1. Chapter 3 Buying & selling securities
Principles of Investing FIN 330

2. Student Learning Objectives
Investing v-v Investments
Market Trading Dynamics
Full Service vs. Discount Brokers
Types of Accounts
Types of Orders
Measuring Investment Performance
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Dr. David P Echevarria

3. Investing
For many students of investments - there is a large disconnect between “learning about investing” and “learning how to invest”.
The goal of this chapter is to be sure that you understand exactly what it would take to physically invest your money.

4. A Usual First Step to Investing
Employer-sponsored retirement plans
Your employer may offer you the opportunity to invest in a retirement plan that they administer on your behalf.
401(k), 403(b), or 457
Your employer may offer you the opportunity to direct a percentage of your paycheck into a qualified plan.
Qualified plans provide certain tax incentives.
Your employer may even match a portion of your contribution.
Example: 100% on the first 6%

5. A Second Option For Investing
Brokerage Account
An arrangement with an investment company that allows the owner to trade and hold securities within the account.
Once established, a brokerage account generally offers you significantly more flexibility for your investments than an employer-sponsored plan.
You can choose to invest for retirement or any other financial goals.
Account types (taxable, IRA, Roth, 529, etc.)

6. Stock Brokers Full service brokerage firm Discount broker
Assigned broker - personalized service
Gives investment advice (research reports)
Executes orders
Discount broker
Lower commissions
Some advise (research reports)
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Dr. David P Echevarria

7. Stock Brokerage Accounts
Cash account
Pay full cost of all securities purchased
2 business days settlement (recent change)
“Investors must settle their security transactions in two business days. This settlement cycle is known as "T+2" — shorthand for "trade date plus two days."
Margin account
Finance portion of purchases (interest charges)
Short sellers must have a margin account
Subject to hypothecation agreement (stock as collateral)
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Dr. David P Echevarria

8. Stock Brokerage Accounts
Management of Accounts
In most cases, any equities held in a brokerage account are held in street name, which means that the broker’s name appears on the certificate (instead of your name).
This makes owning stocks much more convenient as the broker can transfer securities with much less risk and delay than individual owners.

9. Using Margin Accounts
Most brokerage firms are willing to lend money to margin account holders at an interest rate only slightly higher than the “call money rate”, which is the rate at which banks are willing to lend to the investment company.
Since margin accounts allow you to invest with the broker’s money, there is the opportunity to leverage your investment dollar.
Investing on margin provides the potential to earn higher returns on your investment dollars, but also has significant risks.

10. Using Margin Accounts
Initial margin – the minimum margin that must be supplied on a securities purchase.
Since 1974, this has been 50% for stocks
Set by the FED
Maintenance margin – the minimum margin that must be present at all times in a margin account.
Called “house” margin as it is set by the broker
For the NYSE – this is 25%, but many brokers may require 30%
Margin call – a demand for more funds that occurs when the margin in an account drops below the maintenance margin.

11. Types of Orders Market Order Limit Order Stop [Loss] Order
Buy or sell at the best current price
Settlement within three days
Limit Order
Puts a limit on price
Time period can vary: day, GTC
Stop [Loss] Order
Becomes order if price reaches specified price
No guarantee of execution at specified price
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Dr. David P Echevarria

12. Types of Orders D. Trailing Stop Orders
A sell trailing stop order sets the stop price at a fixed amount below the market price with an attached "trailing" amount.
As the market price rises, the stop price rises by the trail amount, but if the stock price falls, the stop loss price doesn't change, and a market order is submitted when the stop price is hit.
"Buy" trailing stop orders are the mirror image of sell trailing stop orders, and are most appropriate for use in falling markets.
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Dr. David P Echevarria

13. Stock Positions Buying Long Selling Short
Expectation - market heading higher
Purchase stock via market order at the Ask
Purchase stock via limit order at specified price
Selling Short
Expectation - market heading lower
Stock borrowed from broker
Profits on drop in prices (buy back at price lower than sell price)

14. Trade Volumes Round Lot Block Trade 100 shares
Odd lot: 103 shares => 1 round lot plus 3 share odd
Block Trade
10,000 shares or more (100 round lots)
Dominated by institutions; i.e., mutual funds
Frequently accomplished away from the floor (3rd market ~ ECN)

15. Market [health] indicators
Dow Jones Industrial Average (DJIA): 30 largest industrials (price-weighted index)
Standard & Poor’s 500 Stock Index (~ 75% of total stock market value) (value weighted index)
NASDAQ – 100 stocks, also 500
Bond Indexes: Treasuries dominate
Mutual Fund Indexes: Lipper, Morningstar
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Dr. David P Echevarria

16. Homework Questions
1. In what important ways do Discount Brokers differ from Full Service Brokers? 2. Explain the difference between a cash account and a margin account. 3. What is meant by 2-Day settlement? 4. How does a Limit order differ from a Market order? 5. How does a Stop order differ from a Limit order? 6. What is the difference between a Long position and a Short Position? What are the investor’s expectations for each position type? 7. Describe the initial margin on a short sale? When does a margin call happen? 8. Explain the price-weighted average concept as applied to the Dow Jones Industrial Average. 9. Explain the value-weighted index concept as applied to the S&P 500. How do large market-value firms dominate the SP500 index?

17. Margin example
Margin Trading: Initial Conditions X Corp Stock price = $70 50% Initial Margin 40% Maintenance Margin 1000 Shares Purchased
Initial Position
Stock
$70,000
Borrowed
$35,000
Equity

18. What if the price falls to $60?
New Position
Stock
$60,000
Borrowed
$35,000
Equity
$25,000
The margin percentage is now $25,000/$60,000 = 41.67%
What was the maintenance margin requirement? (40%)
Do we get a margin call?

19. When would we get a margin call?
When trading on margin, most traders wish to know how far the price of their stock could drop before receiving a margin call.
To find this value, take the borrowed amount and divide it by (1 – MMR).
Market value = $35,000 / (1 – 0.40) = $58,333
When the share price falls to $58.33, we will receive a margin call.

20. Selling Short
Suppose you thought a stock price would decrease in value.
You would obviously sell if you had any, but you can take it a step further and sell even more.
This is a short sale – you actually sell a security you do not own.
If the price goes down – you can then buy it at the decreased price and pocket the difference (this is called covering).

21. Some details on short sales
Required initial margin: usually 50% but more for low priced stocks.
If any dividends are paid on the stock while you have the short position, you must pay them.

22. Short sale example
Assume you sell short 100 shares of stock priced at $60 per share.
The proceeds of $6,000 must be pledged to broker.
You must also pledge 50% margin.
You put up $3,000 of your own money.
This means you have a total of $9,000 invested in the margin account.
Why the $3000 margin? Should you lose the bet and cannot make a margin call, the 50% helps to cover losses by Broker when they close the position.

23. Short sale example continued
Assume that the MMR for your short sale is 30%. This equates to a market value of: 30% × $6,000 = $1,800
Therefore, having met the IMR (you put up $3,000), you have $1,200 of excess margin over the MMR.
At what price will you get a margin call?
When the: Market Value = the Total Margin Account / (1+MMR).
Market value = $9,000 / ( ) = $6,923
You receive a margin call when the price of the stock rises to $69.23.

24. But how do you make money with a short sale?
When you sell short – you want the price of the stock to decline so you can buy it back at a less expensive price.
For example – what if the price of the stock declined to $50 and you then closed out (bought back) the stock?
You are able to keep the difference.
$6,000 original proceeds - $5,000 stock replenishment = $1,000 profit.