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Chapter Three

Chapter Three. Participating in the Market. Learning Objectives. Understand how to measure performance Describe the process of buying and selling securities Compare Cash and Margin Accounts Describe trading orders that can be executed Explain tax implications of various strategies.

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Chapter Three

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  1. Chapter Three Participating in the Market

  2. Learning Objectives • Understand how to measure performance • Describe the process of buying and selling securities • Compare Cash and Margin Accounts • Describe trading orders that can be executed • Explain tax implications of various strategies

  3. Participating in the Market • Measures of Price Performance: • Market Indexes • Indexes and Averages • Buying and Selling in the Market • Types of Orders • Cost of Trading • Taxes • Appendix 3-a: More Information on IRAs and Taxes

  4. Measures of Price Performance:Market Indexes • Stock Market Indicators • Dow Jones Industrial Average • Standard and Poor's 50 • Value Line Average • New York Stock Exchange Index • NASDAQ Index • Wilshire 5000 Equity Index • Russell Indexes • International Stock Averages

  5. Dow-Jones Averages • D-J Industrial Average - 30 Stocks • Most Popular stock market indicator • "Blue Chip" Average - High quality stocks, criticized for being too selective. • D-J Transportation Average-20Stocks • D-J Utilities Average - 15 Stocks • D-J Composite Average - 65 Stocks • Published by Dow Jones & Company Inc., publisher of the Wall Street Journal and Barron’s

  6. Dow-Jones Averages (cont’d) • The 30 common stocks comprise over 25% of the market value of 3000 firms, listed on the NYSE. • DJIA is a price weighted average • weighted by the stock prices in the average. • Gives a higher weighting to high-price stocks than to low-price stocks.

  7. Standard & Poor's Indexes S & P 500 Stock index Measure of broad stock market performance. Includes 371 industrial firms, 15 transportation firms, 49 utilities and 65 financial firms. Predominately NYSE firms and some are OTC firms. S&P 500 firms account for 75% of total value on the NYSE. The base period for the S & P 500 is 1941-1943. The base period price is 10.

  8. Standard & Poor's Indexes • S & P's 400 Mid-Cap Index • Composed of 400 middle size firms that have total market values between $250 Million and $6 Billion • S & P's 600 Stock Index • Composed of 600 small size firms

  9. Standard & Poor's Indexes • S & P's 1500 Stock Index • Combines S&P 500, SP 400 Mid- Cap, and S&P Small Cap 600 • S&P 100 Index • 100 Blue Chip stocks • S&P Indexes are Market Value weighted

  10. Value Line Average • Represents 1700 companies NYSE, AMEX and NASDAQ • Equal weighted index • more closely corresponds to stock holdings in small investor portfolios

  11. Other Market Indexes • Nasdaq Composite • Nasdaq 100 • Amex Composite • Wilshire 5000 Equity Index • 5000 stocks • all NYSE and AMEX issues • Most active Nasdaq issues • All are Value-weighted indexes

  12. International Stock Averages • Dow Jones World Stock Index • Morgan Stanley Capital Int'l. Indexes • Solomon-Russell World Equity Index • Tokyo Nikkei 225 Average

  13. Other Market Indicators • Bond Market indicators • Treasury bonds, corporate securities, tax-exempt, mortgage backed, etc. • Mutual Fund Averages (Table 3-4) • General Equity indexes, Specialized Equity indexes, Other Equity indexes, Fixed-income Indexes

  14. Buying and Selling In The Market • Cash Account requires full payment. • Margin Account allows the investor to borrow a percentage of the purchase price from the brokerage firm. • Investors pay interest on borrowed funds. • Interest rate is negotiated. • Either account is subject to a three business days settlement period. • Margin Requirements are set by the Federal Reserve Board. Currently, it is 50% of the value of the securities.

  15. Margin Trading • Margin accounts are used by investors who think their long-run return will exceed the cost of borrowing. • The percentage of total cost the investor must pay is called the margin. • Brokerage houses require a $2,000 minimum in an account before lending. • Borrowed funds rate is 1 to 2% over the prime rate

  16. Margin Trading • Securities and Exchange Commission publishes a list of marginable securities. • Margined securities may not be delivered to the investor. • Minimum maintenance margin requirement is 25%. If equity position falls below 25% investor is subject to a margin call.

  17. Margin Trading Example Buy 100 shares Hershey Food on 50% margin 100 shares @ $60/share = $6,000 Borrow: Cost x (1 - Margin %) = 3,000 Margin: Equity contributed = 3,000 Price rises to $80 / share 100 shares @ $80 = $8000 Borrowed = 3000 Equity = 5000 Return = Gain/equity = $2000/3000 = 67% Result: 67% gain on equity with 25% increase in price. (Leverage)

  18. Margin Trading Example Buy 100 shares Hershey Food on 50% margin 100 shares @ $60/share = $6,000 Borrow: Cost x (1 - Margin %) = 3,000 Margin: Equity contributed = 3,000 Price falls to $40 / share 100 shares @ $40 = $4000 Borrowed = 3000 Equity = 1000 Return = loss/equity = -$2000/3000 = -67% Margin call: customer must increase equity assets in his account to 35% of more of portfolio equity value.

  19. Account Positions • Long position: • Purchase of securities whether margin or cash. • Securities are held by broker. • Short position: • Securities are borrowed from broker and sold. • Subject to strict margin requirements.

  20. Types of Orders 1. Market Order to buy or sell 2. Limit order Limits the buy or sell price buy - - no higher than limit sell - - no lower than limit 3. Stop order Sets specific price to buy or sell If stock reaches set price, order is executed

  21. Brokerage Firms • Full-Service • Brokerage function • Research and stock analysis • Tax info • Financial planning services • Discount brokers • Bare bones brokerage service

  22. Cost of trading Trader classifications Full Service broker: Merrill Lynch, et.al. Discount broker: Charles Schwab, et. al. On-line brokers: E-trade, et. al. Average Cost of 100 share trade Full-service average cost = $100 Discount broker average cost = $42 Online broker average cost = $15

  23. Tax Example Average tax = $5634/ $34,000 = 16.57%

  24. Capital Gains • Assets held 12 months or longer qualify as long-term capital gains • Tax rates • Short term capital gains: ordinary income tax rates • Long term capital gains tax rate = 20%

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