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Subject: The Investment FAQ (part 19 of 20)

This article was archived around: 20 Jun 2006 04:24:16 GMT

All FAQs in Directory: investment-faq/general
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Archive-name: investment-faq/general/part19 Version: $Id: part19,v 1.62 2005/01/05 12:40:47 lott Exp lott $ Compiler: Christopher Lott
The Investment FAQ is a collection of frequently asked questions and answers about investments and personal finance. This is a plain-text version of The Investment FAQ, part 19 of 20. The web site always has the latest version, including in-line links. Please browse http://invest-faq.com/ Terms of Use The following terms and conditions apply to the plain-text version of The Investment FAQ that is posted regularly to various newsgroups. Different terms and conditions apply to documents on The Investment FAQ web site. The Investment FAQ is copyright 2005 by Christopher Lott, and is protected by copyright as a collective work and/or compilation, pursuant to U.S. copyright laws, international conventions, and other copyright laws. The contents of The Investment FAQ are intended for personal use, not for sale or other commercial redistribution. The plain-text version of The Investment FAQ may be copied, stored, made available on web sites, or distributed on electronic media provided the following conditions are met: + The URL of The Investment FAQ home page is displayed prominently. + No fees or compensation are charged for this information, excluding charges for the media used to distribute it. + No advertisements appear on the same web page as this material. + Proper attribution is given to the authors of individual articles. + This copyright notice is included intact. Disclaimers Neither the compiler of nor contributors to The Investment FAQ make any express or implied warranties (including, without limitation, any warranty of merchantability or fitness for a particular purpose or use) regarding the information supplied. The Investment FAQ is provided to the user "as is". Neither the compiler nor contributors warrant that The Investment FAQ will be error free. Neither the compiler nor contributors will be liable to any user or anyone else for any inaccuracy, error or omission, regardless of cause, in The Investment FAQ or for any damages (whether direct or indirect, consequential, punitive or exemplary) resulting therefrom. Rules, regulations, laws, conditions, rates, and such information discussed in this FAQ all change quite rapidly. Information given here was current at the time of writing but is almost guaranteed to be out of date by the time you read it. Mention of a product does not constitute an endorsement. Answers to questions sometimes rely on information given in other answers. Readers outside the USA can reach US-800 telephone numbers, for a charge, using a service such as MCI's Call USA. All prices are listed in US dollars unless otherwise specified. Please send comments and new submissions to the compiler. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Trading - Order Routing and Payment for Order Flow Last-Revised: 25 Nov 1999 Contributed-By: Bill Rini (bill at moneypages.com), Terence Bergh, Chris Lott ( contact me ), W. Felder A common practice among brokerage firms is to route orders to certain market makers. These market makers then "rebate" 1 to 4 cents per share back to the brokerage firm in exchange for the flow of orders. These payments are known as "payment for order flow" (PFOF). (The account executive does not receive this compensation.) Order routing and PFOF occurs in stocks traded on the NYSE, AMEX and NASDAQ. NYSE and AMEX stocks traded away from the exchange are said to be traded "Third Market." Payment for order flow has been a mechanism that for many years has allowed firms to centralize their customers' orders and have another firm execute them. This allowed for smaller firms to use the economies of scale of larger firms. Rather than staffing up to handle 1,000, 5,000 or so orders a day, a firm can send it's 1,000 or 5,000 orders to another firm that will combine this with other firm's orders and in turn provide a quality execution which most of the time is automated and is very broad in nature. Orders are generally routed by computer to the receiving firm by the sending firm so there is little manual intervention with orders. This automation is an important part of this issue. Most small firms cannot handle the execution of 3,000 or more different issues with automation, so they send their orders to those firms that can. For example, Firm A can send it's retail agency orders to a NASDAQ market maker or Third Market dealer (in the case of listed securities) and not have to have maintain day-in and day-out the infrastructure to "handle" their orders. In return for this steady stream of retail order the receiving firm will compensate Firm A for it's relationship. This compensation will generally come in the form of payment per share. In the NASDAQ issues this is generally 2 cents, while in NYSE issues its 1 cent per share. Different firms have different arrangements, so what I have offered is just a rule of thumb. These "rebates" are the lifeblood of the deep discount brokerage business. Discount brokerage firms can afford to charge commissions that barely cover the fixed cost of the trade because of the payments they receive for routing orders. But understand that payment for order flow is not limited to discounters, many firms with all types of MO's use payment for order flow to enhance their revenues while keeping their costs under control. Also understand that if you require your discount broker to execute your orders on the NYSE (in the case of listed securities), you will find that the broker you are using will eventually ask you to pay more in commissions. Firms that pay for order flow provide a very important function in our marketplace today. Without these firms, there would be less liquidity in lower tier issues and in the case of the Third Market Dealers, they provide an alternative to a very expensive primary market place i.e. NYSE and ASE. For example if you take a look at Benard Madoff (MADF) and learn what their execution criteria is for the 500 to 600 listed issue that they make a market in, you would be hard pressed to find ANY difference between a MADF execution and one executed on the NYSE. In some cases it will even be superior. There are many Third Market Firms that provide quality execution services to the brokerage community, DE Shaw, Trimark