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even for bonds that are actually listed on the NYSE. This market is a network of bond dealers
such as Merrill Lynch, Salomon Smith Barney, or Goldman, Sachs that is linked by a com-
puter quotation system. However, because these dealers do not carry extensive inventories of
the wide range of bonds that have been issued to the public, they cannot necessarily offer to
sell bonds from their inventory to clients or even buy bonds for their own inventory. They may
instead work to locate an investor who wishes to take the opposite side of a trade. In practice,
however, the corporate bond market often is quite “thin,” in that there may be few investors
interested in trading a bond at any particular time. As a result, the bond market is subject to a
type of liquidity risk, for it can be difficult to sell one™s holdings quickly if the need arises.
Bodie’Kane’Marcus: I. Elements of Investments 3. How Securities Are © The McGraw’Hill
Essentials of Investments, Traded Companies, 2003
Fifth Edition

3 How Securities Are Traded


Electronic Communication Networks
Go to the New York Federal Reserve™s website, http://www.ny.frb.org/rmaghome/
curr_iss/ci6-12. html, to read “The Emergence of Electronic Communication Networks
(ECNs) in the U.S. Equity Markets,” by James McAndrews and Chris Stefanadis,
researchers at the Federal Reserve Bank of New York.
After reading this article, answer the following questions:
1. What is an ECN and how does it differ from a traditional market such as the
2. List and briefly describe the four potential advantages of an ECN as identified by
the authors.
3. What risk is related to the fragmentation that may accompany the development
of the ECNs?
Listing Requirements
Go to www.nasdaq.com/sitemap/sitemap.stm. On the sitemap there is an item labeled
listing information. Select that item and identify the following items in Initial Listing
Standards for the National Market System 1, 2, and 3 and the Nasdaq SmallCap
Market for domestic companies:
1. Public float in millions of shares.
2. Market value of public float.
3. Shareholders of round lots.
Go to www.nyse.com and select the listed company item or information bullet. Under
the bullet select the listing standards tab. Identify the same items for NYSE (U.S.
Standards) initial listing requirements.
4. In what two categories are the listing requirements most significantly different?

Most of the information in this section applies to all securities traded on exchanges. Some
of it, however, applies just to stocks, and in such cases we use the specific words, stocks or

The Participants
We begin our discussion of the mechanics of exchange trading with a brief description of the
potential parties to a trade. When an investor instructs a broker to buy or sell securities, a
number of players must act to consummate the deal.
The investor places an order with a broker. The brokerage firm for which the broker works,
and which owns a seat on the exchange, contacts its commission broker, who is on the floor of
the exchange, to execute the order. When the firm™s commission brokers are overloaded and
have too many orders to handle, they will use the services of floor brokers, who are inde-
pendent members of the exchange (and own seats), to execute orders.
The specialist is central to the trading process. All trading in a given stock takes place at
one location on the floor of the exchange called the specialist™s post. At the specialist™s post is
a monitor called the Display Book that presents all the current offers from interested traders to
buy or sell shares at various prices as well as the number of shares these quotes are good for.
Bodie’Kane’Marcus: I. Elements of Investments 3. How Securities Are © The McGraw’Hill
Essentials of Investments, Traded Companies, 2003
Fifth Edition

72 Part ONE Elements of Investments

The specialist manages the trading in the stock. The market making responsibility for each
stock is assigned by the NYSE to one specialist firm. There is only one specialist firm per
stock but most firms will have responsibility for trading in several stocks. The specialist firm
also may act as a dealer in the stock, trading for its own account. We will examine the role of
the specialist in more detail shortly.

