A stock exchange is a market for trading in securities. But it is not an ordinary market; it is a market with several peculiar features. In a stock exchange, buyers and sellers do not directly meet and interact with each other for making their trades. The investors (buyers and sellers of securities) trade through brokers who are members of a stock exchange. In stock exchanges, trading procedures are fully automated and member brokers interact and trade through a networked computer system. Trading in a stock exchange takes place in two phases; in the first phase, the member brokers execute their buy or sell orders on behalf of their clients (or investors) and, in the second phase, the securities and cash are exchanged.
For the exchange of securities and cash between the traders, the services of two other
agencies are required, namely the clearing house (corporation) of the stock exchange and
the depositories. Further, unlike other ordinary markets, stock exchanges are markets where the prices of the items traded (namely, securities) fluctuate constantly. This fluctuation in security prices leads to speculative activities in the stock exchanges.
We need to understand clearly the trading system in stockexchanges, how the trades are settled through exchange of securities and cash, the role of the clearing corporation and the depositories, etc. We also need to understand the different types of speculative activities taking place in a stock exchange. The information about the prices of securities traded in a stock exchange is useful in understanding the behaviour of the stock markets.
Trading System
The system of trading prevailing in stock exchanges for many years was known as floor trading. In this system, trading took place through an open outcry system on the trading floor or ring of the exchange during official trading hours.
In floor trading, buyers and sellers transact business face to face using a variety of signals. Under this system, an investor desirous of buying a security gets in touch with a broker and places a buy order along with the money to buy the security. Similarly, an investor intending to sell a security gets in touch with a broker, places a sell order and hands over the share certificate to be sold.
After the completion of a transaction at the trading floor between the brokers acting on behalf of the investors, the buyer investor would receive the share certificate and the seller investor would receive the cash through their respective brokers.
In the new electronic stock exchanges, which have a fully automated computerised mode of trading, floor trading is replaced with a new system of trading known as screenbased trading. In this new system, the trading ring is replaced by the computer screen and distant participants can trade with each other through the computer network. The member brokers can install trading terminals at any place in the country. A large number 54 of participants, geographically separated from each other, can trade simultaneously at high speeds from their respective locations. The screen-based trading systems are of two types
1. Quote driven system
2. Order driven system.
Under the quote driven system, the market-maker, who is the dealer in a particular security, inputs two-way quotes into the system, that is, his bid price (buying price) and offer price (selling price). The market participants then place their orders based on the bidoffer quotes. These are then automatically matched by the system according to certain rules.
Under the order driven system, clients place their buy and sell orders with the brokers. These are then fed into the system. The buy and sell orders are automatically matched by the system according to predetermined rules.
Types of Orders
An investor can have his buy or sell orders executed either at the best price prevailing on the exchange or at a price that he determines. Accordingly, an investor may place two types of orders, namely, market order or limit order.
Market Orders
In a market order, the broker is instructed by the investor to buy or sell a stated number of shares immediately at the best prevailing price in the market. In the case of a buy order, the best price is the lowest price obtainable; in the case of a sell order, it is the highest price obtainable. When placing a market order, the investor can be fairly certain that the order will be executed, but he will be uncertain of the price until after the order is executed.
Limit Orders
While placing a limit order, the investor specifies in advance the limit price at which he wants the transaction to be carried out. In the case of a limit order to buy, the investor specifies the maximum price that he will pay for the share; the order has to be executed only at the limit price or a lower price. In the case of a limit order to sell shares, the investor specifies the minimum price he will accept for the share and hence, the order has to be executed only at the limit price or a price higher to it. Thus for limit orders to purchase shares the investor specifies a ceiling on the price, and for limit orders to sell shares the investor specifies a floor price.
Limit orders are generally placed “away from the market” which means that the limit price is somewhat removed from the prevailing market price. In the case of a limit order to buy, the limit price would be below the prevailing price and in the case of a limit order to sell, the limit price would be above the prevailing market price. The investor placing limit orders believes that his limit price will be reached and the order executed within a reasonable period of time. But the limit order may remain unexecuted.
There are certain special types of orders which may be used by investors to protect their profits or limit their losses. Two such special kinds of orders are stop orders (also known as stop loss orders) and stop limit orders.
