Chapter 2 Buying and Selling Securities

2-2 Buying and Selling Securities “Take all your savings and buy some good stock and hold it till it goes up. If it don’t go up, don’t buy it.” “Half our life is spent trying to find something to do with the time we have rushed through life trying to save." – Will Rogers

2-3 Learning Objectives In this chapter we will understand: 1. The various types of securities brokers and brokerage accounts. 2. How to calculate initial and maintenance margin. 3. The workings of short sales.

2-4 The Brokerage Account A brokerage account is an account with a securities firm that allows you to buy and sell securities.

2-5 Choosing a Broker Brokers are now divided into three groups: 1.Full-service brokers 2.Premium brokers 3.Discount brokers These three groups can be distinguished by the level of service provided, as well as the level of commissions charged.

2-6 Choosing a Broker As the brokerage industry becomes more competitive, the differences among broker types continues to blur. Another important change is the rapid growth of online brokers, also known as e-brokers or cyberbrokers. Online investing has really changed the brokerage industry. –slashing brokerage commissions –providing investment information –Customers place buy and sell orders over the Internet

2-7 Securities Investor Protection Corporation Securities Investor Protection Corporation (SIPC): Insurance fund covering investors’ brokerage accounts when member firms go bankrupt or experience financial difficulties. 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. Important: The SIPC does not guarantee the value of any security (unlike FDIC coverage). Rather, SIPC protects whatever amount of cash and securities that were in your account, in the event of fraud or other failure.

2-8 Broker-Customer Relations There are several important things to remember when you deal 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. – However, brokerage firms make profits from brokerage commissions.

2-9 Brokerage Accounts A Cash account is a brokerage account in which securities are paid for in full. A Margin account is a brokerage account in which, subject to limits, securities can be bought and sold short on credit.

2-10 Margin Accounts In a margin purchase, the portion of the value of an investment that is not borrowed is called the margin and is represented as a percentage of the total investment. Of course, the portion that is borrowed incurs an interest charge. –The interest rate that is charged customers for borrowing to buy shares is normally based on the call money rate or the prime rate. –Call money rate is the rate charged by banks to brokers for money used to finance investors' margin loans. –Prime rate is the rate at which banks will lend money to their most- favored customers.

2-11 Margin Accounts Assets Liabilities and Account Equity Value of shares purchased Margin Loan Account Equity Total To understand the set up of a margin account, it is useful to construct a ‘balance sheet’ in the following format:

2-12 Margin Accounts In a margin purchase, the minimum margin that must be supplied is called the initial margin. Reg T requires that a customer must deposit at least 50% of the value of the margin purchase The maintenance margin is the margin amount that must be present at all times in a margin account. This margin can vary but it is typically 30 – 35%.

2-13 Margin Accounts When the margin drops below the maintenance margin, the broker can demand more funds. This is known as a margin call. Margin is a form of financial leverage. It magnifies your losses and gains.

2-14 Below what price do we receive a margin call? We can solve for the critical stock price using the following equation:

2-15 Annualizing Returns A holding period return (HPR) is the percentage by which the value of an asset has grown for a particular period. This period usually coincides with when you buy and sell the asset. However, to compare investments it is more useful to calculate the effective annual return (EAR). The EAR is the return on an investment expressed on a per-year or annualized basis: where m is the number of periods in a year.

2-16 Hypothecation and Street Name Registration Hypothecation is the act of pledging securities as a collateral against a loan. This pledge is needed so that the securities can be sold by the broker if the customer is unwilling or unable to meet a margin call. Street name registration is an arrangement under which a broker is the registered owner of a security. (You, as the account holder are the “beneficial owner.”)

2-17 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 authorize your broker to trade for you. –Asset management account - Provide for complete money management, including check-writing privileges, credit cards, and margin loans.

2-18 Short Sales Note that an investor who buys and owns shares of stock is said to be “long the stock” or to have a “long position”, someone who short sells a stock is said to be “short the stock” or to have a “short position.” Short Sale is a sale in which the seller does not actually own the security that is sold. Borrow shares from someone Borrow shares from someone Sell the Shares in the market Sell the Shares in the market Buy shares From the market Buy shares From the market Return the shares Return the shares TodayIn the Future

2-19 Short Sales An investor with a long position benefits from price increases. –Easy to understand –You buy today at $34, and sell later at $57, you profit! –Buy low, sell high An investor with a short position benefits from price decreases. –Also easy to understand –You sell today at $83, and buy later at $27, you profit. –Sell high, buy low When you decide to close your position by buying the shares it is called “covering the position.”

2-20 Short Sales Similar to purchasing shares on margin, short sales also require an initial margin. This initial margin is 50% of the short sales proceeds. Additionally, you must leave the proceeds from the short sale in your account. Finally, you are responsible for paying any dividends that the stock pays.

2-21 Short Sales The balance sheet for a short sales transaction: Assets Liabilities and Account Equity Sale Proceeds Short Position Initial Margin Deposit Account Equity Total

2-22 What is the critical (margin call) price for a short sale? Just like when purchasing stock on margin, if your short sale margin falls below the maintenance margin, you will receive a margin call. The margin for a short position is calculated as the account equity divided by the value of the short position. The price below which you will receive a margin call is:

2-23 More on Short Sales Short interest is 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 theoretical limit to how high the stock price may rise. From September 19, 2008 to October 2, 2008, the SEC banned short-selling on 799 financial stocks in an attempt to reduce the downward pressure on the markets. A company’s (or exchange’s) short interest can provide you with an indication of investor’s perception of the stock or market.

2-24 Readings Chapter 2 up to page 55.