Types of Orders
Market orders Market orders are simply buy or sell orders that are to be executed im-
mediately at current market prices. For example, an investor might call his broker and ask for
the market price of IBM. The retail broker will wire this request to the commission broker on
the floor of the exchange, who will approach the specialist™s post and ask the specialist for best
current quotes. Finding that the current quotes are $98 per share bid, and $98.10 asked, the in-
vestor might direct the broker to buy 100 shares “at market,” meaning that he is willing to pay
$98.10 per share for an immediate transaction. Similarly, an order to “sell at market” will re-
sult in stock sales at $98 per share. (Until 2001, when U.S. markets adopted decimal pricing,
the minimum possible bid“ask spread was “one tick,” which on the NYSE was $ 1„8 until 1997
and $ 1„16 thereafter. With decimal pricing, the spread can be far lower.) When a trade is exe-
cuted, the specialist™s clerk will fill out an order card that reports the time, price, and quantity
of shares traded and the transaction will be reported on the exchange™s ticker tape.
There are two potential complications to this simple scenario, however. First, as noted ear-
lier, the posted quotes of $98 and $98.10 actually represent commitments to trade up to a spec-
ified number of shares. If the market order is for more than this number of shares, the order
may be filled at multiple prices. For example, if the asked price is good for orders up to 600
shares and the investor wishes to purchase 1,000 shares, it may be necessary to pay a slightly
higher price for the last 400 shares than the quoted asked price.
The second complication arises from the possibility of trading “inside the quoted spread.” If
the broker who has received a market buy order for IBM meets another broker who has re-
ceived a market sell order for IBM, they can agree to trade with each other at a price of $98.05
per share. By meeting in the middle of the quoted spread, both the buyer and the seller obtain
“price improvements,” that is, transaction prices better than the best quoted prices. Such “meet-
ings” of brokers are more than accidental. Because all trading takes place at the specialist™s
post, floor brokers know where to look for counterparties to take the other side of a trade.

Limit orders Investors also may choose to place a limit order, where they specify prices
at which they are willing to buy or sell a security. If IBM is selling at $98 bid, $98.10 asked,
for example, a limit buy order may instruct the broker to buy the stock if and when the share
price falls below $97. Correspondingly, a limit sell order instructs the broker to sell as soon as
the stock price goes above the specified limit.
Figure 3.5 is a portion of the limit order book for shares in Intel on the Island exchange on
one day in 2001. Notice that the best orders are at the top of the list: the offers to buy at the
highest price and to sell at the lowest price. The buy and sell orders at the top of the list”
$27.88 and $27.93”are called the inside quotes; they are the buy and sell orders with the
closest prices. For Intel, the inside spread is only 5 cents per share.
What happens if a limit order is placed in between the quoted bid and ask prices? For ex-
ample, suppose you have instructed your broker to buy IBM at a price of $98.05 or better. The
order may not be executed immediately, since the quoted asked price for the shares is $98.10,
which is more than you are willing to pay. However, your willingness to buy at $98.05 is
better than the quoted bid price of $98 per share. Therefore, you may find that there are traders
who were unwilling to sell their shares at the currently quoted $98 bid price but are happy to
sell shares to you at your higher bid price of $98.05.
Bodie’Kane’Marcus: I. Elements of Investments 3. How Securities Are © The McGraw’Hill
Essentials of Investments, Traded Companies, 2003
Fifth Edition

3 How Securities Are Traded

F I G U R E 3.5
refresh island home disclamer help
The limit order book
INTC for Intel on the Island
exchange, November
9, 2001.
Price 27.8900 Orders 16,774
Time 14:24:45 Volume 4,631,778
Shares Price Shares Price
100 27.8800 1,000 27.9300
500 27.8500 1,000 27.9690
200 27.8500 1,000 27.9800
1,000 27.8200 1,000 27.9900
3,300 27.8100 1,000 28.0000
300 27.8000 1,800 28.0600
75 27.7500 1,000 28.0800
101 27.7300 1,000 28.1000
5,000 27.7200 2,000 28.1100
1,000 27.72 1,000 28,1800
(416 more) (395 more)

