Buying and Selling Equities

1
Chapter 4

• Buying and Selling Equities

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CHAPTER 4 OVERVIEW

• Simple Buy-Sell Decisions
• Buying on Margin
• Selling Short
• Initial Public Offerings
• Individual Retirement Accounts
• Taxes

3
KEY TERMS Buying Selling Equities

• Bid
• Ask
• bid-ask spread
• ticker symbols
• bid size
• round lots
• market depth
• inverted bid-ask spread
• market order
• limit order
• stop order

• stop-limit order
• day order
• stopped out
• buy stop order
• stop-loss order
• stop-limit order
• day order
• open order
• good til canceled order
• All-or-none
• fill-or-kill

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Stock Quotes from freerealtime.com

• PHILLIPS MORRIS COS-NYSEMO
• Bid (size) Ask(size)
• 19.63(1000) 19.69(631)
• Deep market

• T.ROWE PRICE ASSOC-NASDAQ Stock MarketTROW
• Bid(size) Ask(size)
• 32.81(5) 33.13(1)
• Relatively thin market

• If you would like to buy Phillips Morris Stock,
  which price should you look at? The price under
  bid or under ask?
• If you would like to sell Phillips Morris Stock,
  which price should you look at? The price under
  bid or under ask?
• What does the size measure?
• How do you measure the depth of the market?

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Simple Buy-Sell Decisions

• Bid highest price an investor is willing to pay
  to buy a security
• Ask lowest price an investor will accept to sell
  a security
• Bid-Ask Spread gap between bid and ask prices
  for a particular security
• price markup that investor faces
• profit margin for specialist or margin maker
• usually positive in unusually volatile markets,
  spread becomes inverted, with bid price higher
  than ask price
• Ticker Symbol unique stock identifier
• One, two, or three letters on NYSE
• Four letters on OTC

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EVALUATING MARKET DEPTH How Many Buyers and
Sellers?

• Round Lot 100 shares of stock
• Bid Size number of round lots sought by current
  buyers at any moment
• MO Bid size 1000? the bid price of 19.63 is
  good for 1000100 100,000 shares
• Ask Size number of round lots for sale at any
  moment
• MO Ask size 631? the ask price of 19.69 is good
  for ____100 _______ shares
• Measure of Price Stability gauges supply and
  demand and identifies upward or downward pressure
  on price

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Inverted Bid-Ask Spread Again

• Inverted bid-ask spread The quoted bid price is
  higher/ lower than the quoted ask price
• If the bid size is only 100 shares, an eager
  seller of 10,000 shares might end up with
  accepting a lower price.
• Which scenario do you think that the inverted
  bid-ask spread most likely occur?
• The bid size is very large compared with the ask
  size.
• The bid size is very small compared with the ask
  size.

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THE LONG AND THE SHORT OF IT

• Long signifies ownership or those who hold a
  security
• Going long purchasing a security
• Being long having a net positive position in a
  security
• Taking a long position expecting prices to rise
  bullish

• Short signifies sale or those who owe a security
• Shorting a stock selling a security even when
  you dont own it
• Being short having a net negative position in a
  security
• Taking a short position expecting prices to
  fall bearish

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JUST FOLLOWING ORDERS..

• Market order instructions to buy or sell at
  current price
• Limit order instructions to buy or sell at a
  specific price
• Stop order market order to buy or sell a certain
  quantity if a particular price is reached or
  passed
• Stopped out when a purchase or sale is offset by
  the execution of a stop order

• Buy stop buy order held until market price rises
  to specific stop price
• Stop-loss order stop order to sell a security
  purchase (a long position) at a specific price
  below the current market
• Stop-limit order order to buy or sell at a
  specified price or better, but only after market
  reaches a specified price

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ExampleStop, Stop-Loss Order

• Stop-Loss Order
• You own 100 shares of AOL,which is currently
  selling for 50 per share.
• Because you believe that the stock price could
  decline rapidly at any time, you place a
  stop-loss order to sell at 40. (You do not want
  to hold the stock anymore if its price goes below
  that specified price. You would like to stop your
  loss from holding that stock.)
• If the stock price does in fact drop to 40, your
  100 share will be sold at the best price
  available at that time. In other words, once the
  price falls to the price you specified, the
  stop-loss order is converted to a market order to
  sell at the best price available.
• Your 100 shares will be sold at the best price
  available at that time. If the market price
  declines to 38 by the time your stop-loss order
  comes up, you will receive less than 40 per
  share, that is, youll end up with selling your
  stock for 39 per share

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ExampleStop, Stop-Loss Order

• Stop-Loss Order
• What happens if the market price stays above 40
  per share?
• You will have lost nothing as a result of placing
  the order because the stop order will never be
  initiated.

