The Secondary Market

When investors buy and sell

shares among themselves

Primary Market
When the firm issues securities, it is said to
be a Primary Market transaction. The firm
gets cash (or some other consideration) in
exchange for the securities
They could be issuing stock to the public or
in a private placement
When stock is traded between investors,
we call that a secondary market trade and
the company gets nothing

Markets
First Market When a stock trades on an
organized exchange like the New York Stock
Exchange, there are also regional exchanges
and the American Stock Exchange
Second market when stocks trade over the
counter (OTC) through NASDAQ or some other
system
Third Market Exchange-listed securities that
trade OTC
Fourth Market direct trades between investors

Stock Exchanges
There is a physical location where trades
occur
NYSE is open from 9:30 4 (New York time)
There are several posts (shaped like a big
bar) on the trading floor. Each post has
several specialists (Each bar has a bunch of
cash registers). Each specialists handles all of
the transactions for a few different companies
(all coke sales go through one specialist while
pepsi sales go through a different specialist).

Listed Firms
In order to trade on an Exchange, firms must
apply and have to meet certain conditions.
Firms are said to be listed
NYSE has about 2700 listed firms. If each
specialist handles five firms, there would be
about 540 specialists. If each post had ten
specialists, there would be about 54 posts.
American Stock Exchange has a lot of ADRs,
closed-end funds, and energy companies
A firm can be listed on the NYSE and several
regional exchanges

Trading
Floor
Post
Specialis
t

Role of the Specialist

Manage the auction process
Double auction process as people are constantly offering to buy and/or sell
securities
Best price wins; if same shares, it goes to who called out first; if same price
then it goes to most shares, if no agreement then specialist decides or
splits between market (Priority, Precedence, or Parity)

Execute Orders for floor brokers specialist keeps the limit order
book and knows how many people want to buy or sell stock at
different prices
Provide capital to stabilize prices specialist makes money by
buying and selling stock from his own account, but he is required to
buy stock in a falling market and sell in a rising market even if he
loses money. Specialist does not set the price, but he can
influence it. If major news about a company comes out, then the
exchange may halt trading in order to determine a new equilibrium
price

Special Transactions
SuperDOT or SDBK most small
transactions are matched electronically.
Upstairs Market large institutions (mutual
funds, banks, ) often make deals to trade
large volumes off the trading floor
Halted trade If stock prices change too
much, the exchange can halt trading for
individual stocks or for the entire market.
They could also restrict trading using
curbs (Rule 80A and 80B)

Over the Counter

NASDAQ is a network of security dealers that have set
up this system to trade securities. Any dealer can be a
market maker for any number of stocks which means
that they are always willing to buy and sell stock from
their own account. If you want to buy stock, your
broker will log on to the system to find the dealer that
has the lowest price.
Level 1 quotes are highest bid and lowest ask among all
market makers
Level 2 quotes are bids and asks from all market makers
Level 3 is where market makers input their prices

NASDAQ is a negotiated market while the NYSE is an

auction market.

OTC Continued
A dealer trades with you from their own account
and earns a spread. A broker earns a commission
by filling your order. You should NEVER pay a
commission if your broker is also acting as a dealer.
If your brokerage firm is acting as a dealer, they
cant charge more than a 5% markup over the best
price. Also, their price must by better than the best
price plus a commission.
Stocks that arent listed on an exchange and dont
qualify for NASDAQ are said to trade on the OTC
Bulletin Board and/or Pink Sheets

Trading Stock
In order to buy stock in a company, you usually have to
set up an account with a broker.
Full Service Broker Provides investment advice and
portfolio management
Discount Broker May have some research available
Online Only Pretty much just accepts orders from
customers
Often times you can borrow up to 50% of the investment
on margin from the broker
Most stocks on the NYSE have prices of $10-$50 no
matter how big the company is, so you need to have
several thousand dollars to invest
Stock Prices are constantly changing
Low priced stocks of small companies on smaller
exchanges are often called penny stocks

Securities Exchange Act of

1934
Created the SEC
Focus is on trading of securities after issue
(People Act)
Broker handles transactions for others
Dealer handles transactions for themselves
Firms are registered with SEC, brokers are
registered with the member firm through U-4 form
U-4 form has info about the individual including
criminal info. Potential members may be
disqualified for Misdemeanors involving fraud or
theft or for any Felonies

SEA 1934 Cont.

