FIN 638 Vicentiu Covrig Buying and Selling Equities

FIN 638 Vicentiu Covrig Buying and Selling Equities (chapter 3) 1

FIN 638 Vicentiu Covrig Buying and Selling n Stock Price Quotes - Bid u The highest price a market maker is willing to pay (and is lower than the ask). - Ask u The lowest price a market maker is willing to accept to sell. - Bid-Ask Spread u Gap between the ask and the bid quotes. u Profit to the market maker n Market depth - How many people are buying and selling? How much can I buy or sell without moving the price? u Bid size: the number of shares offered at the bid price u Ask size: the number of shares offered at the ask price 2

FIN 638 Buy now, or wait for a better price? Vicentiu Covrig n Market order (executed immediately) - Buy (or sell) now at market price - “Buy 50 shares of Home Depot at market” - “Sell 100 shares of Apple Computer at market” n Limit order (may take awhile to execute, or never) - Buy when the price gets a little better - How long to wait? u Fill or kill u Day order u Good ‘til canceled - “Sell 100 shares of IBM at $82. 70 or better, today” - “Buy 200 shares of Dell at $30. 72 or better, fill or kill” u When would these trades execute? 3

FIN 638 Vicentiu Covrig Place an order to trade when certain price levels are reached (before the emotions set in!) n Stop order - Placing an order to sell a stock after the price has risen to a specified price. n Stop-loss order - Placing an order to sell when a stock falls to a specific price. 4

FIN 638 Vicentiu Covrig Pitfalls to Trading n Active trading (day trading) - Induces the same emotions as casinos try n to elicit. Investment decisions are more likely to be influenced by emotions and psychological biases. The allure of active trading is strong. - People who believe they have superior information or skill feel like they should benefit by trading n Trading costs are important! (commissions and bid-ask spread) 5

FIN 638 Vicentiu Covrig Illusions n Illusion of Knowledge - The illusion that more information creates more knowledge and better predictions u Does telling you what the last five rolls of a dice help you predict what the next roll will be? u The internet is full of information Ø How much is true? Ø Can you turn this info into wisdom? n Illusion of Control - People often believe that they have influence over the outcome of uncontrollable events. u People seem to believe that they have greater odds of winning the lottery with their own numbers than randomly picked numbers. n These illusions may cause investors to trade too much and eventually experience lower returns! 6

FIN 638 Vicentiu Covrig Impact on Return n n A study of 1, 607 investors which moved from discount broker to online broker. Before going online: - average turnover was 70% - beat the market by 2. 4% per year n After going online: - turnover jumped to 120% - under performed the market by 3. 5% per year Brad Barber and Terrance Odean, 2002, “Online Investors: Do 7 the Slow Die First? ” Review of Financial Studies, 15, 455 -487.

FIN 638 Vicentiu Covrig Buying Stocks Using Debt n Cash account - Most investors use a cash account. The fund the account with cash and then use the cash to buy stocks. n Margin account - You can borrow money from the brokerage firm to buy more - stock. You must start with no less than 50% of the position as your equity (called initial margin) If the stock price falls, it is your equity that is declining u. If your margin falls below 20%, you will be asked (a margin call) to sell or add more cash. (minimum maintenance margin level) 8

FIN 638 Vicentiu Covrig Computing your equity in a margin position n Consider that you borrowed $10, 000 to buy $20, 000 of stock. - If the value of the stock increases to $25, 000, what is your margin? - If the value of the stock declines to $15, 000, what is your margin? 9

FIN 638 Vicentiu Covrig Leverage, the reason to use margin n Using margin magnifies the realized return. n Example: - buy 200 shares at $40 per share ($8, 000 total) - Use $4, 000 or your own money and borrow $4, 000. - What is your return if the stock rises to $44? (a 10% increase) n Solution: - Profit is ($44 - $40) × 200 = $800 - Return is $800 / $4, 000 = 20% - A 20% return from a stock that increased 10%! 10

FIN 638 Vicentiu Covrig Leverage, the reason NOT to use margin n Using margin magnifies the realized return. n Example: - buy 200 shares at $40 per share ($8, 000 total) - Use $4, 000 or your own money and borrow $4, 000. - What is your return if the stock falls to $34? (a 15% decline) n Solution: - Loss is ($34 - $40) × 200 = -$1, 200 - Return is -$1, 200 / $4, 000 = -30% - A -30% return from a stock that declined -15%! 11