are two others that do a great job in this field. However, please realize that the third market community would have a hard time existing without the quote, size and prints displayed by the primary exchanges. The firm that receives payment for its order flow must disclose this fact to you. It is generally disclosed on the back of your customer confirmation and regularly on the back of your monthly statement. This disclosure will not identify the exact amount (as it will vary depending on the order involved, affected by variables such as the market, limit, NMS, spread, etc.), but you can contact your broker and ask how much was received for your order if in fact payment was received for your order. You will probably get a very confused response from a retail broker because this matter (the exact amount i.e., 2 cents or 1.5 cents ) will generally not be disclosed to your individual broker by the firm he/she is employed by. It is hard to "tell" if your order has been subject to payment. Look closely at your confirmation. For example if the indicated market is NYSE or ASE then you can be rest assured that no other payment was received by your firm. If the market is something like "other" coupled with a payment disclosure, your order may in fact be subject to payment. There are two schools of thought about the quality of execution that the customer receives when his/her order is routed. The phrase "quality of execution" means how close was your fill price to the difference between the bid/ask on the open market. Those who feel that order routing is not detrimental argue that on the NASDAQ, the market maker is required to execute at the best posted bid/ask or better. Further, they argue, many market making firms such as Mayer Schweitzer (a division of Charles Schwab) execute a surprising number of trades at prices between the bid/ask. Others claim that rebates and conflict of interest sometimes have a markedly detrimental affect on the fill price. For a lengthy discussion of these hazards, read on. To realize the lowest overall cost of trading at a brokerage firm, you must thoroughly research these three categories: 1. The broker's schedule of fees. 2. Where your orders are directed. 3. If your NYSE orders are filled by a 19c-3 trading desk. Category 1 includes "hidden" fees that are the easiest costs to discover. Say a discount broker advertises a flat rate of $29.00 to trade up to 5,000 shares of any OTC/NASDAQ stock. If the broker adds a postage and handling fee of $4.00 for each transaction it boosts the flat rate to $33.00 (14% higher). Uncovering other fees that could have an adverse impact on your ongoing trading expenses requires a little more digging. By comparing your broker's current fees (if any) for sending out certificates, accepting odd-lot orders or certain types of orders (such as stops, limits, good-until-canceled, fill-or-kill, all-or-none) to other brokers' schedules of fees, you'll learn if you're being charged for services you may not have to pay for elsewhere. Category 2 is often overlooked. Many investors, especially those who are newer to the market, are not aware of the price disparities that sometimes exist between the prices of listed stocks traded on the primary exchanges (such as the NYSE or AMEX), and the so-called "third marketplace." The third marketplace is defined as listed stocks that are traded off the primary exchanges. More than six recent university studies have concluded that trades on the primary exchanges can sometimes be executed at a better price than comparable trades done on the third market. Although there is nothing intrinsically wrong with the third market, it may not be in your best interest for a broker to route all listed orders to that marketplace. If you can make or save an extra eighth of a point on a trade by going to the primary exchange, that's where your order should be directed. After all, an eighth of a point is $125.00 for each 1,000 shares traded. Here's how the third market can work against you: Say you decide to purchase 2,000 shares of a stock listed on the NYSE. The stock currently has a spread of 21 to 21 1/4. Your order, automatically routed away from the NYSE to the third market, is executed at 21 1/4. Yet at the NYSE you could have gone in-between the bid-ask and gotten filled at 21 1/8, a savings of $250.00. Only a few of the existing deep discount brokers will route your listed stock orders to the primary exchanges. Most won't as a matter of business practice even if asked to do so. The only way to be sure that your listed stock orders are being filled on the primary exchanges is to carefully scrutinize your confirmations. If your confirmation does not state your listed order was filled on the NYSE or AMEX then it was executed on the third market. You run the greatest risk of receiving a bad fill -- or sometimes missing an opportunity completely -- whenever you trade any of the stocks added to the NYSE since April 26, 1979, and your trade is routed away from the primary exchange onto the third market. Almost all AMEX stocks run this risk. Category 3 was understood only by the most sophisticated of investors until recently. A 19c-3 trading desk is a (completely legal) method of filling NYSE orders in-house, without exposing the orders to the public marketplace at all. Yes, you'll get your orders filled, but not necessarily at the best prices. NYSE stocks listed after April 26, 1979, sector funds (primarily "country" funds such as the Germany Fund or Brazil Fund), and publicly-traded bond funds are the securities traded at these in-house desks. Recently, the NYSE approached the Securities Exchange Commission asking that Rule 19c-3, that allows this trading practice, be repealed. Edward Kwalwasser, the NYSE's regulatory group executive vice president stated flatly that, "The rule hasn't done what the Commission thought it would do. In fact, it has become a disadvantage for the customer." Here's a scenario that helps explain the furor that has developed over the 19c-3 wrinkle. Let's say that XYZ stock is trading with a spread of 9 1/2 to 9 3/4 per share on the floor of the NYSE. An investor places an order to buy the stock and the broker routes that order away from the NYSE to the internal 19c-3 desk. The problem emerges when the order reaches this desk, namely that the order is not necessarily filled at the best price. The desk may immediately fill it from inventory at 9 3/4 without even attempting to buy it at 9 5/8 for the customer's benefit -- this is the spread's midpoint on the floor of the exchange. Then, after