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Buying and Selling Securities

2. Buying and Selling Securities. Brokerage Types. Broker-Customer Relations. Advice not guaranteed SIPC insured Your broker = your agent Legal duty to act in your best interest “Best Execution” Brokerage firms profit from commissions

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Buying and Selling Securities

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  1. 2 Buying and Selling Securities

  2. Brokerage Types

  3. Broker-Customer Relations • Advice not guaranteed • SIPC insured • Your broker = your agent • Legal duty to act in your best interest • “Best Execution” • Brokerage firms profit from commissions • Disputes settled by final and binding arbitration

  4. Securities Investor Protection Corporation • Securities Investor Protection Corporation (SIPC):Insurance fund covering investors’ brokerage accounts when member firms go bankrupt or experience financial difficulties. • Most brokerage firms belong to the SIPC, which insures each account for up to $500,000 in cash and securities, with a $100,000 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.

  5. Brokerage Accounts • Cash account = a brokerage account in which securities are paid for in full • Margin account = a brokerage account in which, subject to limits, securities can be bought and sold short on credit.

  6. Margin Accounts • Margin = the portionof the value of an investment that is not borrowed • Borrowed portion incurs interest • Call money rate • Rate brokers pay to borrow money to lend to customers in their margin accounts

  7. Example: Margin Accounts,The Balance Sheet • You buy 1,000 Pfizer (PFE) 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% EX 2.1

  8. Margin Accounts • Initial Margin = the minimum margin that must be supplied in a margin purchase • Minimum = 50% set by Federal Reserve • Broker can require more • Maintenance margin = amount that must be present at all times in a margin account. • Margin Call = broker demands more funds to bring margin amount back up to the maintenance margin.

  9. Example: The Workings of a Margin Account, I • Initial margin = 50% Maintenance margin = 30% • Miller Moore Equine Enterprises (WHOA) is selling for $50. • With $20,000 you can buy $20,000 / 0.5 = $40,000 worth of WHOAor 800 shares

  10. Example: The Workings of a Margin Account, II • After your purchase, shares of WHOA fall to $35. • New margin = $8,000 / $28,000 = 28.6% < 30% • You are subject to a margin call.

  11. Margin and Leverage Suppose you buy 1,000 shares of Coca-Cola (KO) at $50 per share. You put up 60% initial margin and borrowed the remainder at 6% per year (call money rate plus the spread). • If a year later, KO is trading at $60 per share: • What is your return on this investment? • What would be your return if you had not invested on margin? • What if KO is trading at $40 per share?

  12. Margin & Leverage: Sell at $60

  13. Margin & Leverage: Sell at $40

  14. Margin & Leverage Margin provides leverage which magnifies profits and losses

  15. Example: How Low Can it Go? • Suppose you want to buy 300 shares of Pepsico, Inc. (PEP) at $55 per share. • Total cost: $16,500 • You have only $9,900—so you must borrow $6,600. • Your initial margin is $9,900/$16,500 = 60%. • Suppose your maintenance margin is 40%. At what price will you receive a margin call?

  16. Margin Call Let P* be the critical margin call price: Amount borrowed = B $6,600 Number of shares = N 300 Value of stock = V 55 x P* Account equity = AE 55 x P* - $6,600 Maintenance margin = MM 40% 2.1

  17. Margin Call Price

  18. Annualized Returns Effective Annual Rate (EAR) Where: HPR = Holding Period Return M = Number of Holding Periods per year

  19. Annualizing Returns on a Margin Purchase • You buy 1,000 shares of Costco at $60 per share • You put up 50% initial margin and borrowed the remainder at 11% per year (call money rate of 9% plus a 2% spread) • Three months later, Costco is selling for $63 per share and you decide to close out your position • What is your annualized return?

  20. Annualized Return Loan withinterest = $30,000 x (1.11).25 3 months = 1/4 of a year = 0.25 Annualized Return = (1+HPR)4 -1 There are 4 HPs in a year

  21. Hypothecation and Street Name Registration • Hypothecation: • Pledging securities as collateral against a loan • Securities can be sold by the broker if the customer fails to meet a margin call. • Street name registration: • Broker = registered owner of a security • Account holder = “beneficial owner.”

  22. Trading Account Management • Advisory account • You pay someone else to make buy and sell decisions on your behalf. • Wrap account • All the account expenses are “wrapped” into a single fee.

  23. Trading Account Management • Discretionary account • You authorize your broker to trade for you. • Asset management account • Provides complete money management, including check-writing privileges, credit cards, and margin loans.

  24. Borrow shares from someone Sell the Shares in the market Buy shares in the market Return the shares Today In the Future Short Sales Short Sale = a sale in which the seller does not actually own the security that is sold.

  25. Long Positions When an investor buys and owns shares of stock, he holds a “Long Position.” • A long position benefits from price increases. • You buy today at $34, and sell later at $57, you profit! • Buy low, sell high

  26. Short Positions When an investor sells shares that he does not own, he holds a “Short Position.” • “Shorting” the stock • A short position benefits from price decreases. • You sell today at $83, and buy later at $27, you profit. • Sell high, buy low • “Buy low, sell high” in reverse

  27. Example: Short Sales • You short 100 shares of TI at $30 per share. • Your broker has a 50% initial margin and a 40% maintenance margin on short sales.

  28. Example: Short Sales • TI stock falls to $20 per share. • Shorted at $30, value today is $20, so you are "ahead" by $10 per share, or $1,000. • New margin: $2,500 / $2,000 = 125%

  29. Example: Short Sales • TI 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. • New margin = $500 / $4,000 = 12.5% < 40% Therefore, you are subject to a margin call.

  30. More on Short Sales • Short interest is the amount of common stock held in short positions. • A “bearish” indicator • With a short position, • No theoretical limit to how high the stock price may rise • No limit to potential losses

  31. Investment Objectives • Basic Question: Why invest at all? • Invest today to have more tomorrow • Deferred consumption • Choose to wait to have more to spend later • Individual risk-return trade-off: • How much risk can you handle?

  32. Investment Strategies and Policies • 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?

  33. Investor Constraints • Resources: What is the minimum sum needed? What are the associated costs? • Horizon: When do you need the money? • Liquidity: Will you need to sell the asset quickly? • Taxes: Which tax bracket are you in? • Special circumstances

  34. Useful Internet Sites • www.finra.org (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 building a portfolio—search the site for “Build your first stock portfolio”) • 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)

  35. 2 Chapter End Buying and Selling Securities

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