Chapter 2 Mc GrawHillIrwin Buying and Selling Securities

Buying and Selling Securities “Don’t Gamble! Take all your savings and buy some good stock and hold it till it goes up. If it don’t go up, don’t buy it. ” – Will Rogers 2

Learning Objectives Don’t sell yourself short. Instead, learn about these key investment subjects: 1. The various types of securities brokers and brokerage accounts. 2. How to calculate initial and maintenance margin. 3. The workings of short sales. 4. The importance of investor objectives, constraints, and strategies. 3

Buying and Selling Securities • This chapter covers the basics of the investing process. • We begin by describing how you go about buying and selling securities, such as stocks and bonds. • Then, we outline some important considerations and constraints to keep in mind as you get more involved in the investing process. 4

Getting Started (a) Open a brokerage or trading account (b) Deposit $10, 000 into account (d) Pay Commission, Say $50 (c) Buy 100 Shares of Disney at $33 per share (e) $6, 650 Cash in Account $3, 300 Stock In Account 5

Choosing a Broker, I. • Brokers are now divided into three groups: 1. Full-service brokers 2. Discount brokers 3. Deep-discount brokers • These three groups can be distinguished by the level of service provided, as well as the level of commissions charged. 6

Choosing a Broker, II. • As the brokerage industry becomes more competitive, the differences among broker types continues to blur. • Another important change is the rapid growth of online brokers, also known as e-brokers or cyberbrokers. • Online investing has really changed the brokerage industry. – slashing brokerage commissions – providing investment information – Customers place buy and sell orders over the Internet 7

Securities Investor Protection Corporation • Securities Investor Protection Corporation (SIPC): Insurance fund covering investors’ brokerage accounts when member firms go bankrupt or experience financial difficulties. • Most brokerage firms belong to the SIPC, which insures each account for up to $500, 000 in cash and securities, with a $100, 000 cash maximum. • Important: The SIPC does not guarantee the value of any security (unlike FDIC coverage). • Rather, SIPC protects whatever amount of cash and securities that were in your account, in the event of fraud or other failure. 8

Broker-Customer Relations • There are several important things to remember when you deal with a broker: • – Any advice you receive is not guaranteed. – Your broker works as your agent and has a legal duty to act in your best interest. – However, brokerage firms make profits from brokerage commissions. Your account agreement will probably specify that any disputes will be settled by arbitration and that the arbitration is final and binding. 9

Brokerage Accounts • A Cash account is a brokerage account in which securities are paid for in full. • A Margin account is a brokerage account in which, subject to limits, securities can be bought and sold short on credit. (more on selling short later) 10

Margin Accounts • In a margin purchase, the portion of the value of an investment that is not borrowed is called the margin. • Of course, the portion that is borrowed incurs an interest charge. – This interest is based on the broker’s call money rate. – The call money rate is the rate brokers pay to borrow money to lend to customers in their margin accounts. 11

Example: Margin Accounts, The Balance Sheet • You buy 1, 000 Pfizer shares at $24 per share. • You put up $18, 000 and borrow the rest. • Amount borrowed = $24, 000 – $18, 000 = $6, 000 • Margin = $18, 000 / $24, 000 = 75% Liabilities and Account Equity Assets 1, 000 Shares, PFE Total $ 24, 000 Margin Loan $ 6, 000 Account Equity $ 18, 000 Total $ 24, 000 12

Margin Accounts • In a margin purchase, the minimum margin that must be supplied is called the initial margin. • The maintenance margin is the margin amount that must be present at all times in a margin account. • When the margin drops below the maintenance margin, the broker can demand more funds. This is known as a margin call. 13

Example: The Workings of a Margin Account, I • Your margin account requires: • an initial margin of 50%, and • a maintenance margin of 30% • A Share in Miller Moore Equine Enterprises (WHOA) is selling for $50. • You have $20, 000, and you want to buy as much WHOA as you can. • You may buy up to $20, 000 / 0. 5 = $40, 000 worth of WHOA. Liabilities and Account Equity Assets 800 Shares of WHOA @ $50/share Total $ 40, 000 Margin Loan $ 20, 000 Account Equity $ 20, 000 Total $ 40, 000 14

