Investments: Analysis
and Behavior
Chapter 3- Buying and Selling
Equities
©2008 McGraw-Hill/Irwin
Learning Objectives

Know the costs of trading securities.
Be able to place a buy or sell order.
Be able to compute margin debt and returns for long and
short positions.
Implement a dollar cost average strategy.

Examine the Initial Public Offer market.



3-2
Buying and Selling

Stock Price Quotes

Bid


Ask


The lowest price a market maker is willing to accept to sell.
Bid-Ask Spread



The highest price a market maker is willing to pay (and is lower than the ask).
Gap between the ask and the bid quotes.
Profit to the market maker
Market depth

How many people are buying and selling? How much can I
buy or sell without moving the price?


Bid size: the number of shares offered at the bid price
Ask size: the number of shares offered at the ask price
3-3
Quote from specialist market
3-4
Quote from dealer market
3-5
Buy now, or wait for a better price?

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”
Limit order (may take awhile to execute, or never)


Buy when the price gets a little better
How long to wait?





Fill or kill
Day order
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”

When would these trades execute?
3-6
Place an order to trade when certain price levels
are reached (before the emotions set in!)

Stop order
 Placing
an order to sell a
stock after the price has
risen to a specified price.

Stop-loss order
 Placing
an order to sell
when a stock falls to a
specific price.
3-7
Pitfalls to Trading

Active trading (day trading)



The allure of active trading is
strong.


Induces the same emotions as
casinos try to elicit.
Investment decisions are more likely
to be influenced by emotions and
psychological biases.
People who believe they have
superior information or skill feel like
they should benefit by trading
Trading costs are important!
(commissions and bid-ask spread)
3-8
Illusions

Illusion of Knowledge

The illusion that more information creates more knowledge and
better predictions


Does telling you what the last five rolls of a dice help you predict
what the next roll will be?
The internet is full of information



Illusion of Control

People often believe that they have influence over the outcome of
uncontrollable events.


How much is true?
Can you turn this info into wisdom?
People seem to believe that they have greater odds of winning the
lottery with their own numbers than randomly picked numbers.
These illusions may cause investors to trade too much
and eventually experience lower returns!
3-9
Impact on Return


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
After going online:


turnover jumped to 120%
under performed the
market by 3.5% per year
3-10
Brad Barber and Terrance Odean, 2002, “Online Investors: Do the Slow Die First?” Review of Financial Studies, 15, 455-487.
Buying Stocks Using Debt

Cash account
 Most
investors use a cash account. The fund the
account with cash and then use the cash to buy stocks.

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

If your margin falls below 20%, you will be asked (a margin
call) to sell or add more cash. (minimum maintenance margin
level)
3-11
Computing your equity in a margin position

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?
PercentEquity 
Stock Value  Debt
Equity

Stock Value
Stock Value
PercentEquity 
$25,000  $10,000
 0.60  60%
$25,000
If the value of the stock declines to $15,000, what is your margin?
PercentEquity 
$15,000  $10,000
 0.33  33.3%
$15,000
3-12
Leverage, the reason to use margin

Using margin magnifies the realized return.

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)
Solution:



Profit is ($44 - $40) × 200 = $800
Return is $800 / $4,000 = 20%
A 20% return from a stock that increased 10%!
3-13
Leverage, the reason NOT to use margin

Using margin magnifies the realized return.

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)
Solution:



Loss is ($34 - $40) × 200 = -$1,200
Return is -$1,200 / $4,000 = -30%
A -30% return from a stock that declined -15%!
3-14
Profiting from falling stock prices

The simple rule of “buy low, sell high” works well when
prices are increasing.
When prices are falling, can you “sell high, buy low?”

Can only be executed on an uptick.