filling the customer's order internally, the firm's trader may then turn around and buy the stock on the exchange, pocketing the extra 12 1/2 cents per share for the firm. Project this over millions of shares per year and you can get an idea of the extra profits some brokers are squeezing out at the expense of their trusting, but ignorant, customers. You can most likely resolve this dilemma between low commissions and quality of execution by examining the volume of trades you do. If you buy a few shares of AT&T once a year for your children, then the difference in fees between a trade done by a discount broker as compared to a full-service wire house will most likely dominate an 1/8 or even a 1/4 improvement in the fill price. However, if you work for Fidelity (why are you reading this?) and regularly trade large amounts, then you certainly have negotiated nicely reduced commissions for yourself and care deeply about getting a good fill price. Finally, the whole issue may become much less important soon. Under the new rules for handling limit orders on the NASDAQ market, payment for order flow is becoming more and more burdensome on execution firms. With the advent of day trading, specialty firms that use the NASDAQ's SOES execution system, along with other systems to "game" the market makers, the ability of firms to pay others for their orders is becoming increasingly difficult. This "gaming" of the market place is due to different trading rules for different market participants (this issue by itself can take hours to explain and has many different viewpoints). Many firms have discontinued paying for limit orders as they have become increasingly less profitable than market orders. As of November 1999, the Wall Street Journal that payment for order flow is a practice that is dying out fairly rapidly. Note: portions of this article are copyright (c) 1996 by Terrence Bergh, and are taken from an article that originally appeared in Personal Investing News, March 1995. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Trading - Day, GTC, Limit, and Stop-Loss Orders Last-Revised: 5 May 1997 Contributed-By: Art Kamlet (artkamlet at aol.com) Day/GTC orders, limit orders, and stop-loss orders are three different types of orders you can place in the financial markets. This article concentrates on stocks. Each type of order has its own purpose and can be combined. * Day and GTC orders: An order is canceled either when it is executed or at the end of a specific time period. A day order is canceled if it is not executed before the close of business on the same day it was placed. You can also leave the specific time period open when you place an order. This type of order is called a GTC order (good 'til cancelled) and has no set expiration date. * Limit orders: Limit orders are placed to guarantee you will not sell a stock for less than the limit price, or buy for more than the limit price, provided that your order is executed. Of course, you might never buy or sell, but if you do, you are guaranteed that price or better. For example, if you want to buy XYZ if it drops down to $30, you can place a limit buy @ $30. If the price falls to $30 the broker will attempt to buy it for $30. If it goes up immediately afterwards you might miss out. Similarly you might want to sell your stock if it goes up to $40, so you place a limit sell @ $40. * Stop-loss orders: A stop-loss order, as the name suggests, is designed to stop a loss. If you bought a stock and worry about it falling too low, you might place a stop-loss sell order at $20 to sell that stock when the price hits $20. If the next trade after it hits $20 is 19 1/2, then you would sell at 19 1/2. In effect the stop loss sell turns into a market order as soon as the exchange price hits that figure. Note that the NASDAQ does not officially accept stop loss orders since each market maker sets his own prices. Which of the several market makers would get to apply the stop loss? However, many brokers will simulate stop-loss orders on their own internal systems, often in conjunction with their own market makers. Their internal computers follow one or perhaps several market makers and if one of them quotes a bid which trips the simulated stop order, the broker will enter a real order (perhaps with a limit - NASDAQ does recognize limits) with that market maker. Of course by that time the price might have fallen, and if there was a limit it might not get filled. All these simulated stop orders are doing is pretending they are entering real stops (these are not official stop loss orders in the sense that a stock exchange stop order is), and some brokers who work for the firms that offer this service might not even understand the simulation issue. If you sell a stock short, you can protect yourself against losses if the price goes too high using a stop-loss order. In that case you might place a stop-loss buy order on the short position, which turns into a market order when the price goes up to that figure. Example: Let's combine a stop loss with a limit sell and a day order. XYZ - Stop-Loss Sell Limit @ 30 - Day Order Only The day order part is simple -- the order expires at the end of the day. The stop-loss sell portion by itself would convert to a sell at market if the price drops down to $30. But since it is a stop-loss sell limit order, it converts to a limit order @ $30 if the price drops to $30. It is possible the price drops to 29 1/2 and doesn't come back to $30 and so you never do sell the stock. Note the difference between a limit sell @ $30 and a stop-loss sell limit @ $30 -- the first will sell at market if the price is anywhere above $30. The second will not convert to a sell order (a limit order in this case) until the price drops to $30. You can also work these same combinations for short sales and for covering losses of short stock. Note that if you want to use limit orders for the purpose of selling stock short, there is an exchange uptick rule that says you cannot short a stock while it is falling - you have to wait until the next uptick to sell. This is designed to prevent traders from forcing the price down too quickly. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Trading - Pink Sheet Stocks Last-Revised: 2 Sep 1999 Contributed-By: Art Kamlet (artkamlet at aol.com) A company whose shares are traded on the so-called "pink sheets" is commonly one that does not meet the minimal criteria for capitalization and number of shareholders that are required by the NASDAQ and OTC and most exchanges to be listed there. The "pink sheet" designation is a holdover from the days when the quotes for these stocks were printed on pink paper. "Pink Sheet" stocks have both advantages and disadvantages. Disadvantages: 1. Thinly traded. Can make it tough (and expensive) to buy or sell shares. 