CHAPTER 2
Buying and Selling Securities
Chapter Sections:
Getting Started
Brokerage Accounts
Short Sales
Investor Objectives, Constraints, and Strategies
We are going to focus on margin accounts and
selling short.
1
Brokerage Firms

2
Full Service (Traditional)
 Companies such as Merrill Lynch and Morgan
Stanley that provide investment recommendations

Discount
 Companies such as Schwab that traditionally left
the stock picking to the investor but now have their
own stock rating / recommendation services
 Deep-discount (a.k.a. Internet brokers)
 Companies that have emphasized technology to
reduce brokerage costs dramatically
What can you expect to pay for each?
What kind of service can you expect from each?
3
Brokerage Firms
(continued)

Commissions – Then and Now
 Traditionally, virtually all brokerage firms made their
money from commissions




Full-service brokers – $70 to $100+ per trade
Discount – $45  $29  $19  $13  $9 per trade
Deep-discount – $5 to $18 per trade or less!
Mutual fund companies! Examples: Fidelity &
Vanguard (Both offer free commissions on their own funds)
 A couple of companies experimented with $0
commissions
 One failed and the other now charges $5 per trade
Wait a minute! How can a brokerage firm make any money with a
$0 commission? In fact, how can a company make money with $5
or $7 per trade?
4
Brokerage Firms
(continued)

The following disclaimer is placed on each
trade confirmation from Scottrade
SCOTTRADE INC. RECEIVES REMUNERATION FOR
DIRECTING ORDERS TO PARTICULAR
BROKER/DEALERS OR MARKET CENTERS FOR
EXECUTION. SUCH REMUNERATION IS CONSIDERED
COMPENSATION TO THE FIRM AND THE SOURCE
AND AMOUNT OF ANY COMPENSATION RECEIVED
BY THE FIRM IN CONNECTION WITH YOUR
TRANSACTION WILL BE DISCLOSED UPON REQUEST
Remember this slide from Chapter 5?
5
Brokerage Firms
(continued)

Alternative Methods of Paying Your Broker
 As the competition for your business as gotten
fiercer
 The methods of charging investors for investment
services have gotten more “creative”
 Merrill Lynch experimented with charging $3,000
per year for unlimited trades
 (They do not have that program anymore)
 There are many other methods
The new, modern-day-a-go-go-way to soak customers… uh, I mean,
charge for brokerage services is called “Wealth Management.”
6
Brokerage Firms
(continued)

Wealth Management Account
 a.k.a. Wrap account, Financial advisor account
 Instead of charging per transaction, the brokerage
firms tacks on a yearly 1% or 2% “wealth
management” fee
 Do you remember the mutual fund F shares?
 These types of programs are being pushed by all
the major full-service brokerage firms
 There are many flavors of this program
The latest wrinkle to this method is the new “performance-based
wealth management” program.
7
Brokerage Firms
(continued)

Performance-based Wealth Management
 Only pay your advisor when you make money!
 The advisor receives 10% to 20% of your




earnings when you make money
The advisor receives nothing when you lose
money (or do not make anything)
It is a variation of the way hedge funds charge
their shareholders
Currently marketed to “high-net worth investors”
Example: Dunham & Associates
 http://www.dunham.com/ForInvestors.aspx?UltimateMenu1B=Investors
Although it sounds tempting, the reality is that you have the potential
to pay far, far more for your investment services using this method.
ANTI-Brokerage Firms

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Dividend Reinvestment Plans
 a.k.a. DRIPs, Direct low-cost investment plans
 Bypass the middleman!
 Many of the large, well-established companies
offer their own DRIPs
 Some are totally free – some are close to free
 There are many other DRIP programs available
 NAIC – www.better-investing.org (now uses Foliofn.com)
DRIPs are low-cost, yes. But they are not perfect. How would you like
having to sift through 18 different statements? Some charge a monthly
fee to allow you to keep all your DRIPs in one place. Many traditional
brokerage firms now offer DRIPs.
Cash Account