Regulation T Federal Reserve can
establish margin requirements
Regulates
Pump and Dump
Wash Sales
Matching Orders
False Information
Insider Trading
Limits Short Sales

FINRA
Self-regulatory organization comprised of brokerage
firms. Individual people are NOT members. Principals
and Representatives must also register through a U-4
form.
Four Major Bylaws
Rules of Fair Practice: How to deal with customers including
research reports, advertising, and commissions/fees/markups
Uniform Practice Code: Delivery of securities between
brokers and settlement dates
Code of Procedure: investigates and handles violations of
conduct rules
Code of Arbitration: Handles disputes between member firms

Conduct Rules
Trading Ahead of Customer Orders If a
customer wants to buy/sell stock at the same
time that the firm wants to buy/sell stock for
their own account, the customer comes first
Front running Buying/Selling stock for your
own account before a customer places an
order
Trading ahead of Research Reports You cant
buy/sell stock for your own account before
issuing a research report

More No-nos
Communications with Public -- prohibits
deceptive advertising, correspondence, and
sales literature
Inappropriate recommendations (especially
with senior citizen accounts)
Excessive Trading (churning) especially
mutual funds
Fraudulent Activities unauthorized trading,
fake accounts
Faulty research reports used to generate sales

Where can you find a stock quote, and what

does one look like?
Stock quotes can be found in a variety of print
sources (Wall Street Journal or the local
newspaper) and online sources (Yahoo!
Finance, CNNMoney, or MSN MoneyCentral).

Quote
Bid Price someone is willing to pay for a
stock. If you sell stock, you will take the
highest bid price.
Ask Price someone else is willing to sell
stock. If you buy stock, you will pay the
lowest ask price.
Highest Bid is always lower than lowest Ask
(otherwise theyd trade)
Spread difference between highest bid
and lowest ask

Order types
Market Orders You want to buy/sell stock at the current price. Order goes
through automatically
Limit Orders You enter the price youre willing to pay (bid) or accept (ask). Your
bid price must be below the lowest ask price (Otherwise youd just buy it at the
lowest ask). Your ask must be higher than the highest bid. If the stock price never
reaches your price, no transaction will occur.
Stop Orders Stop orders to sell protect investors from falling prices. Suppose
the current price is $25. You dont want to sell it, but if it starts falling, you want
to sell before it falls further so you put in a stop order at $24. Notice that you are
NOT willing to sell it for $25, but ARE willing to sell it for $24. You can also have
stop orders to buy at prices above the current price. You can have a stop-limit
order too
Restrictions
Day vs. Good til Canceled
Open or Close
Fill or Kill If the entire order cant be filled immediately, cancel the entire order
Immediate or Cancel Do what you can right now, cancel the rest
All or None If the entire order cant be filled, dont do anything (but dont cancel it either)

Selling Short
Borrow stock from your broker (or one of their
other clients) in order to sell it. Hope that the
price falls so that you can buy it back and return
it.
You can only short stock on an uptick (the price
has to be higher than the last different price)
If you short stock 100 shares of stock for $2,000,
you must keep the $2,000 in your account plus
you must put up a 50% margin ($1,000). Assets
= $3,000 in cash, Liabilities = 100 shares of
stock worth $2,000, Equity = $1,000.

Stock Market indices

You may hear that the stock market has gone
up or down. What does that mean?
Usually they are talking about a stock market
index such as the the Dow Jones Industrial
Average, the S&P 500, or the NASDAQ Index.
Each of these is comprised of a lot of different
companies that are meant to represent the
overall market. The DJIA only has 30 companies
while the S&P 500 has 500 companies. The
NASDAQ has more companies, but they focus
on tech companies.

Historical stock market performance, S&P 500

(1968-2004)

Individual Retirement
Accounts
You can open an account at almost any bank or brokerage
Contributions of up to $5,500 (this number changes each
year). $6,500 if over 50.
Contributions to plans reduce your Adjusted Gross Income
so you dont pay any taxes on that income. Money is
taxed when you withdraw money from the account.
If you participate in an employer-based plan (or have a
high salary), you can still have an IRA, but you may not be
able to deduct contributions
Money can be used to invest in almost anything, but there
are no short sales, margin trading, or naked options.