2. Bid/Ask spreads tend to be pretty steep. So if you bought today the stock might have to go up 40-80% before you'd make money. 3. Market makers may be limited. Much discussion has taken place in this group about the effect of a limited number of market makers on thinly traded stocks. (They are the ones who are really going to profit). 4. Can be tough to follow. Very little coverage by analysts and papers. Advantages: 1. Normally low priced. Buying a few hundred share shouldn't cost a lot. 2. Many companies list in the "Pink Sheets" as a first step to getting listed on the National Market. This alone can result in some price appreciation, as it may attract buyers that were previously wary. In other words, there are plenty of risks for the possible reward, but aren't there always? The National Quotation Bureau maintains the list of pink-sheet stocks. Their site gives the history of the pink-sheet listing service and information about real-time quotes for OTC issues. http://www.nqb.com/ Online quotes are offered by the National Quotation Bureau for registered users only. http://www.otcquote.com/ --------------------Check http://invest-faq.com/ for updates------------------ Subject: Trading - Price Improvement Last-Revised: 26 Feb 1997 Contributed-By: John Schott (jschott at voicenet.com), Chris Lott ( contact me ) In a nutshell, price improvement means that your broker filled an order at a price better than you might have expected from the bid and asked prices prevailing at the time you placed the order. More concretely, you were able to pay less than the asked price if you bought, and you received better than the bid price if you sold. Two of the ways that this happens imply extra work by your broker, the third is just luck. First, a market order may be filled inside the spread. For example, a market order for 100 sh of IBM means that your broker should just buy the shares for you at the current asking price. If the price you pay is less than the current asking price, you experienced price improvement Second, a limit order may be filled better than the limit. For example, if you wanted to buy 100 sh of IBM at a maximum price of 150, and you were filled at 149 7/8, that's price improvement also. And third, the market may simply have moved in your favor during the time it took to route your order to the exchange, resulting in a lucky saving for you. Price improvement is extremely important to people who frequently trade large blocks of stocks. These people care more about superior executions (i.e., price improvement) than the brokerage house's commission. After all, a 1/8-point improvement on a 1000-share trade makes a $125 difference. So beware saving a penny on the commission and losing a pound on the execution price. It is difficult for the small investor to determine independently whether his or her order was filled with price improvement or not. (I'm assuming that the average small investor doesn't have access to a live/delayed data feed.) However, there are several sources on the net for intraday price charts that may help you analyze your fills. On a lightly traded stock, spotting you own trade crossing the tape is easy - and a minor thrill. In theory, when you place an order with a broker, the broker should search all possible places (be they markets or market makers) to get the best possible execution price for you. This is especially true with NASDAQ, where a host of market makers may trade in a given stock. In fact, many brokers (especially discounters or so-called "introducing brokers") simply dump their order on another firm for execution. This broker may not be so diligent in checking out all possible sources, due to a custom called "Payment for Order Flow" (PFOF). PFOF is a small (typically $0.03-0.06/share) payment made by the executing broker to the your broker for the privilege of handling the order. If you think about it, the money can only come from someone's pocket - and it might be from yours via a less than top-flight execution. For many stocks, remember that there are a lot of places it may trade beyond the exchange it is listed on. Some large firms are trade on exchanges from Tokyo to London. Domestically, the same is true. For example, the Philadelphia stock exchange specialists make a market (i.e., offer quotes) on any stock listed on the NYSE. And then there are alternate (mostly electronic markets), like Reuters' Instinet. Moreover, big brokers often have a small inventory of actively traded stocks they make a market in and can effectively cut-off (cross) an order before it hits the exchanges. A brokerage house can also program its computer to recognize when two orders flowing in from their regional offices make a pairing that can be summarily crossed. Generally, the broker keeps the spread, but some brokers give the advantage to the customer. Most notable in this respect is Schwab's new "no spread" trading system which crosses customer orders for participants. Instead of executing your order on the normal markets immediately, Schwab routes it to their "waiting room". If there is another order there that mates with yours the trade is immediate - if not, you sit there until that mating order shows up. In either case, Schwab takes its commission and splits the spread with the two customers. It remains to be seen how well this idea works. Evaluating the potential for a delayed trade and the price volatility of the stock itself versus the spread savings will make it difficult for an individual to decide whether to participate. Due to the need for speed, your broker might be more interested in moving the order (and generating some PFOF revenue) than delaying the trade while looking around for a better price. For example, if you are trying to beat an anticipated market move, paying an extra 1/8th to get immediate execution can be a good investment. Some regular and discount brokerage houses now advertise that they automatically attempt price improvement on all orders placed with them. One small West Coast discounter recently advertised that about 38% of its order flow achieved price improvement. All this discussion shows that price improvement requires a little more work (and perhaps a little less profit) for the dealing brokers when compared to straight trading. It also shows that you should understand your broker's normal practice when you consider how and where to place your orders. Related topics include the recent SEC-NASDAQ settlement. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Trading - Process Date Last-Revised: 23 Oct 1997 Contributed-By: Art Kamlet (artkamlet at aol.com), Chris Lott ( contact me ) Transaction notices from any broker will generally show a date called the process date. This is when the trade went through the broker's computer. This date is nearly always the same as the trade date, but there are exceptions. One exception is an IPO; the IPO reservation could be made a week in advance and until a little after the IPO has gone off, the broker might not know how many shares his firm was allocated so doesn't know how many shares a buyer gets. A day or two after the IPO has gone off, things might settle down. (The IPO syndicate might be allowed to sell say 10% more shares than obligated to sell - and might sell those even after the IPO date "as of" the IPO date.) So a confirmation might list a trade date that is two days before the process date. Other times the broker might have made an error and admit to it, and so correct it "as of" the correct date. So the confirmation slip might show August 15 as the process date of a trade "as of" a trade date of August 12. It happens. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Trading - Round Lots of Shares Last-Revised: 21 Mar 1998 Contributed-By: Art Kamlet (artkamlet at aol.com), buddyryba at pipeline.com, Uncle Arnie (blash404 at aol.com) There are some advantages to buying round lots, i.e., multiples of 100 shares, but if they don't apply to you, then don't worry about it. Possible limitations on odd lots (i.e., lots that are not multiples of 100) are the following: * The broker might add 1/8 of a point to the price -- but usually the broker will either not do this, or will not do it when you place your order before the market opens or after it closes. * Some limit orders might not be accepted for odd lots. * If these shares cover short calls, you usually need a round lot. * If you want to write covered calls, you'll need a round lot. Other than that, there's just nothing magic about selling 100 shares or 59 shares or any other number. Don't be concerned that your order to buy or sell 59 shares won't be considered until all 100-share orders are run. Your order doesn't just sit there waiting for an exact match on stocks that trade actively. Your order will likely just be swept into the specialist/market makers/brokers trading account along with other items. If you're buying very small numbers of stocks priced under $100 or so, your biggest problem is to find a broker who will bother with the order and give reasonable commission. The discounters may not touch the small order or charge more - and a lot of bigger firms have minimum commissions of $35 - 75 or so. Many firms want a minimum size account to open one, too. If you're trading penny stocks (commonly defined as having a price under $5 per share), there may be additional restrictions. For example, one reader reports that on the Toronto exchange, a round lot for an issue priced under CDN$1 is 500 shares. This seems like a good place to mention the terminology for very big orders. Block trades are large trading orders (very round lots?), where large is defined by the stock exchange. On the NYSE, a block trade is any transaction in which 10,000 shares or more of a single stock are traded, or a transaction with a value of $200,000 and up. So why does an investor still hear so much about odd lots? Well, once upon a time, there was a difference. At that time, if you wanted to sell 100 shares, your order would be forwarded to an NYSE or AMEX floor broker, who would then trek over to the trading area for that particular stock and try to find a buyer. If you wanted to sell only 50 shares, the floor broker would instead hoof it over to an odd lot broker. If you were in a hurry and specified "no print," the odd lot broker would buy the 50 shares at one eighth of a point below the posted bid price for the stock. Otherwise, the trade would go through at one eighth off the next trade (one quarter point if over $40/share). But all this is ancient history. The "odd lot differential" of one eighth or one quarter of a point was one of the ways that the odd lot broker made money. But these days, there are no odd lot brokers--and hence no odd lot differentials. Small stock trades, whether for 50 shares or 100 shares, are handled by computer rather than by people. The only thing that's left of the odd lot broker system is a reluctance by many people to place orders for less than 100 shares. At one time, these orders were subject to the odd lot differential, so people learned to avoid them whenever possible. The notion that orders of less than 100 shares were bad entered the investment world's folk lore, and like many other sorts of folk wisdom, it has a remarkable ability to persist even though it is no longer justified by the facts. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Trading - Security Identification Systems Last-Revised: 8 Aug 2000 Contributed-By: Chris Lott ( contact me ), Peter Andersson (peter at ebiz.com.sg) This article lists some of the identification systems used to assign unique numbers to securities that are traded on the various exchanges around the world. * CUSIP A numbering system used to identify securities issued by U.S. and Canadian companies. Every stock, bond, and other security has a unique, 9-digit CUSIP number chosen according to this system. The first six digits identify the issuer (e.g., IBM); the next two identify the instrument that was issued by IBM (e.g., stock, bond); and the last digit is a check digit. The system was developed in the 1960's by the Committee on Uniform Security Identification Procedures (CUSIP), which is part of the American Banker's Association. For a full history and all the gory details of the numbering system, see their web site: http://www.cusip.com * CINS The CUSIP International Numbering System (CINS) is a close cousin to CUSIP. Like CUSIP, it is a 9-digit numbering scheme that is used by the US finance industry. Unlike CUSIP, the numbers are used to identify securities that are traded or issued by companies outside the US and Canada. * EPIC Commonly used on the UK stock market. * ISID The International Securities Identification Directory (ISID) is a cross reference for the many different identification schemes in use. ISID Plus seems to be an expanded version of ISID (allowing more characters in the identifier). * ISIN