Buying And Selling Securities Buying And Selling Securities

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Chapter

Buying and Selling Securities

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First you buy a stock. First you buy a stock. If it goes up, sell it. If it doesn’t go up, don’t buy it. – Will Rogers

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Buying and Selling Securities This chapter covers the Goal basics of the investing process.  We begin by describing how you go about buying and selling securities such as stocks and bonds.  Then we outline some important considerations and constraints to keep in mind as you get more involved in the investing process.

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Getting Started Open aa brokerage brokerage Open or trading trading account account or Deposit money money Deposit into account account into Withdraw money money Withdraw from account account from

Buy securities securities Buy Sell securities securities Sell Close account account Close 4

Choosing a Broker • Brokers are traditionally divided into three groups.  full-service

brokers  discount brokers  deep-discount brokers

• These three groups can be distinguished by the level of service provided, as well as the resulting commissions charged. 5

Choosing a Broker Commissions Level of # of shares ($50/share) 200 500 Service 1000 Provides extensive Full-Service Brokers A.G. Edwards $150 $200 $300 investmen t advice Merrill Lynch Discount Brokers Charles Schwab $100 $125 $150 Maintains Fidelity Brokerage account and Deep-Discount Brokers Olde Discount $50 $75 $100 executes buy/sell Quick & Reilly orders6

Choosing a Broker • However, as the brokerage industry becomes more competitive, the differences among the broker types seem to be blurring (mờ nhạt). • Another important change is the rapid growth of online brokers, also known as ebrokers or cyberbrokers. • Online investing has fundamentally changed the discount and deep-discount brokerage industry by slashing costs dramatically. 7

Choosing a Broker Broker Simple Trade Charles Schwab shares

Commission for $29.95, up to 1000

 http://www.schwab.com

Fidelity Investments shares

$25, up to 1000

CSFBdirect shares

$20, up to 1000

E*Trade shares

$14.95, up to 5000

TD Waterhouse

$12, up to 5000

 http://www.fidelity.com

 http://www.csfbdirect.com

 http://www.etrade.com 8

Security Investors Protection Corporation Security Investors Protection Corporation (SIPC) Insurance fund covering investors’ brokerage accounts with member firms. • 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. • Note that SIPC does not guarantee the value of any security. 9

Broker-Customer Relations • There are several important things to keep in mind when dealing with a broker.  Any

advice you receive is not guaranteed.  Your broker works as your agent and has a legal duty to act in your best interest. On the other hand, brokerage firms are in the business of generating brokerage commissions.  Your account agreement will probably specify that any disputes will be settled by arbitration (tòa án) and that the arbitration is final and binding.

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Brokerage Accounts Cash account A brokerage account in which all transactions are made on a strictly cash basis. Margin account A brokerage account in which, subject to limits, securities can be bought and sold on credit. 11

Margin Accounts • In a margin purchase, the portion of the value of an investment that is not borrowed is called the margin. • The portion that is borrowed incurs an interest that is based on the broker’s call money rate, which is the rate brokers pay to borrow bank funds for lending to customer margin accounts. 12

Margin Accounts Example: The Account Balance Sheet • You want to buy 1000 Wal-Mart shares at $24 per share. You put up $18,000 and borrow the rest. 

Amount borrowed = $24,000 – $18,000 = $6,000 Assets Liabilities & Account  Margin = $18,000 / $24,000 = 75% Equity 1000 WM shares$24,000 Margin loan $ 6,000 Account equity18,000 Total $24,000 Total $24,000 13

Margin Accounts • In a margin purchase, the minimum margin that must be supplied is called the initial margin. • The maintenance margin is the minimum margin that must be present at all times in a margin account. • When the margin drops below the maintenance margin, the broker may demand for more funds. This is known as a margin call. 14

Margin Accounts Example: Margin Requirements • Your account requires an initial margin of 50% and a maintenance margin of 30%. Stock A is selling at $50 per share. You have $20,000, and you want to buy as much of stock A as you possibly can.  You may buy up to $20,000 / 0.5 = $40,000 worth of shares. Assets Liabilities & Account Equity 800 A shares $40,000 Margin loan $20,000 Account equity20,000 Total $40,000 Total $40,000 15

Margin Accounts Example: Margin Requirements • After your purchase, the share price of stock A falls to $35 per share. Assets 800 A shares $28,000 Total 

$28,000

Liabilities & Account Equity Margin loan $20,000 Account equity 8,000 Total $28,000

New margin = $8,000 / $28,000 = 28.6% < 30% Therefore, you are subject to a margin call. 16

Margin Accounts • Margin is a form of financial leverage. – When you borrow money to make an investment, the impact is to magnify both your gains and your losses.

