2
Buying and
Selling Securities
2-1
Brokerage Types
Broker Type
Service Level Commissions
Full Service
Discount
Deep
Discount
High
Medium
Low
High
Medium
Low
Online e-broker
Varies;
unbundled
Low/varies
2-2
Broker-Customer Relations
• Advice not guaranteed
• SIPC insured
• Your broker = your agent
•
•
Legal duty to act in your best interest
“Best Execution”
•
Brokerage firms profit from
commissions
• Disputes settled by final and binding
arbitration
2-3
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.
2-4
Brokerage Accounts
• Cash account = a brokerage account
in which securities are paid for in full
• Margin account = a brokerage account
in which, subject to limits, securities can
be bought and sold short on credit.
2-5
Margin Accounts
• Margin = the portion of the value of
an investment that is not borrowed
• Borrowed portion incurs interest
• Call money rate
• Rate brokers pay to borrow money to
lend to customers in their margin
accounts
2-6
Example: Margin Accounts,
The Balance Sheet
You buy 1,000 Pfizer (PFE) 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%
•
EX 2.1
Liabilities and
Account Equity
Assets
1,000 Shares, PFE $ 24,000
Total
$ 24,000
Margin Loan
$ 6,000
Account Equity
$ 18,000
Total
$ 24,000
2-7
Margin Accounts
• Initial Margin = the minimum margin that
must be supplied in a margin purchase
• Minimum = 50% set by Federal Reserve
• Broker can require more
• Maintenance margin = amount that must be
present at all times in a margin account.
• Margin Call = broker demands more funds to
bring margin amount back up to the
maintenance margin.
2-8
Example: The Workings of
a Margin Account, I
Initial margin = 50%
Maintenance margin = 30%
•Miller Moore Equine Enterprises (WHOA) is selling for $50.
•With $20,000 you can buy $20,000 / 0.5 = $40,000 worth of
WHOA or 800 shares
Liabilities and
Account Equity
Assets
800 Shares of
WHOA @ $50/share
Total
$ 40,000
$ 40,000
Margin Loan
$ 20,000
Account Equity
$ 20,000
Total
$ 40,000
2-9
Example: The Workings of
a Margin Account, II
•
After your purchase, shares of WHOA fall to $35.
•
New margin = $8,000 / $28,000 = 28.6% < 30%
•
You are subject to a margin call.
Liabilities and
Account Equity
Assets
800 Shares of
WHOA @
$35/share
Total
$ 28,000
$ 28,000
Margin Loan
$ 20,000
Account Equity
$ 8,000
Total
$ 28,000
2-10
Margin and Leverage
Suppose you buy 1,000 shares of Coca-Cola (KO) at
$50 per share. You put up 60% initial margin and
borrowed the remainder at 6% per year (call money
rate plus the spread).
• If a year later, KO is trading at $60 per share:
• What is your return on this investment?
• What would be your return if you had not invested on
margin?
• What if KO is trading at $40 per share?
2-11
Margin & Leverage: Sell at $60
Margined
t=0
t=1
60% of 1,000 shares @ $50
$30,000
Sell 1,000 shares @ $60
$60,000
Borrow $20,000 @ 6%
$20,000
Repay loan with interest
-$21,200
Buy 1,000 shares @ $50
-$50,000
$0
Rate of return on margined investment =
$38,800
($38,800 - $30,000) / $30,000 = 29.33%
Not Margined
t=0
Put up 100%
Buy 100 shares @ $100
t=1
$50,000
Sell 100 shares @ $60
$60,000
-$50,000
$0
Rate of return on unmargined investment = ($60,000-$50,000) / $50,000 =
$60,000
20.00%
2-12
Margin & Leverage: Sell at $40
Margined
t=0
t=1
60% of 1,000 shares @ $50
$30,000
Sell 100 shares @ $40
Borrow $20,000 @ 8%
$20,000
Repay loan with interest
Buy 1,000 shares @ $50
$40,000
-$21,200
-$50,000
$0
Rate of return on margined investment =
$18,800
($18.800 - $30,000) / $30,000 = -37.33%
Not Margined
t=0
Put up 100%
Buy 1,000 shares @ $50
t=1
$50,000
Sell 100 shares @ $40
$40,000
-$50,000
$0
$40,000
Rate of return on unmargined investment = ($40000 - $50,000)/ $50,000 = -20.00%
2-13
Margin & Leverage
Price @ t=1
$60
$40
Rate of Return
Margined
Not Margined
29.3%
-37.3%
20.0%
-20.0%
Margin provides leverage
which magnifies profits and losses
2-14
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?