An International Securities Identification Number (ISIN) code consists of an alpha country code (ISO 3166) or XS for securities numbered by CEDEL or Euroclear, a 9-digit alphanumeric code based on the national securities code or the common CEDEL/Euroclear code, and a check digit. The Association of National Numbering Agencies (ANNA) makes available International Securities Identification Numbers (ISIN) in a uniform structure. More information is available at: http://www.anna-nna.com/ * QUICK A numbering system used in Japan (anyone know more?). * RIC Reuters Identification Code, used within the Reuters system to identify instruments worldwide. Contains an X character market specific code (can be the CUSIP or EPIC codes) followed by .YY where YY stand for the two digit country code. i.e IBM in UK would be IBM.UK. More information is available at http://www.reuters.com * SEDOL Stock Exchange Daily Official List. The stock code used to identify all securities issued in the UK or Eire. This code is the basis of the ISIN code for UK securities and consists of a 7-digit number allocated by the master file service of the London Stock Exchange. * SICOVAM A 5-digit code allocated to French securities (Socie'te' Interprofessionelle pour la Compensation des Valeurs Mobili`eres). * Valoren Telekurs Financial, the Swiss numbering agency, assigns Valoren numbers to identify financial instruments. This seems to be the CUSIP of Switzerland. For much more information, visit the handbook of world stock, derivative and commodity exchanges (subscription required): http://www.exchange-handbook.co.uk/ --------------------Check http://invest-faq.com/ for updates------------------ Subject: Trading - Shorting Stocks Last-Revised: 9 Mar 2000 Contributed-By: Art Kamlet (artkamlet at aol.com), Rich Carreiro (rlcarr at animato.arlington.ma.us) Shorting means to sell something you don't own. If I do not own shares of IBM stock but I ask my broker to sell short 100 shares of IBM I have committed shorting. In broker's lingo, I have established a short position in IBM of 100 shares. Or, to really confuse the language, I hold 100 shares of IBM short. Why would you want to short? Because you believe the price of that stock will go down, and you can soon buy it back at a lower price than you sold it at. When you buy back your short position, you "close your short position." The broker will effectively borrow those shares from another client's account or from the broker's own account, and effectively lend you the shares to sell short. This is all done with mirrors; no stock certificates are issued, no paper changes hands, no lender is identified by name. My account will be credited with the sales price of 100 shares of IBM less broker's commission. But the broker has actually lent me the stock to sell. No way is he going to pay interest on the funds from the short sale. This means that the funds will not be swept into the customary money-market account. Of course there's one exception here: Really big spenders sometimes negotiate a full or partial payment of interest on short sales funds provided sufficient collateral exists in the account and the broker doesn't want to lose the client. If you're not a really big spender, don't expect to receive any interest on the funds obtained from the short sale. If you sell a stock short, not only will you receive no interest, but also expect the broker to make you put up additional collateral. Why? Well, what happens if the stock price goes way up? You will have to assure the broker that if he needs to return the shares whence he got them (see "mirrors" above) you will be able to purchase them and "close your short position." If the price has doubled, you will have to spend twice as much as you received. So your broker will insist you have enough collateral in your account which can be sold if needed to close your short position. More lingo: Having sufficient collateral in your account that the broker can glom onto at will, means you have "cover" for your short position. As the price goes up you must provide more cover. When you short a stock you are essentially creating a new shareholder. The person who held the shares in a margin account (the person from whom the broker borrowed the shares on the short seller's behalf) considers himself or herself a shareholder, quite justifiably. The person who bought the (lent) shares from the the short seller also considers himself or herself a shareholder. Now what happens with the dividend and the vote? The company sure as heck isn't going to pay out dividends to all of these newly created shareholders, nor will it let them vote. It's actually fairly straightforward. If and when dividends are paid, the short seller is responsible for paying those dividends to the fictitious person from whom the shares were borrowed. This is a cost of shorting. The short seller has to pay the dividend out of pocket. Of course the person who bought the shares might hold them in a margin account, so the shares might get lent out again, and so forth; but in the end, the last buyer in the chain of borrowing and shorting transactions is the one who will get the dividend from the company Tax-wise, a short seller's expense of paying a dividend to the lender is treated as a misc investment expense subject to the 2% of AGI floor. It does not affect basis (though I believe there is an exception that if a short position is open for 45 days or less, any dividends paid by the short seller are capitalized into basis instead of being treated as an investment expense -- check the latest IRS Pub 550). Voting of shares is also affected by shorting. The old beneficial owner of a share (i.e., the person who lent it) and the new beneficial owner of the share both expect to cast the vote, but that's impossible--the company would get far more votes than shares. What I have heard is that in fact the lender loses his chance to vote the shares. The lender doesn't physically have the shares (he's not a shareholder of record) and the broker no longer physically has the shares, having lent them to the short seller (so the broker isn't a shareholder of record anymore, either). Only a shareholder-of-record can vote the shares, so that leaves the lender out. The buyer, however, does get to vote the shares. Implicit in this is that if you absolutely, positively want to guarantee your right to vote some shares, you need to ask your broker to journal them into the cash side of your account in time for the record date of the vote. If a beneficial owner whose broker lent out the shares