Understanding the Traditional Process

By Dr. David Edward Marcinko MBA MEd CMP

SPONSOR: http://www.CertifiedMedicalPlanner.org

To see how the transactions are actually handled on the floor of an exchange, let us assume that an order to buy 100 shares of General Electric has been given by a doctor customer to the registered representative (stock broker), of a member firm in Atlanta. The order is a market order (an order to buy at the lowest possible price at the time the order reaches the floor of the exchange). This order is telephoned by direct wire, or computer, to the New York office of the member firm, which in turn telephones its order to its clerk on the floor of the exchange.

Each member firm has at least one member of the exchange representing them making trades on the floor. Each one of these members is assigned a number for identification. When the floor clerk receives the order to purchase the General Electric, he causes his member’s call number to appear on 3 large boards situated so that one is always in view. These boards are constantly watched brokers so that they will know when wanted at the phone, since there’s too much noise on the floor to use a paging system. Seeing his number on the board, the broker hurries to his telephone station or cell phone and receives the order to buy 100 shares of G.E. “at the market”. Acting as a commission broker, he immediately goes to the post where G.E. is traded and asks “how’s G.E”, of the specialist?

Order and Position Types

At this point, it is important to understand the different types of orders and positions that can be used to buy and sell securities from the specialist.

Market Order:

A market order is an order to be executed at the best possible price at the time the order reaches the floor. Market orders are the most common of all orders. The greatest advantage of the market order is speed. The doctor specifies no price in this type of order, he merely orders his broker to sell or buy at the best possible price, regardless of what it may be. The best possible price on a buy is the lowest possible price. The best possible price on a sell is the highest possible price. In other words, if a medical professional customer is buying, he logically wants to pay as little as possible, but he is not going to quibble over price. He wants the stock now, whatever it takes to get it. If he’s a seller, the doctor client wants to receive as much as possible, but will not quibble, he wants out, and will take what he can get, right now. No other type of order can be executed so rapidly. Some market orders are executed in less than one minute from the time the broker phones in the order. Because the investor has specified no price, a market order will always be executed. The doctor is literally saying, “I will pay whatever it takes, or accept whatever is offered”.

Limit Order:

The chief characteristic of a limit order is that the doctor decides in advance on a price at which he decides to trade. He believes that his price is one that will be reached in the market in reasonable time. He is willing to wait to do business until he has obtained his price even at the risk his order may not be executed either in the near future or at all. In the execution of a limit order, the broker is to execute it at the limit price or better. Better, means that a limit order to buy is executed at the customer’s price limit or lower, in a limit order to sell, at price limit or higher. If the broker can obtain a more favorable price for his doctor customer than the one specified, he is required to do so.

Order Length:

Now, even though the doctor has given his price limit, we need to know the length of effectiveness of the order. Is the order good for today only? If so, it is a day order, it automatically expires at the end of the day.  Alternatively, the doctor may enter an open or, “good until canceled” order. This type of order is used when the doctor believes that the fluctuations in the market price of the stock in which he’s interested will be large enough in the future that they will cause the market price to either fall to, or rise to, his desired price, i.e. his limit price. He is reasonably sure of his judgment and is in no hurry to have/his order executed. He knows what he wants to pay or receive and is willing to wait for an indefinite period.

Years ago, such orders were carried for long periods of time without being reconfirmed. This was very unsatisfactory for all parties concerned.  A doctor would frequently forget his order existed and, if the price ever reached his limit and the order was executed, the resulting trade might not be one he wished to make. To avoid the problem, open (GTC) orders must be reconfirmed by the doctor customer each six months. Does that mean six months after the order is entered? … No! The exchange has appointed the last business day of April and the last business day of October as the two dates per year when all open orders must be reconfirmed.

Example: Dr. Smith wants to buy 100 shares of XYZ. The price has been fluctuating between 50 and 55. He places a limit order to buy at 51, although the current market price is 54. Limit orders to buy (buy limit orders) are always placed below the current market. To do otherwise makes no sense. It is possible that, within a reasonable time, the price will drop to 51 and his broker can purchase the stock for him at that price. If the broker can purchase the stock at less that 51, that would certainly be fine with the doctor customer since he wants to pay no more than 51. A sell limit order works in reverse and is always placed above the current market price.

Example: Dr. Smith wants to sell 100 shares of XYZ stock. The order is 54. A sell limit order is place at 56. Sell limit orders are always placed above the market price. As soon as the pride rises to 56, if it ever does, the broker will execute it at 56 or higher. In no case will it be executed at less than 56.

The advantage of the limit order is that the doctor has a chance to buy at less or to sell at more than the current market price prevailing when he placed the order. He assumes that the market price will become more favorable in the future than it is at the time the order is placed. The word” chance ” is important. There is also the “chance” that the order will not be executed at all. The doctor just mentioned, who wanted to buy at 51, may never get his order filled since the price may not fall that low.  If he wanted to sell at 56, the order may also not ever be executed since it might not rise that high during the time period the order is in effect.

