Level 1 CFA® Exam:
Investor's Positions & Orders
A position in an asset is the quantity of a financial instrument that someone holds or owes. If an investor holds positions in more than one asset, they make up a portfolio. There are two positions an investor can take:
- a long position, and
- a short position.
A long position is taken when an instrument is purchased. As a result, an entity becomes the owner of an instrument. One example of taking a long position is the purchase of shares or bonds. You make a profit on such a transaction if the price of the instrument goes up.
If you sell a financial instrument, you take a short position. In this case, a profit is made when the price of the instrument goes down. When someone sells short, he or she repurchases an instrument at a lower price, and the profit is the difference between the sale price and the purchase price. This position is often taken by both information-motivated traders and hedgers.
In the case of futures and forward contracts, we distinguish between a short side and a long side. The future delivery of the underlying asset will be made to the long side of the contract. The short side delivers the underlying asset at settlement. Note that settlement can be in cash as well.
In the case of option contracts, the long side (called the holder of an option) is the one entitled to exercise the option. The short side (called the writer) is obliged to meet the obligation under the contract.
Short positions are taken by different kinds of entities for a variety of reasons. A short seller opens a short position in a contract by selling the contract. We can say that a short seller is the issuer of a contract because its sale involves potential liabilities. This is a similar mechanism to the issuance of bonds by corporations. As the issuer, a company takes a short position in its bonds and receives cash in return.
In the case of securities we can talk about the process called short selling.
The algorithm of short selling:
- An investor borrows a security from other entity.
- Then, sells it in the market, and
- After some time, the investor repurchases the security in the market and returns it to the lender of the security.
Many markets offer a possibility of buying financial instruments using money borrowed from a broker, which we call a margin loan, in exchange for the payment of an interest rate referred to as the call money rate. Call money rates are higher than government bill rates, because lenders are exposed to greater risk than when investing in government bills. What's important, the call money rate is negotiable, and the greater the amount invested by a market participant, the lower the rate he or she is borrowing at. Note that even if we borrow money from the broker, we still need to cover a large fraction of the purchase price. The minimum portion that the buyer must contribute is called the initial margin requirement.
Buying securities partly for borrowed money (which is called buying on margin) allows greater potential returns. At the same time, the risk of potential losses for the money invested also goes up. The mechanism is called financial leverage. Leverage increases together with the fraction of borrowed money in an investment. In other words, the greater the borrowed amount relative to the investment, the greater the leverage. Leverage is measured using the so-called leverage ratio:
An investor decides to buy shares on margin. Supposing that the borrowed amount makes up 70% of the transaction, what is the value of the leverage ratio?
If the investor borrows 70% of the investment, it means that the equity investment is equal to 30% of the total investment. So the leverage ratio is equal to 1 divided by 0.3 and amounts to 3.33.
How can we interpret this value of the leverage ratio?
If the price of the instrument goes up by 10%, the value of the investor's position will increase by 33.3%. As you can imagine, leverage will work similarly if the price of the instrument goes down by 10%. If this happens, the position will lose 33.3% of its value.
Here are 3 other formulas that might be useful in your CFA exam:
If someone decides to make a transaction in the financial market, they express their intention to do so by submitting an order. An order has to include all necessary information on the investor's expectations concerning a trade. There are three categories of such instructions, namely:
- execution instructions, which include information on how an order should be filled,
- validity instructions, which state when to fill an order,
- clearing instructions, which indicate who should carry out the final settlement of trades.
When it comes to the types of orders, we distinguish between bid orders and ask orders:
- the price that a potential buyer is willing to pay is the bid price,
- the price expected by the seller is the ask price.
The difference between the best bid (that is the one with the highest price) and the best offer (that is the one with the lowest price) is called the bid-ask spread.
The two most popular types of execution instructions are market orders and limit orders.
A market order is one that is filled immediately at the best price offered on the other side of the book. The most significant disadvantage of market orders is that they can fill at disadvantageous prices in low-liquidity markets.
A limit order is one that includes a specified price. Note that it doesn't mean that a transaction can be made at this particular price only. In a bid offer, it's the maximum price and in an ask offer it's the minimum price. One drawback of limit orders is that they cannot be filled if there is no one to take the other side of the trade at a price within the limit. Let's have a look at an example of how both types of orders work.
The table shows orders for shares of Green Company
We will analyse what will happen in two scenarios:
- The first scenario involves a limit order. It is an order to sell 20 shares with a limit of 25.15.
- The second scenario involves a market order. It's an order to buy 20 shares.
Some orders come with additional conditions:
- An all-or-nothing order can only be filled in full. If that's not an option, it's rejected.
- Hidden orders are only disclosed to brokers and exchanges, but not to investors.
- Iceberg orders, which shows only a part of the order while the other part remains hidden.
Other additional conditions that may be attached to orders are validity instructions. They specify when an order may be filled.
A day order is only valid until the end of the day's trading on the day it was submitted. Otherwise the order expires unfilled.
The name of a good-till-cancelled order is self-explanatory. If it's not filled, it stays in the system until it's removed.
There are also “immediate or cancel” orders, which, as you've probably guessed, are cancelled if they can't be filled immediately. They're informally known as “fill or kill” orders, which hits the nail on the head.
Another type of order is a good-on-close order. It can only be filled at the end of the day's trading. Good-on-close orders are often used by institutional investors that value their assets at closing prices.
Finally, let's talk about stop orders, which market participants often call stop-loss orders. They become valid only when the price reaches a specified level. The phrase “stop loss” is an accurate name as this type of order is used by investors who want to reduce potential losses on a transaction. Let's analyse an example of how stop-loss order works.
Example 4 (stop-loss order)
An investor has bought shares of IT Company for USD 15.30 each. At present, the price of the company's shares is USD 15.50. The investor is worried that it might soon go below USD 15. To prevent further losses the investor submits a stop-loss order at 15.10. It turns out that the price of IT Company's shares goes down to 14.20 a few days later. However, before that happened, the order kicked in and the investor sold the shares at USD 15.10, which helped him reduce his losses.
Probably the most important instructions attached to orders specify who should carry out the final settlement of trades. They're called clearing instructions. Transactions made by retail customers are settled by customers' brokers. In the case of institutional transactions, this is done by custodians or other brokers.
- An investor can take a long position or a short position. A long position makes a profit if the price goes up. A short position makes a profit if the price goes down.
- Leverage increases together with the fraction of borrowed money in an investment.
- There are 2 major types of exchange orders: market orders and limit orders.
- There are 3 categories of instructions in orders: execution instructions, validity instructions, clearing instructions.
- The difference between the best bid (that is the one with the highest price) and the best offer (that is the one with the lowest price) is called the bid-ask spread.
- A market order is one that is filled immediately at the best price offered on the other side of the book. A limit order is one that includes a specified price. In a bid offer, it's the maximum price and in an ask offer it's the minimum price.
- Stop-loss orders become valid only when the price reaches a specified level. They are used by investors who want to reduce potential losses.