Buying and
Selling Securities
“Don’t Gamble! Take all your savings and buy some good
stock and hold it till it goes up. If it don’t go up, don’t buy
it.”
– Will Rogers

In formulating investment objectives, the
individual must balance return objectives with risk
tolerance.
 Investors must think about risk and return.
 Investors must think about how much risk they can handle.

Your risk tolerance is affected by
 Your ability to take risk
 Your willingness to take risk
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Resources. What is the minimum sum needed? What are
the associated costs?
Horizon. When do you need the money?
Liquidity. How high is the possibility that you need to sell
the asset quickly?
Taxes. Which tax bracket are you in?
Special circumstances. Does your company provide any
incentive? What are your regulatory and legal restrictions?

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?

Most people are inclined to think security selection is the
more important element for successful investing.

Research shows asset allocation is the more important
determinant of portfolio returns:
 ~ 90% of portfolio performance stems from asset allocation.
 ~10%of portfolio performance comes from security selection.

How is this possible? Well, consider the Crash of 2008.
 Bonds outperformed stocks in 2008
 Even those elusive “skilled stock pickers” might underperform

You will probably have access to a company-sponsored retirement plan such
as a 401(k).

In a typical plan, you (the employee) decides how much money to contribute
to the plan through payroll deductions.

Generally, your employer also makes contributions to the plan.
 For example, your company could make dollar-for-dollar matching
contributions up to a certain percentage of your salary.
 Even after your contributions hit the maximum amount your employer will
match, you can still contribute additional funds.
 The amount of your total contribution is limited by the Internal Revenue
Service (IRS).

The investing approach applies to your retirement plan.
 You decide your percentage allocations to asset classes (like stocks, bonds,
and T-bills, foreign or domestic).

The primary benefit of company-sponsored plans is that
money you deposit into the account lowers your taxable
income.
 So, your tax bill is lower, and your net “out of pocket” cost is lower.
 For example, if you are in the 25 percent tax bracket and decide to deposit
$12,000 next year, your net out of pocket cost is only $9,000.
 Why? You will pay $3,000 (.25*$12,000) less in taxes than you would if you
had not made this deposit.

You must pay taxes on the withdrawals you make during
retirement.

The essential difference between IRAs lies in taxes (“Pay me now, or
pay me later.”)
 Roth Individual Retirement Account (Roth IRA)
 Today, you invest after-tax money.
 Therefore, you pay no taxes when you make withdrawals.
 So, capital gains and dividends accumulate tax-free.
 “Tax-Deferred” or Traditional IRAs
 You do not pay taxes on money you place into this account.
 When money is removed from this account, you pay taxes.

Roth IRAs benefit younger investors in a low tax bracket.

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Brokers are now divided into three groups:
1. full-service brokers
2. discount brokers
3. deep-discount brokers
These three groups can be distinguished by the level of
service provided, as well as the level of commissions
charged.
As the brokerage industry becomes more competitive, the
differences among broker types continues to blur.

Another important change is the rapid growth of online
brokers, also known as e-brokers or cyberbrokers.
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Online investing has really changed the brokerage industry.
 slashing brokerage commissions
 providing investment information
 Customers place buy and sell orders over the Internet
Security Investors Protection Corporation (SIPC): Insurance fund
covering investors’ brokerage accounts with member firms.

Most brokerage firms belong to the SIPC, which insures each account for
up to $500,000 in cash and securities, with a $250,000 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.

There are several important things to remember when you
deal with a broker:
 Any advice you receive is not guaranteed.
 Your broker works as your agent and has a legal duty to act
in your best interest.
 However, brokerage firms make profits from brokerage
commissions.

Your account agreement will probably specify that any
disputes will be settled by arbitration and that the arbitration is
final and binding.

A Cash account is a brokerage account in which securities are paid for in
full.

A Margin account is a brokerage account in which, subject to limits,
securities can be bought and sold short on credit.

In a margin purchase, the portion of the value of an investment that is
not borrowed is called the margin.
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Of course, the portion that is borrowed incurs an interest charge.
 This interest is based on the broker’s call money rate.
 The call money rate is the rate brokers pay to borrow money to lend to
customers in their margin accounts.
• You buy 1,000 Wal-Mart shares 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%
Liabilities and
Account Equity
Assets
1,000 Shares, WMT
Total
$ 24,000
$ 24,000
Margin Loan
$ 6,000
Account Equity
$ 18,000
Total
$ 24,000
In a margin purchase, the minimum margin that must be
supplied is called the initial margin.

The maintenance margin is the margin amount that must be
present at all times in a margin account.

When the margin drops below the maintenance margin, the
broker can demand more funds. This is known as a margin call.

• Your margin account requires:
• an initial margin of 50%, and
• a maintenance margin of 30%
• A Share in Miller Moore Equine Enterprises (WHOA) is selling for $50.
• You have $20,000, and you want to buy as much WHOA as you can.
• You may buy up to $20,000 / 0.5 = $40,000 worth of WHOA.
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
•
After your purchase, shares of WHOA fall to $35.
•
New margin = $8,000 / $28,000 = 28.6% < 30%
•
Therefore, 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
You have $30,000 in a margin account, 60% initial margin
required.
 You can buy $50,000 of stock with this account (why?).
 Your borrowing rate from your broker is 6.00%.
 Suppose you buy 1,000 shares of IBM, for $50/share.
 Assume no dividends, and that your borrowing rate is still
6.00%, what is your return if:

 In one year, IBM stock is selling for $60 per share?
 In one year, IBM stock is selling for $60 per share, but you
did not borrow money from your broker?

