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7/18/2019 CH.2 Buying and Selling Securities
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2
C h a p t e rBuying and Selling Securities
second edition
Fundamentals
of InvestmentsValuation & Management
CharlesJ.Corrado BradfordD.Jordan
McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu
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2002 by The McGraw-Hill Co!anies" Inc# $ll ri%h&s reser'ed#McGraw Hill / Irwin
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First you uy a stoc!.
First you buy a stock.
If it goes up, sell it. If it doesnt go up, dont buy it.
" Will Rogers
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Buying and Selling Securities
#his cha$ter covers the asics of the
investing $rocess.Goal
%e egin y descriing ho you go aoutuying and selling securities such as stoc!s and
onds.
#hen e outline some im$ortant considerations
and constraints to !ee$ in mind as you get
more involved in the investing $rocess.
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Close account
Close account
Buy securities
Buy securities
Sell securities
Sell securities%ithdra moneyfrom account
%ithdra moneyfrom account
De$osit moneyinto account
De$osit moneyinto account
'etting Started
($en a ro!erageor trading account
($en a ro!erageor trading account
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Choosing a Bro!er
#he first ste$ in o$ening an account is choosing a
ro!er . ro!ers are traditionally divided into three
grou$s ) Full service ro!ers
Discount ro!ers
Dee$ discount ro!ers
%hat distinguish the three grou$s is the level of
service they $rovide and the resulting commissions
they charge .
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Choosing a Bro!er
%ith dee$ discount ro!er ) essentially the only services$rovided are account maintenance and order e*ecution that is +uying and selling +
%ith full service ro!er ill $rovide investment advice
regarding the ty$es of securities and investment strategies thatmight e a$$ro$riate for you to consider , or avoid - the large
ro!erage firms do e*tensive research on individualcom$anies and securities and maintain lists of recommendedsecurities .a full service ro!er ill even manage your account
for you if you ish . %ith discount ro!er ith fall somehere eteen the to
cases offering more investment counseling than the dee$discounters and loer commissions than the full service
ro!ers .
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%hich ty$e of ro!er should you choose /
It de$end on ho much advice and service you
ant . if you are the do "it "yourself ty$e then
you may see! out the loer commissions if
you are not then a full service ro!er might emore suitale .
(ften investors egin ith a full service
ro!er and then as they gain e*$erience andconfidence move on to a discount ro!er .
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(nline ro!er
#he most im$ortant recent change in the
ro!erage industry is the ra$id groth of
online ro!ers also !non as e0 ro!ers or
cyer ro!ers . ith an online ro!er you$lace uy and sell orders over the internet
using a e roser .
online ro!ers ill almost surely ecome thedominant form ecause of their enormous
convenience and the lo commission rates.
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Choosing a Bro!er
Commissions
1 of shares ,345share- 244 344 6444
Full-Service Brokers
7.'. 8dards 634 244 944Merrill :ynch
Discount BrokersCharles Scha 644 623 634
Fidelity Bro!erageDeep-Discount Brokers
(lde Discount 34 ;3 644rovides
e*tensiveinvestmentadvice
Maintainsaccount and
e*ecutesuy5sell
orders only
Level ofService
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Choosing a Bro!er
?oever as the ro!erage industry ecomes
more com$etitive the differences among the
ro!er ty$es seem to e lurring.
7nother im$ortant change is the ra$id groth
of online brokers also !non as e0ro!ers or
cyerro!ers.
(nline investing has fundamentally changed
the discount and dee$0discount ro!erage
industry y slashing costs dramatically.
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Choosing a Bro!er
Bro!er Commission for Sim$le #radeCharles Scha 2@.@3 u$ to 6444 shareshtt$)55.scha.com
Fidelity Investments 23 u$ to 6444 shareshtt$)55.fidelity.com
CSFBdirect 24 u$ to 6444 shareshtt$)55.csfdirect.com
8A#rade 6.@3 u$ to 3444 shares
htt$)55.etrade.com#D %aterhouse 62 u$ to 3444 shareshtt$)55.tdaterhouse.com
7meritrade no share limits
htt$)55.ameritrade.com
http://www.schwab.com/http://www.fidelity.com/http://www.csfbdirect.com/http://www.etrade.com/http://www.tdwaterhouse.com/http://www.ameritrade.com/http://www.ameritrade.com/http://www.ameritrade.com/http://www.ameritrade.com/http://www.ameritrade.com/http://www.tdwaterhouse.com/http://www.tdwaterhouse.com/http://www.tdwaterhouse.com/http://www.tdwaterhouse.com/http://www.etrade.com/http://www.etrade.com/http://www.etrade.com/http://www.etrade.com/http://www.csfbdirect.com/http://www.csfbdirect.com/http://www.csfbdirect.com/http://www.csfbdirect.com/http://www.fidelity.com/http://www.fidelity.com/http://www.schwab.com/http://www.schwab.com/http://www.schwab.com/http://www.schwab.com/7/18/2019 CH.2 Buying and Selling Securities
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Security Investors >rotection Cor$oration
Most ro!erage firms elong to the SI>C hichinsures each account for u$ to 344444 in cash
and securities ith a 644444 cash ma*imum.ote that SI>C does not guarantee the value of
any security.
