This video discusses various order instructions that are supplied along with an order. The video also explains market orders, limit orders, stop loss orders and other order instructions.

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In the stock markets buyers and sellers interact with the brokers and the exchange in order to issue and fulfill their orders. At the minimum an order specifies which instrument to trade, how much and whether the trader wants to buy or sell it. Apart from that, there are additional instructions that are supplied along with the order that define the behavior of the order and its execution.

There are three types of instructions. The execution instructions indicate how the order is fulfilled. The validity instructions indicate when the order may be fulfilled. And the clearing instructions indicate how the trade is finally settled. There are specific order instructions for each of these instructions that the traders use to achieve their objectives.

The two most common execution instructions are market orders and limit orders. In a market order, the broker gets the best available price and executes the trade immediately. For a buy order the broker will accept the lowest price available and for the sell order the broker will accept the higher price available. The problem with market orders is that there is no guarantee of execution price. The price could rise or fall from the time the order is placed to the time it is executed.

The limit order is similar to a market order, and the broker is required to find the best available price. However, there is a limit set for the execution price. For a buy order, the broker cannot execute the trade at a price higher than the specified limit, and for a sell order the broker cannot execute the trade at a price lower than the specified limit. A problem with limit orders is that they may not get executed if the broker is not able to find the price within the limit specified.

Validity instructions specify when the order is executed. Most orders are day orders, i.e., they will expire if not executed by the end of the day. The good-till-cancelled orders remain live till they are cancelled by the trader. Immediate-or-cancel orders are cancelled if they cannot be executed immediately. A good-on-close order is fulfilled only at the end of the trading day, and a good-on-open order is fulfilled at the open of the trading day.

A stop loss order lies idle and turns into market order when a certain price is reached, i.e., the stop price. For example, “buy if price rises to $60” or “sell if price falls to $58”. They are also called stop loss orders, because an investor is able to prevent losses or to protect profits.

Similarly there are stop limit orders which turn into a limit order when the stop is reached. For example, a stop limit order may specify - “buy if price rises to $60, but execute only at $65 or less”

Clearing instructions specify how the order is cleared and settled. These are generally standing instructions and are not linked to the order. Retail orders are cleared by the trader’s broker. The institutional trades may be cleared by a custodian or another broker. An important clearing instruction is whether the sale order is a long sale or a short sale.

Equity: Types of Orders

An investor who wants to take a position in a stock but doesn't have enough funds can use borrowed funds to purchase the asset. This is called a leveraged position, and the investor is said to be using leverage. One of the ways to use borrowed funds is called margin loan. Let's look at how it works.

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To purchase an asset on margin, an investor can borrow funds from his broker. This is called a margin loan. The investor usually pays an interest on this loan which is called the call money rate.

No broker will allow an asset to be fully financed. The investor will have to provide a minimum amount of equity, called the initial margin requirement. For example, a 50% initial margin requirement means that for an asset worth $100, $50 of equity should be provided by the investor, and the remaining $50 will be provided as margin loan by the broker. This is also called financial leverage and it adds additional risk to the investor portfolio. Let’s look at the dynamics of a margin transaction.

Let’s assume that an investor buys 100 shares of a stock at $100 per share. The initial margin requirement is 50%, that means the investor has to provide an initial equity of 5,000, i.e., 50% of total money required to purchase the stocks. We’ve assumed that there is no transaction cost.

Suppose the stock price increases to $120 after one year. The gain on stock is $2,000. The investor also receives a dividend of $200. Since half of the transaction is on margin money, the investor has to pay interest on these borrowed funds to the broker. Assuming a call money rate of 3%, the interest paid will be $150. Keeping all the gains and expenses, the net gain for the investor is $2,050 or 41% of the equity invested.

As the value of the asset changes over time, the percentage of equity in the margin account will also change. The broker expects the investor to maintain a minimum equity percentage, which is called the maintenance margin requirement. In most cases, this requirement is 25% of the position value. However, the brokers may require a higher maintenance margin for highly volatile stocks. If the value of equity falls below the maintenance margin requirement, the buyer will receive a margin call to deposit additional equity.

In our example, the initial stock price was $100 and the initial equity was $50 or 50%. If the stock value falls to $66.67, the equity will drop to $16.67, which is 25% of the stock price. If the stock value falls any further the investor will receive a margin call from the broker. In case the investor fails to deposit additional equity, the broker can closeout the position to avoid further losses.

Margin Trading - Purchasing Stocks on Margin

A position in a financial asset refers to the quantity of an asset owned or owed by a person. The two types of positions are long and short position.

