Small Lots Trading
Surprising to many people, the process of completing a small lot transaction differs depending on where the security is traded and what type of security it is.
- For an NYSE-traded stock, the transaction begins with an investor placing the order and ends with the actual transaction being executed on the floor of the New York Stock Exchange. Here, the trade is a physical, as opposed to an electronic one.
- For Nasdaq-traded stocks, the transaction typically originates with an investor placing an order with a broker and ends with that broker selling stock from his current inventory of securities (stocks the broker actually owns). An excellent analogy of this type of market, called an Over-the-Counter (OTC) Market, is that a trader acts like a pawn shop, selling an inventory of securities when a buyer desires, just like the pawn shop owner sells a watch to a store visitor. And, when an investor wishes to sell securities, he or she contacts a trader who willingly purchases them at a price dictated by the trader, just like the pawn shop owner gives prices at which he will buy watches. In the OTC scenario, the actual storage of the securities is electronic, residing inside the trader's computer.
- For bonds, transactions rarely occur in small lots. By convention, most bonds have a face value of S 1,000, and orders for one or even 10 bonds are not common. However, the execution of the trade is similar to Nasdaq stocks. Traders carry inventory on their computer and buy and sell on the spot without the need for an NYSE-style trading pit.
ORDER: You call in an order of 1,000 shares of ABCD stock to your retail broker. For small orders, you agree on a trade placed "at the market." That is, you say you are willing to pay the "ask" price as it is currently trading in the market.
EXECUTION: First, the retail broker calls the appropriate trader to handle the transaction. The Nasdaq trader, called a market maker, carries an inventory of stocks available for purchase.
TRANSACTION: The market maker checks his inventory of stock. If he carries the security, he simply makes the trade, selling the 1,000 shares of ABCD from his account (the market maker's account) to you. If he does not already own the stock, then he will buy 1,000 shares directly from another market maker and then sell them immediately to you.
NYSE
ORDER: You decide to buy 1,000 shares of XYZ. You contact your broker and give the information to buy 1,000 shares. The broker tells you that the last trade price (65%) and the current quote (65 3/8 bid, 65% ask) and takes your order to buy 1,000 shares at the market. The broker also notes the volume of stock available for buy and sell, currently 500 X 500 (i.e. 500 shares of XYZ in demand at the bid and 500 shares of XYZ available for sale at the ask).
THE TRADE: The specialist's book displays a new order to buy 1,000 shares of XYZ at the market At this point, the specialist can fill the order himself from his own account at the last trade price of 65%, or alternatively, he can transact the 1,000 shares trade at 65%. In the latter case, 500 shares would come from the public customer (who had 500 shares of stock available at the bid price) and 500 shares would come from the specialist selling from his own account.
THE TRADE FINALIZED: If the floor specialist elects to trade at 65 %, he sends the details of the trade to his back office via the Exchange's computer system and also electronically to the brokerage firm. This officially records the transaction.
The NYSE, the largest exchange in the world, is comprised of more than 3,000 listed stocks with a total market capitalization of more than 12 trillion dollars as of June 1999. The NYSE is often referred to as "The Big Board."
We have all seen the videos of frantic floor brokers scrambling to execute trades in a mass of bodies and seeming confusion. To establish order amidst the chaos, trading in a particular stock occurs a specific location on the floor (the trading post), so that all buy and sell interests can meet in one piece to determine a fair price.
The NYSE hires what are called specialists to oversee the auctioning or trading of particular securities.
Specialists match buyers and sellers, but sometimes there is insufficient public interest in one side of a trade (i.e. there is a seller but no buyer, or a buyer and no seller). Since the specialist cannot match the other side of the trade, the Exchange requires the specialist to act as a dealer to buy (or sell) the stock to fill in the gap. According to the NYSE, specialists are directly involved in approximately 10 percent of trades executed on the floor, while they act as the auctioneer the other 90 percent of the time.
Note that while the NYSE is a physical trading floor, the Nasdaq is actually a virtual trading area. Approved Nasdaq dealers "make a market" in particular stocks by buying and selling shares through a computerized trading system. This is called an over-the-counter system or OTC system, with a network of linked computers acting as the auctioneer.
According to the NYSE's web site, "To buy and sell securities on the Trading Floor, a person must first meet rigorous personal and financial standards and be accepted for membership in the NYSE." Members are said to have a "seat" on the NYSE, but they rarely find time to sit down. Members, like everyone else at the NYSE, are on their feet most of the working day. A "seat" is simply the traditional term for the right to trade on the NYSE's Trading Floor.
According to the Exchange: "The number of seats is limited to 1,366, and the price of a seat, like a stock, depends on supply and demand. The price of a seat dipped to as low as $35,000 during the 1977 recession. Today, a seat can cost more than $1 million. It takes more than money to become a member, though. Each prospective member must pass a thorough test covering NYSE rules and regulations."
Block Trades
Small trades placed through brokers (often called retail trades) require a few simple entries into a computer. In these cases, traders record the exchange of a few hundred shares or a few thousand shares, and the trade happens with a few swift keystrokes.
However, when a large institutional investor seeks to buy or sell a large chunk of stock, or a block of stock, the sheer size of the order involves additional facilitation. A buy order for 200,000 shares of IBM stock, for instance, would not easily be accomplished without a block trader. At any given moment, only so much stock is available for sale, and to buy a large quantity would drive the price up in the market (to entice more sellers into the market to sell).
For a NYSE stock, the process of block trading is similar to that of any small buy or sell order. The difference is that a small trade arrives electronically to the specialist on the floor of the exchange, while a block trade runs through a floor broker, who then hand-delivers the order to the specialist. The style of a block trade also differs, depending on the client's wishes. Some block trades are done "at the market" and some block trades involve "working the order."
- At the market Say Fidelity wishes to buy 200,000 shares of IBM, and they first contact the block trader at an investment bank. If Fidelity believed that IBM stock was moving up, they would indicate that the purchase of the shares should occur "at the market." In this case, the trader would call the floor broker (in reality, he contacts the floor broker's clerk), to tell him or her to buy the next available 200,000 shares of IBM. The clerk delivers the ticket to the floor broker, who then takes it to the specialist dealing in IBM stock. Again, the specialist acts as an auctioneer, matching sellers to the IBM buyer. Once the floor broker accumulates the entire amount of stock, likely from many sellers, his or her clerk is sent back to the phones to call back the trader. The final trading price is a weighted average of all of the purchase prices from the individual sellers.
- Working the order. Alternately, if Fidelity believes that IBM was going to bounce around in price, they might ask the trader to "work the order" in order to hopefully get a better price than what is currently in the market. The trader then would call the floor broker and indicate that he or she should work at hiding as low a price as possible. In this case, the floor broker might linger at the IBM trading post, watching for sell orders to come in, hoping to accumulate the shares at as low a price as possible.
Bond trading takes place in OTC fashion, just as stocks do on the Nasdaq. That is, there is no physical lading floor for bonds, merely a collection of linked computers and market makers around the world (literally). As such, there is no central open outcry market floor for bonds, as there is for NYSE stocks. Therefore, for bond orders, the transaction flow is similar to that of an OTC stock. A buyer calls a broker-dealer, indicates him bonds he wishes to buy, and the trader sells the securities with a phone call and a few keystrokes on his computer.
