Investments
BSC III
Winter Semester 2010
Lahore School of Economics
Chap 5
How Securities Are Traded
Chapter 5
How Securities are Traded
Learning Objectives
 What are brokerage transactions?
 How Orders Work?
 What is Investor Protection?
 What is Margin?
 What are Short Sales?
Brokerage Firms
 Full Service Brokers
 Discount Brokers
 Online Discount Brokers
Brokerage Firms
 Full Service Brokers
A brokerage Firm offering full range of services
including information & advice, selling shares of
mutual funds owned by their own firm, sale of
IPOs & principal Transactions.
 Discount Brokers
Discount brokers provide all of the same
services as Full Service Brokers except they may
not offer advice & publication services will
charge less for the execution of trades.
 Online Discount Brokers
Types of Brokerage Accounts
 Cash Account
 Margin Account
 Asset Management Account
 Wrap Account
 Drip (Dividend Reinvestment Plan)
Types of Brokerage Accounts
 Cash Account
Customer may make Only cash transactions
 Margin Account
Allows cash and debt transactions
 Asset Management Account
Offers investment of cash balances and Check
writing
 Wrap Account
All costs (Cost of the broker & money manager,
all transaction costs etc) are wrapped in one fee.
 Drip (Dividend Reinvestment Plan)
Free reinvestment by companies
How Orders Work
 National Stock Exchanges (NYSE)
 Regional Stock Exchanges
 Over The Counter (System of dealers)
 Third Market (Segment of OTC)
Types of Orders
 Market Orders
 Limit Orders
 Stop Orders
 Market if touched Orders
Market Order
Market Order is an order executed at best Price
available in the Market.
Advantage:
Sure Execution of Order
Risk?
Market Order
Market Order is an order executed at best Price
available in the Market.
Advantage:
Sure Execution of Order
Risk?
Order may end up being executed at a Price much
different from what investor had in mind!
Limit order
Limit order designates a Price threshold for the
execution of the trade.
 Buy Limit Order
 Sell Limit order
Risk?
Limit order
Limit order designates a Price threshold for the
execution of the trade.
 Buy Limit Order
In a Buy limit order, the designated price is less than
the current market price of the security.
 Sell Limit order
In a sell limit order, the designated price is greater than
the current market price of the security.
Stop Orders
(Stop Loss Orders)
Stop orders are used to protect profits or prevent
losses.
Stop order specifies that the order is not to be executed
until the market moves to a designated price at which
time it becomes a market order.
Stop order to Buy
Stop order to Sell
Two Risks?
Stop Orders
(Stop Loss Orders)
Stop order to Buy
In a Buy Stop order, the designated price is greater
than the current market price of the security.
Stop order to Sell
In a Sell Stop order, the designated price is less than
the current market price of the security
Risks:
 Price changes might be temporary
 Once, the designated Price is reached, the stop order
becomes a market order & is subject to uncertainty of
the execution price
Market if-touched orders
This order becomes a market order once a designated
Price is reached.
Market If-touched orders to Buy
Market if-touched Orders to sell
Market if-touched Orders are Orders designed to get
into a position at an acceptable price.
Market if-touched orders
This order becomes a market order once a designated
Price is reached.
Market If-touched orders to Buy
Market If-touched orders to Buy becomes a Market
order if the market falls to a given Price.
Market if-touched Orders to sell
Market if-touched Orders to sell becomes a market
order if the market rises to a specified Price.
Short Selling
 The practice of selling securities that are not owned at
the time of sale is referred to as Selling Short.
Short Selling
The practice of selling securities that are not owned
at the time of sale is referred to as Selling Short.
For a short Sale, the short seller:
1. Simultaneously borrows & sells securities through a
broker,
2. Must returns securities at the request of the lender
or when the short sale is closed out,
3. Must keep a portion of the proceeds of the short sale
(Margin) on deposit with the broker.

Short Selling – Three Rules
Three rules apply to short selling:
1. The up tick Rule
2. The short seller must pay all dividends due to the
lender of the security.
3. The short seller must deposit collateral (Margin) to
guarantee the eventual repurchase of the security.