Security Investors Protection Corporation(SIPC)
Insurance fund covering investorsE
ro!erage accounts ith memer firms.
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Security Investors >rotection Cor$oration
7s you $roaly aare hen you de$osit money in
a an! your account is normally $rotected ,u$ to
644444 - y the federal de$osit insurance
cor$oration or FDIC hich is an agency of the .Sgovernment . hoever ro!erage firms even though
they are often called investment an!s can not offer
FDIC coverage . most ro!erage firms do elong to
the SI>C hich as created in 6@;4 . the S>ICinsures your account for u$ to ,344444 in cash and
securities ith a 644444 cash ma*imum -
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Security Investors >rotection Cor$oration
SI>C is not a government agency it is a
$rivate fund su$$orted y the securities
industry . hoever in the S7 all the
ro!erage firma o$erating in it must e amemer of the S>IC .
(#8 Gthat under S>IC your money are not
guaranteed so you can lose every thing in anS>IC covered account if the value of your
securities falls to Hero .
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Bro!er0Customer =elations
#here are several im$ortant things to !ee$ in mind
hen dealing ith a ro!er. 7ny advice you receive is notguaranteed.
our ro!er or!s as your agent and has a legal duty to actin your est interest. (n the other hand ro!erage firms
are in the usiness of generating ro!erage commissions.
Finally in the unli!ely event of a significant $rolem
your account agreement ill $roaly s$ecify very closelythat you must aive your right to sue or see! a ury trial
instead you are going to agree that any dis$utes ill e
settled y aritration and that aritration is final and
inding .
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Bro!erage 7ccounts
Cash account
7 ro!erage account in hich all transactions aremade on a strictly cash asis.
So securities can e $urchased to the e*tent thatsufficient cash is availale in the account .
Margin account
7 ro!erage account in hich suect tolimits securities can e ought and sold oncredit.
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Margin 7ccounts
#hose securities $urchased on credit using
money loaned to you y your ro!er such a
$urchase is called a margin $urchase . the
interest rate you $ay on the money you orrois ased on the ro!erKs call money rate
hich is the rate the ro!er $ays to orro the
money so you $ay some a mount over the callmoney rate called thespread hich de$end
on your ro!er and the siHe of the loan .
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Margin 7ccounts
Margin ) the $ortion of the value of an investmentthat is not orroed .
In general hen you $urchase securities on credit
some of the money is yours and the rest is orroed .the amount that is yours called the margin .
Margin is usually e*$ressed as a $ercentage fore*am$le )
If you ta!e ;444 of your on money and orro anadditional 9444 from your ro!er your totalinvestment ill e 64444 ;444 from you andthe margin is 64444 5;444 L;4
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Margin 7ccounts
Example !he "ccount #alance $heet ou ant to uy 6444 %al0Mart shares at 2 $er
share. ou $ut u$ 6444 and orro the rest.
7mount orroed L 2444"6444 L N444
Margin L 6444 5 2444 L ;3
:iailities & 7ccount 8Ouity7ssets
6444 %M shares 2444 Margin loan N444
7ccount eOuity 6444
#otal 2444 #otal 2444
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Margin 7ccounts
In a margin $urchase the minimum margin that must
e su$$lied is called the initial margin.
#he maintenance marginis the minimum margin that
must e $resent at all times in a margin account.
%hen the margin dro$s elo the maintenance
margin the ro!er may demand for more funds. #his
is !non as a margin call. ote ) there is little initial margin reOuirement for
government onds . on the other hand margin is not
alloed at all on certain other ty$es of securities .
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Margin 7ccounts
Example %argin Re&uirements our account reOuires an initial margin of 34 and a
maintenance margin of 94. Stoc! 7 is selling at 34$er share. ou have 24444 and you ant to uy as
much of stoc! 7 as you $ossily can. ou may uy u$ to 24444 5 4.3 L 4444 orth of
shares.:iailities & 7ccount 8Ouity7ssets
44 7 shares 4444 Margin loan 24444
7ccount eOuity 24444
#otal 4444 #otal 4444
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Margin 7ccounts
Example %argin Re&uirements 7fter your $urchase the share $rice of stoc! 7 falls to
93 $er share.
e margin L 444 5 2444 L 2.N P 94
#herefore you are suect to a margin call.