Stop Orders:

A very important type of order is the stop order, frequently called a stop-loss order. There are two distinct types of stop orders. One is the stop order to sell, called a sell stop, and the other is a stop order to buy, called a buy stop. Either type might be thought of as a suspended market order; it goes into effect only if the stock reaches or passes through a certain price.

The fact that the market price reaches or goes through the specified stop price does not mean the broker will obtain execution at the exact stop price. It merely means that the order becomes a market order and will be executed at the best possible price thereafter. The price specified on a stop order bears a relationship to the current market price exactly opposite to that on a limit order. Whereas a sell limit is placed at a price above the current market, a sell stop is placed at a price below the current market. Similarly, while a buy limit is placed at a price below the current market, a buy stop is placed at a price above the current market. Why would a doctor investor use a stop order?

There are two established uses for stop orders. One of them might be called protective; the other might be called preventive.

Protective: This order protects a doctors’ existing profit on a stock currently owned.

For example, a doctor purchases a stock at 60. It rises to 70. He has made a paper profit of $10 per share. He realizes that the market may reverse itself. He therefore gives his broker a stop order to sell at 67. If the reversal does occur and the price drops to 67 or less, the order immediately becomes a market order. The stock is disposed of at the best possible price. This may be exactly 67, or it may be slightly above or below that figure. Why? …Because what happened at 67 was that his order became a market order; the price he actually received was dependent upon the next activity in the market. Let us suppose that the sale was made at 66 1/2. The doctor customer made a gross profit of 6 1/2 points per share on his original purchase. Without the stop order, the stock may have dropped considerably below that before the customer could have placed a market order and his profit might have been less or, in fact, he might have even sold at a loss.

Preventive:

A doctor purchases 100 shares of a stock at 30. He obviously anticipates that the price of the stock will rise in the near future (why else would he buy?). However, he realizes that his judgment may be faulty. He therefore, at the time of purchase, places a sell stop order at a price somewhat below his purchase price, for example, at 28. As yet, he has made neither profit nor loss; he’s merely acting to prevent a loss that might follow if he made the wrong bet and the stock does fall in price. If the stock does drop, the doctor knows that once it gets as low as 28, a market order will be turned in for him and, therefore, he will lose only 2 points or thereabout. It might have been much more had he not used the sell stop.

Miscellaneous Orders and Positions

Beside market, limit and stop orders, there are some other miscellaneous orders to know.

A stop limit order is a stop order that, once triggered or activated, becomes a limit order. Realize that it is possible for a stop limit to be triggered and not executed, as the limit price specified by the doctor may not be available.

In addition, there are all or none and fill or kill orders, and even though both require the entire order to be filled, there are distinct differences. An all or none (AON) is an order in which the broker is directed to fill the entire order or none of it. A fill or kill (FOK) is an order either to buy or to sell a security in which the broker is directed to attempt to fill the entire”‘ amount of the order immediately and in full, or that it be canceled.

The difference between an all or none and a fill or kill order is that with an all or none order, immediate execution is not required, while immediate execution is a critical component of the fill or kill. Be cause of the immediacy requirement, FOK orders are never found on the specialist’s book. Another difference is that AON orders are only permitted for bonds, not stocks, while FOK orders may be used for either.

Also, there exists an immediate or cancel order (IOC), which is an order to buy or sell a security in which the broker is directed to attempt to fill immediately as much of the order as possible and cancel any part remaining. This type of order differs from a fill or kill order which requires the entire order to be filled. An IOC order will permit a partial fill. Because of the immediacy requirement, IOC and FOK orders are never found on the specialist’s book.

Long and Short Positions

A long buy position means that shares are for sale from a market makers inventory, or owned by the medical investor, outright. Market makers take long positions when customers and other firms wish to sell, and they take short positions when customers and other firms want to buy in quantities larger than the market maker’s inventory. By always being ready, willing, and able to handle orders in this way, market makers assure the investing public of a ready market in the securities in which they are interested. When a security can be bought and sold at firm prices very quickly and easily, the security is said to have a high degree of liquidity, also known as marketability.

A short position investor seeks to make a profit by participating in the decline in the market price of a security.

Now, let’s see how these terms, long and short, apply to transactions by medical investors, rather than market makers, in the securities markets.

When a doctor buys any security, he is said to be taking a long position in that security. This means the investor is an owner of the security. Why does a doctor take a long position in a security? Besides – receiving dividend income, to make a profit from an increase in the market price. Once the security has risen sufficiently in price to satisfy the investor’s profit needs, the investor will liquidate his long position, or sell his stock. This would officially be known as a long sale of stock, though few people in the securities business use the label “long sale”. This is the manner in which the above investor had made a profit is the traditional method used; buy low, sell high.

