L ECTURE N O. 3 M Fahad Siddiqi Lecturer - Finance IBMS

T OPICS FOR TODAYS LECTURE What is Stock Market Basic Terminologies of Stock Market How to deal in Stock Market What is Index What is Free Floating Capitalization How KSE-100 Index is calculated What is the Short Selling & its Process

B ASIC T ERMINOLOGIES OF S TOCK M ARKET Averaging Down : This is when an investor buys more of a stock as the price goes down. This makes it so your average purchase price decreases. Bear Market : This is trading talk for the stock market being in a down trend, or a period of falling stock prices. This is the opposite of a bull market. Beta : A measurement of the relationship between the price of a stock and the movement of the whole market. If stock XYZ has a beta of 1.5, that means that for every 1 point move in the market, stock XYZ moves 1.5 points and vice versa. Blue Chip Stocks : These are the large, industry leading companies. They offer a stable record of significant dividend payments and have a reputation of sound fiscal management. The expression is thought to have been derived from blue gambling chips, which is the highest denomination of chips used in casinos.

A BOUT S TOCK M ARKET “Stock market” is a term used to describe the physical location where the buying and selling of stocks take place. The correct term to be used in pertaining to the physical location for trading stocks is “stock exchange.” The Stock market in Pakistan consists of about 3 stock markets. KSE is the largest one The stock exchanges constitute a market where securities issued by the Central & State Govt., Public bodies & Joint Stock companies are traded.

B ASIC T ERMINOLOGIES OF S TOCK M ARKET Bull Market : This is when the stock market as a whole is in a prolonged period of increasing stock prices. Opposite of a bear market. Broker : A person who buys or sells an investment for you in exchange for a fee (a commission). Day Trading : The practice of buying and selling within the same trading day, before the close of the markets on that day. This is what Tim typically does, although he does have a long-term portfolio as well. Traders that participate in day trading are often called “active traders” or “day traders.” Dividend : this is a portion of a company’s earnings that is paid to shareholders, or people that own Hat Company’s stock, on a quarterly or annual basis. Not all company’s do this.

B ASIC T ERMINOLOGIES OF S TOCK M ARKET Exchange : An exchange is a place in which different investments are traded. The most well-known in the Pakistan is KSE. Execution : When an order to buy or sell has been completed. If you put in an order to sell 100 shares, this means that all 100 shares have been sold. Hedge : This is used to limit your losses. You can do this by taking an offsetting position. For example, if you hold 100 shares of XYZ, you could short the stock or futures positions on the stock. Index : An index is a benchmark which is used as a reference marker for traders and portfolio managers. It tells about the performance of the stock.

B ASIC T ERMINOLOGIES OF S TOCK M ARKET Initial Public Offering (IPO) : The first sale or offering of a stock by a company to the public, rather than just being owned by private or inside investors. Margin : A margin account lets a person borrow money (take out a loan essentially) from a broker to purchase an investment. The difference between the amount of the loan, and the price of the securities, is called the margin. Moving Average : A stock’s average price-per-share during a specific period of time. Some time frames are 50 and 200 day moving averages. Order : An investor’s bid to buy or sell a certain amount of stock or option contracts. You have to put an order in to buy or sell 100 shares of stock.

B ASIC T ERMINOLOGIES OF S TOCK M ARKET Portfolio : A collection of investments owned by an investor. You can have as little as one stock in a portfolio to an infinite amount of stocks. Quote : Information on a stock’s latest trading price. This is sometimes delayed by 20 minutes unless you are using an actual broker trading platform. Rally : A rapid increase in the general price level of the market or of the price of a stock. Sector : A group of stocks that are in the same business. An example would be the “Technology” sector including companies like Apple and Microsoft. Spread : This is the difference between the bid and the ask prices of a stock, or the amount someone is willing to buy it and someone is willing to sell it.