Lucent Technologies
Share Statistics
Selling short (or short selling)

Shares Outstanding:
4.44B
% Held by Insiders:
0.15%
% Held by Institutions:
33.40%
Shares Short (as of 10-May-05)3:
175.38M
Short Ratio (as of 10-May-05)3:
3.6
Shares Short (prior month)3:
164.40M

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.
3-15
Most shorts are done on margin


Since the first thing you do in selling short is to
sell stock you don’t own, you would not need to
put up any cash of your own for the position.
You are required to put cash in a margin account
that is no less than 50% of the sale proceeds.
 So,
selling short is usually a margin position
3-16
Short Example

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?
($60 - $66) × 100 = -$600
= -$600 / $3,000 = -20%
 Margin:
 Loss =
 Return
PercentageEquity 
Stock Value when Sold  Cash  Current Stock Value
Equity

Current Stock Value
Current Stock Value
PercentageEquity 
$6,000  $3,000  $66 100
 0.364  36.4%
$66 100
3-17
Short Example

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:
PercentageEquity 

$6,000  $3,000  $50 100
 0.80  80%
$50 100
At what stock price would a margin call occur (in the
maintenance margin is 20%?
0.20 


$6,000  $3,000  P  100
P  100
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.
3-18
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
Share
Shares
Share
Shares
Share
Shares
Investment
Price
Purchased
Price
Purchased
Price
Purchased
8
$40.00
10
$400
$4.00
100
$50.0
0
400
8.00
50
25.00
16
25.00
16
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
16.00
25
4.00
100
400
20.00
20
16.00
25
8.00
50
400
20.00
20
10.00
40
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
$18.00
$11.85
$18.0
$10.67
$18.00
$4,800
480
3-19
$10.00
Issuing New Securities


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.
The selling of shares for the first
time in a new company is called a
initial public offering (IPO)
3-20
Underwriting
Investment banks: advise or underwrite
new issues; distribute shares to
institutional investors through road shows
 Firm-commitment underwriting: investment
bankers buy entire issue and assume risk
 Best-efforts underwriting: investment
agrees to make its best effort at placing
shares; issuing firm assumes risk
 All-or-none offerings: investment bank
tries to sell entire issue or sale is cancelled

3-21
Underwriting revenue of top
investment banks
Issue Amount (billions)
2005 Market Share
2004 Market
Share
J.P. Morgan
$3.09
7.1%
6.9%
Citigroup
3.09
7.1
7.4
Goldman Sachs
2.39
5.5
5.7
Deutsche Bank
2.36
5.4
4.9
Credit Suisse F.B.
2.22
5.1
5.4
Morgan Stanley
2.22
5.1
6.0
UBS
2.19
5.0
5.0
Merrill Lynch
2.04
4.7
4.5
Lehman Brothers
1.69
3.9
4.1
Banc of America Sec.
1.66
3.8
4.3
Top 10 Totals
$22.93
52.7%
54.2%
Industry Totals
$43.48
100.0%
100.0%
3-22
For Large Issues, a Syndicate is Used

Group of underwriters

Syndicate manager

Underwriter’s allotment

Dealers agreement

Tombstone ads
3-23
SEC Requirements
IPOs

Securities Act of 1933

Registration Statement

Filing Date

Cooling-Off Period

Preliminary Prospectus

Red Herring

Effective Date

Deficiency Letter

Due Diligence

Final Prospectus

Meanwhile, the underwriter
puts on a Road Show

Presentations to large,
institutional investors

Assess demand

Helps to determine the best
offer price
3-24
Check Out IPOs
See IPO Central at Hoovers Online
www.hoovers.com
Public Date,
2005
Name (Ticker)
Offer Price
First Day Open/
Close Price
Price as of
December
15, 2005
30-Nov
Actions Semiconductor Co., Ltd. (ACTS)
$8.00
$7.90/$8.00
$7.30
22-Nov
Union Drilling, Inc. (UDRL)
$14.00
$13.61/$14.41
$14.48
22-Nov
Brookdale Senior Living Inc. (BKD)
$19.00
$23.10/$25.43
$28.52
18-Nov
Under Armour, Inc. (UARM)
$13.00
$31.00/$25.30
$27.39
18-Nov
Dover Saddlery, Inc. (DOVR)
$10.00
$10.06/$10.25
$10.00
15-Nov
Vimicro International Corporation
(VIMC)
$10.00
$10.01/$8.36
$8.76
9-Nov
Saifun Semiconductors Ltd. (SFUN)
$23.50
$31.18/$35.30
$28.62
2-Nov
Newkirk Realty Trust, Inc. (NKT)
$16.00
$15.05/$15.05
$15.73
2-Nov
Cbeyond Communications, Inc. (CBEY)
$12.00
$12.00/$12.00
$12.07
3-25
Who gets IPO shares?

Hot Issue Market




Cold market


During some periods, over 50 news firms go public every
month.
Many investors want these shares
Initial returns are high
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!
3-26