Investments: Analysis and Behavior

1. Investments: Analysis and Behavior Chapter 3- Buying and Selling Equities

2. Learning Objectives • Know the costs of trading securities. • Be able to place a buy or sell order. • Be able to compute margin debt and returns for long and short positions. • Implement a dollar cost average strategy. • Examine the Initial Public Offer market.

3. Buying and Selling • Stock Price Quotes • Bid • The highest price a market maker is willing to pay (and is lower than the ask). • Ask • The lowest price a market maker is willing to accept to sell. • Bid-Ask Spread • Gap between the ask and the bid quotes. • Profit to the market maker • Market depth • How many people are buying and selling? How much can I buy or sell without moving the price? • Bid size: the number of shares offered at the bid price • Ask size: the number of shares offered at the ask price

4. Quote from specialist market

5. Quote from dealer market

6. Buy now, or wait for a better price? • Market order (executed immediately) • Buy (or sell) now at market price • “Buy 50 shares of Home Depot at market” • “Sell 100 shares of Apple Computer at market” • Limit order (may take awhile to execute, or never) • Buy when the price gets a little better • How long to wait? • Fill or kill • Day order • Good ‘til canceled • “Sell 100 shares of IBM at $82.70 or better, today” • “Buy 200 shares of Dell at $30.72 or better, fill or kill” • When would these trades execute?

7. Place an order to trade when certain price levels are reached (before the emotions set in!) • Stop order • Placing an order to sell a stock after the price has risen to a specified price. • Stop-loss order • Placing an order to sell when a stock falls to a specific price.

8. Pitfalls to Trading • Active trading (day trading) • Induces the same emotions as casinos try to elicit. • Investment decisions are more likely to be influenced by emotions and psychological biases. • The allure of active trading is strong. • People who believe they have superior information or skill feel like they should benefit by trading • Trading costs are important! (commissions and bid-ask spread)

9. Illusions • Illusion of Knowledge • The illusion that more information creates more knowledge and better predictions • Does telling you what the last five rolls of a dice help you predict what the next roll will be? • The internet is full of information • How much is true? • Can you turn this info into wisdom? • Illusion of Control • People often believe that they have influence over the outcome of uncontrollable events. • People seem to believe that they have greater odds of winning the lottery with their own numbers than randomly picked numbers. • These illusions may cause investors to trade too much and eventually experience lower returns!

10. Impact on Return • A study of 1,607 investors which moved from discount broker to online broker. • Before going online: • average turnover was 70% • beat the market by 2.4% per year • After going online: • turnover jumped to 120% • under performed the market by 3.5% per year Brad Barber and Terrance Odean, 2002, “Online Investors: Do the Slow Die First?” Review of Financial Studies, 15, 455-487.

11. Buying Stocks Using Debt • Cash account • Most investors use a cash account. The fund the account with cash and then use the cash to buy stocks. • Margin account • You can borrow money from the brokerage firm to buy more stock. • You must start with no less than 50% of the position as your equity (called initial margin) • If the stock price falls, it is your equity that is declining • If your margin falls below 20%, you will be asked (a margin call) to sell or add more cash. (minimum maintenance margin level)

12. Computing your equity in a margin position • Consider that you borrowed $10,000 to buy $20,000 of stock. • If the value of the stock increases to $25,000, what is your margin? • If the value of the stock declines to $15,000, what is your margin?

13. Leverage, the reason to use margin • Using margin magnifies the realized return. • Example: • buy 200 shares at $40 per share ($8,000 total) • Use $4,000 or your own money and borrow $4,000. • What is your return if the stock rises to $44? (a 10% increase) • Solution: • Profit is ($44 - $40) × 200 = $800 • Return is $800 / $4,000 = 20% • A 20% return from a stock that increased 10%!

14. Leverage, the reason NOT to use margin • Using margin magnifies the realized return. • Example: • buy 200 shares at $40 per share ($8,000 total) • Use $4,000 or your own money and borrow $4,000. • What is your return if the stock falls to $34? (a 15% decline) • Solution: • Loss is ($34 - $40) × 200 = -$1,200 • Return is -$1,200 / $4,000 = -30% • A -30% return from a stock that declined -15%!

15. Profiting from falling stock prices • The simple rule of “buy low, sell high” works well when prices are increasing. • When prices are falling, can you “sell high, buy low?” • Can only be executed on an uptick. • Selling short (or short selling) • By executing a short sale, the investor sell stock that they do not own (by borrowing it from the brokerage). • Later, after the price falls (hopefully!) the stock is repurchased (called covering the short) and given back to the broker.

16. Most shorts are done on margin • Since the first thing you do in selling short is to sell stock you don’t own, you would not need to put up any cash of your own for the position. • You are required to put cash in a margin account that is no less than 50% of the sale proceeds. • So, selling short is usually a margin position

17. Short Example • Short 100 shares at $60 using 50% margin • Total proceeds: $60 × 100 = $6,000 • Amount borrowed of own money used = $3,000 • What is the equity margin and return if the price rises to $66? • Loss = ($60 - $66) × 100 = -$600 • Return = -$600 / $3,000 = -20% • Margin:

18. Short Example • What is the equity margin and return if the price falls to $50? • Profit = ($60 - $50) × 100 = -$1,000 • Return = $1,000 / $3,000 = 33.3% • Margin: • At what stock price would a margin call occur (in the maintenance margin is 20%? • P = $75 • Short Squeeze: when prices rise, investors short often have to cover their short, which involves buying stock, and causing more increases in price.

19. Dollar-Cost Averaging If you buy stock over time, you will be some shares at a low price and some at a high price as the price fluctuates.

20. Issuing New Securities • New securities are issued with the help of investment banks (or underwriter) • New issues are sold on the primary market first, and subsequently sell on the secondary market. • The secondary markets are the security exchanges. • The selling of shares for the first time in a new company is called a initial public offering (IPO)

21. Underwriting • Investment banks:advise or underwrite new issues; distribute shares to institutional investors through road shows • Firm-commitment underwriting: investment bankers buy entire issue and assume risk • Best-efforts underwriting: investment agrees to make its best effort at placing shares; issuing firm assumes risk • All-or-none offerings: investment bank tries to sell entire issue or sale is cancelled

23. For Large Issues, a Syndicate is Used • Group of underwriters • Syndicate manager • Underwriter’s allotment • Dealers agreement • Tombstone ads

24. SEC Requirements IPOs • Securities Act of 1933 • Registration Statement • Filing Date • Cooling-Off Period • Preliminary Prospectus • Red Herring • Effective Date • Deficiency Letter • Due Diligence • Final Prospectus • Meanwhile, the underwriter puts on a Road Show • Presentations to large, institutional investors • Assess demand • Helps to determine the best offer price

25. Check Out IPOs See IPO Central at Hoovers Online www.hoovers.com

26. Who gets IPO shares? • Hot Issue Market • During some periods, over 50 news firms go public every month. • Many investors want these shares • Initial returns are high • Cold market • During other periods, less than 10 IPOs are issued in a month. • Who gets shares? • Those who want shares ask their broker. • When more shares are sought, than are being issued, priority tends to go to the large shareholders and the broker’s best clients. • If you are a small-money investor and receive shares of an IPO, look out, it may be a lemon!