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ExampleStop, Stop-Loss Order

• Stop Order to Buy
• An investor may place a stop order to buy 100
  shares of MSFT, currently selling for 70 per
  share, once its price rises to 75. (the stop
  price)
• When to use this type of order?
• Limit losses on short sales.
• Buy a stock just as its price begins to rise.

13
ExampleStop-Limit Order

• Stop-Limit Order
• You own 100 shares of MSFT stocks, which is
  currently selling for 50 per share.
• Because you believe that the stock price could
  decline rapidly at any time, you place a
  stop-limit order to sell at 40.
• If the stock price does in fact drop to 40, your
  100 share will be sold at 40 0r better.
• There would be no risk of getting less than 40
  unless the price of the stock kept right on
  falling. In that case, as is true for any limit
  order, you might miss the market altogether and
  end up with stock much less than 40. Say, price
  from 50 to 41 to 39 and to 30 youll end up
  with stock for 30 per share.

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YOU WANT THAT WHEN?

• Day order instructions to buy or sell only
  during present trading session
• Open order limit order that has not yet been
  executed or filled
• Good-til-canceled order standing or open order
• All-or-none buy or sell instruction that must be
  filled exactly or not at all
• Fill-or-kill all-or-none order that must be
  immediately filled or canceled

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More

• What kind of order is it?
• Buy 100 shares of Walt Disney at the current ask
  price
• Buy 500 shares of Walt Disney at 35 or less
• Automatically expires if it cannot be executed
  during the trading session in which it is entered
• Stays active until it is executed or canceled by
  the investor
• In some instances, broker set a time limit of
  30-60 days
• Either fill the entire order or do not fill it at
  all
• Immediately fill the entire order or completely
  cancelled
• Why bother to use all-or-none or fill-or-kill
  order?
• The potential for paying higher brokerage
  commissions on orders that are executed in
  piecemeal fashion.

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DO YOU REMEMBER The difference between

• Defined Benefit Retirement Plans
• and
• Defined Contribution Retirement Plans???

Dollar-Cost Averaging Strategy of investing a
fixed amount in a security at regular intervals
ideal for defined contribution savings plans
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Retirement Plans

• Defined-benefit plans

• Defined-contribution plans

• Company agrees to pay fixed dollar amount based
  on years worked and salary level
• Company assumes market risk on invested funds

• Employee pays in set amount per pay period
• Employee chooses investment options
• Employee is responsible for investment performance

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Dollar-Cost Averaging Again

• Dollar-Cost Averaging Strategy of investing a
  fixed amount in a security at regular intervals
  ideal for defined contribution savings plans
• Its a passive buy-and-hold strategy.

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How Does Dollar-Cost Averaging Work?

• Invest 400 per month to buy Citis stock.
• Investment horizon 1 year
• Three different market environments are shown
  Rising, Falling, and directionless but highly
  volatile market
• The average cost per share is always lower than
  the average price per share.

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Rising Market
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Falling Market
22
Volatile Market
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Dollar-Cost Averaging

• Findings
• The more volatile the better.
• The average cost of shares purchased by regular
  investors will always be than the average share
  price.
• Neither will dollar-cost averaging ensure a
  profit or protect against a loss in declining
  market, nor will it prevent a loss if it is
  discontinued when the value of an account is less
  than its cost.
• The success of the dollar-cost averaging depends
  on the investor making regular purchases
  irrespective of the market conditions.

