INVESTMENTS

1
INVESTMENTS

• Lecture 3
• How Securities Are Traded

2
Objectives

• Explain brokers roles and how brokerage firms
  operate
• appreciate the changing nature of the securities
  business
• understand how orders to buy and sell securities
  work in various marketplaces
• assess the role of regulation in the securities
  markets
• understand how margin trading and short selling
  contribute to investor opportunities

3
Investing Your Money

• Where do you go to invest and what type of
  account do you want to use?
• Where
• Full service broker
• Discount broker
• On-line brokerage service
• What type of account
• Cash account
• Margin account
• Asset management account
• Wrap account

4
Market Mechanics

• Types of orders
• 1. Market order
• Order to buy or sell a stock at the best
  available price
• Most common order type
• May be issued as a discretionary order, where
  your broker has the right to hold the order in
  order to get a better price.

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Example 1

• Assume we want to buy 1000 shares of Disney.
• We call our broker and enter a market order for
  Disney.
• At the time of the order the quotes on Disney are
  33½ bid and 33¾ ask.
• This means the highest quote the Disney
  specialist has to buy Disney is 33½ and the
  lowest price anyone will sell at is 33¾.
• Our market order will be filled at 33¾ so our
  transaction will cost 33750 plus commissions.

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Example 2

• I am aware of some anecdotal evidence regarding
  an investor who wanted to purchase an internet
  stock.
• A market order was placed for 1000 shares at 9
  (the current price)
• The order was filled at 90
• The stock closed the next day at 40

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Market Mechanics

• Types of orders
• 2. Limit Order
• A limit order is a buy or sell order that is
  executed at a specified price or a more favorable
  price. The limit order is given to the
  specialist who executes the order when the price
  is met.
• Limit orders can be for virtually any time period
  some typical orders are
• day order
• open-ended order (good until canceled or GTC)

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Example 3

• Assume we again want to buy Disney but do not
  want unless the price hits 31.
• We would make a limit buy order with a broker at
  31.
• The broker will transfer the order to the
  specialist who enters the order in a limit book.
• Your order will be filled if the ask price of
  Disney falls to or below 31.

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Market Mechanics

• Types of orders
• 3. Stop loss order
• This is an order you put in to insure a limited
  loss on a stock. Stop loss orders become a
  market order once the specified price is reached.
  

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Example 4

• Assume we buy Disney at 31 and want to insure we
  do not lose too much on the stock.
• We can place a stop loss order at 27 and if
  Disney falls to 27 the order will automatically
  be executed.
• In a SLO the stock might be sold at less than 27

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Market Mechanics

• Types of orders
• 4. Stop buy order
• Opposite of a stop loss, generally used to cover
  short positions
• 5. Stop limit order
• Combination of a stop and limit order.
• The order becomes a limit order as soon as a bid
  or ask is made at a price equal to or less
  favorable than the stop price.
• With a stop limit order you must give the broker
  two prices a stop price and a limit price.

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Example 5

• Suppose that we bought Disney for 33¾. We want
  to protect ourselves against losses so we could
  put a stop limit order with a stop at 30 and a
  limit at 28.
• Once the bid price of Disney falls below 30 a
  limit order of 28 will be placed.

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Market Mechanics

• Types of orders
• 6. Market-if-touched
• The order is executed at the best available price
  after a trade occurs at a specified price. This
  differs from a limit order which must be executed
  at the limit price or a more favorable price.

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Market Mechanics

• Short sales
• A short sale is executed when a trader expects
  the price of a security to fall
• Short sales involve borrowing a security and
  selling it and then buying the security back at a
  lower price and returning it to the owner.

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Example 6

• Assume we think the price of Disney is going to
  fall. We will sell Disney short in order to
  benefit from this price decrease
• In order to do this we would borrow 1000 shares
  of Disney and sell it for 33½. We receive 33500
  for this transaction.
• If Disney falls to a 30 ask price we can buy
  1000 shares of Disney for 30000 and return it to
  its owner.
• We make 33500 30000 3350 less commission
  and interest on the transaction.

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Market Mechanics

• Short sales
• Short sale restrictions
• Short sales can only be made on an up-tick
• The short position owes the owner of the security
  any dividends paid.
• In order to short a stock you must have a margin
  account with a broker

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Market Mechanics

• Margin accounts
• Margin refers to borrowing part of the cost of a
  security when a purchase is made
• The amount of money that is put up by the
  investor is referred to as the margin.
• Your broker will charge you interest on the
  margin. Typical interest rates are 1.5 above
  the call money rate (which is generally slightly
  below the prime rate)

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Market Mechanics

• Margin Accounts
• Initial margin
• Initial margin is the part of the original
  transaction value paid for by the investor
• Currently the initial margin requirement on stock
  is 50 (required by law)
• Brokers can charge higher initial margins
• Investors equity
• The investor's equity position is the market
  value of the stock minus the amount borrowed
• Actual margin
• (investors equity)/(market value)

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Market Mechanics

• Margins accounts
• Maintenance margin
• Maintenance is the minimum value the actual
  margin can reach before a margin call is made.
  Current requirements call for a minimum
  maintenance margin of 25.
• Margin call
• A margin call requires the investor to either put
  up enough cash to restore the initial margin
  requirement of 50 or close the position

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Example 7

• Assume we want to buy 1000 shares of Disney at
  35 using a margin account. The initial margin
  requirement is 50 and the maintenance margin is
  35
• Now assume Disney goes to 45
• What is the market value?
• What is the investors equity?
• What is the actual margin?
• What is the return? Return without margin?

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Example 7 (cont.)

• Now assume Disney falls to 30
• Now Disney falls to 20
• At what price will a margin call occur?

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Example 8

• Suppose you buy a round lot of Maginn Industries
  stock on 55 margin when the stock is selling at
  20 a share. The broker charges a 10 annual
  interest rate and commissions are 3 of the total
  stock value on both purchase and sale. A year
  after purchase you receive a 50 cent dividend and
  sell the stock for 27. What is your rate of
  return on this stock?

23
Example 9

• You decide to sell short 100 shares of Charlotte
  Horse Farms when it is selling at its yearly high
  of 56. Your broker tells you that the margin
  requirement is 45 percent and the commission on
  the purchase is 155. While you are short the
  stock, Charlotte pays a 2.50 per share dividend.
  At the end of one year you buy 100 shares of
  Charlotte at 45 to close out your position and
  are charged a commission of 145 and 8 interest
  on the money borrowed. What is your rate of
  return on this investment?