F I G U R E 3.6
Limit orders
Price below Price above
the limit the limit

Limit buy Stop-buy
Buy order order

Stop-loss Limit sell
order order

Stop-loss orders are similar to limit orders in that the trade is not to be executed unless
the stock hits a price limit. Here, however, the stock is to be sold if its price falls below a stip-
ulated level. As the name suggests, the order lets the stock be sold to stop further losses from
accumulating. Similarly, stop-buy orders specify that a stock should be bought when its price
rises above a limit. These trades often accompany short sales (sales of securities you don™t own
but have borrowed from your broker) and are used to limit potential losses from the short posi-
tion. Short sales are discussed in greater detail later in this chapter. Figure 3.6 organizes these
types of trades in a convenient matrix.
Orders also can be limited by a time period. Day orders, for example, expire at the close of
the trading day. If it is not executed on that day, the order is canceled. Open or good-till-
canceled orders, in contrast, remain in force for up to six months, unless canceled by the
Bodie’Kane’Marcus: I. Elements of Investments 3. How Securities Are © The McGraw’Hill
Essentials of Investments, Traded Companies, 2003
Fifth Edition

74 Part ONE Elements of Investments

Specialists and the Execution of Trades
A specialist “makes a market” in the shares of one or more firms. This task may require the
specialist to act as either a broker or a dealer. The specialist™s role as a broker is simply to ex-
A trader who makes a
ecute the orders of other brokers. Specialists also may buy or sell shares of stock for their own
market in the shares
portfolios. When no other broker can be found to take the other side of a trade, specialists will
of one or more firms
and who maintains a do so even if it means they must buy for or sell from their own accounts. The NYSE commis-
“fair and orderly sions these companies to perform this service and monitors their performance.
market” by dealing
Part of the specialist™s job as a broker is simply clerical. The specialist maintains a “book”
personally in the
listing all outstanding unexecuted limit orders entered by brokers on behalf of clients.
Actually, the book is now a computer console. When limit orders can be executed at market
prices, the specialist executes, or “crosses,” the trade.
The specialist is required to use the highest outstanding offered purchase price and the low-
est outstanding offered selling price when matching trades. Therefore, the specialist system re-
sults in an auction market, meaning all buy and all sell orders come to one location, and the
best orders “win” the trades. In this role, the specialist acts merely as a facilitator.
The more interesting function of the specialist is to maintain a “fair and orderly market” by
acting as a dealer in the stock. In return for the exclusive right to make the market in a specific
stock on the exchange, the specialist is required by the exchange to maintain an orderly mar-
ket by buying and selling shares from inventory. Specialists maintain their own portfolios of
stock and quoted bid and ask prices at which they are obligated to meet at least a limited
amount of market orders. If market buy orders come in, specialists must sell shares from their
own accounts at the ask price; if sell orders come in, they must stand willing to buy at the
listed bid price.4
Ordinarily, however, in an active market, specialists can match buy and sell orders without
using their own accounts. That is, the specialist™s own inventory of securities need not be the
primary means of order execution. Sometimes, the specialist™s bid and ask prices are better
than those offered by any other market participant. Therefore, at any point, the effective ask
price in the market is the lower of either the specialist™s ask price or the lowest of the unfilled
limit-sell orders. Similarly, the effective bid price is the highest of the unfilled limit buy orders
or the specialist™s bid. These procedures ensure that the specialist provides liquidity to the
market. In practice, specialists participate in approximately one-quarter of the transactions on
the NYSE.
By standing ready to trade at quoted bid and ask prices, the specialist is exposed to ex-
ploitation by other traders. Larger traders with ready access to superior information will trade
with specialists when the specialist™s quotes are temporarily out of line with assessments of
value based on that information. Specialists who cannot match the information resources of
large traders will be at a disadvantage when their quoted prices offer profit opportunities to
more advantaged traders.
You might wonder why specialists do not protect their interests by setting a low bid price
and a high ask price. Specialists using that strategy would protect themselves from losses in a
period of dramatic movements in the stock price. In contrast, specialists who offer a narrow
spread between the bid and ask price have little leeway for error and must constantly monitor
market conditions to avoid offering other investors advantageous terms.
Large bid“ask spreads are not viable options for the specialist for two reasons. First, one
source of the specialist™s income is frequent trading at the bid and ask prices, with the spread
as a trading profit. A too-large spread would make the specialist™s quotes uncompetitive with
the limit orders placed by other traders. If the specialist™s bid and asked quotes are consistently


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