1 C HAPTER 2 Buying and Selling Securities Chapter Sections: Getting Started Brokerage Accounts...

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CHAPTER 2Buying and Selling Securities

Chapter Sections:Getting StartedBrokerage AccountsShort SalesInvestor Objectives, Constraints, and Strategies

We are going to focus on margin accounts and selling short.

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Brokerage Firms Full Service (Traditional)

Companies such as Merrill Lynch and Morgan Stanley that provide investment recommendations

Discount Companies such as Schwab that traditionally left

the stock picking to the investor but now have their own stock rating / recommendation services

Deep-discount (a.k.a. Internet brokers) Companies that have emphasized technology to

reduce brokerage costs dramatically

What can you expect to pay for each? What kind of service can you expect from each?

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Brokerage Firms Commissions – Then and Now

Traditionally, virtually all brokerage firms made their money from commissions Full-service brokers – $70 to $100+ per trade Discount – $45 $29 $19 $13 $9 per trade Deep-discount – $5 to $18 per trade or less! Mutual fund companies! Examples: Fidelity &

Vanguard (Both offer free commissions on their own funds)

A couple of companies experimented with $0 commissions One failed and the other now charges $5 per trade

Wait a minute! How can a brokerage firm make any money with a $0 commission? In fact, how can a company make money with $5

or $7 per trade?

(continued)

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Brokerage Firms(continued)

The following disclaimer is placed on each trade confirmation from Scottrade

Remember this slide from Chapter 5?

SCOTTRADE INC. RECEIVES REMUNERATION FOR DIRECTING ORDERS TO PARTICULAR

BROKER/DEALERS OR MARKET CENTERS FOR EXECUTION. SUCH REMUNERATION IS CONSIDERED

COMPENSATION TO THE FIRM AND THE SOURCE AND AMOUNT OF ANY COMPENSATION RECEIVED

BY THE FIRM IN CONNECTION WITH YOUR TRANSACTION WILL BE DISCLOSED UPON REQUEST

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Brokerage Firms Alternative Methods of Paying Your Broker

As the competition for your business as gotten fiercer The methods of charging investors for investment

services have gotten more “creative” Merrill Lynch experimented with charging $3,000

per year for unlimited trades (They do not have that program anymore)

There are many other methods

The new, modern-day-a-go-go-way to soak customers… uh, I mean, charge for brokerage services is called “Wealth Management.”

(continued)

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Brokerage Firms Wealth Management Account

a.k.a. Wrap account, Financial advisor account Instead of charging per transaction, the brokerage

firms tacks on a yearly 1% or 2% “wealth management” fee Do you remember the mutual fund F shares?

These types of programs are being pushed by all the major full-service brokerage firms

There are many flavors of this program

The latest wrinkle to this method is the new “performance-based wealth management” program.

(continued)

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Brokerage Firms Performance-based Wealth Management

Only pay your advisor when you make money! The advisor receives 10% to 20% of your

earnings when you make money The advisor receives nothing when you lose

money (or do not make anything) It is a variation of the way hedge funds charge

their shareholders Currently marketed to “high-net worth investors” Example: Dunham & Associates

http://www.dunham.com/ForInvestors.aspx?UltimateMenu1B=Investors

Although it sounds tempting, the reality is that you have the potential to pay far, far more for your investment services using this method.

(continued)

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ANTI-Brokerage Firms Dividend Reinvestment Plans

a.k.a. DRIPs, Direct low-cost investment plans Bypass the middleman! Many of the large, well-established companies

offer their own DRIPs Some are totally free – some are close to free

There are many other DRIP programs available NAIC – www.better-investing.org (now uses Foliofn.com)

DRIPs are low-cost, yes. But they are not perfect. How would you like having to sift through 18 different statements? Some charge a

monthly fee to allow you to keep all your DRIPs in one place. Many traditional brokerage firms now offer DRIPs.

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Cash Account Cash Account

A brokerage account in which all transactions are made on a strictly cash basis

Cash accounts are the simplest arrangements requiring no credit check of the customer by the brokerage firmOnce you have established a good relationship, most brokerage

firms will allow you to purchase shares of stock even if you do not have enough cash in the account. This is because stock

transactions settle in three business days. You have three business days to get the money into the account. Some of the deep-discount

Internet brokers (example: Scottrade) do not allow this.(Conversely, when you sell a stock, it takes three business days to

receive the money.)

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Margin Account Margin Account

A brokerage account in which, subject to limits, securities can be bought and sold on credit

If you open a margin account, the brokerage firm will do a credit check to determine your credit worthiness Since you will be borrowing money from them

The interest rate you pay on money borrowed from your broker is called the margin rate. It is actually a very good interest rate. It

is often the prime rate plus 1 or 2 percentage points or 2 or 3 points above the current money market rates, depending on how

much you borrow.