Cash Account
 A brokerage account in which all transactions are
made on a strictly cash basis
 Cash accounts are the simplest arrangements
requiring no credit check of the customer by the
brokerage firm
Once you have established a good relationship, most brokerage
firms will allow you to purchase shares of stock even if you do not
have enough cash in the account. This is because stock transactions
settle in three business days. You have three business days to get the
money into the account. Some of the deep-discount Internet brokers
(example: Scottrade) do not allow this.
(Conversely, when you sell a stock, it takes three business days to
receive the money.)
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Margin Account

Margin Account
 A brokerage account in which, subject to limits,
securities can be bought and sold on credit
 If you open a margin account, the brokerage firm
will do a credit check to determine your credit
worthiness
 Since you will be borrowing money from them
The interest rate you pay on money borrowed from your broker is
called the margin rate. It is actually a very good interest rate. It
is often the prime rate plus 1 or 2 percentage points or 2 or 3
points above the current money market rates, depending on how
much you borrow.
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Buying on Margin

A margin account allows you to perform
Margin Trading
 a.k.a. “Buying on margin” “leveraged account”
 The use of borrowed funds to purchase
securities; magnifies returns by reducing the
amount of equity that the investor must put up
 Margin
 The portion of the value of an investment that is not
borrowed (Shouldn’t it be the other way ‘round?)
 The amount of equity stated as a percentage in the
investment
 Example: 75% margin, 25% borrowed
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Why Buy on Margin?

12
Buying on margin allows the investor to use
financial leverage
 The use of debt financing to magnify investment
returns

Buying on margin also allows an investor to
tap into the equity in their account
 Without actually selling their investments
 And generating commissions and taxable
transactions
Buying on margin is much like buying a house. When you purchase a
house, you do not come up with the total amount. You put up 10% or 20%
down and finance the rest. Stocks require at least 50% down.
13
Buying on Margin
(continued)

Margin Requirement
 a.k.a. Initial margin
 The minimum amount of equity that must be a
margin investor’s own funds; set by the Federal
Reserve Board
 Currently the margin requirement is 50%
 You must put up at least 50% of your own funds
 This allows you to purchase the same amount of
stock with less money

Margin Loan
 a.k.a. Debit Balance
 The amount of your account borrowed
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Buying on Margin
(continued)

Buying on Margin Example
 You put up $10 and borrow $10 from your broker
 Initial Margin = 50%; Margin Loan = $10
 You purchase one share of common stock for $20
 The market price rises to $30
Congratulations! You made $10 on a $10 investment!
That is half of what you had to come up with when you
simply purchased the stock outright with your own money.
Instead of a 50% return on your investment, you received
a 100% return on your investment.
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Buying on Margin
(continued)

Buying on Margin Example Revisited:
 You put up $10 and borrow $10 from your broker
 You purchase one share of common stock for $20
 Same as before, but this time…
 The market price drops to $10
Oops! Only ½ of the money was yours! You borrowed the rest.
You have lost your entire investment.
Buying on margin magnifies your gains and your losses.
Margin buying was one of the major contributing factors to the
Crash of 1929. At the time, the margin requirement was only 10%.
For this reason, the above scenario is prohibited today and our
intrepid investor would have had a “margin call” long ago.
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Buying on Margin
(continued)

Margin Trading (continued)
 Because margin trading is inherently more risky,
margin accounts are more highly scrutinized by
brokerage firms
 Restricted account
 A margin account whose equity is less than the
initial margin requirement; the investor may not
make further margin purchases and must bring the
margin back to the initial margin requirement when
the securities are sold
Information technology has made the brokerage firm’s job of
scrutinizing margin clients much easier. Now, the computer spits
out a list of customers that are restricted.
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Buying on Margin
(continued)