A person is said to have a long position when he owns the asset. This means that he has paid money to buy that asset. For example, when someone buys a stock, he is long a stock. A long position holder benefits when the price of the asset appreciates as he can sell it at a higher price. A long position provides unlimited profit potential.

A person is said to have a short position when he sells the asset that he does not own. This is equivalent to writing and selling a contract. A short position holder benefits when the price of the asset falls. Typically, a short seller will short sell at a higher price and wait for the price to fall and then repurchase the asset at a lower price to close his position.

Short selling is also useful as a hedging tool. Let’s take an example of a manufacturer who holds a large inventory of aluminium. The risk for him is that the price of aluminium may fall. He can protect himself by selling aluminium futures short. If the price of aluminium falls, then he will lose money on the value of inventory, but will gain from his short position.

Since a short seller does not own the security that he is selling, he does so by borrowing the security from a security lender who has a long position in the security. The short seller borrows the security and sells it to other traders. To close the position he will repurchase the security and return it to the security lender. The profit potential in a short sale is limited with a cap equal to the price at which the security was short sold. The losses can be unlimited as the short seller loses money when the stock price appreciates.

When a security lender lends the security, he does not technically own the security for the period of the loan. Therefore, to protect his interest, he enters into a detailed agreement with the borrower that specifies the terms. This includes things such as the following: 1) The borrower should pass on any dividends or interest received on the security during the period of the loan to the lender. This is called payment in-lieu of dividends. 2) The lender should be protected from a stock split. 3) The short seller is required to keep the proceeds from the short sale with the lender as collateral. The lender can invest this deposit in short-term securities. The interest is rebated to the short sellers at short rebate rates (usually 10 bps less than overnight rate in interbank funds market).

Long and Short Positions in Financial Assets

When a company wants to raise money from the public, it does so by approaching investors in the primary market. The process of raising money by issuing new securities to the investors in the primary market is known as Initial Public Offering. Once the security has been issued, investors can trade these securities (buy and sell) in the secondary market. In this article we will understand the process of initial public offering.



To raise money through an IPO, the issuer is required to approach an investment bank that helps them in selling these securities to the public. Together with the investment bank, the issuer will come out with a prospectus for the offering, which will contain many details about the offer, the company, the risks involved, the purpose of funds, growth prospects and so on.



Once the offering is ready, the <a href="https://financetrain.com/the-world-of-investment-banking/" class="rank-math-link">investment bank</a> will campaign for the IPO and approach investors to subscribe to the offer. This process is called the book building process. For this reason, the investment banker is also sometimes called the book runner. In the book building process the investment bank also plays an advisory role and helps its investors to make wise investment choices.



There are two types of offerings, namely, underwritten offering and best efforts offering. Between the two, the underwritten offering is the most common way of raising money.



Underwritten Offering



In an underwritten offering, the investment bank acts as the underwriter for the offering. The issuer and the bank will mutually decide the best price at which the offer should be made. After that the bank is committed to sell the entire offer at the specified price. If the issue is oversubscribed, then the securities may be allocated to clients on a preferred or pro-rata basis. However, if the issue is undersubscribed, then the investment bank will have to buy the securities that it is unable to sell to the public. Along with this commitment, the investment bank also promises to be the market maker for a month in the secondary market. This ensures liquidity and price support for the new offer. For an underwritten offer, the bank charges an underwriting fee of about 7% to the issuer. If it’s a very large issue, then a syndicate of many investment banks, with one of them as the lead underwriter, will do the booking building.



Best Efforts Offering



In case of a best efforts offering, the investment bank does not have any commitment to fully subscribe the offer. The bank will make its best effort to reach the highest subscription, but in case the offer is undersubscribed, the issuer will have to accept whatever is sold.



Setting the right price for the issue is crucial. If the price set is seen as very high by the investors, then the issue will be undersubscribed, and the investment bank will have to buy shares itself to fill the offer. This is an unfavourable scenario for the investment bank. On the other hand, if the price set is low, then the issue will be oversubscribed, and securities are allocated on a preferred or pro-rata basis. Due to these factors, the IPO prices generally get lowered. This also explains why we see sudden price rise when the stock starts trading in the <a href="https://financetrain.com/secondary-market-exchanges-vs-otc-market/" class="rank-math-link">secondary markets</a>. The issuers are also generally okay with a slightly lower price because they want to avoid an undersubscribed offering which is seen as unfavourable prospects for the business.

What is Initial Public Offering (IPO)?

