ch.2 buying and selling securities

7/18/2019 CH.2 Buying and Selling Securities

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2

C h a p t e rBuying and Selling Securities

second edition

Fundamentals

of InvestmentsValuation & Management

CharlesJ.Corrado BradfordD.Jordan

McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu


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2002 by The McGraw-Hill Co!anies" Inc# $ll ri%h&s reser'ed#McGraw Hill / Irwin

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First you uy a stoc!.

First you buy a stock.

If it goes up, sell it. If it doesnt go up, dont buy it.

" Will Rogers


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Buying and Selling Securities

#his cha$ter covers the asics of the

investing $rocess.Goal

%e egin y descriing ho you go aoutuying and selling securities such as stoc!s and

onds.

#hen e outline some im$ortant considerations

and constraints to !ee$ in mind as you get

more involved in the investing $rocess.


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Close account

Close account

Buy securities

Buy securities

Sell securities

Sell securities%ithdra moneyfrom account

%ithdra moneyfrom account

De$osit moneyinto account

De$osit moneyinto account

'etting Started

($en a ro!erageor trading account

($en a ro!erageor trading account


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Choosing a Bro!er

#he first ste$ in o$ening an account is choosing a

ro!er . ro!ers are traditionally divided into three

grou$s ) Full service ro!ers

Discount ro!ers

Dee$ discount ro!ers

%hat distinguish the three grou$s is the level of

service they $rovide and the resulting commissions

they charge .


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Choosing a Bro!er

%ith dee$ discount ro!er ) essentially the only services$rovided are account maintenance and order e*ecution that is +uying and selling +

%ith full service ro!er ill $rovide investment advice

regarding the ty$es of securities and investment strategies thatmight e a$$ro$riate for you to consider , or avoid - the large

ro!erage firms do e*tensive research on individualcom$anies and securities and maintain lists of recommendedsecurities .a full service ro!er ill even manage your account

for you if you ish . %ith discount ro!er ith fall somehere eteen the to

cases offering more investment counseling than the dee$discounters and loer commissions than the full service

ro!ers .


7/47 2002 by The McGraw-Hill Co!anies" Inc# $ll ri%h&s reser'ed#McGraw Hill / Irwin

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%hich ty$e of ro!er should you choose /

It de$end on ho much advice and service you

ant . if you are the do "it "yourself ty$e then

you may see! out the loer commissions if

you are not then a full service ro!er might emore suitale .

(ften investors egin ith a full service

ro!er and then as they gain e*$erience andconfidence move on to a discount ro!er .



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(nline ro!er

#he most im$ortant recent change in the

ro!erage industry is the ra$id groth of

online ro!ers also !non as e0 ro!ers or

cyer ro!ers . ith an online ro!er you$lace uy and sell orders over the internet

using a e roser .

online ro!ers ill almost surely ecome thedominant form ecause of their enormous

convenience and the lo commission rates.



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Choosing a Bro!er

Commissions

1 of shares ,345share- 244 344 6444

Full-Service Brokers

7.'. 8dards 634 244 944Merrill :ynch

Discount BrokersCharles Scha 644 623 634

Fidelity Bro!erageDeep-Discount Brokers

(lde Discount 34 ;3 644rovides

e*tensiveinvestmentadvice

Maintainsaccount and

e*ecutesuy5sell

orders only

Level ofService



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Choosing a Bro!er

?oever as the ro!erage industry ecomes

more com$etitive the differences among the

ro!er ty$es seem to e lurring.

7nother im$ortant change is the ra$id groth

of online brokers also !non as e0ro!ers or

cyerro!ers.

(nline investing has fundamentally changed

the discount and dee$0discount ro!erage

industry y slashing costs dramatically.



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Choosing a Bro!er

Bro!er Commission for Sim$le #radeCharles Scha 2@.@3 u$ to 6444 shareshtt$)55.scha.com

Fidelity Investments 23 u$ to 6444 shareshtt$)55.fidelity.com

CSFBdirect 24 u$ to 6444 shareshtt$)55.csfdirect.com

8A#rade 6.@3 u$ to 3444 shares

htt$)55.etrade.com#D %aterhouse 62 u$ to 3444 shareshtt$)55.tdaterhouse.com

7meritrade no share limits

htt$)55.ameritrade.com
http://www.schwab.com/http://www.fidelity.com/http://www.csfbdirect.com/http://www.etrade.com/http://www.tdwaterhouse.com/http://www.ameritrade.com/http://www.ameritrade.com/http://www.ameritrade.com/http://www.ameritrade.com/http://www.ameritrade.com/http://www.tdwaterhouse.com/http://www.tdwaterhouse.com/http://www.tdwaterhouse.com/http://www.tdwaterhouse.com/http://www.etrade.com/http://www.etrade.com/http://www.etrade.com/http://www.etrade.com/http://www.csfbdirect.com/http://www.csfbdirect.com/http://www.csfbdirect.com/http://www.csfbdirect.com/http://www.fidelity.com/http://www.fidelity.com/http://www.schwab.com/http://www.schwab.com/http://www.schwab.com/http://www.schwab.com/