Margin Trading (continued)
 Maintenance margin
 The absolute minimum amount of margin (equity)
that an investor must maintain in the margin
account at all times – typically 25% to 35% (25% min)
 Margin call
 Notification of the need to bring the equity of an
account whose margin is below the maintenance
level up to the initial margin level or to have enough
margined holdings sold to reach this standard
If the investor does not meet the margin call in sufficient time
(typically 72 hours), the brokerage firm is authorized to sell enough of
the securities to meet the margin call. “Never meet a margin call!”
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Buying on Margin
(continued)

Margin Trading (continued)
 Of course, if your investments do very well, then
you can use the excess margin you create in your
margin account to purchase additional stock
without having to come up with more money
 Excess margin
 More equity than is required in a margin account
 Pyramiding
 The technique of using excess margin from paper
profits in margin accounts to partly or fully finance
the acquisition of additional securities
What do you think of this strategy?
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Buying on Margin
(continued)

Margin Trading (continued)
 Paying interest on the margin loan also adds yet
another drag on your investment returns
 Your margined investments must meet or exceed
the margin interest rate in order for you to just break
even!
Commissions and interest! Now you know why your broker is
always so happy to take your calls.
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Buying on Margin
(continued)

Margin Trading (continued)
 “So, why would I buy on margin?”
 The easy answer is, “You shouldn’t”
 The risks are not worth the potential reward
 In my humble opinion…
 However, there is a valid, logical reason for having
a margin account
 A margin account allows you to temporarily borrow
against your investments without having to sell them
 You do not incur commission costs and …
 You do not trigger capital gains taxes, but …
 You do pay interest!
Discussion: Do you think you would want to margin securities?
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Buying on Margin
(continued)

Margin Trading (Examples:)
 Stock selling for $50
 You put up $30 and borrow $20
 ( $50 - $20 ) / $50 = 60%
 Stock price rises to $80
 ( $80 - $20 ) / $80 = 75%
 Stock price falls to $25
 ( $25 - $20 ) / $25 = 20% − Uh, Oh! Margin Call!
Value of Security – Margin Loan
Margin = ───────────────────
Value of Security
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Buying on Margin
(continued)

The Account Balance Sheet
 Traditionally, with margin accounts, the brokerage
firms would create an Account Balance Sheet to
keep track of the account
 It is all computerized now
 Those of you with accounting experience will
recognize this as…
 Assets = Liabilities + Equity
 The balance sheet also makes it easier to
calculate the margin
 Margin = Account Equity / Total Assets
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Buying on Margin
(continued)

The Account Balance Sheet (Example: Page 43)
 You purchase 800 shares at $50
 You put up $20,000 & borrow the rest ($20,000)
 Margin = $20,000 / $40,000 = 50%
Assets
800 Shares @ $50/shr
Liabilities and Account Equity
$40,000
Total $40,000
Margin Loan
$20,000
Account Equity
$20,000
Total $40,000
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Buying on Margin
(continued)

The Account Balance Sheet (Example: Page 43)
 Uh, Oh! Your shares falls to $35
 The company was caught artificially inflating
earnings!
 Margin = $8,000 / $28,000 = 28.6%
Assets
800 Shares @ $35/shr
Liabilities and Account Equity
$28,000
Margin Loan
Account Equity
Total $28,000
$20,000
$8,000
Total $28,000
Your brokerage’s maintenance margin is 30%. Margin call!
Long Stock Purchases

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Long Purchase
 a.k.a. “Buying long,” “Going long”
 A transaction in which investors buy securities in
the hope that they will increase in value and can
be sold at a later date for profit
 This is the type of transaction that people
commonly think of when they hear that someone
bought stock
 Buying long is the most common form of
transaction
 Expectation of dividends or capital appreciation or
both
 “Buy low, sell high”
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Long Stock Purchases
(continued)