Margin Transactions
Margin Transactions involve buying securities with
borrowed money.
Initial Margin
Maintenance Margin
Margin Call
Margin Transactions
Margin Transactions involve buying securities with
borrowed money.
Initial Margin: The initial Margin requirement is the
proportion of the total Market value of securities that
the investor must Pay for in cash.
Maintenance Margin: Minimum amount of equity
needed in the investor’s Margin Account as compared
to the total Market Value.
Margin Call: Whenever actual Margin in the investor’s
account is less than Maintenance Margin, investor
receives a Margin Call.
Margin Transactions
Margin Transactions involve buying securities with
borrowed money.
Initial Margin
= Investor’s Equity Investment / Total Market Value
Maintenance Margin
Minimum %age of securities value which must be on
hand as equity at all times
MARKED TO MARKET EVERYDAY!!!
Margin Transactions
Actual Margin =
Market Value of % of securities kept
as collateral.
Market Value of securities - Amount Borrowed
Actual Margin (%)= Market Value of Securities – Amount Borrowed
Market Value of Securities
Margin Transactions - Example
1.
2.
Assume that an investor purchases 100 shares of a
stock for $75 per share on Margin when initial
margin requirement was 50%. Compute investor’s
Actual Margin in Account if:
Price increases to $85/share
Price decreases to $65/share
Margin Transactions - Example
1.
2.
Assume that an investor purchases 100 shares of a
stock for $75 per share on Margin when initial
margin requirement was 50%. Compute investor’s
Actual Margin in Account if:
Price increases to $85/share
Price decreases to $65/share
Initial Margin deposited by investor:
= Total Market Value in the beginning * IM
= (75*100) * 0.50
= 3750
Margin Transactions
1.
1.
Assume that an investor purchases 100 shares of a
stock for $75 per share. Compute investor’s Actual
Margin in Account if:
Price increases to $85/share
Actual Margin = (85*100) - 3750 = $4750
Actual Margin in the Account Increased!
Price decreases to $65/share
Actual Margin = (65*100) - 3750 = $2750
Actual Margin in the Account decreased!
Margin Transactions
If you have purchased shares on Margin:
 Actual Margin in the Margin Account increases when Share
Price increases.
 Actual Margin in the Margin Account decreases when share
Price decreases.
Margin Transactions – Return on
Margin Trades
1.
2.
Assume that an investor purchases 100 shares of a
stock for $75/share. Compute investor’s return if the
stock is sold for $150/share and the transaction was:
100% Cash
A margin purchase with an initial Margin
requirement of 60%
Margin Transactions – Return on
Margin Trades
1.
Assume that an investor purchases 100 shares of a
stock for $75/share. Compute investor’s return if the
stock is sold for $150/share and the transaction was:
100% Cash
Return =
(P1 – P0) / (Investor’s Investment)
=
(15000 -7500) / 7500
=
100%
Margin Transactions – Return on
Margin Trades
1.
Assume that an investor purchases 100 shares of a stock for
$75/share. Compute investor’s return if the stock is sold for
$150/share and the transaction was:
A margin purchase with an initial Margin requirement of
60%:
Return
=
(P1 – P0) / (Investor’s Investment)
=
(15000 -7500)/ 4500
=
167%
Margin Transactions
 In a margin transaction, change in price of stock after
the trade, will cause the balance of the margin account
to fluctuate.
 Should the price go up, the investor’s profit accumulate
at a rate higher than 100% equity position.
 Should the price go down, the investor’s losses
accumulate at a rate higher than 100% equity position.
Thus,
Just as leverage may enhance returns, it can also
magnify losses (High Variability / Risk)
Margin Transactions –
Trigger price
If an investor’s Margin Account Balance falls below the
maintenance Margin, the investor will receive a Margin
call & will be required to either liquidate a position or
bring the account back to its Maintenance margin
requirement.
The following formula indicates the stock price at
which Margin Account is just at Maintenance Margin:
Trigger Price = P0 [ ( 1 – IM ) / (1 – MM ) ]
Or,
Trigger Price = Amount borrowed
N*(1-MM)
Margin Transactions –Trigger price
Example
Assume you bought a stock for $40 per share. If the
initial Margin requirement is 50% and the Maintenance
Margin requirement is 25%, at what price will you get a
Margin call?