Example: The Workings of a Margin Account, II • After your purchase, shares of WHOA fall to $35. (Woe!) • New margin = $8, 000 / $28, 000 = 28. 6% < 30% • Therefore, you are subject to a margin call. Liabilities and Account Equity Assets 800 Shares of WHOA @ $35/share Total $ 28, 000 Margin Loan $ 20, 000 Account Equity $ 8, 000 Total $ 28, 000 15

Example: The Effects of Margin, I. • • • You have $30, 000 in a margin account, 60% initial margin required. You can buy $50, 000 of stock with this account (why? ). Your borrowing rate from your broker is 6. 00%. Suppose you buy 1, 000 shares of Coca-Cola (KO), for $50/share. Assume no dividends, and that your borrowing rate is still 6. 00%, what is your return if: – In one year, KO is selling for $60 per share? – In one year, KO stock is selling for $60 per share, but you did not borrow money from your broker? 16

Example: The Effects of Margin, II. • KO is selling for $60 per share. • Your investment is worth $60, 000. • You owe 6% on the $20, 000 you borrowed: $1, 200. • If you pay off the loan with interest, your account balance is: $60, 000 – $21, 200 = $38, 800. • You started with $30, 000. • Therefore, your return is $8, 800 / $30, 000 = 29. 33%. • Suppose Coca-Cola stock was selling for $40 per share instead of $60 per share? What is your return? 17

Example: The Effects of Margin, III. • Coca-Cola stock is selling for $60 per share, but you did not borrow from your broker. • You started with $30, 000, which means you were able to buy $30, 000 / $50 = 600 shares. • Your investment is now worth $36, 000. • Therefore, your return is $6, 000 / $30, 000 = 20. 00%. • Suppose Coca-Cola is selling for $40 per share instead of $60 per share. What is your return in this case? 18

Example: How Low Can it Go? • Suppose you want to buy 300 shares of Pepsico, Inc. (PEP) at $55 per share. – Total cost: $16, 500 – You have only $9, 900—so you must borrow $6, 600. • Your initial margin is $9, 900/$16, 500 = 60%. • Suppose your maintenance margin is 40%. At what price will you receive a margin call? 19

Example: How Low Can it Go? Answer. • This will happen when the price of Pepsico, Inc. drops to $36. 67. How so? Well, 20

Example: Annualizing Returns on a Margin Purchase, I. • You buy 1, 000 shares of Costco (COST) at $60 per share. • Your initial margin is 50%. • You borrow at the 9 percent call money rate plus 2 percent. • You sell Costco (COST) 3 months later for $63. • There were no dividends paid (and suppose the prices above are net of commissions). • What is your holding period percentage return and your EAR? 21

Annualizing Returns on a Margin Purchase, II. Answer: First, you have to repay the 3 -month loan, so: t = (3/12 =. 25) Amount Repaid = Amount Borrowed × (1 + interest rate per year)t Amount Repaid = $30, 000 × (1 +. 11). 25 = $30, 000 × 1. 02643 = $30, 792. 90 Your Sale Proceeds = Cash from Sale – Amount Repaid = $63, 000 – 30, 792. 90 = $32, 207. 10 Your Profit = Your Sale Proceeds – Your Investment = $32, 207. 10 - $30, 000 = $2, 207. 10 22

Annualizing Returns on a Margin Purchase, III. Note that there are 12/3 = 4 three -month holding periods in a year. Therefore, m = 4. 23

Hypothecation and Street Name Registration • Hypothecation is the act of pledging securities as a collateral against a loan. • This pledge is needed so that the securities can be sold by the broker if the customer is unwilling or unable to meet a margin call. • Street name registration is an arrangement under which a broker is the registered owner of a security. (You, as the account holder are the “beneficial owner. ”) 24

Other Account Issues, I. • Trading accounts can also be differentiated by the ways they are managed. – Advisory account - You pay someone else to make buy and sell decisions on your behalf. – Wrap account - All the expenses associated with your account are “wrapped” into a single fee. – Discretionary account - You authorize your broker to trade for you. – Asset management account - Provide for complete money management, including check-writing privileges, credit cards, and margin loans. 25

Other Account Issues, II. • To invest in financial securities, you do not need an account with a broker. • One alternative is to buy securities directly from the issuer. • Another alternative is to invest in mutual funds. 26

Short Sales, I. • Short Sale is a sale in which the seller does not actually own the security that is sold. Borrow shares from someone Sell the Shares in the market Today Buy shares From the market Return the shares In the Future Note that an investor who buys and owns shares of stock is said to be “long the stock” or to have a “long position. ” 27