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Security Investors >rotection Cor$oration

Most ro!erage firms elong to the SI>C hichinsures each account for u$ to 344444 in cash

and securities ith a 644444 cash ma*imum.ote that SI>C does not guarantee the value of

any security.

Security Investors Protection Corporation(SIPC)

Insurance fund covering investorsE

ro!erage accounts ith memer firms.



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7s you $roaly aare hen you de$osit money in

a an! your account is normally $rotected ,u$ to

644444 - y the federal de$osit insurance

cor$oration or FDIC hich is an agency of the .Sgovernment . hoever ro!erage firms even though

they are often called investment an!s can not offer

FDIC coverage . most ro!erage firms do elong to

the SI>C hich as created in 6@;4 . the S>ICinsures your account for u$ to ,344444 in cash and

securities ith a 644444 cash ma*imum -

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SI>C is not a government agency it is a

$rivate fund su$$orted y the securities

industry . hoever in the S7 all the

ro!erage firma o$erating in it must e amemer of the S>IC .

(#8 Gthat under S>IC your money are not

guaranteed so you can lose every thing in anS>IC covered account if the value of your

securities falls to Hero .

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Bro!er0Customer =elations

#here are several im$ortant things to !ee$ in mind

hen dealing ith a ro!er. 7ny advice you receive is notguaranteed.

our ro!er or!s as your agent and has a legal duty to actin your est interest. (n the other hand ro!erage firms

are in the usiness of generating ro!erage commissions.

Finally in the unli!ely event of a significant $rolem

your account agreement ill $roaly s$ecify very closelythat you must aive your right to sue or see! a ury trial

instead you are going to agree that any dis$utes ill e

settled y aritration and that aritration is final and

inding .

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Bro!erage 7ccounts

Cash account

7 ro!erage account in hich all transactions aremade on a strictly cash asis.

So securities can e $urchased to the e*tent thatsufficient cash is availale in the account .

Margin account

7 ro!erage account in hich suect tolimits securities can e ought and sold oncredit.

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Margin 7ccounts

#hose securities $urchased on credit using

money loaned to you y your ro!er such a

$urchase is called a margin $urchase . the

interest rate you $ay on the money you orrois ased on the ro!erKs call money rate

hich is the rate the ro!er $ays to orro the

money so you $ay some a mount over the callmoney rate called thespread hich de$end

on your ro!er and the siHe of the loan .

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Margin 7ccounts

Margin ) the $ortion of the value of an investmentthat is not orroed .

In general hen you $urchase securities on credit

some of the money is yours and the rest is orroed .the amount that is yours called the margin .

Margin is usually e*$ressed as a $ercentage fore*am$le )

If you ta!e ;444 of your on money and orro anadditional 9444 from your ro!er your totalinvestment ill e 64444 ;444 from you andthe margin is 64444 5;444 L;4

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Margin 7ccounts

Example !he "ccount #alance $heet ou ant to uy 6444 %al0Mart shares at 2 $er

share. ou $ut u$ 6444 and orro the rest.

7mount orroed L 2444"6444 L N444

Margin L 6444 5 2444 L ;3

:iailities & 7ccount 8Ouity7ssets

6444 %M shares 2444 Margin loan N444

7ccount eOuity 6444

#otal 2444 #otal 2444

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Margin 7ccounts

In a margin $urchase the minimum margin that must

e su$$lied is called the initial margin.

#he maintenance marginis the minimum margin that

must e $resent at all times in a margin account.

%hen the margin dro$s elo the maintenance

margin the ro!er may demand for more funds. #his

is !non as a margin call. ote ) there is little initial margin reOuirement for

government onds . on the other hand margin is not

alloed at all on certain other ty$es of securities .