Margin Transactions –Trigger price
Example
Assume you bought a stock for $40 per share. If the initial
Margin requirement is 50% and the Maintenance Margin
requirement is 25%, at what price will you get a Margin call?
Trigger Price
= 40 * [ ( 1 – 0.5 ) / ( 1 – 0.25 )]
= $26.67
A Margin Call is triggered at a price below $ 26.67!
Assignment # 4 (4 Questions)
Q1: Assume that an investor purchases 100 shares of a stock
for $25 per share on Margin when initial margin
requirement was 60%. Compute investor’s Actual
Margin in Account & Return on investment if:
A. Price increases to $30/share
B. Price decreases to $15/share
C. At what price will investor receive Margin Call if
Maintenance Margin requirement was 30%.
D. Also, Calculate investor’s return on investment under
both price scenarios assuming that transaction was on
100% cash (100% Equity position). What can you
conclude from this?
Assignment # 4 (4 Questions)
Q2: Assume that an investor purchases 150 shares of a stock
for $55 per share on Margin when initial margin
requirement was 50%. Compute investor’s Actual Margin
in Account & Return on investment if:
A. Price increases to $60/share
B. Price decreases to $45/share
C. At what price will investor receive Margin Call if
Maintenance Margin requirement was 25%.
D. Also, Calculate investor’s return on investment under
both price scenarios assuming that transaction was on
100% cash (100% Equity position). What can you
conclude from this?
Assignment # 4 (4 Questions)
Q3:
Assume that an investor buys 100 shares of stock
at $50 per share & stock rises to $60 per share. What is
the profit in dollars & Return on Investment, assuming
an initial margin requirement of 50%? 40%?60%?
Assignment # 4 (5 Questions)
Q4:
A.
B.
C.
D.
Assume an initial Margin requirement of 50% & a
maintenance Margin of 30%. An investor buys 100
shares of stock on Margin at $60 per share. The
price of the stock subsequently drops to $50.
What is the Actual Margin at $50?
The price rises to $55, Is the account restricted?
If price declines to $45, is there a margin call?
Assume that the price declines to $45, what is the
amount of the margin call? At $35?
Assignment # 5 (4 Questions)
Q1: Assume that an investor sold short 100 shares of a
stock for $25 per share on Margin when initial
margin requirement was 50%. Compute investor’s
Actual Margin in Account & Return on investment:
A. Price increases to $40/share
B. Price decreases to $20/share
C. Price increases to $30/share
D. Price decreases to $15/share
E. At what price will investor receive Margin Call if
Maintenance Margin requirement was 25%.
Assignment # 5 (4 Questions)
Q2:
A.
B.
C.
D.
Assume an initial Margin requirement of 50% & a
maintenance Margin of 25%. An investor sold
short 100 shares of stock at $60 per share. The
price of the stock subsequently drops to $50.
What is the Actual Margin at $50?
The price rises to $75, Is the account restricted?
If price declines to $45, is there a margin call?
Assume that the price rises to $70, what is the amount of
the margin call? At $95?
Assignment # 5 (4 Questions)
Q3: Assume that an investor short sell 150 shares of a stock for
$55 per share on Margin when initial margin requirement
was 45%. Compute investor’s Actual Margin in Account &
Return on investment if:
A. Price increases to $60/share
B. Price decreases to $45/share
C. At what price will investor receive Margin Call if
Maintenance Margin requirement was 25%.
D. Also, Calculate investor’s return on investment under both
price scenarios assuming that transaction was on 100% cash
(100% Equity position). What can you conclude from this?
Assignment # 5 (4 Questions)
Q4:
Assume that an investor short sell 100 shares of
stock at $50 per share & stock rises to $65 per share.
What is the profit in dollars & Return on Investment,
assuming an initial margin requirement of 50%?
40%?60%?
Chapter 5
How Securities are Traded
Learning Summary
 What are brokerage transactions?
 How Orders Work?
 What is Investor Protection?
 What is Margin?
 What are Short Sales?