Short Sales, II. • An investor with a long position benefits from price increases. – Easy to understand – You buy today at $34, and sell later at $57, you profit! – Buy low, sell high • An investor with a short position benefits from price decreases. – Also easy to understand – You sell today at $83, and buy later at $27, you profit. – Sell high, buy low 28

Example: Short Sales, I. • You short 100 shares of Texas Instruments (TXN) at $30 per share. • Your broker has a 50% initial margin and a 40% maintenance margin on short sales. • The value of stock borrowed that will be sold short is: $30 × $100 = $3, 000 Liabilities and Account Equity Assets Sale Proceeds $ 3, 000 Short Position $ 3, 000 Initial Margin Deposit $ 1, 500 Account Equity $ 1, 500 Total $ 4, 500 29

Example: Short Sales, II. • Texas Instrument stock price falls to $20 per share. • Sold at $30, value today is $20, so you are "ahead" by $10 per share, or $1, 000. • Also, new margin: $2, 500 / $2, 000 = 125% Liabilities and Account Equity Assets Sale Proceeds $ 3, 000 Short Position $ 2, 000 Initial Margin Deposit $ 1, 500 Account Equity $ 2, 500 $ 4, 500 Total 30

Example: Short Sales, III. • Texas Instruments stock price rises to $40 per share. • You sold short at $30, stock price is now $40, you are "behind" by $10 per share, or $1, 000. (He who sells what isn’t his’n, must buy it back—or go to prison. ) • Also: new margin = $500 / $4, 000 = 12. 5% < 40% Therefore, you are subject to a margin call. Assets Liabilities and Account Equity Sale Proceeds $ 3, 000 Short Position $ 4, 000 Initial Margin Deposit $ 1, 500 Account Equity $ Total $ 4, 500 500 31

More on Short Sales • Short interest is the amount of common stock held in short positions. • In practice, short selling is quite common and a substantial volume of stock sales are initiated by short sellers. • Note that with a short position, you may lose more than your total investment, as there is no theoretical limit to how high the stock price may rise. 32

Biggest Short Positions (from The Wall Street Journal) 33

Investment Objectives • Fundamental Question: Why invest at all? – We invest today to have more tomorrow. – Investment is simply deferred consumption. – We choose to wait because we want more to spend later. • In formulating investment objectives, the individual must balance return objectives with risk tolerance. – Investors must think about risk and return. – Investors must think about how much risk they can handle. 34

Investment Strategies and Policies • Investment management. Should you manage your investments yourself? • Market timing. Should you try to buy and sell in anticipation of the future direction of the market? • Asset allocation. How should you distribute your investment funds across the different classes of assets? • Security selection. Within each class, which specific securities should you buy? 35

Investor Constraints • Resources. What is the minimum sum needed? What are the associated costs? • Horizon. When do you need the money? • Liquidity. How high is the possibility that you need to sell the asset quickly? • Taxes. Which tax bracket are you in? • Special circumstances. Does your company provide any incentive? What are your regulatory and legal restrictions? 36

Forming an Investment Portfolio, I. • Take the Risk Tolerance Quiz in the textbook. • What score did you get? 37

Forming an Investment Portfolio, II. • What does your score mean? 38

Useful Internet Sites • • • www. finra. org (a reference for dispute resolution) www. bearmarketcentral. com (a reference for short selling) www. nasdaq. com (a reference for short interest) www. moneycentral. msn. com (a reference for building a portfolio—search the site for “Build your first stock portfolio”) www. sharebuilder. com (a reference for opening a brokerage account) www. buyandhold. com (another reference for opening a brokerage account) www. individual. ml. com (a risk tolerance questionnaire from Merrill Lynch) www. money-rates. com (a reference for current broker call money rate) finance. yahoo. com (a reference for short sales on particular stocks) 39

Chapter Review, I. • Getting Started – – Choosing a Broker Online Brokers Security Investors Protection Corporation Broker-Customer Relations • Brokerage Accounts – – – Cash Accounts Margin Accounts A Note on Annualizing Returns Hypothecation and Street Name Registration Other Account Issues 40

Chapter Review, II. • Short Sales – Basics of a Short Sale – Some Details • Investor Objectives, Constraints, and Strategies – Risk and Return – Investor Constraints – Strategies and Policies 41