, so you’ve got an extra $5000 of borrowing capacity.
  • You can leverage this game and keep playing it upwards, higher and higher, and in bull market times, in years past, this is what people were doing with assets, with securities, even with houses, they tell me, in the mid-2000s in the US. The green side is always the good side to look at.
  • What if the price of the security drops from 20, which is what you bought it for, down to 14.
  • The market value of the 1000 shares you purchased is 14,000.
  • That doesn’t change, it’s still the same 10,000 it used to be, no interest.
  • Of the 10,000 of equity you put in, only 4000 is left because the market value has eroded.
  • Your margin, which is just the equity to your total market value 4/14 is 28%. Price went down 30, but your paper loss is actually 60%. That doubling happens on the downside as well.
  • Let’s also introduce the idea of a maintenance margin into this setup.
  • Remember the initial margin that you are first required to deposit the moment you made the transaction was 50.
  • To protect the lender against declines in value, there was a maintenance margin, which in this case we have said was 25%. As it stands now, you are at 28.6, so you haven’t quite reached that threshold level yet.
  • At 25%, you get what is known as a margin call, and let’s kind of take a sense of how that works.

Week 3: TRADING LOCATIONS AND PRACTICES > Advanced Margin Considerations > Lecture: Advanced Margin Considerations

  • You ride it out, but then, risk management sort of says, “Well, how low a price am I going to have to tolerate before I get a margin call?” and that’s what this illustration shows you.
  • Suppose market value is P, you just solve the equation for the margin, definition which is equity over market value, which in the market value is now a 1000P, and what’s left over is market value minus debt is the equity.
  • Divide one by the other and you see a margin call of 25.
  • You definitely, definitely get a margin call if you are at 16% margins, way below the threshold level.
  • Not all the way up to the initial margin of 50, but up to the 25% maintenance margin account.
  • Basically, if your equity stays the same because the market value and the debt values have adjusted once you sold stock and paid off debt from market value into debt, right? So, the 2000 of equity will support an $8000 of market value to bring you at maintenance level requirements of 25%. So, you have to sell; you have to bring your market value down from 12,000 down to 8000, which is a sale of a $4000 position in that stock.
  • It’s also easy to do it when you have margin rates of-when you have margin rates of 50% initial and 25% maintenance, but what if it was, say 65 and 35.
  • That’s it for the margins trading stories, but I do want to tell you a couple of things around it that, you know, bring this concept of a margin into context.
  • In bull market modes, in the US- which is the kind as I always tell you, my more familiar sort of turf- margin borrowing goes through periods of increase and decrease when markets are very bullish.
  • What does that mean? It means that if markets take a sudden dive for the worse, lots of investors could get deluged with margin calls.
  • In the examples I showed you, we came up with ways to put up the money to meet the maintenance margin call and live to play the game another day.
  • If you are talking about big investors, big hedge funds that take all kinds of risky positions, they get a margin call, they may not be able to come up with the bucks or get a loan facility from a bank who sees them in trouble in order to make good on the margin call.
  • Now, that margin broker who is selling your securities doesn’t really care about getting you the best price for them.
  • What- and this happens periodically when you see markets really taking a dive, and you will see on the tape, huge blocks of shares just trading down, sometimes after 2 o’clock in the afternoon, and if you are a market watcher looking at market prices, this will not make sense to you until you stop and take-recognize that this is probably somebody in trouble and some margin broker is just puking out that positions left and right.
  • Margins are a dangerous game, and that’s what I’m trying to get-they have the-the green portions of my slide showed you the appealing side of it, the red portion showed you the non- appealing side of it.

