Investments:
Theory and Applications
Mark Hirschey
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Chapter 4
(Part 1)
Buying and Selling
Equities
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
CHAPTER 4 OVERVIEW
 Simple Buy-Sell Decisions
 Buying on Margin
 Selling Short
 Initial Public Offerings
 Individual Retirement Accounts
 Taxes
4-3
Simple Buy-Sell
Decisions
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
KEY TERMS
 Bid
 stop-limit order
 Ask
 day order
 bid-ask spread
 buy stop order
 ticker symbols
 bid size
 round lots
 market depth
 inverted bid-ask spread
 stop-loss order
 stop-limit order
 day order
 open order
 market order
 good ‘til canceled order
 limit order
 All-or-none
 stop order
 fill-or-kill
4-5
Bid-Ask Spreads
 Bid: highest price an investor is willing to pay to buy a security
 Ask: lowest price an investor will accept to sell a security
 Bid-Ask Spread: gap between bid and ask prices for a
particular security
 price markup faced by investors
 profit margin earned by exchange specialist or Nasdaq
market maker
 usually positive
 Ticker Symbol: unique stock identifier to facilitate transaction
speed and accuracy
 NYSE: unique one-, two-, or three-letter stock symbol
 OTC: typically assigned unique four-letter symbols, given
the large numbers of such companies
4-6
Bid-Ask Spreads
 Round Lot: 100 shares of stock
 Bid Size: number of round lots sought by current
buyers at any moment

Example: A bid size of 1,000 means that a bid of $19.63
for Philip Morris is good for (1000 x 100) 100,000 shares
worth (100,000 x $19.63) $1,963,000
 Ask Size: number of round lots for sale at any
moment

Example: An ask size of 631 means that the ask price of
$19.69 for Philip Morris is good for up to (631 x 100)
63,100 shares worth (63,100 x $19.69) $1,242,439.
4-7
Bid-Ask Spreads
 The spread of the bid-ask “size”: is an indicator of
supply and demand and identifies upward or
downward pressure on the stock price
 In the Philip Morris Example:



The bid size of 100,000 shares is somewhat larger than the
ask size of 63,100
demand is somewhat greater than supply at the current bidask spread
this tends to place upward pressure on Philip Morris’s stock
price
4-8
Bid-Ask Spreads
 Market Depth: Refers to the number of active
buyers and sellers

In our example: Individual or institutional
shareholders can buy or sell a significant amount
of Philip Morris stock at prices near the last quote
of $19.69
4-9
Bid-Ask Spreads
 Normally, the bid-ask spread is positive
 In unusually volatile markets, an inverted bid-ask
spread is observed: The quoted bid price is higher than
the quoted ask price.



Usually occurs when the bid size is very small compared
with the ask size
An absence of ready buyers
If the bid size is only 100 shares, an eager seller of 10,000
shares might be willing to accept a lower price
4-10
Types of Orders
 Market order: an instruction to immediately buy
or sell a security at the current market (bid)
price

In contrast to 
4-11
Types of Orders
 Limit Order: Instruction to buy or sell at a
“specified” price

Can be executed only if the market price reaches at least the
specified price target

With a “buy “limit order: securities are bought at or below
the specified price target.


i.e. buy 100 shares of Walt Disney at $35 or less
With a “sell” limit order: securities are sold at or above the
specified price target

i.e. sell 100 shares of Walt Disney at $35 or better
4-12
Types of Orders
 Stop order: Market order to buy or sell a certain
quantity of a security if a specified price (the
stop price) is reached or passed.

A position is said to be stopped out: when a
position is offset by the execution of a stop order.
4-13
Types of Orders
 Buy Stop Order: buy order held until market
price rises to specific stop price at which point it
becomes a “market order”

Often used by short sellers (those who sell
borrowed stock) who wish to limit their risk
exposure

Not permitted for over-the-counter trading.
4-14
Types of Orders
 Stop-loss order: Stop order to sell a long
position at a specified price that is “below” the
current market price.

Typically used by investors “long” in the stock.


Long position – means you own the stock
“Stops the loss”

if the price of the stock you own begins to fall, the
stock will automatically be sold at the specified price.
4-15
Types of Orders
 Stop-limit order: order to buy or sell a certain
quantity of a security at a specified price or better, but
only after a specified price has been reached.