B ASIC T ERMINOLOGIES OF S TOCK M ARKET Stock Symbol : A one-character to three-character, alphabetic root symbol, which represents a publically traded company on a stock exchange. Apple’s stock symbol is AAPL. Volatility : This refers to the price movements of a stock or the stock market as a whole. Highly volatile stocks are ones with extreme daily up and down movements and wide intraday trading ranges. This is often common with stocks that are thinly traded, or have low trading volumes. This is also common with the stocks that Tim trades. Volume : The number of shares of stock traded during a particular time period, normally measured in average daily trading volume.

B ASIC T ERMINOLOGIES OF S TOCK M ARKET Yield : This usually refers to the measure of the return on an investment that is received from the payment of a dividend. This is determined by dividing the annual dividend amount by the price paid for the stock. If you bought stock XYZ for $40-a-share and it pays a $1.00-per-year dividend, you have a “yield” of 2.5% Corrections : A reverse movement, usually negative, of at least 10% in a stock, bond, commodity or index to adjust for an overvaluation. Corrections are generally temporary price declines interrupting an uptrend in the market or an asset. A correction has a shorter duration than a bear market or a recession, but it can be a precursor to either.

T RADING AT S TOCK E XCHANGE To buy and sell shares at stock exchanges, investors have to open accounts with brokerage houses In Pakistan, most of the brokerage houses require initial deposit of Rs.100,000, some allow deposit of Rs.50,000 There are 200 member of KSE Account opening form Broker’s Guidelines KSE Calculation Guide

After opening an account, an investor can trade by placing orders through phone, or internet (live accounts) Orders placed for purchase of shares are called bid order Orders placed for sale of shares are called offer orders T RADING AT S TOCK E XCHANGE

T YPE OF O RDERS Broadly classified: Two types of orders Limit Orders Market Orders

L IMIT O RDERS When an investor specifies the price at which he is willing to buy or sell, such orders are called Limit order Limit orders are sorted on the basis of price and then on first come and first serve basis Bid orders with highest bid price are placed at the top Offer orders with the lowest offer prices are placed at the top

O RDERS S ORTING Orders with similar prices are sorted on the basis of first come first serve Orders at the top are fulfilled first Limit orders are fulfilled only when matching price is available i.e. a bid order of 100 shares at Rs.30 each will have to wait until someone offers his shares at Rs.30 Limit orders are fulfilled neither below nor above the price at which they are placed

E XAMPLE O RDERS S ORTING 1. A bid order of 5000 shares of NML is placed with Rs.70 a share 2. Another investor bids 100 shares of NML at Rs SNoBid QPriceOffer QPrice SNoBid QPriceOffer QPrice

3. An order for sale of 3000 shares of NML at Rs. 72 is placed 4. A purchase order of 700 share at Rs is placed SNoBid QPriceSN o Offer QPrice SNoBid QPriceSN o Offer QPrice

5. Someone offers 1000 shares of NML at Rs a share 6. A bid order to buy 1000 shares at market is placed SNoBid QPriceSN o Offer QPrice SNoBid QPriceSN o Offer QPrice

M ARKET O RDERS Orders that are to be executed immediately at currently placed limit orders If a market order is not completely fulfilled from the top limit order, it is fulfilled from the next limit order in the sequence

T YPES OF LIMIT ORDERS Stop Loss order: The stock has to be sold if its price falls bellow stipulated level Allow investor to avoid unexpected losses Also useful in very uncertain markets At KSE, maximum variation in prices is 5% per day One can place stop loss order at 3% and avoid the 2% loss, if anything abnormal happens with the stock

Stop-Buy Orders: Specifies that a stock should be bought when price of a security rises above a limit It is usually used with short-sell to limit possible losses from short position At KSE, orders have a validity of one day

B ROKER ’ S C OMMISSION ; L IVE T RADE O NLINE

Introduced at 1 st November 1999 with base value of 1,000 points. 100 companies selected on the basis of sector representation and highest market capitalization. Captures over 80% of the total market capitalization. Out of the following 35 Sectors, 34 companies are selected i.e. one company from each sector (excluding Open-End Mutual Fund Sector) History KSE100 index

