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Chapter 3

Chapter 3. How Securities are Traded How firms issue securities How securities are traded Trading basics Trading cost Order type Buying on margin Short sales. Primary vs. Secondary Security Sales. Primary New issue Key factor: issuer receives the proceeds from the sale Secondary

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Chapter 3

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  1. Chapter 3 How Securities are Traded How firms issue securities How securities are traded Trading basics Trading cost Order type Buying on margin Short sales

  2. Primary vs. Secondary Security Sales • Primary • New issue • Key factor: issuer receives the proceeds from the sale • Secondary • Existing owner sells to another party • Issuing firm doesn’t receive proceeds and is not directly involved

  3. Public Offerings • Public offerings: registered with the SEC and sale is made to the investing public • Initial Public Offerings (IPOs)

  4. Private Placements Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration • Dominated by institutions • Very active market for debt securities • Not active for stock offerings

  5. Costs of Trading • Commission: fee paid to broker for making the transaction • Spread: cost of trading with dealer (NOT an explicit cost, it is not a fee, but will affect your return) • Bid: price dealer will buy from you • Ask: price dealer will sell to you • Spread: ask - bid

  6. Types of Orders Instructions to the brokers on how to complete the order • Market order: executed immediately at current market prices • Limit order: An order specifying a price at (or better than) which an investor is willing to buy or sell • Limit buy: buy at price same or below the stipulated limit price • Limit sell: Sell at price same or above the stipulated limit price

  7. Types of Orders • Stop order: trade is not executed unless stock hits a price limit • Stop-loss orders: • Def: A stock is to be sold if its price falls below a price limit • Idea: sell to stop further loss • Stop-buy orders: • Def: a stock should be bought when price rises above a limit • Idea: limit loss from short sales • Idea 2:don’t want to lose opportunity to buy before prices goes even higher

  8. Margin Trading • Using only a portion of the proceeds for an investment • Borrow remaining component • Margin: • The net worth (Equity) of the investor’s account • Margin =Asset-Liability ( borrowed funds or stocks) • % margin=Equity/Value of stock • The idea for margin requirement: The % of decline of your stock value before equity value drops to zero. It serves as a cushion for the lender.

  9. Stock Margin Trading • Maintenance margin: minimum percentage of margin in trading before additional funds must be put into the account • Initial margin: maintenance margin when first purchasing the stock • Margin call: notification from broker you must put up additional funds

  10. Margin Trading - Initial Conditions X Corp $70 50% Initial Margin 40% Maintenance Margin 1000 Shares Purchased Initial Position Stock $70,000 Borrowed $35,000 Equity 35,000

  11. Margin Trading - Maintenance Margin Stock price falls to $60 per share New Position Stock $60,000 Borrowed $35,000 Equity 25,000 Margin% = $25,000/$60,000 = 41.67% If sock price falls 41.67%, equity will be wiped out (equity value will be zero).

  12. Margin Trading - Margin Call How far can the stock price fall before amargin call? (1000P - $35,000)* / 1000P = 40% P = $58.33 * 1000P - Amt Borrowed = Equity

  13. Short Sales Purpose: to profit from a decline in the price of a stock or security Mechanics • Borrow stock through a dealer • Sell it and deposit proceeds and margin in an account • Closing out the position: buy the stock and return to the party from which is was borrowed • % Margin=Equity / Values of stocks owned

  14. Short Sale - Initial Conditions Z Corp 100 Shares 50% Initial Margin 30% Maintenance Margin $100 Initial Price Sale Proceeds $10,000 Margin & Equity 5,000 Stock Owed 10,000

  15. Short Sale - Maintenance Margin Stock Price Rises to $110 Sale Proceeds $10,000 Initial Margin 5,000 Stock Owed 11,000 Net Equity 4,000 Margin % (4000/11000) 36% If stock price rises 36%, equity will be zero.

  16. Short Sale - Margin Call How much can the stock price rise before a margin call? ($15,000* - 100P) / (100P) = 30% P = $115.38 * Initial margin plus sale proceeds

  17. Warning • Don’t short! • Short has unlimited potential loss • Short is against the long term trend (positive return for investing) • Stay away from: • Small cap, fast growing, high valuation (Netflix) • Potential turning around company (Ford) • Potential taken over target

  18. Short candidates • Stocks with a broken business model (BBI, DTV, BKS) • and struggling in competition (Dell, MOT,NOK…) • and with a high valuation • and with a large Cap. (small cap stocks can rise very fast and kill the shorts)

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