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A Note on Annualizing Returns • To compare investments, we will usually need to express returns on a per-year, or annualized, basis. • Such a return is often called an effective annual return (EAR). • 1 + EAR = (1 + holding period % return)m where m is the number of holding periods in a year. 18

Hypothecation and Street Name Registration Hypothecation Pledging securities as a collateral against a loan, so that the securities can be sold by the broker if the customer is unwilling or unable meetregistration a margin call. Street to name An arrangement under which a broker is the registered owner of a security. The account holder is the “beneficial owner.”

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Other Account Issues • Trading accounts can also be differentiated by the ways they are managed. – Advisory account - You pay someone else to make buy and sell decisions on your behalf. – Wrap account - All the expenses associated with your account are “wrapped” into a single fee. – Discretionary account - You simply authorize your broker to trade for you. – Asset management account - Provide for complete money management, including check-writing privileges, credit cards, and margin loans.

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Other Account Issues • To invest in financial securities, a brokerage account is not a necessity. – One alternative is to buy securities directly from the issuer. – Another alternative is to invest in mutual funds.

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Short Sales Short sale A sale in which the seller does not actually own the security that is sold.

Borrow Borrow shares shares from from broker broker

Sell the the Sell shares shares

Buy Buy shares shares from from market market

Return Return the the shares shares

Note that an investor who buys and owns shares of stock is said to be long in the stock or to have a long position. 22

Short Sales • An investor with a long position benefits from price increases.

 On the other hand, an investor with a short position benefits from price decreases.

Bu se y low ll h igh , !

Se bu ll hig yl ow h, !

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

Assets Liabilities & Account Worth of stock borrowed = $30 × $100 = Equity $3,000 from sale$3,000 Proceeds Short position $ 3,000 Initial margin deposit1,500 Account equity 1,500 24

Short Sales Example: Short Sales …continued • Scenario 1: The stock price falls to $20 per share. Assets Liabilities & Account Equity Proceeds from sale$3,000 Short position $ 2,000 Initial margin deposit1,500 Account equity 2,500 Total = 125% $4,500  Total New margin $4,500 = $2,500 / $2,000 25

Short Sales Example: Short Sales …continued • Scenario 2: The stock price rises to $40 per share. Assets Liabilities & Account Equity Proceeds from sale$3,000 Short position $ 4,000 Initial margin deposit1,500 Account equity 500 Total = 12.5% $4,500  Total New margin $4,500 = $500 / $4,000 < 40% Therefore, you are subject to a margin call.

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Short Sales Short interest The amount of common stock held in short positions. • In practice, short selling is quite common and a substantial volume of stock sales are initiated by short sellers. • Note that with a short position, you may lose more than your total investment, as there is no limit to how high the stock price may rise.

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Risk and Return • In formulating investment objectives, the individual must balance return objectives with risk tolerance.

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Investor Constraints • Resources. What is the minimum sum needed? What are the associated costs? • Horizon. When do you need the money? • Liquidity. How high is the possibility that you need to sell the asset quickly? • Taxes. Which tax bracket are you in? • Special circumstances. Does your company provide any incentive? What are your regulatory and legal restrictions?

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Strategies and Policies Be e! ti v c A

Pa Be ssi ve !

• 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? 30

Strategies and Policies Be e! ti v c A

Pa Be ssi ve !

• 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?

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Chapter Review • Getting Started – Choosing a Broker – Online Brokers – Security Investors Protection Corporation – Broker-Customer Relations

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Chapter Review • Brokerage Accounts – Cash Accounts – Margin Accounts – A Note on Annualizing Returns – Hypothecation and Street Name Registration – Other Account Issues

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Chapter Review • Short Sales – Basics of a Short Sale – Some Details

• Investor Objectives, Constraints, and Strategies – Risk and Return – Investor Constraints – Strategies and Policies 34