Long Purchase Example
 You purchase one share of common stock for $20
 The market price rises to $30
Congratulations! You made $10 on a $20 investment!
That is a 50% increase.
Of course, if the price dropped to $10, you lost $10, or ½
of your investment – a 50% decrease.
Selling Short

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You are gonna’ love this!
Short Selling
 a.k.a. “Selling short,” “Shorting the stock,” “Going
short”
 The sale of borrowed securities, their eventual
repurchase by the short seller, and their return to
the lender
 It is the opposite of “buying long”
 You are hoping that the price goes down
 “Sell high, buy low”
 Selling short must take place in a margin account
 Since you are borrowing the stock you sell from the
brokerage firm
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Selling Short
(continued)

Short Selling (continued)
 Here is how it works:
 You borrow the stock from another shareholder
(without their knowledge) and sell it on the market
 You receive money for selling stock that you do not own!
 You wait for the stock price to go down
 You then buy back the shares at a lower price
 Pocketing the difference
 The shareholder you borrowed the shares from
never knows that the shares were borrowed
 The brokerage firm does all the financial sleight-of-hand
 By the way, you must pay any dividends the
company declares to the investor who bought the
shares that you sold short…
Doesn’t it sound as though it should be illegal!?
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Selling Short
(continued)

Short Selling (continued)
 Here is how it works:
Borrow
shares
from
someone
Sell the
shares
in the
market
Today:
Buy
shares
from the
market
Return
the
shares
In the Future:
If the price goes down, you have made money. If the price goes up,
you have lost money. It is the opposite of buying long.
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Selling Short
(continued)

Short Selling Example:
 You sell a stock short for $20
 You receive $20 from the sale of the stock
 Even though the stock was not yours. You borrowed it from
someone else
 The stock price goes down to $10
 You buy back the stock at $10
 “Closing out the transaction”
 You give the stock back to the person you borrowed
it from
 You get to keep the $10 difference
Congratulations! You just made $10 on a $0 investment!
Well, not quite…
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Selling Short
(continued)

Short Selling Example:
 You can not really make $10 on a $0 investment
 It is a margin account, remember?
 You borrowed the stock that you sold
 The rules for a margin account still apply
 You must put up at least 50%
 “50% of what?”
 50% of what you borrowed! (Huh? What?)
 50% of the proceeds from the sale of the borrowed
stock – You borrowed the stock that you sold
 Again, the brokerages use the Account Balance
Sheet to keep track of the investor’s margin
Examples of margin requirements accounting to follow in a bit.
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Selling Short
(continued)

Short Selling Example Revisited:
 You sell a stock short for $20
 You receive $20 from the sale of the stock
 Even though the stock was not yours. You borrowed it from
someone else
 The stock price goes up to $40
 You buy back the stock at $40
 Remember, you borrowed it
 You must replace it at some future date
 You must buy it back
Uh-oh! You just lost $20 on your short transaction!
33
Selling Short
(continued)

Short Selling (continued)
 When you buy long, you can only lose the
purchase price of the stock
 Buy a stock for $20, it goes to zero, you lost $20
 Once a stock reaches $0, it can not go any lower
 But when you sell short, there is no limit to the
amount of money you can lose (theoretically)
 Why? Because there is no limit to the price of a
stock
 The price can always go higher
“He who sells what isn’t his’n, Must
buy it back or go to prison.”
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Selling Short
(continued)

Calculating the margin on short sales
Margin deposit + Short sale proceeds - Value of security
Margin = –––––––––––––––––––––––––––––––––––––––––––
Value of Security
 Example: If the stock were sold short at $20, you
would have to deposit $10
Margin = ($10 + $20 - $20 ) / $20 = $10 / $20 = 50%
Again, the Account Balance Sheet makes the calculation easier.
35
Selling Short
(continued)