Week 3: TRADING LOCATIONS AND PRACTICES > Short Selling – Basics > Lecture: Short Selling – Basics

  • Not just you, but some-every individual who owns shares in “street name” as it’s called, has provided the ability for it to be lent to somebody else.
  • When a short seller comes calling and saying, “I want to locate shares to borrow,” your broker finds the shares for you from somebody else’s account and sells them in the market place at the going market price.
  • Your strategy is to borrow the shares, sell them at 75, and turn around at some future point and buy them back when the prices have hit some level that you think is reasonable for the stock to be at.
  • Another question for you is, is there a time frame within which I need to return the shares or I need to pay back the shares to the person I borrowed it from? Prof. S.G. Badrinath: Technically, there is no time frame.
  • ” Usually the way this borrowing and shorting happens, it happens through a margin account and so, what you get is something like a margin call, which will mean that you will have to make some deposits to continue the short sale going, and there’s no limit other than that.
  • It’s when you eventually choose to buy the shares back and return them to the lender of the stock-that process is known as a covering the short sale, by the way.
  • The other thing that could happen is, in the interim between the shares having been lent to you and your having short sold them to somebody, say there is a dividend comes along.
  • The guy who originally owned them and doesn’t know they have been lent and the second guy who actually borrowed them when they were short sold.
  • What if I borrowed it and he wants to sell those shares to somebody? Prof. S.G. Badrinath: If he borrows … if he wants to sell those shares, this rarely happens – given that there is so much liquidity in this market-there is lots of borrowing and lending at least in the west that tends to take place.
  • If he needs the shares back for whatever reason, the broker can always find a way to replace them without having to come back to you.
  • Just to add to that, here in India, short selling is not particularly common because this lending market, and the ease at which lending and ownership transferring happens is not very much in place.
  • Prabhu: Can you give me an example of what strategies traders normally use to do shorting? Prof. S.G. Badrinath: Think first for the reasons of why people short.
  • Something is wrong with the fundamentals of the company or some characteristics of the company’s expected near-term future performance is not reflected in the market price, so they want to go out and short it.
  • Having shorted it, of course, it is not different from a long position, in that instead of waiting for prices to go up, we are now waiting for prices to come down, and maybe the prices do come down, maybe they don’t.
  • Many people, not just yourself, may have gone short that stock because they are all expecting the same thing you are that when this news becomes public, the price is going to collapse, and this piece of evidence called-this piece of data called short interest is actually something that is published every so often.
  • Just to fill in the gaps on that, if you go out and look, most short-on most stocks, the short interest is never more than 5, 7, 10%. This is not a huge activity in the market place.
  • People tend to be much more long than short for the most part.

Week 3: TRADING LOCATIONS AND PRACTICES > Short Selling – Games and Strategies > Lecture: Short Selling – Games and Strategies