LIST OF SECTORS 1. Open-end Mutual Funds19. Oil & Gas Marketing Companies 2. Close-end Mutual Funds20. Oil & Gas Exploration Companies 3. Modarabas21. Engineering 4. Leasing Companies22. Automobile Assembler 5. Investment Banks/Investment Cos./Securities Cos. 23. Automobile Parts & Accessories 6. Commercial Banks24. Cable & Electrical Goods 7. Insurance25. Transport 8. Textile Spinning26. Technology & Communication 9. Textile Weaving27. Fertilizer 10. Textile Composite28. Pharmaceuticals 11. Woollen29. Chemical 12. Synthetic & Rayon30. Paper & Board 13. Jute31. Vanaspati & Allied Industries 14. Sugar & Allied Industries32. Leather & Tanneries 15. Cement33. Food & Personal Care Products 16. Tobacco34. Glass & Ceramics 17. Refinery35. Miscellaneous 18. Power Generation & Distribution

Objective KSE100 index The primary objective of the KSE100 index is to have a benchmark by which the stock price performance can be compared to over a period of time. In particular, the KSE 100 is designed to provide investors with a sense of how the Pakistan equity market is performing. Thus, the KSE100 is similar to other indicators that track various sectors of the Pakistan economic activity such as the gross national product, consumer price index, etc.

F REE F LOAT M ETHODOLOGY Free-Float means proportion of total shares issued by a company that are readily available for trading at the Stock Exchange. It generally excludes the shares held by controlling directors / sponsors / promoters, government and other locked-in shares not available for trading in the normal course. Free-Float calculation can be used to construct stock indices for better market representation than those constructed on the basis of total Free Float market capitalization of companies

F REE -F LOAT C ALCULATION M ETHODOLOGY : Total Outstanding Shares XXX Less: Shares held by Directors/sponsors XXX Government Holdings as promoter/acquirer/ Controller XXX Shares held by Associated Companies (Cross holdings) XXX Shares held with general public in Physical Form XXX XXX _______ Free-Float: XXX

D ETERMINING F REE -F LOAT F ACTOR : Free-Float Bands: % Free-Float Free-Float Factor > 0 – 5% 0.05 > 5 – 10% 0.10 >10 – 15% 0.15 >15 – 20% 0.20 >20 – 25% 0.25 >25 – 30% 0.30 >30 – 35% 0.35 >35 – 40% 0.40 >40 – 45% 0.45 >45 – 50% 0.50 >50 – 55% 0.55 >55 – 60% 0.60 >60 – 65% 0.65 >65 – 70% 0.70 >70 – 75% 0.75 >75 – 80% 0.80 >80 – 85% 0.85 >85 – 90% 0.90 >90 – 95% 0.95 >95 – 100% 1.00

STOCK SELECTION RULES Rule # 1 Largest market capitalization in each of the 34 Karachi Stock Exchange sectors excluding Open-end Mutual Fund Sector; Rule # 2 The remaining index places (in this case 66) are taken up by the largest market capitalization companies in descending order. Rule # 3 Company which is on the Defaulters’ Counter and/or its trading is suspended, declare Non-Tradable (i.e. NT) in preceding 6 months from the date of decomposition shall not be considered in the decomposition of KSE-100 Index.

CALCULATION METHODOLOGY

Maintenance of the index over time will require an on-going semi-annual recomposition process, internal and external- buffer files of shares that exceed (shares outside the index) or fall below (shares inside the index) the above criteria will be maintained under the jurisdiction of the Board of Directors/Management of the Exchange. Recomposition rules fall into two general categories: Sector Rules Free-Float Capitalisation Rules. RECOMPOSITION OF THE KSE- 100 INDEX

S ECTOR R ULES Two rules are recommended to undertake selection in this area-one, a time based rule and the other is a value-based rule. Application can be triggered by compliance with either rule. 1 Time-based rule: A company (not in the index) which becomes the largest in its sector (by any amount of value) will enter the index after maintaining its position as largest in the sector for two consecutive recomposition periods. 2 Value-based rule: A company (not in the index) which becomes the largest in its sector by a minimum of 10% greater in capitalisation value than the present largest in the sector (in the index) will enter the index after one recomposition period.