accidentally receives the proxy materials (accidentally because the person is not entitled to them), the broker should have his computers set up to disallow that vote. Even if you hold your short position for over a year, your capital gains are taxed as short-term gains. A short squeeze can result when the price of the stock goes up. When the people who have gone short buy the stock to cover their previous short-sales, this can cause the price to rise further. It's a death spiral - as the price goes higher, more shorts feel driven to cover themselves, and so on. You can short other securities besides stock. For example, every time I write (sell) an option I don't already own long, I am establishing a short position in that option. The collateral position I must hold in my account generally tracks the price of the underlying stock and not the price of the option itself. So if I write a naked call option on IBM November 70s and receive a mere $100 after commissions, I may be asked to put up collateral in my account of $3,500 or more! And if in November IBM has regained ground and is at $90, I would be forced to buy back (close my short position in the call option) at a cost of about $2000, for a big loss. Selling short is seductively simple. Brokers get commissions by showing you how easy it is to generate short term funds for your account, but you really can't do much with them. My personal advice is if you are strongly convinced a stock will be going down, buy the out-of-the-money put instead, if such a put is available. A put's value increases as the stock price falls (but decreases sort of linearly over time) and is strongly leveraged, so a small fall in price of the stock translates to a large increase in value of the put. Let's return to our IBM, market price of 66 (ok, this article needs to be updated). Let's say I strongly believe that IBM will fall to, oh, 58 by mid-November. I could short-sell IBM stock at 66, buy it back at 58 in mid-November if I'm right, and make about net $660. If instead it goes to 70, and I have to buy at that price, then I lose net $500 or so. That's a 10% gain or an 8% loss or so. Now, I could buy the IBM November 65 put for maybe net $200. If it goes down to 58 in mid November, I sell (close my position) for about $600, for a 300% gain. If it doesn't go below 65, I lose my entire 200 investment. But if you strongly believe IBM will go way way down, you should shoot for the 300% gain with the put and not the 10% gain by shorting the stock itself. Depends on how convinced you are. Having said this, I add a strong caution: Puts are very risky, and depend very much on odd market behavior beyond your control, and you can easily lose your entire purchase price fast. If you short options, you can lose even more than your purchase price! One more word of advice. Start simply. If you never bought stock start by buying some stock. When you feel like you sort of understand what you are doing, when you have followed several stocks in the financial section of the paper and watched what happens over the course of a few months, when you have read a bit more and perhaps seriously tracked some important financials of several companies, you might -- might -- want to expand your investing choices beyond buying stock. If you want to get into options (see the article on options ), start with writing covered calls. I would place selling stock short or writing or buying other options lower on the list -- later in time. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Trading - Shorting Against the Box Last-Revised: 5 Jul 1998 Contributed-By: Rich Carreiro (rlcarr at animato.arlington.ma.us) This article discusses a strategy that once helped investors delay a taxable event with relative ease. Revisions made to the tax code by the act of 1997 effectively eliminated the "Short Against The Box" strategy as of July 27, 1997 (although not totally - see the bottom of this article for a caveat). Shorting-against-the-box is the act of selling short securities that you already own. For example, if you own 200 shares of FON and tell your broker to sell short 200 shares of FON, you have shorted against the box. Note that when you short against the box, you have locked in your gain or loss, since for every dollar the long position gains, the short position will lose and vice versa. An alternative way to short against the box is to buy a put on your stock. This may or may not be less expensive than doing the short sale. The IRS considers buying a put against stock the same as shorting against the box. The name comes from the idea of selling short the same stock that you are holding in your (safety deposit or strong) box. The term is somewhat meaningless today, with so many people holding stock in street name with their brokers, but the term persists. The obvious way to close out any short-against-the-box position is to buy to cover the short position and to sell off the long. This will cost you two commissions. The better way is to simply tell your broker to deliver the shares you own to cover the short. This transaction is free of commission at some brokers. The sole rationale for shorting-against-the-box is to delay a taxable event. Let's say that you have a big gain on some shares of XYZ. You think that XYZ has reached its peak and you want to sell. However, the tax on the gain may leave you under-withheld for the year and hence subject to penalties. Perhaps next year you will make a lot less money and will thus be in a lower bracket and therefore would rather take the gain next year. Or maybe you have some other reason. Or perhaps you think, "This is great! I have a stock that I've held for 9 months but I think it has peaked out. Now I can lock in my gain, hold it for 3 more months, and then get a long-term gain instead of a short-term gain, saving me a bundle in taxes!" Bzzt. The answer is absolutely NOT! Unfortunately, the IRS has already thought of this idea and has set the rules up to prevent it. From IRS Publication 550: If you held property substantially identical to the property sold short for one year or less on the date of short sale or if you acquire property substantially identical to the property sold short after the short sale and on or before the date of closing the short sale, then: * Rule 1. Your gain, if any, when you close the short sale is a short-term capital gain; and * Rule 2. The holding period of the substantially identical property begins on the date of the closing of the short sale or on the date of the sale of this property, whichever comes first. So if