In the previous article we looked at the process of <a title="What is Initial Public Offering (IPO)?" href="https://financetrain.com/what-is-initial-public-offering-ipo/">initial public offering</a>. Let’s now take an example to understand how the maths and numbers in an IPO work.

Let’s say that a fictitious company Sound Electronics comes out with an IPO in which it raises $300 million by selling 100 million ordinary shares at a price of $3 per ordinary share.

Let’s say that the company has raised money earlier also and after the IPO has total 250 million shares outstanding.

The company receives $50 million in gross proceeds. This means they sold total 16,666,667 shares at the rate of $3 per share. The balance number of shares i.e., 83,333,333 (100,000,000 - 16,666,667) are sold by the founders.

Since the company sold 16,666,667 new shares, there were 233,333,333 (250,000,000 - 16,666,667) outstanding before the IPO. In terms of percentages, the founders sold 83,333,333/233,333,333 = 35.7% of the company.

If the net proceeds were $46,500,000, the company paid $3,500,000 (7%) as cost of placement.

Let’s say when the trading commenced for the stock on the stock exchange on which it was listed, the stock opened at $3.10 and closed at $3.20 by the end of the day.  The average returns that students made on the first day of trading would be ($3.20 - $3)/$3 = 6.67%.

Understanding Initial Public Offering with an Example

When a new stock or a financial instrument is <a title="What is Initial Public Offering (IPO)?" href="https://financetrain.com/what-is-initial-public-offering-ipo/">newly issued</a> and starts trading in the secondary market, its price may exhibit substantial volatility in the initial period after which the short-term effects would settle down and the price will become more stable. Once the security has been trading in the secondary market for a long enough period, it’s called a seasoned security.

For example, in the Euromarket a security becomes a seasoned security after it has been actively trading for a period of 40 days. The word seasoned reflects the fact that these securities have a certain track record and are considered worth more to the investors.

What is a Seasoned Security?

Sometimes the companies issue their securities to a small select group of investors via a private placement. So, instead of opening the issue to the entire public through an <a title="What is Initial Public Offering (IPO)?" href="https://financetrain.com/what-is-initial-public-offering-ipo/">IPO</a>, the issue is sold directly to qualified investors using the services of an investment bank. For this reason, such an issue of securities is also called non-public offering.

These qualified investors are considered to have the money and the knowledge required to participate in the private placement. They also have a better understanding of the risk they are taking. These investors include institutional, venture capital and other sophisticated investors. A private placement memorandum (PPM) is prepared that provides details about the private placement and is used by the investors to make a sound investment decision.

The company has the advantage that it can get the money without going to the public. It also does not have to make as much public disclosure as would be required for a public offering. The costs of private placement in terms of preparing and implementing the placement are also lower. These investors will generally require a higher rate of return because these securities cannot be sold in the secondary market.

Private placements can be made for all kinds of financial securities issued by corporations such as common stock, preferred stock, warrants, promissory notes, and bonds.

In the US, even though a private placement is subject to the Securities Act of 1933, the securities do not have to be registered with SEC if they conform to certain rules. Private placements are governed by Securities and Exchange Commission (SEC) Regulation D, which provides rules for issuing securities without having to register those securities with the SEC.

What is Private Placement of Shares?

Shelf registration, also known as shelf offering, is a type of public offering in which a company can use a single prospectus to issue <a title="What is a Seasoned Security?" href="https://financetrain.com/what-is-a-seasoned-security/">seasoned securities</a> to the public multiple times over a period of many years. The company does not have to have a separate prospectus for each offering.

In such a case, the company will make all the public disclosures as it would have in case of an <a title="What is Initial Public Offering (IPO)?" href="https://financetrain.com/what-is-initial-public-offering-ipo/">Initial Public Offering (IPO)</a>, however, will not issue all the securities at one time. Instead, based on the market conditions it will stagger the issue of securities over several years.

Let’s take an example to understand this. Let’s say a company files a self-registration statement with a prospectus to issue 10,000,000 shares. Once the registration is done, the company may decide to sell all, none, or a part of these shares. For example, it may sell 2 million shares in the first year, 3 million shares in the second year and so on. Self registration with a single prospectus can include offer for more than one type of security, such as stocks, bonds, convertible bonds, warrants, etc.

Before making each offer and sale, the company will have to file a short statement with SEC specifying any changes in business and finance since the self registration statement was filed.

By using self registration, companies get the flexibility in planning their capital requirements. They are also able to avoid an unfavourable market by avoiding issuing securities when the markets are down. The companies can fulfil all registration and disclosure related procedures and offer securities in the market when conditions become favourable.