Let’s look at an actual investment in General Motors to investigate this principle further. A medical investor has taken a long position in 100 shares of General Motors stock at a price of $70 per share. This means that the manner in which he can do that is by placing a market order which will be executed at the best “available market price at the time, or by the / placing of a buy limit order with a limit price of $70 per share. The investor firmly believes, on the basis of reports that he has read about the automobile industry and General Motors specifically, that at $70 a share, General Motors is a real bargain. He believes that based on its current level of performance, it should be selling for a price of between $80 and $85 per share. But, the doctor investor has a dilemma. He feels certain that the price is going to rise but he cannot watch his computer, or call his broker, every hour of every day. The reason he can’t watch is because patients have to be seen in the office. The only people who watch a computer screen all day are those in the offices of brokerage firms (stock broker registered representatives), and doctor day traders, among others.

In the above example, with a sell limit order, if the doctor investor was willing to settle for a profit of $12 per share, what order would he place at this time? If you said, “sell at $82 good ’til canceled”, you are correct. Why GTC rather than a day order? Because our doctor investor knows that General Motors is probably not going to rise from $70 to $82 in one day. If he had placed an order to sell at $82 without the GTC qualification, his order would have been canceled at the end of this trading day. He would have had to re-enter the order each morning until he got an execution at 82. Marking the order GTC (or open) relieves him of any need to replace the order every morning. Several weeks later, when General Motors has reached $82 per share in the market, his order to sell at 82 is executed. The medical investor has bought at 70 and sold at 82 and realized a $12 per share profit for his efforts.

Let’s suppose that the medical investor, who has just established a $12 per share profit, has evaluated the performance of General Motors common stock by looking at the market performance over a period of many years. Let’s further assume that the investor has found by evaluating the market price statistics of General Motors is that the pattern of movement of General Motors is cyclical. By cyclical, we mean that it moves up and down according to a regular pattern of behavior. Let’s say the investor has observed that in the past, General Motors had repeated a pattern of moving from prices in the $60 per share range as a low, to a high of approximately $90 per share. Further, our investor has observed that this pattern of performance takes approximately 10 to l2 months to do a full cycle; that is, it moves from about 60 to about 90 and back to about 60 within a period of roughly l2 months. If this pattern repeats itself continually, the investor would be well advised to buy the stock at prices in the low to mid 60’s hold onto it until it moves well into the 80’s, and then sell his long position at a profit. However, what this means is that our investor is going to be invested in General Motors only 6 months of each year. That is, he will invest when the price is low and, usually within half a year, it will reach its high before turning around and going back to its low again. How can the doctor investor make a profit not only on the rise in price of General Motors in the first 6 months of the cycle, but on the fall in price of General Motors in the second half of the cycle? One technique that is available is the use of the short sale.

The Short Sale

If a doctor investor feels that GM is at its peak of $ 90 per share, he may borrow 100 shares from his brokerage firm and sell the 100 shares of borrowed GM at $ 90. This is selling stock that is not owned and is known as a short sale. The transaction ends when the doctor returns the borrowed securities at a lower price and pockets the difference as a profit. In this case, the doctor investor has sold high, and bought low.

Odd Lots

Most of the thousands of buy and sell orders executed on a typical day on the NYSE are in 100 share or multi-100 share lots. These are called round lots. Some of the inactive stocks traded at post 30, the non-horseshoe shaped post in the northwest corner of the exchange, are traded in 70 share round lots due to their inactivity. So, while a round lot is normally 700 shares, there are cases where it could be 10 shares. Any trade for less than a round lot is known as an odd lot. The execution of odd lot orders is somewhat different than round lots and needs explanation.

When a stock broker receives an odd lot order from one of his doctor customers, the order is processed in the same manner as any other order. However, when it gets to the floor, the commission broker knows that this is an order that will not be part of the regular auction market. He takes the order to the specialist in that stock and leaves the order with the specialist. One of the clerks assisting the specialist records the order and waits for the next auction to occur in that particular stock. As soon as a round lot trade occurs in that particular stock as a result of an auction at the post, which may occur seconds later, minutes later, or maybe not until the next day, the clerk makes a record of the trade price.

Every odd lot order that has been received since the last round lot trade, whether an order to buy or sell, is then executed at the just noted round lot price, the price at which the next round lot traded after receipt of the customer’s odd lot order, plus or minus the specialist’s “cut “.  Just like everything else he does, the specialist doesn’t work for nothing. Generally, he will add 1/8 of a point to the price per share of every odd lot buy order and reduce the proceeds of each odd lot sale order by 1/8 per share. This is the compensation he earns for the effort of breaking round lots into odd lots. Remember, odd lots are never auctioned but, there can be no odd lot trade unless a round lot trades after receipt of the odd lot order.

Conclusion

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