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KEY TERMS Leveraged Trading

• Margin Account
• Margin Debt
• Margin Call
• Broker Call Rate
• Short Sale
• Cover the Short
• Short Interest
• Short Interest Ratio
• Short Squeeze

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Put Some Muscle Behind It Leverage

• Securities purchased or sold using borrowed funds
  called margin accounts

• Brokers make such loans collateralized by stocks
  or bonds
• Minimum initial margin in U.S. 50
• Margin accounts regulated by the Federal Reserve
  Board

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BUYING ON MARGIN

• Used by short-term investors or traders
• Minimum initial margin is 50, but most
  brokerages allow minimum maintenance margin of
  25-30 on equities (higher for volatile issues)
• Margin debt amount borrowed to buy or maintain a
  security investment
• Broker call rate low interest rate brokers
  charge to finance margin loans

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MARGIN CALL RISK

• Margin call brokers demand for additional cash
  or security collateral. If not met, brokerage
  will liquidate position.
• Increases volatility of investment returns
• Force sale at worst possible time as stock prices
  tumble

• Exposes investors to enormous risk of loss and
  premature sale of stocks

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Problem-Buying on Margin

• I would like to buy 1000 shares of stock at 10
  per share, but I only have 5000. How can I do?
• Buy on margin?I can open a margin account with
  initial margin 50.
• Margin Account account that holds securities
  purchased with a combination of cash and borrowed
  funds
• At the beginning, my margin account will have
  1000 shares worth at 10 per share-a combination
  of 5000 cash and borrowed funds 5000.

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Problem-Buying on Margin

• If the price goes up to 20 per share, what is my
  margin now?
• I have 1000 shares worth at 20 per share now,
  and my original loan to finance these 1000 shares
  is 5000. Therefore, my margin will become
  (20000-5000)/20000 75.

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Problem-Buying on Margin

• If the price goes down to 7 per share, what is
  my margin now?
• I have 1000 shares worth at 7 per share now, and
  my original loan to finance these 1000 shares is
  5000. Therefore, my margin will become
  (7000-5000)/7000 28.57.
• If the maintenance margin(the absolute minimum
  amount of margin (equity) that an investor must
  maintain in the margin account at all times) is
  set equal to 30, I will receive a margin call
  from my broker to bring the equity up to the
  initial margin level within 3 business days. If
  not brokerage will liquidate position to bring
  accounts equity back up to 50.

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Problem-Buying on Margin

• Stock purchases with 50 initial margin trigger a
  30 maintenance margin call following a ____
  decline in price.
• Initial purchase priceP0 Margin debt 0.5 P0
• To ensure 30 initial margin, total debt must be
  less than or equal to 70 of the current market
  price,P, of any stock purchased on margin. That
  is, Debt ? 0.7P
• 0.5 P0 ? 0.7P ? 0.5/0.7 ? P/ P0 ? 0.714 ? P/ P0
  ? 0.714 must be less than or equal to the ratio
  of the current market price divided by the
  initial purchase price. Alternatively, a stock
  purchased with 50 initial margin could fall by
  as much as 28.6 ((P- P0)/ P0 (0.714 P0 - P0)/
  P0
• -0.286 P0 / P0 -0.286-28.6)

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Buying on Margin-Summary Table 4.4 Panel A
Investment results with an initial purchase of
1,000 shares at 10 using 50 initial margin.
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More Practice-Buy on Margin

• If the initial margin requirement is 40, an
  investor buying 100 shares at 100 per share must
  furnish equity of _______
• Initial purchase price shares purchased
  initial margin

34
More Practice-Buy on Margin

• The purchase of a stock at 50 with 50 initial
  margin would result in a margin call (for 30
  initial margin) if the stock falls in price
  to_____
• Margin debt 0.5 P0? Margin debt
• To ensure 30 initial margin, total debt must be
  less than or equal to 70 of the current market
  price,P, of any stock purchased on margin. That
  is, Debt ? 0.7P ?

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Other Problems With Leverage

• Other peoples moneypoor investment selection
  (moral hazard)
• Encourages customers to buy too much of
  individual issuepoor diversification
• Skyrocketing margin debtmagnify typical
  downturn(if speculators are forced to sell in a
  declining market) specter of Fed intervention
• Virtually no successful stock investors use
  leverage-Recall three superstars mentioned in Ch1?