The Account Balance Sheet (Example: Page 49)
 You sell short 100 shares of Texas Instruments at
$30
 You receive $3,000 from the sale (100shrs * $30)
 Margin = $1,500 / 3,000 = 50%
Assets
Liabilities and Account Equity
Proceeds from sale
of Texas Instruments
$3,000
Short position
$3,000
Initial margin deposit
$1,500
Account Equity
$1,500
Total
$4,500
Total
$4,500
Margin = Account Equity / Short Position
36
Selling Short
(continued)

The Account Balance Sheet (Example: Page 50)
 The stock price of Texas Instruments falls to $20
 The short position falls to $2,000 (100shrs * $20)
 Margin = $2,500 / $2,000 = 125%
Assets
Liabilities and Account Equity
Proceeds from sale
of Texas Instruments
$3,000
Short position
$2,000
Initial margin deposit
$1,500
Account Equity
$2,500
This side does not
change (unless you
$4,500
Total
Total
$4,500
deposit more $$$)
The short position fell and the account equity rose.
You made money because the stock price fell.
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Selling Short
(continued)

The Account Balance Sheet (Example: Page 50)
 Uh, Oh! What if the stock price of TI rises to $40?
 The short position rises to $4,000 (100shrs * $40)
 Margin = $500 / $4,000 = 12.5%
Assets
Liabilities and Account Equity
Proceeds from sale
of Texas Instruments
$3,000
Short position
Initial margin deposit
$1,500
Account Equity
Recall, this side
does not change
Total
$4,500
$4,000
$500
Total
$4,500
Uh, oh! Your brokerage’s maintenance margin is 40%. Margin call!
38
Selling Short
(continued)

Margin Call Price Level – page 52
( margin deposit + short sale proceeds ) / number of shares
Price = –––––––––––––––––––––––––––––––––––––––––––––
1 + maintenance margin
 Example: If you sold 100 shares short at $20, your
proceeds are $2,000, you deposited $1,000 and the
maintenance margin = 25%
Price = [ ($1,000 + $2,000 ) / 100 ] / ( 1 + 0.25) =
($3,000 / 100 ) / 1.25 = $30 / 1.25 = $24
Selling short is very risky. The brokerage firm will keep
a close eye on you.
39
Selling Short
(continued)

Short Squeeze
 When the market is going down, momentum investors will
often short stocks to try to take advantage of the down
momentum
 This pushes the market down even further
 But eventually, the short shares must all be repurchased
 The subsequent up movement of the market is often
dramatic as short sellers cover their positions

Short interest
 The amount of stock shares that have been sold short
In August of 2002, short interest was the highest it had ever been in the
history of the United States stock markets. That gave me great comfort
because it meant that the market downturn was close to an end.
40
Selling Short
(continued)

Short Selling (continued)
 Actually, there used to be a valid reason for
shorting a stock
 “Shorting against the box”
 Shorting stock that you already owned
 It allowed you to essentially sell the stock without
creating a taxable transaction until you closed out
the transaction with your own stock
 For example, you could sell the stock short in December,
receive the money and then deliver your shares in January,
effectively postponing the taxes for another year
 The IRS removed this loophole in 1997
My advice? Never short a stock!
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Careers in Stocks

Registered Representative
 a.k.a. Stockbroker, Financial Representative,
Account Executive, Financial Planner
 Background check
 No shenanigans with other peoples’ money
 Must take Series 7 and Series 66
 Series 7 is difficult, 6 hours, 2 months of studying
 Series 66 is much easier, 2 to 4 weeks study
 Must be sponsored by a brokerage firm
 Some brokerages exist simply to sponsor people
 Expect to pay a fee to them for the privilege of being
sponsored
 Many brokerages now sponsoring new recruits!
CHAPTER 2 – REVIEW
Buying and Selling Securities
Chapter Sections:
Getting Started
Brokerage Accounts
Short Sales
Investor Objectives, Constraints, and Strategies
Next: Miscellaneous Topics in Investing: Account Types,
REITs, Real Estate, Precious Metals, Hard Assets, etc.
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