How Stock Trades?
An investor first needs to choose a broker through whom he wants to trade with and enter into broker-client agreement. It is the responsibility of the broker to explain different terms and conditions of the trade transactions and their implications before entering into an agreement with an investor. This agreement is mandatory. The features of this agreement that reduce the chances of any dispute on terms and conditions which relate to placement of order, trade confirmation, brokerage charges by a broker and delivery of securities and payments.
When an investor has decided to buy shares in a particular company, he contacts his broker. Investor can place an order to buy a fixed number of shares, or shares up-to a certain value.
For selling, again the investor contacts his broker. The stock broker is obliged to sell at the best price he can get, but an investor can decide what should be the minimum price he is prepared to accept. Stock broker assists the investor in buying and selling of shares at best price but in no way he is under any obligation to supervise the investment or to advice or to make any recommendation to the investor/clients with respect to the sale/purchase of shares.
Electronic Trading Terminals
Electronic trading terminals use information technology (computers) to bring buyers and sellers together in a virtual market place, rather than on a trading floor. Electronic trading, either directly with counterparties or through a broker, has transformed traditional methods of trading through exchanges. Rather than reaching the exchange and trade from the floor, institutional investors, brokers, and dealers can trade directly through the Electronic Trading Terminals installed at member’s rooms at Stock Exchange building or at remote premises of the broker.
Examples of electronic trading terminals in Pakistan are:
- Karachi Automated Trading System (KATS) at KSE
- Trading Workstations (TWS) at LSE
- Ultra Trading System (UTS) at ISE
Entry of Quotes and Orders
Quotes and Orders are entered in the Stock Exchange through the Order Entry Window of the Electronic Trading Terminals, provided to the brokers, of the exchanges. Following information is required to be entered into the Order/Quote Entry Windows:
- Type of Order (BUY or SELL)
- Type of Market (Regular, Futures, etc.)
- Type of Order (Market, Limit, Stop loss, etc.)
- Volume or Order (Quantity)
- Symbol of the Security
- Rate (Price to buy or sell)
- Account (assigned account number of a client)
The process continues as long as the incoming order remains executable. If not executed upon entry, an order is held in the central order book.
Also, it is possible for a single order to generate multiple executions at different points in time. For example, an order may generate a partial execution upon entry, while the remaining open order remains in the order book. The open portion may get executed a minute later, an hour later, or even a day later, if its validity extends beyond the current trading day.
All executions are subject to the restrictions of the Market Order Matching Range. Market orders have the highest priority for matching. Since the purpose of the market order is to be executed as quickly as possible at the best possible price, it must be entered without execution restrictions. If several market orders are booked in the order book, the system takes into account the timestamp of the orders to establish matching priority. The earliest market order entered receives the highest priority.
In the case of limit orders, orders with the best possible prices (highest price limit for buy orders, lowest price limit for sell orders) always take precedence in the matching process over other orders with worse prices. Again, if the limit orders have the same price limit, the criterion used for establishing matching priority is the order timestamp.
The orders already present in the order book are always executed at their specified limit price. Price improvements for orders in the order book are only possible during an auction process - opening or closing auction. Orders going into the order book are always matched at the appropriate prices available in the order book, up to the specified limit price.
Order Types
Taking up different types of orders allow you to be more precise about how you’d like your broker to carry on with your trades. Below are some often used, types of orders.
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Limit Order
An order placed with a brokerage to purchase or sell a set amount of shares at a stated price is said to be Limit Order.
This is the default order type for all single option, spread and stock orders. Because the limit order is not the market order therefore, it may not be executed if the price stated by the investor cannot be met during the tenure in which the order is left open. The limit price for buy orders is placed below the current market price. The limit price for sell orders is set above the current market price. Limit orders will be filled at the limit price or better, but are not assured a fill.
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Market Order
An order which an investor makes through a broker or brokerage service to purchase or sell an investment straightaway at the best available existing price is said to be Market Order.
Market order assures an execution, but do not guarantee a price or time of execution. It does not contain restrictions on the buy/sell price as well as the timeframe therefore, is likely to be executed. The risk of market orders is that you have no control over what the execution price is.
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Stop Loss
An order that is placed through a broker for the intention of selling a security when it achieves a certain price is called as Stop Loss Order.