A combination of a Stop Order and a Limit Order

Stop Order: Market order to buy or sell a certain quantity
of a security if a specified price (the stop price) is reached
or passed.

Limit Order: Instruction to buy or sell at a “specified”
price
4-16
Types of Orders
 Day Order: Instruction to buy or sell during the
present trading session

Automatically expires if it can’t be executed during the
trading session in which it is entered
4-17
Types of Orders
 Open order: limit order that has not yet been executed
or filled

Created when an investor places an offer to buy or sell a
security at a price that differs from the current market price

Stays active until it is executed (filled) or canceled by the
investor

Brokers may set a time limit (30 to 60 days) after which
open orders are sometimes automatically canceled unless
the investor instructs the broker to keep it active
 Good-’til-canceled order: another expression for an
open order
4-18
Types of Orders
 All-or-none: buy or sell instruction that must be
filled exactly or not at all

A stipulation to a buy or sell order that instructs the
broker to either fill the entire order or do not fill it
at all.

Partial fulfillment of an order is not allowed

Used when investors are concerned about the potential
for paying higher brokerage commissions on orders that
are executed in piecemeal fashion.
4-19
Types of Orders
 Fill-or-kill: an all-or-none order that must be
immediately filled or canceled

A special type of all-or-none order

Must be immediately filled in its entirety or, if this
is not possible, completely canceled

Again: Used when investors are concerned about
the potential for paying higher brokerage
commissions on orders that are executed in
piecemeal fashion.
4-20
Dollar-Cost Averaging
 Over brief periods of time, financial markets are inherently
unpredictable.
 It’s not possible to consistently choose the best time to buy
or sell
 Dollar-Cost Averaging (Table 4.3): Strategy of investing
a fixed amount in a security at regular intervals.
4-21
Dollar-Cost Averaging
 Provides a mechanical means by which an individual
investor can benefit from market volatility by investing
a fixed amount in a particular security at regular
intervals (401k, IRA, etc.)
 Amount invested remains constant – the investor buys
more shares when the price is low but fewer shares
when the price is high
 The more volatile prices are, the greater the benefit that
will be gained through dollar-cost averaging
4-22
Dollar-Cost Averaging
 Dollar –cost averaging is an appropriate means for
investing a stream of money over time
 Allows long-term investors to reduce the effects of
market risk by acquiring more shares when share
prices are at their lowest
 The average cost of shares purchased by regular
investors will always be lower than the average share
price

Table 4.3, Page 120: Illustration of Dollar-Cost
Averaging
4-23
Dollar-Cost Averaging
 However:

It does not eliminate the risks of investing in financial
markets
 It does not ensure a profit or protect against a loss in
declining markets
 It will not prevent a loss if it is discontinued when the
value of an account is less than its cost
 The “success” of dollar-cost averaging depends on the investor
making regular purchases irrespective of market conditions
 There is no guarantee that dollar-cost averaging will always be
the most efficient means for investing a large” lump-sum”
amount
4-24
Dollar-Cost Averaging
 Instead of trying to choose the right time to
invest, dollar-cost averaging helps the investor
reduce risk and build a significant investment
portfolio “over time”!
4-25
Dollar-Cost Averaging
for Retirement
 Defined “Contribution” Retirement Plans: A
retirement plan in which the employer is responsible
only for making specified payments into the plan on
behalf of qualifying participants (such as 401-k plans).

Most common pension plans offered by employers
 Sometimes employer contributions are used to match
additional voluntary contributions made by employees.
 Most often, the employee simply directs the employer to
deduct a specific amount from his or her paycheck on a
weekly or monthly basis. (a type of dollar-cost averaging)
4-26
Dollar-Cost Averaging
for Retirement
 Defined “Contribution” Retirement Plans Con’t:

At the time of employee retirement, the plan amount
depends on the amount of income generated from
investments made possible by employer and employee
contributions to the employee’s account which is the
employee’s asset and not a debt obligation of the plan
sponsor.
4-27
Dollar-Cost Averaging
for Retirement
 Defined “Benefit” Retirement Plan: A pension plan
in which the corporate sponsor agrees to make
specified dollar payments.