  • He covers, somebody else covers, and before you know it, like a rocket, the stock price has gone up higher.
  • That’s what is known as a short squeeze, and it’s not even a-it shouldn’t even be called a strategy, it is just a game unsuspecting people play on traders, and this tends to happen, you know, whenever there is some really good or bad news about a particular stock causing all this kind of market gyration.
  • There is one other strategy that I want to mention here, and that you can use the short sale as a hedging device.
  • The way I understand is that short squeeze is more like some kind of a game played in the market and not technically a strategy.
  • What are the other strategies then that people make money with in terms of shorting? Prof S.G. Badrinath: One strategy that long people use is come to be called market neutral strategies.
  • Here, the idea is that you take both long and short positions in different stocks.
  • You might think Urban Outfitters or Abercrombie and Fitch have really good prospects down the road, and you want to take long positions in them.
  • You could long the stocks that you think are going to do well, and simultaneously, short the stocks that you think are going to do badly.
  • You’ve got a pair of longs and shorts, and you can do them in whatever scale you like.
  • You could be-80% of your money could be long something and only 20% you could be short.
  • If you are market neutral, which is a particular variation of this theme, you have enough exposure short and long to both these stocks, so that net-net your market beta is close to zero.
  • The good stocks you are long could do badly and the stocks that you are short could do really well, in which case, you are bleeding money on both sides as well.
  • I think, this conversation is just about what else can you do to long or short, and the most common is a pairs trade, a market-neutral trade, that kind of thing.
  • Talking about pairs, let’s say, I’m doing my taxes and I’ve made a lot of money this year and I’ve made certain profits with certain stocks, and I don’t want to book the profits this year because I already have a lot of tax on hand, but at the same time, if I don’t cash in my profit, there is a possibility that I will not have this money next year.
  • So what can I do with shorting? Prof. S. G. Badrinath: It’s an interesting question.
  • All you do is you short a second batch of shares at 50.
  • Your long, say 1000 shares at 25 and short, 1000 shares at 50.
  • That technically amounts to selling my shares today, but not in a physical way, just in terms of shorting other shares, which I’ve borrowed.
  • The long position you own is up 35 now, but the short position you own is down 10.
  • For the five-dollar gain you have on the long side, look at the short side.
  • You short at 50, covered at 30, you have a 20- dollar gain there, 25 is still preserved.
  • In the US, decades ago, what they said was if you do that second short sale at 50, the tax rules have now changed to make you treat that second sale as a constructed sale of the first one.
  • People said, “Well, if I can’t do that on the same stock, what if I find a stock that is similar and short a similar stock? Then, I’m fine.
  • “I will do options on the same stock rather than the stock it sells.
  • I joke with my students often about there is a fine line between tax avoidance, which is legal and tax evasion which is not, and this kind of falls in that gray area some place.
  • It’s to get you to think in terms of managing risk, in terms of locking in profits, and there are lots of strategies like these, not just in the context of short sales that are available to people who want to hedge, manage their exposures in many ways.

Week 3: TRADING LOCATIONS AND PRACTICES > Setting the Valuation Stage > Lecture: Setting the Valuation Stage

  • What does top down mean? Top down essentially means that you start first by looking at macro-economic conditions, local and now increasingly global in this integrated market place that we inhabit on the planet.
  • The macro conditions exercise is really, sort of, a bit like reading the tea leaves.
  • Broad brushstrokes are really what are sort of attempted here.
  • Once we get past that sort of broad-brush understanding of macro-economic things, we then look at industry specific stuff; what’s happening in different sectors of the economy, financials, banking, technology, retail, that sort of thing.
  • This is the sort of process we will follow as we go ahead. So, the first thing I want to do is to give you a sense of the kinds of macro numbers that are relevant here.
  • As I have mentioned many times before in this presentation to you, I am sort of splitting things between the US largely and India to some extent, where I currently reside.
  • A few will be India based then we will, sort of, go back and forth trying to get a sense of other locales as well.
  • It averages out to about 2.5 to 3% a year looking over a really long-term perspective, which is, if you think about it, a pretty dynamic sort of growth rate for a large mature economy like the US is.
  • Central banks and policy makers in the US and other places are continuously trying to learn to measure, to revise, to tweak, to affect how the total production of goods and services, which is what GDP is, comes out in the future.
  • Earlier this year in 2015, the Indian statisticians actually came up with some pretty dramatic ways in which they measure GDP, again, to be, sort of, consistent with global practices, if you will.
  • You can look at it in terms of a per capita basis, which is not very commonly done, but again, I have this little slide that I want to give you a feel for how per capita numbers might change things because per capita things, as you know, are clearly tied to population growth.
  • This has caused all kinds of global concerns and witnessed a sort of dramatic rapid decline in commodity prices, especially in oil prices over the last year or so.
  • Especially if you are studying emerging economies, a constant sort of concern that is raised by anybody deploying capital in these locations is of how reliable are these numbers, and that is why these methods, these processes are being constantly tweaked.