FIN 638 Vicentiu Covrig Profiting from falling stock prices n The simple rule of “buy low, sell high” works well when prices are increasing. When prices are falling, can you “sell high, buy low? ” n Can only be executed on an uptick. n n Lucent Technologies Share Statistics Shares Outstanding: 4. 44 B % Held by Insiders: 0. 15% % Held by Institutions: 33. 40% Shares Short (as of 10 -May-05)3: 175. 38 M Short Ratio (as of 10 -May-05)3: 3. 6 Shares Short (prior month)3: 164. 40 M Selling short (or short selling) - By executing a short sale, the investor - sell stock that they do not own (by borrowing it from the brokerage). Later, after the price falls (hopefully!) the stock is repurchased (called covering the short) and given back to the broker. 12

FIN 638 Vicentiu Covrig Short Example n n Short 100 shares at $60 using 50% margin - Total proceeds: $60 × 100 = $6, 000 - Amount borrowed of own money used = $3, 000 What is the equity margin and return if the price rises to $66? - Loss = ($60 - $66) × 100 = -$600 - Return = -$600 / $3, 000 = -20% - Margin: 13

FIN 638 Vicentiu Covrig Short Example n What is the equity margin and return if the price falls to $50? - Profit = ($60 - $50) × 100 = -$1, 000 - Return = $1, 000 / $3, 000 = 33. 3% - Margin: n At what stock price would a margin call occur (in the maintenance margin is 20%? n P = $75 Short Squeeze: when prices rise, investors short often have to cover their short, which involves buying stock, and causing more increases in price. n 14

Vicentiu Covrig FIN 638 Dollar-Cost Averaging If you buy stock over time, you will be some shares at a low price and some at a high price as the price fluctuates. A Rising Market Totals Average price A Falling Market A Volatile Market Monthly Shares Shares Investment Price Purchased $400 $4. 00 100 $50. 00 8 $40. 00 10 400 8. 00 50 25. 00 16 16. 00 25 400 10. 00 40 20. 00 20 10. 00 40 400 12. 50 32 20. 00 20 8. 00 50 400 12. 50 32 20. 00 20 4. 00 100 400 16. 00 25 4. 00 100 400 20 16. 00 25 8. 00 50 400 20 10. 00 40 400 25. 00 16 5. 00 80 16. 00 25 400 40. 00 10 5. 00 80 25. 00 16 400 40. 00 10 4. 00 100 50. 00 8 $216. 00 405 $216. 450 $216. 0 480 $18. 00 $11. 85 15 $18. 0 $10. 67 $18. 00 $10. 00 $4, 800

FIN 638 Vicentiu Covrig Issuing New Securities n n New securities are issued with the help of investment banks (or underwriter) New issues are sold on the primary market first, and subsequently sell on the secondary market. - The secondary markets are the security exchanges. n The selling of shares for the first time in a new company is called a initial public offering (IPO) 16

FIN 638 Vicentiu Covrig Underwriting Investment banks: advise or underwrite new issues; distribute shares to institutional investors through road shows n Firm-commitment underwriting: investment bankers buy entire issue and assume risk n Best-efforts underwriting: investment agrees to make its best effort at placing shares; issuing firm assumes risk n All-or-none offerings: investment bank tries to sell entire issue or sale is cancelled n 17

FIN 638 Vicentiu Covrig For Large Issues, a Syndicate is Used n Group of underwriters n Syndicate manager n Underwriter’s allotment n Dealers agreement n Tombstone ads 18

FIN 638 Vicentiu Covrig Who gets IPO shares? n n n Hot Issue Market - During some periods, over 50 news firms go public every month. - Many investors want these shares - Initial returns are high Cold market - During other periods, less than 10 IPOs are issued in a month. Who gets shares? - Those who want shares ask their broker. - When more shares are sought, than are being issued, priority tends to - go to the large shareholders and the broker’s best clients. If you are a small-money investor and receive shares of an IPO, look out, it may be a lemon! 19

FIN 638 Vicentiu Covrig Learning objectives Know the bid-ask spread and market depth. Discuss the market, limit and stop orders. Discuss the following pitfalls to trading: hyperactive trading, online brokerage and trading activity, the illusion of knowledge, the illusion of control Discuss buying on margin; know how to calculate the change in the value of the margin account (see slides 9, 10 and 11) Discuss the short selling; know how to calculate the short selling return as in example in slides 13 and 14 Know the underwriting process for IPOs; know the definitions p. 79 to 83 text End of chapter questions 3. 1 to 3. 8 20