Stop loss order opens or closes a position by buying or selling in case the market rises or falls respectively. The stop price for buy orders is placed above the current market price whereas for sell orders, it is placed below the existing market price. A stop order turns into a market order when the stop price is triggered, so the closing execution price or time of a stop order cannot be guaranteed. The stop price doesn’t need to be the same as that of the limit price. Same risks of market orders apply to stop orders.
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Stop Limit Order
And order which has the features of both stop order and that of limit order is termed as Stop Limit Order.
This order is executed at a specified price or, after a given stop price has been achieved. Once the stop price reaches, the stop limit order turns into a limit order to buy (or sell) at the limit price.
Trading Cycle
All stock exchanges in the country have introduced computerized trading system to provide a fair, transparent, and efficient market mechanism to facilitate the market participants, including the investors. The system being operated at KSE is called Karachi Automated Trading system (KATS); LSE is called Trading Workstations (TWS) while ISE is called Ultra.
Whenever a stock is bought or sold, there are two important dates to be kept in mind i.e. transaction date and the settlement date. The abbreviations T+1, T+2, T+3 accounts for the settlement date of the security transactions and signify that the settlement occurs on a transaction date in addition to one day, two day or three days.
T + 2 Settlement Systems:
In the T +2 Settlement systems, purchase and sale of securities is procured and the balance is settled on the second day following the day of trade.
Benefit of T + 2 Settlement Systems:
It reduces the time between execution and settlement of trades, which in turn reduces the market risk. It also reduces settlement risk, as the settlement cycle is shorter from the date of publication of prospectors/offering document.
When the company completes the process of dispatch/credit of allotted shares to subscriber through Central Depository Company (CDC), it is officially listed and placed on the T + 2 counter. Trading on the provisionally listed counter then comes to an end and all the outstanding transactions are transferred to the T + 2 counter with effect from the date of official listing.
T + 1/Spot Transactions:
Spot transactions imply delivery upon payment. Normally in spot transactions the trade is settled within 24 hours.
Futures Contract
A futures contract involves purchase and sale of securities at some future date (normally within one calendar month), at a price fixed today. The number and names of companies to be traded on the Futures contract are determined every six months based on the eligibility criteria approved by the SECP in this regard and which are notified to the market participants in advance.
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Equity Instruments
Equity instruments traded on the exchanges are in the form of shares that proves the ownership interest of common and preferred stock holders in a company. The ownership interest is represented by shares reflecting the assets and earnings.
Equity instruments traded on the local stock exchanges are:
- Ordinary Shares
- Preference Shares
- Shares’ Rights
- Deliverable Futures Contracts
- Cash Settled Futures Contracts
- Stock Index Futures Contracts
- Closed-end Mutual Funds
Debt instruments are the written promise to repay a debt. Examples include bills of exchange, Treasury Bills, TFCs, bonds, notes, CDs, etc.
A futures contract is a standardized contract, to buy or sell a specified commodity of standardized quality at a certain date in the future, at a market determined price (the futures price). The price is determined by the instantaneous equilibrium between the forces of supply and demand among competing buy and sell orders on the exchange at the time of the purchase or sale of the contract.
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Deliverable Futures Contract
For deliverable contracts, all bought and sold positions in existence as at the close of trading in the relevant contract month shall be settled via physical delivery. Deliverable futures contracts are the forward contracts to buy or sell a certain underlying instrument with actual delivery of the underlying instrument occurring. Settlement occurs 30 days after the contract is purchased.
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Cash Settled Futures Contracts
The Cash Settled Futures Contract is a standardized contract, to buy or sell a certain underlying instrument at a certain date in the future, at specified price. All settlement occurs purely on cash basis. Depending on the contract, settlement occurs 30, 60 & 90 days after the contract is purchased.
For further details, candidates are advised to refer to the "Regulations Governing Cash Settled Futures Contract" of KSE available at ICM's as well as KSE's website.
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Index Futures Contracts
Stock Index Futures are traded in a number of contracts. Each contract is to buy or sell a fixed value of the index. Stock Index Futures Contract normally occurs 90 days after the contract is purchased.
Stock Market Index
On a very basic level, any stock market index is simply a numerical value that measures the change in the market. In Pakistan, the main objective for the construction of an index is to track the performance of the various listed stocks according to their market capitalization. In general, a capital weighted index is composed of a basket of securities, which captures the change in market capitalization due to the variation in prices.
