Trading of securities: equity and debentures/ bonds

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Trading of securities: equity and debentures/ bonds

Trading of Securities

1. Definition of Trading Securities

  • Trading Securities: These are financial instruments that an entity buys with the intention to sell in the short term. The primary goal is to profit from anticipated increases in their market prices.

2. Mechanism of Trading

  • Organized Stock Exchange:
    • Role: Acts as a marketplace where buyers and sellers of securities transact. Examples include the New York Stock Exchange (NYSE) and NASDAQ.
    • Function: Provides liquidity, transparency, and fair pricing by matching buy and sell orders through a regulated platform.
  • Direct Transactions:
    • Definition: Securities can be traded directly between parties without using an exchange. This method is less common and typically involves bilateral agreements between investors.

3. Accounting Treatment

  • Balance Sheet:
    • Valuation: Trading securities are reported at their fair value as of the balance sheet date. Fair value is the price that would be received to sell the asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
    • Current Assets: Since these securities are expected to be sold within the short term, they are classified as current assets on the balance sheet.
  • Income Statement:
    • Gains and Losses: Changes in the fair value of trading securities are recorded directly in the income statement. This means that any unrealized gains or losses (i.e., changes in value before the securities are sold) are reported immediately, affecting the company’s earnings.

4. Other Types of Marketable Securities

  • Available-for-Sale Securities:
    • Definition: These are securities not classified as either trading or held-to-maturity. They might be sold before maturity but are not intended for short-term profit-taking.
    • Valuation: Recorded at fair value.
    • Reporting: Unrealized gains or losses are reported in other comprehensive income (OCI) rather than in the income statement. Only realized gains and losses (from actual sales) impact the income statement.
  • Held-to-Maturity Securities:
    • Definition: These are debt securities that the investor intends to hold until they mature.
    • Valuation: Recorded at amortized cost, not fair value. Amortized cost is the initial purchase price adjusted for principal repayments and any amortization of premium or discount.
    • Reporting: Changes in fair value are not reported in financial statements, regardless of market fluctuations, since these securities are intended to be held until maturity.

5. Key Points

  • Purpose: Trading securities are held for the purpose of making short-term profits from market price movements.
  • Fair Value Accounting: The key feature of trading securities is their valuation at fair value with immediate impact on the income statement, distinguishing them from other security classifications.
  • Liquidity and Market Risk: Trading securities are subject to market risk, and their value can fluctuate significantly. This high liquidity allows investors to quickly respond to market conditions but also exposes them to potential volatility.

Summary

Trading securities are a vital part of financial markets, offering opportunities for short-term gains but also introducing volatility and risk. Their accounting treatment reflects their purpose and market dynamics, differentiating them from other types of securities by their fair value adjustments and immediate impact on financial performance.

Types of Orders

  • Market Order
    • Definition: An order to buy or sell a security immediately at the best available price.
    • Execution: This type of order guarantees that the order will be executed but not the price at which it will be executed.
    • Price Consideration: The order is filled at or near the current bid (for a sell order) or ask (for a buy order) price. However, the final execution price might differ slightly from the last-traded price due to market fluctuations.
    • Usage: Market orders are typically used when the priority is to execute the trade quickly rather than achieving a specific price.
  • Limit Order
    • Definition: An order to buy or sell a security at a specific price or better.
    • Types:
      • Buy Limit Order: This order is placed to buy a security at a price lower than the current market price. It will only execute if the price reaches or falls below the specified limit price. For example, if an investor wants to buy a stock but only at $10 or lower, they place a buy limit order at $10.
      • Sell Limit Order: This order is placed to sell a security at a price higher than the current market price. It will only execute if the price reaches or exceeds the specified limit price. For example, if an investor wants to sell a stock but only at $15 or higher, they place a sell limit order at $15.
    • Usage: Limit orders are used when the priority is to achieve a specific price rather than ensuring the execution of the order. This type of order is useful in volatile markets where price precision is critical.
  • Stop Order (Stop-Loss Order)
    • Definition: An order that becomes a market order once a specified stop price is reached.
    • Types:
      • Buy Stop Order: This is placed above the current market price and is used to buy a security once its price surpasses the stop price. It’s typically used to limit losses on a short position or to enter a position once the price trend is confirmed. For example, a buy stop order might be placed at $12 for a stock currently trading at $10.
      • Sell Stop Order: This is placed below the current market price and is used to sell a security once its price falls below the stop price. It’s commonly used to limit losses on a long position or to protect gains. For example, a sell stop order might be placed at $8 for a stock currently trading at $10.
    • Usage: Stop orders are used to protect against adverse price movements or to lock in profits when the market moves favorably.

Margin Trading Facility (MTF)

  • Definition
    • Margin Trading Facility (MTF): A system that allows investors to buy or sell securities by paying only a fraction of the total transaction value, with the broker providing the remainder of the funds. Essentially, it enables leveraging of the investor's position.
    • Collateral: Can be in the form of cash or securities. The broker provides the additional funds needed for the transaction.
  • Recent Changes
    • SEBI Regulation: As of June 13, 2017, the Securities and Exchange Board of India (SEBI) updated its regulations to allow margin trading against securities as collateral, in addition to cash. This change allows investors to use shares they already own as collateral to leverage their trades.
  • Features
    • Leverage: Allows investors to control a larger amount of securities with a smaller amount of their own capital. For example, an investor might be able to buy $10,000 worth of securities by only putting up $2,000 in margin.
    • Position Carry Forward: Positions taken using MTF can be held for T+N days, where T is the trading day, and N is the number of days the position can be carried forward, as defined by the broker. This feature provides flexibility in managing positions.
    • Eligible Securities: SEBI and exchanges specify which securities are eligible for MTF. Typically, securities in Group 1 are eligible, which are considered to be more liquid and less risky.
    • Brokers: Only corporate brokers are allowed to offer MTF as per SEBI regulations. This ensures that the brokers have the requisite infrastructure and regulatory compliance.
  • Benefits for Investors
    • Leverage: Investors can take larger positions in the market with less capital, potentially increasing returns if the market moves in their favor.
    • Collateral Utilization: Investors can use existing securities in their portfolio as collateral, enabling them to trade without needing additional cash.
    • Enhanced Buying Power: MTF increases the buying power of investors, allowing them to capitalize on more significant market opportunities.
    • Regulation: The system is regulated by SEBI and exchanges to ensure that trading practices remain fair and transparent, protecting investors from excessive risk.

Summary

  • Orders: Market orders execute immediately at the current price but don’t guarantee a specific price; limit orders execute only at specified prices or better; stop orders activate into market orders once a stop price is hit, protecting against losses or securing profits.
  • MTF: Allows investors to leverage their trades with a fraction of the total value, using cash or securities as collateral, regulated to ensure investor protection and maintain market integrity.