C APITALIZATION R ULE Capitalization rules govern the selection (or deletion) of companies on the basis of being among the largest free-float capitalization companies in the stock market. Only one rule applies here-time based rule. 1 Time-based rule: A company (not in the index) may qualify for entry if it exceeds the market cap value of the last stock in the index selected on the basis of market cap for two recomposition periods. A qualifying company automatically pushes out the lowest cap selected stock in the index.

R ULES FOR NEW ISSUES A newly listed company or a privatized company shall qualify to be included in the existing index (after one recomposition period) if the Free-Float Capitalization of the new or privatized company is at least 2% of the total Free-Float Capitalization.

RECOMPOSITION OF THE KSE- 100 INDEX Semi-annual recomposition process. Time-based rule Value-based rule Sector Rules Time-based rule Market Capitalization Rules Rules for new issues

AN EXAMPLE OF THE RECOMPOSTION OF THE KSE100 All divisor adjustment are made after the close of trading.

REPLACEMENT OF STOCK IN THE INDEX

A SSIGNMENT DIVIDEND, BONUS AND RIGHT ADJUSTMENTS

W HO SHOULD SHORT SELL ? Short selling is a more advanced investment strategy. It should be executed only by individuals that understand the markets and individuals who would take additional risks. This strategy, although simple in nature, is very confusing to a lot of individuals. After viewing this presentation you will understand: What short selling is How it works Caution: This presentation will not make you an expert. As always, speak with your financial advisor before making any investment decisions. Riskier Investors Investors with a firm understanding of short selling Investors that have discussed short selling with their financial advisor

W HAT IS SHORT SELLING ? Short selling is the investment process of borrowing a good from others, but later returning the good later. The idea here is to borrow high and return it low. For every unit this good goes decreases, you will earn a unit. For every unit the good increases, you will lose a unit. When shorting stocks, you will sell the stock when you believe the price of the stock is too high. Believing the stock is too high, you would want to take advantage of this and earn money while that markets push the stock down to its “fair value.” In other words, you believe the stock is over valued and you want to make money as it decreases in value. If you own the shares that you short, the short sell is said to be “covered.” If you borrow the shares from another person to short sell this is known as a “naked” short sale. Hey, we could not make that up.

C AVEATS Short selling is risky. The risky nature is exponentially greater when this investment style is performed on margin. Most short selling is through margin accounts. If the price goes up you will lose money. If it rises too much you will have to buy the shares back at a higher price. Losing money is never good.

B ASIC EXAMPLE This is an example of a good short sell. Stock XYZ $80 Jane believes that the stock XYZ is over valued based on her research and wants to short sell it. She calls Will, her advisor, and they agree that is an acceptable trade. Jane sells 100 shares at $80. Jane does not receive the $8,000 from the sell because she did not own the stock she sold, she borrowed it. One month passes and XYZ sinks to $60. Jane calls Will and tells him to cover her sale because she believes the stock is fairly valued. She buys the 100 shares at $60 for a total of $6,000 and pockets the remaining $2,000. Stock XYZ $60 $80 x 100shares = $8, This example assumes no transactions costs in order to simplify it. $60 x 100 shares = $6,000.00

B ASIC EXAMPLE This is an example of a bad short sell. Jane believes that the stock XYZ is over valued based on her research and calls her financial advisor Will. Will agrees that the stock price is high and short sells 100 shares of XYZ at a price of $80. Jane on paper received the proceed of $8,000. Two days later XYZ corp. comes out with a magic widget that everyone will need. This news sends the price of XYZ upwards around $110. Jane calls Will and tells him to cover her position immediately. She buys the stock at $110 to cover her position and is out $3,000 ($30 x 100 shares). Again, we assume no transactions costs to simplify this example.

P ICTURE IS WORTH WHAT ? Another way to look at short selling is illustrated below: 1 st Sell High 2 nd Buy Low 2 nd Sell High 1 st Buy Low Short Selling Normal Investing Theory

C ONCLUSION Typically, if the overall market is declining and the industry, of the short selling stock, is in peril, you should earn money on the short sell. Combining your individual research, understanding of short selling, and understanding of the economy/markets will make you a better investment decision maker. We can not stress the point of individual research and discussing this style of investing with your financial advisor.

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