Movements of stock exchange indices are popularly considered as key indicators of the economy of a country. Stock exchange indices are not only barometers of the economy and public opinion of the state of economy, but are also used by many technical analysts to forecast and evaluate market trends and base their opinion on the future direction of the market.
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KSE 100
KSE-100 is the most recognized index of the KSE, representing almost all sectors of the KSE and includes the largest companies on the basis of their market capitalization. It represents approximately 85% of the market capitalization of the Exchange.
For further details, candidates are advised to refer to the Index Brochure of KSE-100 Index of KSE available at ICM as well as on the website of KSE.
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KSE 30
The KSE 30 Index was introduced in 2006 and is based on the “Free Float Methodology”. The index includes only the top 30 most liquid companies listed on the KSE.
For further details, candidates are advised to refer to the Index Brochure of KSE-30 Index of KSE available at ICM as well as on the website of KSE.
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KMI-30 (KSE Meezan Index)
The KMI-30 index was introduced in September 2008 and comprises of 30 Companies that quality the KMI Shariah screening criteria and is weighted by float adjusted market capitalization. There is a 12% cap on weights of individual securities, while rebalancing of the Index is done bi-annually.
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KSE All Shares
The All Share Index consists of all the companies listed on the KSE.
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Market Capitalization
Market capitalization also known as capitalized value of company, is a measurement of economic size equal to the share price times the number of shares outstanding of a public company. As owning stock represents owning the company, including all its equity, capitalization could represent the public opinion of a company's net worth and is a determining factor in stock valuation. Likewise, the capitalization of stock markets or economic regions may be compared to other economic indicators.
Liquidity
Market liquidity is an investment term that refers to an asset's ability to be easily converted through an act of buying or selling without causing a significant movement in the price and with minimum loss of value of the asset. Money, or cash in hand, is the most liquid asset. An act of exchange of a less liquid asset with a more liquid asset is also called liquidation. Liquidity also refers to a business' ability to meet its payment obligations, in terms of possessing sufficient liquid assets.
Financing
It is an act of providing funds for business activities, making purchases or investing in capital or money markets. Financial institutions including banks are in the business of financing as they provide capital to businesses, consumers and investors to help them realize their investment or consumption aspirations.
Local equity markets provide financing to investors through the following financing arrangements available under the Securities (Leveraged Markets and Pledging) Rules, 2011:
- Margin Financing
- Margin Trading
- Securities Lending & Borrowing
Transaction Cost
In economics and related disciplines, a transaction cost is a cost incurred in making an economic exchange. For example, most people, when buying or selling a stock must pay a commission to their broker; that commission is a transaction cost of doing the stock deal. When rationally evaluating a potential transaction, it is important to consider transaction costs that might prove significant.
Following costs are incurred while transacting in the local equity markets:
- Brokerage Commission
- FED (16% of brokerage commission)
- Withholding Tax on Sale (.01% of the transaction value)
- Capital Gain Tax (10% & 7.5% on capital gain for holding period of 6 and 12 months respectively)
Clearing House
A Clearing House is an organization/company affiliated with a Stock exchange through which brokers, financial institutions, and other parties settle trades. Clearing Company handles the validation, delivery and settlement of securities transactions undertaken on the exchange.
Clearing and Settlement is one of the most important aspects in the operation of the securities business. It is the process of reporting, matching, correcting securities transaction and the ultimate delivery or receipt of net balances.
National Clearing and Settlement System (NCSS) is a comprehensive system with well-defined procedures under National Clearing and Settlement System Regulations, 2003. The system provides an electronic system developed to replace the individual Clearing Houses of Pakistan’s three stock exchanges by a single entity. This system is operated by National Clearing Company of Pakistan Limited (NCCPL), which has been registered as a separate legal entity. The operation of NCSS has rapidly gaining acceptance and now majority of the securities have been inducted into the system for settlement purpose.
NCSS provides stability to the market by capping the systemic risk to a great extent. It has also improved efficiency of the settlement process by introducing a consolidated and geographically neutral clearing and settlement system. NCSS, with its technologically advanced features such as automated ‘Pay and Collect’ functionality, has introduced transparency and efficiency in the clearing process.