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How to Profit from Falling Prices

• How can an investor profit from the impending
  decline in a companys stock price if he/she does
  not presently own companies with poor and
  deteriorating fundamentals?
• Short sale

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SELLING SHORT

• Sale of borrowed stock on margin
• Cover the short returning borrowed shares
  after repurchase
• Short sales expose trader to unlimited upward
  risk
• Shorted stock skyrockets
• Cost of margin calls to maintain short
• Short interest(number of shares sold short)
  bearish sentiment for issue
• Short interest ratio short interest expressed in
  terms of of days trading volume number of
  shares sold short relative to the daily trading
  volume in a stock
• High? bullish/ bearish sentiment?

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Margin Call Risk For Short Sellers
Initial margin 50, maintenance margin 30
Debt Initial Debt ?Debt (P 0.5PO) (P
PO)
Debt 2P 1.5PO Debt ? 0.7P
after simplification
1.153 ? P/PO
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Margin Call Risk For Short Sellers

• The current market price of a stock sold short
  can be no more than 15.3 higher((P- P0)/ P0
  (1.153 P0 - P0)/ P0
• 0.153 P0 / P0 .15315.3) than the original
  price before a 30 maintenance marginal call is
  triggered.

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Selling Short on Margin-Summary Table 4.4 Panel B
Investment results with an initial short sale of
1,000 shares at 10 using 50 initial margin.
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Problem-Short Sale

• A short sale of 1,000 American Online at 65 that
  is covered at 60 results in a total
• Proceeds from short sale
• Cost to buy back stocks
• Results

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THE SHORT SQUEEZE

• Rising market short sellers add to momentum as
  they panic to cover their shorts

• Bad for longsinflates stock price on upside
  artificially, followed by collapse when short
  interest is exhausted

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Prescriptions For Limiting Short-Selling Risk

• Timing
• Careful selection
• Limit short positions to no more than 20 of
  portfolio
• Disciplined tradinglimit losses to 20 price
  appreciation

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KEY TERMSIPOsIts Probably Overpriced

• Primary Market
• Secondary Market
• Initial Public Offerings (Ipos)
• Seasoned Issue
• Secondary Offerings
• Private Placements
• Offering Circulars
• Investment Banks
• Underwriter

• Road Show
• Firm-Commitment Offering
• Best Efforts Underwriting
• All-or-none Offerings
• Syndicate
• Underwriters Allotment
• Dealers Agreement
• Tombstone Ad
• Hot IPO
• Flipping Shares

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IPO MARKETS

• IPO newly issued securities in primary market
• Secondary market trades seasoned securities in
  auction or OTC markets
• Seasoned issue additional issue of security for
  which a market already exists
• Secondary offerings public sale of shares
  previously held by large, corporate, or
  institutional investors
• Private placement securities offered to small
  group of investors
• Offering circular special SEC filing that
  describes private placement

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INVESTMENT BANKS

• Investment banks advise or underwrite new
  issues distribute shares to institutional
  investors through road shows
• Firm-commitment underwriting investment bankers
  buy entire issue and assume risk
• Best-efforts underwriting investment agrees to
  make its best effort at placing shares issuing
  firm assumes risk
• All-or-none offerings investment bank tries to
  sell entire issue or sale is cancelled

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THE SYNDICATE

• Group of underwriters
• Syndicate manager
• Underwriters allotment
• Dealers agreement
• Tombstone ads

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SEC REQUIREMENTSIPOs

• Securities Act of 1933
• Registration Statement
• Filing Date
• Cooling-Off Period
• Preliminary Prospectus
• Red Herring
• Effective Date
• Deficiency Letter
• Due Diligence
• Final Prospectus

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Managing Taxes On Investments

• IRAs
• Tax-deductible
• Tax-deferred growthtax collected on
  distributions only
• New Roth IRAs
• After-tax contributions
• No taxes due on distributions
• Education IRAs
• Nondeductible contributions
• Tax-free withdrawals for education purposes

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Other Tax Code Provisions

• Capital Gains Tax Deferral postpones tax
  payments until liquidationrewards long term
  investors

• Capital Gain rates
• Qualified five-year Gains
• Gift and Estate Tax Provisions
• Exclusion for Gain on the Sale of Principal
  Residence