The amount of benefit paid may depend on both number of
years of service and salary income of the plan participant,
etc. with no residual benefit for employee’s survivors.
Represents a debt obligation of the plan sponsor.
4-28
Dollar-Cost Averaging
for Retirement
 Dollar-cost averaging makes a Defined
“Contribution” Retirement Plan an effective tool for
building significant retirement assets
 Dollar-cost averaging is also an appropriate means for
investing in an Individual Retirement Accounts (IRA’s)
or other long-term investments.

i.e. electronic transfer of a fixed amount of money to an
investment account on a regular basis: monthly, bimonthly,
or quarterly, etc.
4-29
Buying on Margin
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Buying on Margin
Key Terms
 Margin Account
 Margin Debt
 Margin Call
 Broker Bill Rate
 Short Sale
 Cover the Short
 Short Interest
 Short Interest Ratio
 Short Squeeze
4-31
Margin Accounts
 A Margin Account is an investor account that holds
securities purchased with a combination of cash and
borrowed funds
 Brokerages earn a significant portion of their total
profit by making such loans.
 The loan in the margin account is collateralized by
stocks or bonds.

If the value of these securities drops sufficiently, the owner
will be asked to either put up more collateral or sell some of
the securities held in the account.
4-32
Margin Accounts
 The minimum “initial” margin (at the time the
account is opened) for:

stock purchases in the U.S. is 50%

i.e. can buy $10,000 worth of stocks with $5,000

investment grade bonds is 30%

Long Term Treasury bonds is 10%
4-33
Margin Accounts
 The minimum “maintenance” margin for:

Common stocks is 25%, but most brokerages require
30%



$10,000 in market value and be maintained with only
$3,000 worth of investment capital.
Investment grade bonds is 25%
Treasury Bonds is 10%
4-34
Margin Accounts
 The initial and maintenance margin
requirements are similar to security deposits.

They protect the lending broker from the loss of
lent funds.
4-35
Margin Accounts
 Margin rules are federally regulated by the Federal
Reserve Board

However, margin requirements and interest rates may vary
“above” legal minimums between individual brokers and
dealers.


Higher concentrated accounts holding fewer than three securities
Accounts that hold especially volatile securities
– (e.g., Internet stocks).
 Margin Debt: is the amount borrowed to buy or
maintain a security investment.
4-36
Margin Accounts
 Margin Call: Broker demand for additional collateral.

Usually due to adverse price movements
 The investor will be asked to increase the account’s equity
back to 50% within three business days.
 If the investor is unable or unwilling to provide additional
cash or securities collateral, the broker will liquidate
sufficient securities in the account to bring the account’s
equity back up to 50%.
 Thus, during adverse market conditions, margin calls can
have the effect of forcing investors to liquidate positions
following a sharp price decline.
4-37
Margin Accounts
 For lenders, margin loans represent a very low
risk loan

Stocks and bonds can be readily liquidated

Low probability of an immediate 30 – 50% loss in
the value of a margin investor’s total portfolio.

Also, the customer remains legally responsible for
the total amount borrowed.
4-38
Margin Accounts
 The Broker Call Rate (or broker loan rate):
is the interest rate that banks and brokerage
houses charge to finance margin loans to
investors.

Due to it’s low risk, the Broker Call Rate is one of
the least expensive interest rates available to
borrowers.

However, brokers sometimes charge high-risk investors
the broker call rate plus a modest markup or service
charge.
4-39
Margin Call Risk
 Although margin accounts are a low-risk proposition
for lenders, they entail substantial risks for margin
account customers



Margin accounts greatly amplify the typical risks of stock
and bond investors.
Customers implicitly agree to sell in the event of a sharp
downturn in the value of their portfolio
Customers could be forced to sale at the worst possible time
in order to meet maintenance margin requirements as stock
prices tumble
4-40
Margin Call Risk
 “Temporary” market downturns do no lasting
damage to the stock portfolios of patient buyand-hold investors.
 However, when buying on margin, even a
temporary market downturn can:

Can cause a margin call and force the liquidation
of margin account securities at low prices
 Can lead to enormous permanent loses for margin
buyers
4-41
Other Problems With
Leverage
 Using “Other people’s money:

Encourages poor investment selection

Encourages customers to buy too much of an individual
issue—resulting in poor diversification
 Non of the most successful stock investors of our time
use leverage:

Neither Warren Buffett, Peter Lynch, nor John Templeton
advocates the use of margin accounts.
4-42
Selling Short
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
How to Profit from
Falling Prices
 Short Sale - Sale of borrowed stock on margin

The borrower hopes to repurchase the shares in
the market at a later date for an amount that is less
than the previous selling price (thus generating a
profit) and return the borrowed shares to the lender
or Cover the Short: Return of borrowed shares.