Risks in Clearing & Settlement
An efficient settlement system diminishes risks inherent in the settlement system. It constantly monitors and enhances risk measures to pre-empt market failures. It tracks the record and performance of members and their net worth. It monitors members’ exposures and collects margins and disables the license of members if the limits are breached.
There are few risks involved in the settlement system:
- Counterparty Risk
It arises when a member doesn’t discharge his/her obligations fully in time or any time thereafter. This leads to two risks – replacement cost risk prior to settlement and principal risk at the time of settlement.
- Replacement Cost Risk: When one of the parties to the transaction fails to deliver their obligations, the non-defaulting party tries to replace the original transaction for his client at current market price. So he loses the profit, that would have accumulated between the date of original transaction and date of replacement transaction, had the counter party would not have defaulted, but not the principal because by that time he has not delivered his obligations. This risk is lessened by reducing time gap between trading and settlement and by legally binding netting systems.
- The Principal Risk: This risk arises when one party delivers obligations and the other party doesn’t. This risk is rare in current day market scenario wherein the clearing corporation makes sure that delivery versus payment mechanism works properly. Clearing corporation acts as a third party to every transaction and delivers the securities to the buyer upon receiving the funds and transfers funds to the seller upon receiving the securities.
- Replacement Cost Risk: When one of the parties to the transaction fails to deliver their obligations, the non-defaulting party tries to replace the original transaction for his client at current market price. So he loses the profit, that would have accumulated between the date of original transaction and date of replacement transaction, had the counter party would not have defaulted, but not the principal because by that time he has not delivered his obligations. This risk is lessened by reducing time gap between trading and settlement and by legally binding netting systems.
- Systemic Risk
This risk arises because of operational risks like errors, frauds and outages and systemic risk for example failure of one part to deliver obligations may lead to the failure of other and it may lead to contagion/ domino effect and even to the complete failure of the settlement system itself.
- Liquidity Risk: When one of the parties defaults his/her obligations the other party looks for replacement. The party has to arrange funds/securities by borrowing these from other members and their funds/securities may not be available at that point in time or the cost may be high.
- Third Party Risk: This arises not because of the defaults by the original parties of the trade but by a third party for example failure of clearing bank, custodian etc. Allowing parties to have accounts with multiple clearing banks reduces this risk.
Depository Services & Types of Accounts
An investor can use any of the three types of CDC accounts, which are described as below along with their salient features:
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Sub - Account
A broker may open, maintain and operate any number of sub-accounts he requires on behalf of his clients. A specific sub-account is used for keeping securities belonging individually to that particular client of the broker.
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Group Client Account
This account is used for keeping securities which are beneficially owned by the broker’s clients who are not willing to utilize the facility of opening separate sub- account. The broker groups all such clients in their group accounts. The detailed break-up of the securities held by each client of a group account is maintained by the broker in his back office.
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Investor Accounts
By opening an investor account with CDC, the client comes with direct contact of CDC. Such account can only be operated by the relevant account holder. The service of CDC is efficient, effective and secure.
Out of the above, the most secure and convenient of different account types is the investor account as the account remains in direct control of the investor. Therefore this type of account is highly recommended to the investors.
Central Depository System
Central Depository System (CDS) is an Electronic Book Entry System to record and maintain securities and to register their transfer. In Central Depository System, ownership will be changed without physical movements of securities or execution of transfer deeds. The ownership will be transferred as soon as securities move from one account to another. CDS is purely a settlement vehicle and will not affect the trading in any manner whatsoever.
There are three elements of Central depository system:
- Account Holders
- Issuers/ Registrars
- Eligible Pledgee
CDS - Account Structure
The Account Holders of CDC are able to settle their transactions within the CDS through four types of accounts, namely:
- Main Account
Each Account Holder in the system is allocated a main account by virtue of being an Account Holder in the CDS. This account is mainly used as a transit account for movement of securities. Any security coming in or moving out of an account holder's family of accounts pass through this account.
- House Account
Used for securities owned beneficially by Account Holders.
- Sub Account (Client Account)
This account is used for keeping securities belonging individually to each of the clients of an Account Holder. An Account Holder may open and maintain any number of sub accounts he requires on behalf of his clients
- Cash Account
Each Account Holder in the system who opts to avail the Delivery vs. Payment (DVP) facility is required to deposit relevant amount to be used for the settlement of DVP obligations