:iailities & 7ccount 8Ouity7ssets
44 7 shares 2444 Margin loan 24444
7ccount eOuity 444
#otal 2444 #otal 2444
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Calculating initial margin
Su$$ose you have N444 in cash in a tradingaccount ith a 34 as initial reOuirement
hat is the largest order you can $lace / if theinitial margin ere N4 ho ould youranser change /
%hen the initial margin 34 the total order is62444
%hen the initial margin N4 the total order LN4445N4 L 64444
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Maintenance margin
Maintenance margin ) the minimum margin that must e$resent at all times in a margin account .this level isestalished y the ro!er and de$end on hat you are uyingas e*am$le for lo "$riced and very volatile stoc!s the house
margin , maintenance margin - can e as high as 644meaning no margin at all .
7ty$ical maintenance margin ill e 94 if your marginfalls elo 94 then you may e suect to a margin call )demand for more funds that occurs hen the margin in an
account dro$s elo the maintenance margin . If you do not com$ly your securities may e sold the loan
ill e re$aid out of the $roceeds and any remaining amountill e credited to your account .
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Margin 7ccounts
Margin is a form offinancial le'erage. %hen you orro money to ma!e an investment
the im$act is to magnify oth your gains and your
losses.
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Calculating the critical $rice
ou can calculate the critical $rice , the loest $riceefore you get a margin call- as follos ) >A L amounts orroed 5numer of shares
QQQQQQQQQQQQQQQQQQQQQQQQQQQQQQQ
6 " maintenance margin For e*am$le ) su$$ose you had a margin loan of
4444 hich you used to $urchase in $art 6444shares . the maintenance margin is 9;.3 hat is
the critical stoc! $rice and ho do you inter$ret it / >A L ,4444 5 6444 - 5 , 6 " 9;.3 - >A L 4 5 4.N23 L N
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7 ote on 7nnualiHing =eturns
#o com$are investments e ill usually need to e*$ress returnson a $er0year or annuali(ed asis.
Such a return is often called an effecti'e annual return )E"R*.
6 RE"RL ,6 R holding $eriod return-m
here mis the numer of holding $eriods in a year. >ercentage return L , >6R # " ># - 5 ># L,3 " 4 - 5 4 L N.23 #he $ercentage N.23 is your return for the three month holding $eriod
ut hat does this return amount to on a $er0year asis / e need toconvert this return to an annualiHes return meaning a return e*$ressed on$er "year asis .
#his called an effective annual return ) the return on an investmente*$ressed on a $er"year or annualiHed asis .
6 RE"RL ,6 R holding $eriod return-m L ,6R 4.4N23- L 6.2; So the annual return is 2;.
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?y$othecation and Street ame =egistration
Hypothecation
>ledging securities as a collateral against a loanso that the securities can e sold y the ro!er ifthe customer is unilling or unale to meet amargin call.
Street name registration
7n arrangement under hich a ro!er is theregistered oner of a security.
#he account holder is the eneficial oner.T
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Street name registration
Some of the enefit of street name onershi$ ) 60 since the ro!er holds the security there is no
danger of theft or other loss of the security . 20 any dividends or interest $ayments are
automatically credited and they are often creditedmore Ouic!ly .
90 the ro!er $rovides regular account statementsshoing the value of securities held in the account
and any $ayments received also for ta* $ur$oses thero!er ill $rovide all the needed information on asingle form at the end of the year greatly reducingthe onerKs record "!ee$ing reOuirements .
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(ther 7ccount Issues
If you do not to manage your account yourself you can set u$ anadvisory accounts you $ay someone else to ma!e uy and selldecisions on your ehalf .
#rading accounts can also e differentiated y the ays they aremanaged. "d'isory account0 ou $ay someone else to ma!e uy and sell
decisions on your ehalf. Wrap account0 7ll the e*$enses associated ith your account are
ra$$edT into a single fee.
+iscretionary account0 ou sim$ly authoriHe your ro!er totrade for you.
"sset management account0 >rovide for com$lete moneymanagement including chec!0riting $rivileges credit cardsand margin loans.
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(ther 7ccount Issues
#o invest in financial securities a ro!erage
account is not a necessity. (ne alternative is to uy securities directly from
the issuer. 7nother alternative is to invest in mutual funds.
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Short Sales
ote that an investor ho uys and ons shares of stoc! issaid to e long in the stockor to have a long position.
Borrosharesfrom
ro!er
Borrosharesfrom
ro!er
Sell theshares
Sell theshares
Buysharesfrom
mar!et
Buysharesfrom
mar!et
=eturnthe
shares
=eturnthe
shares
Short sale
7 sale in hich the seller does not actuallyon the security that is sold.
