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3. IPOs cannot be short sold during the IPO period – the first 30 days after the IPO.
4. Stock must be borrowable – SEC SHO 203b – Borrowing and Delivery Requirements (Short Sales)
a. A security must appear on the clearing firm’s easy to borrow list in order for a short sell to be legal
Short Selling
Rule 10a-1 and Regulation SHO, under the Exchange Act, and Rule 440B apply to short sales. Consequently, no short sale of a stock in an amount less than the unit of trading shall be effected on the Exchange unless such sale is based upon a sale, in the unit of trading, the price of which (1) is higher than the price of the last "regular way" sale on the Exchange of such stock in the unit of trading or (2) is the same as the price of such last sale and such price was higher than the last different price of a "regular way" sale on the Exchange of such stock in the unit of trading.
Illegal versus Erroneous Trades
Notes
An illegal trade is any trade that violates NASD or SEC rules.
§ These trade will no be broken because, in general, one participant in the trade entered into the trade in good faith and will not want it broken; as such, it would be unfair for the SEC or the NASD to break the trade
There are 4 types of illegal trades:
1. Short selling on a down tick
a. A short sale on the NASDAQ can only occur when the level 1 bid is higher than the previous level 1 bid
b. This does not apply to INET, ARCA, the CME, or AMEX
2. Not declaring a short sell
a. If a trader goes from a long position to a short position (accidentally or on purpose) without being flat in between, the trader has not declared the short sell because ProsperPro placed the offers as normal offers and not short offers.
3. Short selling an IPO within the first 30 days
4. Wash trading
a. Intentionally buying and selling within swift trade is not permitted – it may happen from time to time; however, intentional wash trading is illegal.
b. In general, wash trading benefits one trader at the expense of another
An erroneous trade is a trade that may be broken because the trade was made clearly outside of the market.
§ What is considered clearly outside the market depends on many factors; the key issues are the stock price and from how far away from the price the trade occurred.
o Eg. A $21 trade on a stock trading at $20, a $0.25 trade on a stock trading at $0.10
§ The NASD makes decisions on SIZE and Market makers, and ECNs have jurisdiction over trade breaks on trades made through their execution system.
Market Structure
Auction Markets
An auction market is run by a specialist who is god of his or her particular stock(s).
§ the specialist knows everything there is to know about the stock(s) he or she trades
A specialist’s job is to match up buy and sell orders – this is his/her primary function. He has the authority to halt trading on his stock should conditions warrant such action. (big news about the company)
§ orders are matched up in what is known as the “specialist book” (more on this later)
§ if there are no matching orders in the book, the specialist may buy or sell stock at his/her discretion; however, if an order comes in at the market price, the specialist must fill the order from the inventory of the financial institution that employs him or her
Specialists are employed by financial institutions (GSCO, MLCO, MSCO) – not by the market
§ the market will award a stock to a financial institution; the financial institution will hire a person to be the specialist for that stock
§ There is only one specialist per stock
The Specialist Book
§ this book displays the limit orders (bids and offers) – market orders are not displayed
o This allows you to see all bids and offers placed by all traders – even when it results in a locked or crossed market
o The NYSE indicator tells us where the specialist may be printing – in essence, it adds the limit and market orders in the market to indicate where the best price may be
Order filling is not necessarily first come, first served, but with new regulations and electronic order processing, favourtism happens much less frequently than it did years ago.
The NYSE and AMEX are examples of auction markets.
AUCTION MARKETS
An auction market is run by a specialist. The specialist is employed to keep an orderly flow to the market. They are highly knowledgeable about the stock(s) they trade.
In simplest terms, the specialist matches up buy and sell orders as they enter what is called “The Specialist’s Book.” If there is no matching order, the specialist may opt to buy/sell a quantity of stock.
Remember: The specialist’s primary responsibility is to keep an orderly market.
DEALER MARKETS
In a dealer market, orders are filled through market makers and ECNs.
NASDAQ is the primary dealer market in the world.
§ Any other Over-the-counter market is also a dealer market
§ An OTC market is one in which securities are traded through telephone or computer network
Unlike an auction market where there is only one specialist per stock, there are many market makers per stock in a dealer market.
Market Makers
A market maker is a trader employed by a financial institution to manage the company’s inventory of a particular security. They maintain their inventory and use it to make money for the company by buying and selling on the market.
A market maker’s primary responsibility is to provide liquidity to the market – to literally make the market – they are there to provide a flowing market while following the rules as set out by the NASD and SEC.
Market makers are like prop-traders
§ The difference between MMs and traders at Swift Trade is that market makers have more money and more experience
o The MMs that are the most powerful on a particular security are called the AXE
§ They have the same goal as prop traders – to make money trading full time
Market makers used to keep spreads wide and make money off buying at the bid and selling at the ask. Today, their main source of revenue comes from commissions.
Market makers are responsible for the NASDAQ’s official opening price on securities – they can gap stocks up or down as they see fit if they have market order outstanding from the previous night.
The NASD has placed 5 specific restriction on Market Makers:
1. They must fill orders (bids, offers, buys, and sells) on a first come, first serve basis.
2. They cannot fill orders pre or post market hours.
3. They cannot back away from a level 1 price. (requires more detail)
4. They cannot buy through an advertised price
5. They must appear on both sides of the level 2 between 930am and 4pm.
Market makers have 3 responsibilities (in order of importance) that the SEC requires them to uphold:
1. Buy and sell what the public wants
a. This refers to retail clients – your average investing customer
2. Fill institutional orders
a. Mutual funds, pension funds, etc
3. Trade the house account when they are not doing 1 or 2
The reasoning for the above 3 responsibilities comes from the market makers’ source of income.
§ They earn the least from retail clients – the commissions are small and so are the orders
§ The company earns the most in commissions from the institutions – they pay a premium for a top trader to execute their orders
§ The market maker – the person – makes the most from earning money on the house account
Without those responsibilities ordered the way they are, retail clients would be ignored and institutional orders would be executed when convenient.
In a dealer market all buy and sell orders are filled through a market maker’s inventory. A market maker is a trader employed by a securities firm to manage the inventory of a particular stock(s).
Market makers will buy stock from anyone placing a sell order and put the stock in their inventory. Market makers will sell stock from their inventory to anyone placing a buy order.
When a market maker is not filling orders, he or she is free to trade the firm’s account. When they are trading the firm’s account, they are free to buy and sell as they see fit as long as it does not violate the wishes of the company. This is how they adjust their inventories.
Remember: A market maker is an individual working for a firm. They are hired because of their expertise in both the market and a particular sector or stock.
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