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Margin 7ccounts

Example %argin Re&uirements our account reOuires an initial margin of 34 and a

maintenance margin of 94. Stoc! 7 is selling at 34$er share. ou have 24444 and you ant to uy as

much of stoc! 7 as you $ossily can. ou may uy u$ to 24444 5 4.3 L 4444 orth of

shares.:iailities & 7ccount 8Ouity7ssets

44 7 shares 4444 Margin loan 24444

7ccount eOuity 24444

#otal 4444 #otal 4444

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Margin 7ccounts

Example %argin Re&uirements 7fter your $urchase the share $rice of stoc! 7 falls to

93 $er share.

e margin L 444 5 2444 L 2.N P 94

#herefore you are suect to a margin call.


44 7 shares 2444 Margin loan 24444

7ccount eOuity 444

#otal 2444 #otal 2444

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Calculating initial margin

Su$$ose you have N444 in cash in a tradingaccount ith a 34 as initial reOuirement

hat is the largest order you can $lace / if theinitial margin ere N4 ho ould youranser change /

%hen the initial margin 34 the total order is62444

%hen the initial margin N4 the total order LN4445N4 L 64444

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Maintenance margin

Maintenance margin ) the minimum margin that must e$resent at all times in a margin account .this level isestalished y the ro!er and de$end on hat you are uyingas e*am$le for lo "$riced and very volatile stoc!s the house

margin , maintenance margin - can e as high as 644meaning no margin at all .

7ty$ical maintenance margin ill e 94 if your marginfalls elo 94 then you may e suect to a margin call )demand for more funds that occurs hen the margin in an

account dro$s elo the maintenance margin . If you do not com$ly your securities may e sold the loan

ill e re$aid out of the $roceeds and any remaining amountill e credited to your account .

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Margin 7ccounts

Margin is a form offinancial le'erage. %hen you orro money to ma!e an investment

the im$act is to magnify oth your gains and your

losses.

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Calculating the critical $rice

ou can calculate the critical $rice , the loest $riceefore you get a margin call- as follos ) >A L amounts orroed 5numer of shares

QQQQQQQQQQQQQQQQQQQQQQQQQQQQQQQ

6 " maintenance margin For e*am$le ) su$$ose you had a margin loan of

4444 hich you used to $urchase in $art 6444shares . the maintenance margin is 9;.3 hat is

the critical stoc! $rice and ho do you inter$ret it / >A L ,4444 5 6444 - 5 , 6 " 9;.3 - >A L 4 5 4.N23 L N

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7 ote on 7nnualiHing =eturns

#o com$are investments e ill usually need to e*$ress returnson a $er0year or annuali(ed asis.

Such a return is often called an effecti'e annual return )E"R*.

6 RE"RL ,6 R holding $eriod return-m

here mis the numer of holding $eriods in a year. >ercentage return L , >6R # " ># - 5 ># L,3 " 4 - 5 4 L N.23 #he $ercentage N.23 is your return for the three month holding $eriod

ut hat does this return amount to on a $er0year asis / e need toconvert this return to an annualiHes return meaning a return e*$ressed on$er "year asis .

#his called an effective annual return ) the return on an investmente*$ressed on a $er"year or annualiHed asis .

6 RE"RL ,6 R holding $eriod return-m L ,6R 4.4N23- L 6.2; So the annual return is 2;.

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?y$othecation and Street ame =egistration

Hypothecation

>ledging securities as a collateral against a loanso that the securities can e sold y the ro!er ifthe customer is unilling or unale to meet amargin call.

Street name registration

7n arrangement under hich a ro!er is theregistered oner of a security.

#he account holder is the eneficial oner.T

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Street name registration

Some of the enefit of street name onershi$ ) 60 since the ro!er holds the security there is no

danger of theft or other loss of the security . 20 any dividends or interest $ayments are

automatically credited and they are often creditedmore Ouic!ly .

90 the ro!er $rovides regular account statementsshoing the value of securities held in the account

and any $ayments received also for ta* $ur$oses thero!er ill $rovide all the needed information on asingle form at the end of the year greatly reducingthe onerKs record "!ee$ing reOuirements .

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(ther 7ccount Issues

If you do not to manage your account yourself you can set u$ anadvisory accounts you $ay someone else to ma!e uy and selldecisions on your ehalf .

#rading accounts can also e differentiated y the ays they aremanaged. "d'isory account0 ou $ay someone else to ma!e uy and sell

decisions on your ehalf. Wrap account0 7ll the e*$enses associated ith your account are

ra$$edT into a single fee.

+iscretionary account0 ou sim$ly authoriHe your ro!er totrade for you.

"sset management account0 >rovide for com$lete moneymanagement including chec!0riting $rivileges credit cardsand margin loans.

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#o invest in financial securities a ro!erage

account is not a necessity. (ne alternative is to uy securities directly from

the issuer. 7nother alternative is to invest in mutual funds.