Stop Orders
A stop order may be used by an investor to protect a profit or limit a loss. For a stop order, the investor must specify what is known as a stop price. If it is a sell order, the stop price must be below the market price prevailing at the time the order is placed. If it is a buy order, the stop price must be above the market price prevailing at the time of placing the order. If, subsequently, the market price reaches or passes the stop price, the stop order will be executed at the best available price. Thus, a stop order can be viewed as a conditional market order, because it becomes a market order when the market price reaches or passes the stop price.
Examples will help to clarify the working of stop orders. Suppose an investor has 100 shares of a company which were purchased at Rs. 35 per share. The current market price
of the share is Rs. 75. The investor thus has earned a profit of Rs. 40 per share on his share holdings. He would very much like to protect this profit without foregoing the opportunity of earning more profit if the price moves still upwards. This can be achieved by placing a stop sell order at a price below the, current market price of Rs. 75, for example at Rs. 70. Now, if the price subsequently falls to Rs. 70 or below, the stop sell order becomes a market order and it will be executed at the best price prevailing in the market. Thus, the investor will be able to protect the profit of around Rs. 35 per share. On the contrary, if the market price of the share moves upwards, the stop sell order will not be executed and the investor retains the opportunity of earning higher profits on his holding.
Stop orders can also be used to minimise loss in trading. Suppose that a share is currently selling for Rs. 125 and an investor expects a fall in the price of the share. He may place an order for sale of the share at the current market price of Rs. 125 hoping to cover up his position by purchasing the share at a lower price and thus make a profit on the deal. This type of a transaction is known as a short sale. If price of the share falls as anticipated by the investor, he would make a profit. There is a possibility that the price may move upwards and in that case the investor has to purchase the share at a higher price to cover up his position and meet his sales commitment. This will result in a loss to the investor. This loss can be minimised by placing a stop buy order at a price above the current price of Rs. 125, for example at Rs. 130.
Now, if the price of the share rises to Rs. 130 or above, the stop buy order will become a market order and will be executed at the best price available in the market. Suppose that the stop buy order was executed at Rs. 131, then the loss of the investor is limited to Rs. 6 per share, that is, the difference between the selling price of ` 125 and the buying price of Rs. 131 per share.
One disadvantage of the stop orders is that the actual price at which the order is executed is uncertain and may be some distance away from the stop price.
Stop Limit Orders
The stop limit order is a special type of order designed to overcome the uncertainty of the execution price associated with a stop order. The stop limit order gives the investor the opportunity of specifying a limit price for executing the stop orders: the maximum price for a stop buy order and the minimum price for a stop sell order. With a stop limit order, the investor specifies two prices, a stop price and a limit price. When the market price reaches or passes the stop price, the stop limit order becomes a limit order to be executed within the limit price. Hence, a stop limit order can be viewed as a conditional limit order.
Let us consider two examples. Consider a share that is currently selling at Rs. 60. An investor who holds the share may place a stop limit order to sell with stop price of ` 55 and limit price of ` 52. If the market price declines to ` 55 or lower, a limit order to sell the share at the limit price of ` 52 or higher would be activated. Here the order will be executed only if the share is available at ` 52 or above. Thus a stop limit order may remain unexecuted.
Consider an investor who desires to make a short sale of a particular share at its current market price of ` 85. That is, he intends to sell the share without owning it but hoping to buy it later from the market at a lower price. He may also place a stop limit order to buy the share to minimise his loss in case the share price moves upwards contrary to his expectations. He may specify a stop price of ` 90 and a limit price of ` 93 for his stop limit
order to buy. If the price moves up to ` 90 or above, then a limit order to buy the share with limit price of ` 93 would be activated. The order would be executed at a price of ` 93 or lower, if such price is available in the market.
The disadvantage of a stop limit order is that it may remain unexecuted. The stop order results in certain execution at an uncertain price, while a stop limit order results in uncertain execution within a specified price limit.
Trading in stock exchanges takes place continuously during the official trading hours. Stock exchanges are open five days a week, from Monday through Friday. An investor may place orders for trade through his broker at any time during the official trading hours, but he needs to specify the time limit for the validity of the order. The time limit on an order is essentially an instruction to the broker about the time within which he should attempt to execute the order.