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Short Sales
7n investor ith a long $osition
enefits from $rice increases.Buylow,sellhigh
Sellhigh,
!uylow
(n the other hand an investor
ith a short $osition enefits
from $rice decreases.
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Short Sales
Example $hort $ales
ou ant to short 644 Sears shares at 94 $er share.
our ro!er has a 34 initial margin and a 4
maintenance margin on short sales. %orth of stoc! orroed L 94 U644 L 9444
:iailities & 7ccount 8Ouity7ssets
>roceeds from sale 9444 Short $osition 9444
Initial margin de$osit 6344 7ccount eOuity 6344
#otal 344 #otal 344
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Short Sales
Example $hort $ales continued
Scenario 6) #he stoc! $rice falls to 24 $er share.
:iailities & 7ccount 8Ouity7ssets
>roceeds from sale 9444 Short $osition 2444
Initial margin de$osit 6344 7ccount eOuity 2344
#otal 344 #otal 344
e margin L 2344 5 2444 L 623
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Short Sales
Example $hort $ales continued
Scenario 2) #he stoc! $rice rises to 4 $er share.
:iailities & 7ccount 8Ouity7ssets
>roceeds from sale 9444 Short $osition 444
Initial margin de$osit 6344 7ccount eOuity 344
#otal 344 #otal 344
e margin L 344 5 444 L 62.3 P 4
#herefore you are suect to a margin call.
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Short Sales
ou can calculate the critical $rice on a short sale , thehighest $rice efore you get a margin call- as follos )
>A L ,initial margin de$osit R short $roceeds - 5 numer ofshares
QQQQQQQQQQQQQQQQQQQQQQQQQQQQQQQ 6 R maintenance margin
For e*am$le ) su$$ose you shorted 6444 shares at 34 theinitial margin is 34 and the maintenance margin is 4 .
hat is the critical stoc! $rice and ho do you inter$ret it / >A L ,23444 R 34444 - 5 , 6444 shares - W 5 ,6 R 4 -
>A L 39.3;
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Short Sales
In $ractice short selling is Ouite common and
a sustantial volume of stoc! sales are initiated
y short sellers.
ote that ith a short $osition you may lose
more than your total investment as there is no
limit to ho high the stoc! $rice may rise.
Short interest
#he amount of common stoc! held in short$ositions.
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Investor oectives constraints and strategies
Different investors ill have very different investmentoectives and strategies for e*am$le some ill e veryactive uying and selling freOuently others
%ill e relatively inactive uying and holding for long
$eriods of time . Investment mean that e sim$ly deferred consum$tion
instead of s$ending today e choose to ait ecause e ishto have more to s$end later so there are no difference eteeninvesting and saving .
#he $articular investment strategy ill e chosen de$end onamong other things ) illingness to ear ris! the time horiHon and ta*es .
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=is! and =eturn
In formulating investment oectives the
individual must alance return oectives ith
ris! tolerance.
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Investor Constraints
Resources.%hat is the minimum sum needed/
%hat are the associated costs/
-ori(on.%hen do you need the money/
i&uidity. ?o high is the $ossiility that you
need to sell the asset Ouic!ly/
!axes.%hich ta* rac!et are you in/
$pecial circumstances.Does your com$any
$rovide any incentive/ %hat are your
regulatory and legal restrictions/
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Strategies and >olicies
In'estment management. Should you manage
your investments yourself/
%arket timing.Should you try to uy and sell
in antici$ation of the future direction of the
mar!et/
BePassive
Be
"ctiv
e
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Strategies and >olicies
"sset allocation.?o should you distriute
your investment funds across the different
classes of assets/
$ecurity selection.%ithin each class hich
s$ecific securities should you uy/
BePassive
Be
"ctiv
e
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Strategies and >olicies
" useful /ay to distinguish asset allocation
from security selection is to note that assets
allocation is essentially a macro0le'el acti'itybecause the focus is on /hole markets or
classes of assets .security selection is a much
more micro 1le'el acti'ity because the focus ison indi'idual securities .
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2002 by The McGraw-Hill Co!anies" Inc# $ll ri%h&s reser'ed#McGraw Hill / Irwin
Cha$ter =evie
'etting Started Choosing a Bro!er
(nline Bro!ers
Security Investors >rotection Cor$oration
Bro!er0Customer =elations
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2002 by The McGraw-Hill Co!anies" Inc# $ll ri%h&s reser'ed#McGraw Hill / Irwin
Cha$ter =evie
Bro!erage 7ccounts Cash 7ccounts
Margin 7ccounts
7 ote on 7nnualiHing =eturns
?y$othecation and Street ame =egistration
(ther 7ccount Issues
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Cha$ter =evie
Short Sales Basics of a Short Sale
Some Details
Investor (ectives Constraints and
Strategies =is! and =eturn
Investor Constraints
Strategies and >olicies