IBM stock is selling for $60 per share.

Your investment is worth $60,000.

You owe 6% on the $20,000 you borrowed: $1,200.
If you pay off the loan with interest, your account balance is: $60,000 –
$21,200 = $38,800.
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You started with $30,000.
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Therefore, your return is $8,800 / $30,000 = 29.33%.
Suppose IBM stock was selling for $40 per share instead of $60 per share?
What is your return?

IBM stock is selling for $60 per share, but you did not
borrow from your broker.

You started with $30,000, which means you were able to buy
$30,000 / $50 = 600 shares.
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Your investment is now worth $36,000.

Therefore, your return is $6,000 / $30,000 = 20.00%.
Suppose IBM is selling for $40 per share instead of $60 per
share. What is your return in this case?

Suppose you want to buy 300 shares of Ford Motor
Company (F) at $55 per share.
 Total cost: $16,500
 You have only $9,900—so you must borrow $6,600.
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Your initial margin is $9,900/$16,500 = 60%.
Suppose your maintenance margin is 40%. At what price will
you receive a margin call?
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Number of Shares  P   Amount Borrowed
Maintenanc e Margin Level 
*
Number of Shares  P *
Solving for the critical stock price, P * , results in
P 
Amount Borrowed
Number of Shares
1 - Maintenanc e Margin Level
*
So here,
$6,600
P* 
300  22  $36.67.
1 - 0.40
0.60
To compare investments, you should express returns on a
per-year, or annualized, basis.
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Such a return is often called an effective annual return (EAR).

(1 + EAR) = (1 + holding period return)m
(m is the number of holding periods in a year)
You buy Qwest (Q) at $60 and sell it 4 months later for $63.
There were no dividends paid, and suppose the prices above
are net of commissions.
 What is your holding period percentage return and your
EAR?


63 - 60 3
Holding Period Percentage Return 

 0.05
60
60
1  EAR  (1  Holding Period Percentage Return) m
 (1  0.05) 3
 (1.1576), or about 15.76%.
Note that there are three “4month” periods in one year.
Hypothecation is the act of pledging securities as a collateral
against a loan.

This pledge is needed so that the securities can be sold by the
broker if the customer is unwilling or unable to meet a margin
call.

Street name registration is an arrangement under which a
broker is the registered owner of a security. (You, as the
account holder are the “beneficial owner.”)

Trading accounts can also be differentiated by the ways
they are managed.

 Advisory account - You pay someone else to make buy and sell
decisions on your behalf.
 Wrap account - All the expenses associated with your account are
“wrapped” into a single fee.
 Discretionary account - You authorize your broker to trade for you.
 Asset management account - Provide for complete money
management, including check-writing privileges, credit cards, and
margin loans.
To invest in financial securities, you do not need an
account with a broker.

One alternative is to buy securities directly from the
issuer.

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Another alternative is to invest in mutual funds.
• Short Sale is 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
From the
market
Return
the
shares
In the Future
Note that an investor who buys and owns shares of stock is said to
be “long the stock” or to have a “long position.”

An investor with a long position benefits from price increases.
 Easy to understand
 You buy today at $34, and sell later at $57, you profit!
 Buy low, sell high

An investor with a short position benefits from price decreases.
 Also easy to understand
 You sell today at $83, and buy later at $27, you profit.
 Sell high, buy low

You short 100 share of Sears shares at $30 per share.
Your broker has a 50% initial margin and a 40% maintenance
margin on short sales.Value of stock borrowed that will be sold
short = $30 × $100 = $3,000

Value of stock borrowed that will be sold short = $30 × $100 =
$3,000

Liabilities and
Account Equity
Assets
Sale Proceeds
$ 3,000
Short Position
$ 3,000
Initial Margin Deposit
$ 1,500
Account Equity
$ 1,500
Total
$ 4,500
Total
$ 4,500
Sears stock falls to $20 per share.
Sold at $30, value today is $20, so you are "ahead" by $10
per share, or $1,000.
 Also, 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
Sears 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. (He that sells what isn’t
his’n, must buy it back—or go to prison.)
 Also: new margin = $500 / $4,000 = 12.5% < 40% Therefore,
you are subject to a margin call.


Assets
Liabilities and
Account Equity
Sale Proceeds
$ 3,000
Short Position
$ 4,000
Initial Margin Deposit
$ 1,500
Account Equity
$
Total
$ 4,500
Total
$ 4,500
500
Short interest is the amount of common stock held in short
positions.

In practice, short selling is quite common and a substantial
volume of stock sales are initiated by short sellers.

Note that with a short position, you may lose more than your
total investment, as there is no theoretical limit to how high
the stock price may rise.
Initial Margin Deposit Short Proceeds)/Number of Shares
P* 

1  Maintenance Margin

Problems 12, 16
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www.nasd.com (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 risk aversion)
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)
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Getting Started
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Choosing a Broker
Online Brokers
Security Investors Protection Corporation
Broker-Customer Relations
Brokerage Accounts
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Cash Accounts
Margin Accounts
A Note on Annualizing Returns
Hypothecation and Street Name Registration
Other Account Issues

Short Sales
 Basics of a Short Sale
 Some Details
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Investor Objectives, Constraints, and Strategies
 Risk and Return
 Investor Constraints
 Strategies and Policies