Day Orders A day order is an order that is valid only for the trading day on which the order is placed. If the order is not executed by the end of the day, it is treated as cancelled. All orders are ordinarily treated as day orders unless specified as other types of orders.
Week Orders These are orders that are valid till the end of the week during which the orders are placed. They expire at the close of the trading session on Friday of the week, unless they are executed by then.
Month Orders These are orders that are valid till the end of the month during which the orders are placed. Month orders expire at the close of the trading session on the last working day of the month.
Open Orders Open orders are orders that remain valid till they are executed by the brokers or specifically cancelled by the investor. They are also known as good till cancelled orders or GTC orders. However, brokers generally seek periodic confirmation of open orders from the investors.
Fill or Kill Orders These orders are also known as FoK orders. These orders are meant to be executed immediately. If not executed immediately, they are to be treated as cancelled.
Settlement
Trading in stock exchanges is carried out in two phases. In the first phase, the execution of the orders submitted by clients takes place between brokers acting on behalf of the clients or investors. Buy orders are matched with sell orders. In the automated system, trading is carried out in an anonymous environment and the orders are matched by the computer system.
The buyer now has to hand over the money and receive the security; the seller on the other hand has to hand over the security and receive money on account of the sale of the security. This process of transfer of security and cash is done in the second phase which is known as the settlement of the trade. The settlement process involving delivery of securities and payment of cash is carried out through a separate agency known as the clearing house which functions in each stock exchange. The clearing house acts as the counter party for each trade. Member-brokers who sell securities have to deliver the securities to the clearing house and will receive cash from the clearing house. Similarly, the member- brokers who buy securities will have to pay cash to the clearing house and receive the securities from the clearing house. The stock exchanges now follow a settlement procedure known as Compulsory Rolling Settlement (CRS) as mandated by SEBI. The earlier procedure of settlement was “account period settlement” wherein all trades carried out or executed during an account period of a week or fortnight were settled on the last day of the account period. The account period used to vary from exchange to exchange.
Under the rolling settlement system, the trades executed on a particular day are settled after a specified number of business days or working days. Initially, a T + 5 settlement cycle was introduced, which was subsequently reduced to a T + 3 cycle. Currently, a T + 2 settlement cycle is adopted by the stock exchanges. This means that the settlement of transactions done on T, that is, the trade day, has to be done on the second business day after the trade day. The pay-in and pay-out of funds and securities has to take place on the second business day after the day of trade. For example, for an order executed on Tuesday of a week, the settlement (delivery of security and payment of cash) has to be done on Thursday. The pay-in and pay-out of funds and securities are marked through the clearing house.
On the first business day (T + 1) after the trade day (T), the exchange generates delivery and receive orders for transactions done by member-brokers. These provide the relevant information regarding the securities to be delivered /received by the memberbrokers through the clearing house. Similarly, a money statement showing the details of payments/ receipts of monies by the member-brokers is also prepared by the exchange. The Delivery/ Receive orders and the Money Statement can be downloaded by the member brokers.
On the second business day (T + 2) after the day of trade, the member-brokers are required to submit the pay-in instructions to the depositories for transfer of securities to the clearing house in the case of demat securities. In the case of securities in physical form, the certificates have to be delivered to the clearing house. For pay-in of funds by member brokers, the bank accounts of member-brokers maintained with the authorised clearing banks are directly debited through the computerised system.
For pay-out of securities by the stock exchange, the member-brokers are required to collect them from the clearing house on the pay-out day, in case of physical securities. The clearing house arranges for crediting the securities to the demat accounts of member brokers; in the case of demat securities. There is a facility for direct transfer of securities to the investors’ accounts also.
For pay-out of funds by the stock exchange, the bank accounts of member-brokers with the authorised clearing banks are credited by the clearing house. In the rolling settlement system, pay-in and pay-out of both funds and securities are completed on the same day.
The member-brokers are required to make payment to clients for securities sold and deliver securities purchased by clients within one working day. This is the time frame permitted to member-brokers to settle their obligations with the clients as per the by-laws of the exchange
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