you have held a stock for 11 months and 25 days and sell short against the box, not only will you not get to 12 months, but your holding period in that stock is zeroed out and will not start again until the short is closed. Note that your holding period is not affected if you are already holding the stock long-term. The 1997 revisions to the tax code define (or extend) the idea of "constructive sales." A constructive sale is a set of transactions which removes one's risk of loss in a security even if the security wasn't actually disposed of. Shorting against the box as well as certain options and futures transactions are defined as being constructive sales. And any constructive sale is interpreted as being the same as a real sale, which is why this strategy is no longer effective (don't you hate it when the rules change in the middle of the game?). For those who have read this far, there does appear to be a small loophole in the 1997 revisions that permit shorting against the box to delay a taxable event. If you have a short against the box position and then buy in the short within 30 days of the start of the tax year and leave the long position at risk for at least 60 days before ofsetting it again, the constructive sales rules do not apply. So it appears that you can continue shorting against the box to defer gains, but you have to temporarily cover the short and be exposed for at least 60 days at the beginning of each and every year. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Trading - Size of the Market Last-Revised: 26 Apr 1997 Contributed-By: Timothy M. Steff (tim at navillus.com), Chris Lott ( contact me ) The "size of the market" refers to the number of shares that a specialist or market maker is ready to buy or sell. This number is quoted in round lots of 100 shares; i.e., the last two zeros are dropped. The size of the market information is supplied with a quote on professional data systems. For example, if you get a quote of "bid 10, offer 10 1/4, size 10 X 10" this means that the person or company is willing to buy 10 round lots (i.e., 1,000 shares) at 10, or sell you 1,000 shares at 10 1/4. Specialists report size, they do not create it. It seems that different specialists report the size in approximately three ways: 1. Some are very precise; if a quote is 10x10 and 100 trades the offer, the size then becomes 10x9. 2. Some use what seems to be a convention number. That is if there the size is 50x100 the specialist is reporting at least 5,000 shares bid but less than 10,000, and at least 10,000 shares offered but less than 25,000. 3. Some seem to have no discernable method as the trading seems to be unrelated to the reported size. Thousands of shares trade the bid, the price and size remain the same, for example. The floor brokers in front of the specialist may be more important than the specialist in this regard; the specialist is not necessarily a party to the trade as is an OTC market-maker; the brokers may or may not put their orders into the specialists' limit order book, or may cancel their orders in the book later. The floor brokers are able to change the size by bidding and offering, and cancelling existing orders, thereby affecting how others trade. On the NASDAQ, which is not an auction market, size is usually reported as 500 X 500. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Trading - Tick, Up Tick, and Down Tick Last-Revised: 27 Aug 1999 Contributed-By: Chris Lott ( contact me ) The term "tick" refers to a change in a stock's price from one trade to the next (but see below for more). Really what's going on is that a comparison is made between trades reported on the ticker. If the later trade is at a higher price than the earlier trade, that trade is known as an "uptick" trade because the price went up. If the later trade is at a lower price than the earlier trade, that trade is known as a "downtick" trade because the price went down. On a traditional stock exchange like the NYSE, there is a single specialist for each stock, so this measure can be calculated based on the trade data. On the NASDAQ, the tick measure is calculated based on the trades reported (which might well be out of order, delayed, etc.) Something called the "tick indicator" is a market indicator that tries to gauge how many stocks are moving up or down in price. The tick indicator is computed based on the last trade in each stock. Note that certain transactions, namely shorting a stock, can only be executed on an up tick, so this measure is used to regulate the markets (it's not just of academic curiosity). Interestingly, on the NASDAQ, the restriction on short sales is not done based on the tick but rather based on the change in the BID on a stock; i.e., from the stream of bid data. All Market Makers and ECN's who trade on NASDAQ have their change in bids reported one at a time. For example, if a NASDAQ issue trades at 100 then next trades at 101 but at the same time the bid goes from 101 to 100 15/16, that would cause a down tick for the purpose of regulating short sales. The last trade was higher than the trade before (so the traditional tick indicator is positive), but a drop in the bid from 101 to 100 15/16 caused the would result in short sales being prohibited. The Wall Street Journal publishes a short tick indicator table daily with the UP/DOWN cumulative ticks (tick-volume) for selected (i.e., leading) stocks. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Trading - Transferring an Account Last-Revised: 9 Jan 1997 Contributed-By: anonymous; please contact Chris Lott ( contact me ) Transferring an account from one brokerage house to another is a simple, painless process. The process is supported by the Automated Customer Account Transfer (ACAT) system. To transfer your account, you fill out an ACAT form in cooperation with your new broker. The new broker will generally require a copy of your statements from the old brokerage house, plus some additional proof of identity. The transfer will be made within about 5-10 business days for regular accounts, and 10-15 business days for IRA and other types of qualified retirement accounts. The paperwork starts the process, but thereafter it's all done electronically. There is one caveat. Some brokerage houses charge fees as high as $50 to close IRA accounts. Other houses (Quick & Reilly is one) will reimburse you some fixed amount to cover those fees. Be sure to ask, the answer may delight you. --------------------Check http://invest-faq.com/ for updates------------------ Compilation Copyright (c) 2005 by Christopher Lott.