IRA Withdrawals
You can not withdraw money until 59 and
must start by 70 .
Early withdrawals from IRAs are taxed and
penalized 10% if there isnt a legitimate reason.
No penalty if withdrawal is used for:
Medical Expenses greater than 7.5% of AGI
Medical Insurance while unemployed
Up to $10,000 for a first house
Higher Education Expenses
Withdraw an annuity that will reasonably exhaust
the account over your life expectancy

Roth IRAs
Contributions to Roth IRAs are taxed, but withdrawals are not.
Limits are the same as traditional IRAs, but high-income
individuals have lower limits
You can have both IRAs, but there is a single contribution limit to
all IRAs (you can put $4,000 in a Roth and $1,500 in a traditional)
Benefits you if you expect to have a higher tax rate at retirement.
Traditional IRAs can be converted to Roths, but not the other way
around.
You can withdraw funds at age 59 as long as the funds have
been there for five years.
Contributions to Roths can be withdrawn without penalty.
You do NOT have to start withdrawing at 70 . Roths are useful for
estate planning.

Employer-based Plans
If your employer offers them, employer-based
plans are usually better than individual IRAs. You
may not be able to have both
Qualified plans
Receive special tax treatments
Must be available to all eligible employees
Governed by Employee Retirement Income Security Act
(ERISA)

Non-qualified plans
Usually plans for top executives
SEP IRAs and Simple IRAs are non-qualified plans for
small businesses

Defined Benefit Plans

You (and/or your employer) put a designated amount of money
into a general pension fund each year for your retirement. At
retirement, you receive an annual payment based on your salary,
your years of service, and some factor. You are not taxed when
you make the money, you are taxed when you take the money.
If all of the money comes from the employer, then you may still
be eligible for IRA.
Employer takes on the risk that the fund earns enough money to
cover the pension obligations. If the stock market falls, the
employer has to make up the difference.
You may have to work a number of years to be vested.
You can retire whenever the plan says you are eligible. Some
companies follow the Rule of 80 (age + years of service = 80)
Better for a stable work force.

Social Security
Similar to a Defined Benefit Plan
Both you and your employer contribute 6.2% of
income up to $110,100 into a general fund
You must work at least 10 years to be eligible (vest)
Benefit is based on the 35 years with the highest
contributions (indexed for inflation). If you work for
45 years, you are still taxed, but you dont get any
more benefits.
You get full benefit if you retire at the normal
retirement age (currently 65 but rising). You can
retire at age 62 with a reduced benefit or as late as
70 for a higher benefit

Defined Contribution Plans

401(k)s
You put money into an individual account each year for your
retirement. At retirement, you receive the amount in the account. Max
contribution is $18,000.
Your employer may contribute too, they may also match your
contribution which is basically free money.
Investment options are usually limited to a few mutual funds. You may
be able to invest in your companys stock, but that is usually a bad
idea.
Employee takes on the risk that the fund earns enough money to
cover retirement expenses.
Withdrawals can not start until 59 and must start by 70 . Hardship
withdrawals may be allowed, but they are taxed AND penalized.
It is possible to borrow money from your 401(k)
Account can be rolled over to new employers (usually).
Better for a mobile work force.

Mutual Funds
Pool money from individual investors and use it
to buy securities (stocks and bonds).
Provides investor with easy diversification. By
owning stock in one mutual fund, you can
effectively own stock in hundreds of companies.
Also provides professional management
You can invest and withdraw small amounts
Mutual funds do not pay corporate taxes as long
as they distribute the funds to investors. YOU
still pay taxes though

Distributions
When the mutual fund receives dividends
(or interest) from the companies, they pay
it out to their shareholders.
Mutual funds also have capital gains and
losses when they sell securities and they
have to distribute these profits.
As an investor, you pay taxes on these
income and capital gains distributions. If
you sell shares of the mutual fund, you
would have a capital gain or loss.

Open-end vs. Closed-end

funds
Closed-end funds issue a fixed number of shares
and those shares trade on the stock market. Price
is determined by supply and demand. Price is
usually below the funds Net Asset Value (NAV)
Open-end funds are constantly issuing new
shares and redeeming old shares. If you deposit
money, you are buying new shares from the
fund. If you withdraw money, you are selling your
shares back to the firm. Transactions occur at the
end of the day at the funds Net Asset Value

Net Asset Value

(Value of all the securities that the
fund has minus any liabilities)
divided by shares outstanding.
For Open-end funds, both the value
and the shares change daily.
For closed-end funds, the value
changes, but the shares stay
constant.

