Buying and Selling Equities

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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

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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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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
• Ask Size number of round lots for sale at any
  moment
• Measure of Price Stability gauges supply and
  demand and identifies upward or downward pressure
  on price

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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 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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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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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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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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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 specter of Fed intervention
• Virtually no successful stock investors use
  leverage

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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 interestbearish sentiment for issue
• Short interest ratio of days trading volume

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Margin Call Risk For Short Sellers
Debt Initial Debt ?Debt (P 0.5PO) (P
PO)
after simplification
1.153 ? P/PO
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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