A way to profit from the decline in a company’s
stock price
4-44
How to Profit from
Falling Prices
 Shares are borrowed from the existing margin
customers of the brokerage firm who signed “loan
consent” agreements in order to open their margin
accounts.


The brokerage firm will take a position in the stock if
necessary
Lenders of stock sold short profit from:

interest and dividend income during the lending period.
4-45
How to Profit from
Falling Prices
 Selling Short is a strategy used with a company with poor
or deteriorating conditions.



Expected negative future performance for the company and its stock
price
Bearish sentiment for issue: the price of the stock is expected to fall
in the future
Again:

The investor borrows stock and sells
 Hopes to repurchase the shares in the market at a later date
 For an amount that is less than the previous selling price (thus
generating a profit) and
 Cover the Short: Return the borrowed shares to the lender
– Buy low and sell high in reverse order!
4-46
How to Profit from
Falling Prices
 Although the “purchase” of stock on margin is
risky:

If a stock is “bought”:


the potential “loss” is limited to the amount invested.
the potential “gain” is unlimited, or “the sky’s the
limit.”
4-47
How to Profit from
Falling Prices
 The Short Sale of stock is an inherently riskier
proposition:

All short sales are margin account transactions because they
involve the use of borrowed stock
 The potential “gain” is limited



to the amount of proceeds obtained when the borrowed stock is
sold.
If the company went bankrupt and its stock price went to zero, all
sale proceeds could be kept by the short seller.
the potential “loss” is unlimited


If the stock price continues to gallop skyward
Remember: you must buy back the stock and return to the lender.
4-48
How to Profit from
Falling Prices
 Example:
 You borrow shares and sell at $25 per share.
 You hope to repurchase the shares for less than $25 per
share at a later date and return the shares to the lender
(i.e. cover your short).
 The spread between your buy and sell price is your
profit.
 Loss is “unlimited”: there’s no limit to how high the stock
price can climb

Potential gain is “limited”: to the amount of proceeds obtained
when the borrowed stock is sold short
– i.e. the price of the stock can only go to zero
4-49
How to Profit from
Falling Prices
 Short Interest data are reported by brokers to the SEC
once a month and summary short interest data are
published in financial publications.

The amount of short Interest in a particular stock is reported
in two different ways
 Short interest – Number of shares sold short
 Short interest ratio – Short interest expressed in terms
of day’s trading volume


The number of shares sold short relative to the average
daily trading volume in stock.
Useful indicator of the relative amount of short interest
4-50
How to Profit from
Falling Prices
 When either measure of short interest is high,
bearish sentiment is significant.

Negative future performance is expected for the
company and its stock price.

i.e. investors are selling short (selling borrowed
shares) with the expectation that:


the price of the stock will fall
they can repurchase and return the borrowed shares at a
price lower than their original sell price.
4-51
How to Profit from
Falling Prices
 In making a short sale, the investor becomes open to
the possibility of being forced to buy if the stock price
rises for even a brief period of time by even small
amounts.
 If momentum investors jump into an appreciating
stock, a short squeeze can result as buyers “squeeze”
short sellers to cover their short positions.
 Short Squeeze – Pressure on short sellers caused by
rapidly appreciating stock prices
4-52
Margin Call Risk for
Short Sellers
 Selling short is even more risky than the
purchase of a stock on margin

A rise in stock price both cuts the short seller’s
equity and increases the short seller’s margin
requirement.

Margin calls occur about twice as fast following
adverse price moves for short sellers as they do for
stock buyers.
4-53
 In a rising market: as the price of the stock starts to go up,
short sellers add to momentum as they panic to cover their
shorts
 Demand artificially inflates the stock price, followed by
collapse when short interest is exhausted
 (Fig 4.3 Pg 133)
4-54
Ways to Limit
Short-Selling Risk
 Ways to limit Short-Selling Risk:

Stock selection and timing are both vital to a
profitable short sale




Short stocks (sell borrowed stocks) only when their
prices are falling
Limit short positions
Avoid heavily shorted stocks
Never get in the way of momentum buyers
4-55
Margin Call Risk
 Table 4.4, Page 126:

Leverage Increases Potential Gains and Losses

Spreadsheet: Establishing Margin Accounts
4-56