Example
Beginning: Fund has securities worth $100m and
liabilities of $10m. There are 2m shares
outstanding so NAV is $45.
During the day, the value of the securities rises
to $102m. New NAV = (102-10) / 2 = $46
Investors deposit $4m (buy 86,957 shares) and
withdraw $3m (redeem 65,217) shares. Overall,
they added $1m and 21,740 shares.
Beginning of next day: Fund has $103m in assets
minus $10m in liabilities and they have
$2,021,740 shares for a NAV of $46.

Expenses
Management Fee usually about 1-3% of the firms assets each year
Other Expenses
12b-1 fees used for marketing and distribution purposes. No load
funds can charge up to .25%
Loads
Front end fee charged when you buy the fund, usually a commission to
whoever sold you the fund. The fee is subtracted from the amount you
deposited (instead of added to the price). So a 5% fee means that you keep $95
for every $100 that you invest. (5/95 = 5.26%). Front-end loads are sometimes
called A-shares.
Back end fee charged when you redeem your shares. May decline over time if
you hold shares long enough. May be called Contingent Deferred Sales Charges
or B-shares. Higher 12b-1 fees
C-shares may have a 1% 12b-1 fee
No load shares may still have a 12b-1 fee of .25% per quarter

Turnover Firms that do a lot of buying and selling will be less tax
efficient (because you have short term capital gains and losses)

Redeeming Shares
You may be charged a fee for redeeming
shares, especially if you had money in
your account for a short period of time
You may want to establish a redemption
schedule
Fixed-dollar: withdraw $X every period
Fixed-percentage: withdraw X% every period
Fixed-shares: withdraw X shares every period
Fixed time: Balance will be $0 on X periods

Fund Families
There are thousands of mutual funds
out there. A single fund family may
manage hundreds of funds.
Some major fund families are
Fidelity, Putman, American Funds, T.
Rowe Price
Each fund is its own corporation and
has its own fund manager, but the
fund family gets its cut.

Investment Strategy
Does the fund mostly invest in large
cap stocks (worth more than $10b),
mid cap stocks, or small cap stocks
(less than $1b)?
Does the fund invest in Value
companies (PE ratios below 10) or
Growth companies (PE ratios above
20)?

Morningstar Style Box

Market
Capitalizati
on of
Companies
Low
Low
PE Ratios of
Companies

Small Cap
Value

Middle
High

Middle

High
Large Cap
Value

Blended
Small Cap
Growth

Large Cap
Growth

Passive vs. Active Funds

Some funds try to find stocks that they think
will go up in value. They may use fundamental
or Technical analysis to identify investments.
These funds tend to have higher management
fees.
Other funds just try to recreate the overall
stock market. Index funds try to mimic a
specific index like the S&P 500 or the Dow
Jones Industrial Average
Most mutual funds perform worse than the
overall market.

Other funds
Bond Funds Long term vs. Short Term, Investment
grade vs. Junk Bond, Treasury vs. Corporate
Municipal Funds
Money Market Funds invest in short term assets
International Funds Emerging Market vs. Developed,
Global funds include the US
Sector (Specialty) Funds Energy funds, Healthcare,
Financials
Balanced Funds invest in both stocks and bonds
Lifecycle or Retirement Funds Based on expected year of
retirement and automatically become more conservative
Asset Allocation Funds

Mutual Fund Evaluation

Morningstar Five-star rankings
Jensens Alpha = Fund Return CAPM
Required Return
Sharpe Ratio = (Fund Return Risk
Free Return) / Fund Standard
Deviation
Treynor Ratio = (Fund Return Risk
Free Return) / Fund Beta

Other Investment
Companies
Unit Investment Trusts
They do not have to follow diversification rules.
They can invest in a single stock (ADRs are
basically UITs)
They have a set maturity date, but it could be 100
years from now.

Exchange Traded Funds

Funds of Hedge Funds allows small investors
to invest in hedge funds
Principal-protected Funds cant lose
money, but limited gains and illiquid