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Short Sales

ote that an investor ho uys and ons shares of stoc! issaid to e long in the stockor to have a long position.

Borrosharesfrom

ro!er

Borrosharesfrom

ro!er

Sell theshares

Sell theshares

Buysharesfrom

mar!et

Buysharesfrom

mar!et

=eturnthe

shares

=eturnthe

shares

Short sale

7 sale in hich the seller does not actuallyon the security that is sold.

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Short Sales

7n investor ith a long $osition

enefits from $rice increases.Buylow,sellhigh

Sellhigh,

!uylow

(n the other hand an investor

ith a short $osition enefits

from $rice decreases.

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Short Sales

Example $hort $ales

ou ant to short 644 Sears shares at 94 $er share.

our ro!er has a 34 initial margin and a 4

maintenance margin on short sales. %orth of stoc! orroed L 94 U644 L 9444


>roceeds from sale 9444 Short $osition 9444

Initial margin de$osit 6344 7ccount eOuity 6344

#otal 344 #otal 344

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Short Sales

Example $hort $ales continued

Scenario 6) #he stoc! $rice falls to 24 $er share.




#otal 344 #otal 344

e margin L 2344 5 2444 L 623

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Short Sales

Example $hort $ales continued

Scenario 2) #he stoc! $rice rises to 4 $er share.




#otal 344 #otal 344

e margin L 344 5 444 L 62.3 P 4

#herefore you are suect to a margin call.

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Short Sales

ou can calculate the critical $rice on a short sale , thehighest $rice efore you get a margin call- as follos )

>A L ,initial margin de$osit R short $roceeds - 5 numer ofshares

QQQQQQQQQQQQQQQQQQQQQQQQQQQQQQQ 6 R maintenance margin

For e*am$le ) su$$ose you shorted 6444 shares at 34 theinitial margin is 34 and the maintenance margin is 4 .

hat is the critical stoc! $rice and ho do you inter$ret it / >A L ,23444 R 34444 - 5 , 6444 shares - W 5 ,6 R 4 -

>A L 39.3;

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Short Sales

In $ractice short selling is Ouite common and

a sustantial volume of stoc! sales are initiated

y short sellers.

ote that ith a short $osition you may lose

more than your total investment as there is no

limit to ho high the stoc! $rice may rise.

Short interest

#he amount of common stoc! held in short$ositions.

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Investor oectives constraints and strategies

Different investors ill have very different investmentoectives and strategies for e*am$le some ill e veryactive uying and selling freOuently others

%ill e relatively inactive uying and holding for long

$eriods of time . Investment mean that e sim$ly deferred consum$tion

instead of s$ending today e choose to ait ecause e ishto have more to s$end later so there are no difference eteeninvesting and saving .

#he $articular investment strategy ill e chosen de$end onamong other things ) illingness to ear ris! the time horiHon and ta*es .

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=is! and =eturn

In formulating investment oectives the

individual must alance return oectives ith

ris! tolerance.

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Investor Constraints

Resources.%hat is the minimum sum needed/

%hat are the associated costs/

-ori(on.%hen do you need the money/

i&uidity. ?o high is the $ossiility that you

need to sell the asset Ouic!ly/

!axes.%hich ta* rac!et are you in/

$pecial circumstances.Does your com$any

$rovide any incentive/ %hat are your

regulatory and legal restrictions/

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Strategies and >olicies

In'estment management. Should you manage

your investments yourself/

%arket timing.Should you try to uy and sell

in antici$ation of the future direction of the

mar!et/

BePassive

Be

"ctiv

e

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"sset allocation.?o should you distriute

your investment funds across the different

classes of assets/

$ecurity selection.%ithin each class hich

s$ecific securities should you uy/

BePassive

Be

"ctiv

e

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" useful /ay to distinguish asset allocation

from security selection is to note that assets

allocation is essentially a macro0le'el acti'itybecause the focus is on /hole markets or

classes of assets .security selection is a much

more micro 1le'el acti'ity because the focus ison indi'idual securities .

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Cha$ter =evie

'etting Started Choosing a Bro!er

(nline Bro!ers


Bro!er0Customer =elations

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Cha$ter =evie

Bro!erage 7ccounts Cash 7ccounts

Margin 7ccounts

7 ote on 7nnualiHing =eturns

?y$othecation and Street ame =egistration


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Cha$ter =evie

Short Sales Basics of a Short Sale

Some Details

Investor (ectives Constraints and

Strategies =is! and =eturn

Investor Constraints


ch.2 buying and selling securities

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