In the US, self registration is governed by SEC Rule 415.

What is Shelf Registration?

Dividend Reinvestment Plans (DRIPs) are an investment option offered by corporates to its shareholders under which the dividends due to the investors are directly reinvested in the new stocks issued by the corporation.

Such a plan is beneficial for long-term investors, as the money gets reinvested immediately and the investor does not have to incur any brokerage fee for buying the stocks. There is also no wait time between receiving the money and reinvesting it. Under such a plan sometimes the existing stockholders are offered new stocks at a discount to the prevailing market prices.

If the dividend being reinvested is not enough to buy a full stock, then the money will be used to buy fractional shares.

If you are interested in buying a DRIP stock, then following steps will help you in the process.

1. Find stocks that have a DRIP

Not all stocks offer a dividend reinvestment plan. So, the first step is to identify the stocks that have a DRIP. You will be able to find this information easily by doing online research or by talking to your broker to help you identify such stocks.

2. Enrol into a DRIP

You can enrol into a DRIP either directly by approaching the investor’s cell of the company or through a brokerage firm providing this facility. In either case, the shares will be purchased in your name. The better way is to buy DRIPs via your broker so that all your investments are organized in one place.

3. Check the company requirements

Once you have decided which company’s DRIPs you want to buy, the next step is to understand their requirements such as minimum investment amount, minimum number of stocks you can purchase, and any fees that you need to pay.

4. Setup automatic investment in DRIP

Once the DRIP has been purchased, your dividends will start getting reinvested. You can also setup an automatic investment option for your DRIP so that each month more money from your savings account will get invested in the DRIP. This way your DRIP will start growing along with the dividend reinvestment.

Note that the dividend earning on your stocks is taxable income and the investor is required to pay the required tax on this income even though the dividend gets reinvested directly.

How to Buy a DRIP Stock?

Rights issue is yet another way using which companies raise additional capital from the public. In a rights issue, the company offering these rights gives its existing shareholders a right to buy new shares of the company at a discount from its current market price at a specified future date. The right works just like an option, so the investor getting the right can choose to exercise it or not.

The rights issues are generally used by companies that are in urgent need of money and want to raise capital quickly to ease their financial burden. Many companies use the additional capital raised to clear the debt they are finding difficult to service.  Some healthy companies also use the rights issues to fund acquisitions or pursue other growth opportunities.

How it works?

Let’s take an example to understand how a rights issue works. Let’s say you hold 100 stocks of a company. The current market price of the stock is $10. The company is undergoing some financial trouble and comes out with a rights issue to raise additional capital. Under the rights issue, the company is raising $80 million by issuing 10 million new shares at a price of $8 per share. The rights issue is described as a 1-for-4 rights issue. This means that for every four shares of the company that you hold you get the right to buy one more stock at a discounted price of $8. This is a discount of 20% on the market price.  Since you have 100 shares of the company, you are eligible to buy 25 shares under the rights issue.

The shareholder can make one of the following choices:

1. Exercise the right to buy

Under this option you get the maximum benefit from the rights issue. You decide to exercise your right and buy 25 additional shares at a price of $8 per share, spending a total of $200. Note that once the new shares have been issued, your existing shares would have diluted and their market price will fall. Even though the market value of stock can change for many reasons, we can still estimate how much its value will drop just because of the rights issue. The maths is explained below:

Value of existing 100 shares at $10 each = $1000

Value of new 25 shares at $8 each = $200

Value of 125 shares = $1,200

Ex-rights value per share = $1,200/125 = $9.6

We can say that theoretically the new value of each share will be $9.6. This also means that the new shares that you are buying at $8 each will have a market value of $9.6.

2. Sell the rights to someone else

Since it’s a right, you can always ignore it and not do anything. But that does not help because the value of your existing shares will still dilute. To compensate for the dilution factor, the rights themselves also have some value.  The holder of the rights, therefore, has the choice of selling these rights to someone else at a price. Such rights are called renounceable rights and can be sold at a price called nil-paid rights. Theoretically this price will be equal to ex-rights price of $9.6 minus $8 = $1.6. The actual price is slightly difficult to estimate but this is a good estimate. The gain from sale of rights is considered capital gain and taxed accordingly.

Rights issues are generally not preferred by the investors because they need to buy more shares to avoid any loss due to dilution. Also, these rights give the investors signs of increasing financial troubles in the company. It is important that investors appropriately assess the reasons for the rights issue and only then take any action.

Rights Issue of Shares

Equity Market Organization and Structure

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Equity Market Organization and Structure

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