Week 3: TRADING LOCATIONS AND PRACTICES > Economic Analysis: Measurement Issues > Lecture: Economic Analysis – Measurement Issues

  • The reason why people tend to exclude food and energy and focus on a core rate of inflation is that you don’t want to make policy based upon a number or a set of numbers that are very volatile.
  • Remember, central banks carry a big stick and you don’t want them to wield it willy-nilly just because oil prices went a certain way, especially as they are known to be volatile and go a certain way.
  • It is actually in the interests of people that policy is based upon moderated influences of numbers like the core CPI rather than reacting to every fluctuation in a commodity price that is notoriously volatile.
  • In other regions of the globe, people have slightly different preferences.
  • Some look at medium consumer price indexes, some look at both consumer price indexes and producer price indexes.
  • There are, as you know, a gazillion different macro-economic indicators that you could consider.
  • I’m just giving you a sense of how this plays itself out.
  • To complicate this process of trying to read the tea leaves again, adjustments are made by the Bureau of Economic Statistics in the US to sort of take care of all kinds of data issues.
  • One in particular that is worth a mention is what they call a hedonic adjustment, and the hedonic adjustment is basically intended to make adjustments to the quality of products which are constantly increasing because, remember, after all, what is the CPI supposed to do? It is supposed to capture a price change.
  • Think computers and pretty much every next generation of laptop or desktop that comes out is a significant-has been, historically, with different kinds of chips, a significant improvement in processing speeds, data storing capability than the previous times.
  • The price of a PC, while it has stayed constant, the quality of the PC that you can purchase for that price has tended to increase.
  • Collectively, what they might be doing is understating inflation in some cases, right?

Week 3: TRADING LOCATIONS AND PRACTICES > Economic Analysis: Policy Issues > Lecture: Economic Analysis – Policy Issues

  • The bad kind is demand side, that people just stop consuming less, and as populations age, people’s taste and spending patterns kind of tend to slow down.
  • Economists even refer to things like stagflation, where you have this funny business of slowing growth, and higher inflation, and continuously, and unsustainably high unemployment numbers as well.
  • You could even in this time and place in 2015, towards the end of 2015, think in terms of slowing global growth economically at the same time that, you know, consumer prices have bottomed and might possibly start increasing again.
  • Here, again, at this time and place, after decades, almost a decade of no activity- the US Federal Reserve recently increased interest rates a tad. Some are speculating that they may have embarked on interest on a cycle of interest rates, and we will talk about this a little in a couple of slides down the road, but interest rates as you know, are a very significant component of how macro-economic activity tends to get affected.
  • There is a prime rate, there is mortgage rates, there is treasury rates, there is borrowing and lending rates.
  • When a central bank might change a rate, public and private sector banks will follow suit, some short time later, some will adjust it instantaneously.
  • Rates at which people borrow money to buy homes will probably increase with a little longer time kind of a lag.
  • I don’t want this whole presentation to get too deep into sort of macro-economic minutiae and trivia.
  • Here, again, I am thinking in terms broadly of the tools that central banks have and governments have to sort of affect economic activity.
  • Monetary policy is what the central banks typically tend to adjust when they make changes to interest rates.
  • Historically, the Fed has changed interest rates, either upwards or downwards on a sort of gradual basis.
  • Once they start on a loosening or a tightening cycle, as this is commonly known, they tend to continue for several months in succession, changing rates a quarter point or a half point at a time in whichever direction they think economic conditions would warrant.
  • The reason for this sort of graduated approach has typically been that it has worked particularly well in other historical times.
  • To add to the confusion in all of this business, different central bank governors who are associated with the monetary policy committees in the US have come out and said sort of sometimes conflicting, sometimes contradictory things in terms of how many more rate hikes are likely to go.
  • The big issue in my mind as, you know, as I think about how I want to deploy capital down the stretch is, you know, what is-of course informed by what the Fed in the US is likely to do next, and I am kind of these days leaning on the side of one or two and done.
  • You give people a tax rebate of some kind, and they will quickly go, promptly go out and spend the money on things that they want to consume, that they have been postponing for a while.
  • Supply side policies used to have a lot of adherence in the late 70s and 80s. I mention it here because it’s opposite to sort of demand side where you are trying to increase or decrease demand from the consumer level.

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