2-15
Margin Call
Assets
300 shares at $55
Liabilities & Account Equity
$16,500
Margin Loan
$6,600
Account Equity
$9,900
$16,500
$16,500
Let P* be the critical margin call price:
Amount borrowed
=B
$6,600
Number of shares
=N
300
Value of stock
=V
55 x P*
Account equity
= AE 55 x P* - $6,600
Maintenance margin = MM 40%
Amount Borrow ed
Number of shares
P* 
1  Ma int enance Margin
2.1
2-16
Margin Call Price
Am ountBorrow e d
Num be rof s hare s
P* 
1  M ainte nance M argin
$6,600
P* 
300
1  .40
$22
P* 
 $36.667
.60
2-17
Annualized Returns
Effective Annual Rate (EAR)
EAR  (1 HPR )  1
M
Where:
HPR = Holding Period Return
M = Number of Holding Periods per year
2-18
Annualizing Returns on a Margin
Purchase
• You buy 1,000 shares of Costco at $60 per
share
• You put up 50% initial margin and borrowed
the remainder at 11% per year (call money
rate of 9% plus a 2% spread)
• Three months later, Costco is selling for $63
per share and you decide to close out your
position
• What is your annualized return?
2-19
Annualized Return
t=0
t = + 3 months
50% of 1000 shares @ $60
$30,000
Sell 1000 shares @ $63
$63,000
Borrow $30,000 @ 11%
$30,000
Repay loan with interest
-$30,793
Buy 1000 shares @ $60
-$60,000
$0
Holding Period Return
Annualized Return
$32,207
($32,207- $30,000) / $30,000 =
(1.0736)^4 - 1
7.36%
32.85%
Loan with interest = $30,000 x (1.11).25
3 months = 1/4 of a year = 0.25
Annualized Return = (1+HPR)4 -1
There are 4 HPs in a year
2-20
Hypothecation and Street Name
Registration
• Hypothecation:
• Pledging securities as collateral against a
loan
• Securities can be sold by the broker if the
customer fails to meet a margin call.
• Street name registration:
• Broker = registered owner of a security
• Account holder = “beneficial owner.”
2-21
Trading Account Management
• Advisory account
• You pay someone else to make buy and
sell decisions on your behalf.
• Wrap account
• All the account expenses are “wrapped” into
a single fee.
2-22
Trading Account Management
• Discretionary account
• You authorize your broker to trade for you.
• Asset management account
• Provides complete money management,
including check-writing privileges, credit
cards, and margin loans.
2-23
Short Sales
Short Sale = 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
in the
market
Return
the
shares
In the Future
2-24
Long Positions
When an investor buys and owns shares
of stock, he holds a “Long Position.”
• A long position benefits from price
increases.
• You buy today at $34, and sell later at $57,
you profit!
• Buy low, sell high
2-25
Short Positions
When an investor sells shares that he does not
own, he holds a “Short Position.”
• “Shorting” the stock
• A short position benefits from price decreases.
• You sell today at $83, and buy later at $27, you
profit.
• Sell high, buy low
• “Buy low, sell high” in reverse
2-26
Example: Short Sales
• You short 100 shares of TI at $30 per share.
• Your broker has a 50% initial margin and a
40% maintenance margin on short sales.
Liabilities and
Account Equity
Assets
Sale Proceeds
$ 3,000
Short Position
$ 3,000
Initial Margin Deposit $ 1,500
Account Equity
$ 1,500
Total
Total
$ 4,500
$ 4,500
2-27
Example: Short Sales
• TI stock falls to $20 per share.
• Shorted at $30, value today is $20, so you
are "ahead" by $10 per share, or $1,000.
• 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
$ 4,500
Total
2-28
Example: Short Sales
• TI 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.
• New margin = $500 / $4,000 = 12.5% < 40%
Therefore, you are subject to a margin call.
Assets
Sale Proceeds
Liabilities and
Account Equity
$ 3,000
Short Position
$ 4,000
Initial Margin Deposit $ 1,500
Account Equity
$
Total
Total
$ 4,500
$ 4,500
500
2-29
More on Short Sales
• Short interest is the amount of
common stock held in short positions.
• A “bearish” indicator
• With a short position,
• No theoretical limit to how high the
stock price may rise
• No limit to potential losses
2-30
Investment Objectives
• Basic Question: Why invest at all?
• Invest today to have more tomorrow
• Deferred consumption
• Choose to wait to have more to
spend later
• Individual risk-return trade-off:
• How much risk can you handle?
2-31
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?
2-32
Investor Constraints
• Resources: What is the minimum sum
needed? What are the associated costs?
• Horizon: When do you need the money?
• Liquidity: Will you need to sell the asset
quickly?
• Taxes: Which tax bracket are you in?
• Special circumstances
2-33
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)
2-34
2
Chapter End
Buying and
Selling Securities
2-35