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Buying on Margin A margin account allows you to perform

Margin Trading a.k.a. “Buying on margin” “leveraged account” The use of borrowed funds to purchase

securities; magnifies returns by reducing the amount of equity that the investor must put up

Margin The portion of the value of an investment that is not

borrowed (Shouldn’t it be the other way ‘round?)

The amount of equity stated as a percentage in the investment

Example: 75% margin, 25% borrowed

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Why Buy on Margin? Buying on margin allows the investor to use

financial leverage The use of debt financing to magnify investment

returns Buying on margin also allows an investor to

tap into the equity in their account Without actually selling their investments

And generating commissions and taxable transactions

Buying on margin is much like buying a house. When you purchase a house, you do not come up with the total amount. You put up 10% or 20%

down and finance the rest. Stocks require at least 50% down.

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Buying on Margin Margin Requirement

a.k.a. Initial margin The minimum amount of equity that must be a

margin investor’s own funds; set by the Federal Reserve Board

Currently the margin requirement is 50% You must put up at least 50% of your own funds

This allows you to purchase the same amount of stock with less money

Margin Loan a.k.a. Debit Balance The amount of your account borrowed

(continued)

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Buying on Margin Buying on Margin Example

You put up $10 and borrow $10 from your broker Initial Margin = 50%; Margin Loan = $10

You purchase one share of common stock for $20 The market price rises to $30

Congratulations! You made $10 on a $10 investment!That is half of what you had to come up with when you

simply purchased the stock outright with your own money. Instead of a 50% return on your investment, you received

a 100% return on your investment.

(continued)

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Buying on Margin Buying on Margin Example Revisited:

You put up $10 and borrow $10 from your broker You purchase one share of common stock for $20 Same as before, but this time…

The market price drops to $10

Oops! Only ½ of the money was yours! You borrowed the rest.You have lost your entire investment.

Buying on margin magnifies your gains and your losses.

(continued)

Margin buying was one of the major contributing factors to the Crash of 1929. At the time, the margin requirement was only

10%. For this reason, the above scenario is prohibited today and our intrepid investor would have had a “margin call” long ago.

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Buying on Margin Margin Trading (continued)

Because margin trading is inherently more risky, margin accounts are more highly scrutinized by brokerage firms

Restricted account A margin account whose equity is less than the

initial margin requirement; the investor may not make further margin purchases and must bring the margin back to the initial margin requirement when the securities are sold

(continued)

Information technology has made the brokerage firm’s job of scrutinizing margin clients much easier. Now, the computer

spits out a list of customers that are restricted.

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Maintenance margin The absolute minimum amount of margin (equity)

that an investor must maintain in the margin account at all times – typically 25% to 35% (25% min)

Margin call Notification of the need to bring the equity of an

account whose margin is below the maintenance level up to the initial margin level or to have enough margined holdings sold to reach this standard

(continued)

If the investor does not meet the margin call in sufficient time (typically 72 hours), the brokerage firm is authorized to sell enough of

the securities to meet the margin call. “Never meet a margin call!”

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Of course, if your investments do very well, then you can use the excess margin you create in your margin account to purchase additional stock without having to come up with more money

Excess margin More equity than is required in a margin account

Pyramiding The technique of using excess margin from paper

profits in margin accounts to partly or fully finance the acquisition of additional securities

(continued)

What do you think of this strategy?

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Paying interest on the margin loan also adds yet another drag on your investment returns Your margined investments must meet or exceed

the margin interest rate in order for you to just break even!

(continued)

Commissions and interest! Now you know why your broker is always so happy to take your calls.

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“So, why would I buy on margin?” The easy answer is, “You shouldn’t” The risks are not worth the potential reward

In my humble opinion… However, there is a valid, logical reason for having

a margin account A margin account allows you to temporarily borrow

against your investments without having to sell them You do not incur commission costs and … You do not trigger capital gains taxes, but …

You do pay interest!

(continued)

Discussion: Do you think you would want to margin securities?

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Buying on Margin Margin Trading (Examples:)

Stock selling for $50 You put up $30 and borrow $20 ( $50 - $20 ) / $50 = 60%

Stock price rises to $80 ( $80 - $20 ) / $80 = 75%

Stock price falls to $25 ( $25 - $20 ) / $25 = 20% − Uh, Oh! Margin Call!

(continued)

Value of Security – Margin Loan Margin = ───────────────────

Value of Security

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Buying on Margin The Account Balance Sheet

Traditionally, with margin accounts, the brokerage firms would create an Account Balance Sheet to keep track of the account It is all computerized now

Those of you with accounting experience will recognize this as… Assets = Liabilities + Equity

The balance sheet also makes it easier to calculate the margin Margin = Account Equity / Total Assets

(continued)

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The Account Balance Sheet (Example: Page 43)

You purchase 800 shares at $50 You put up $20,000 & borrow the rest ($20,000) Margin = $20,000 / $40,000 = 50%

(continued)

Assets Liabilities and Account Equity

800 Shares @ $50/shr $40,000 Margin Loan $20,000

Account Equity $20,000

Total $40,000 Total $40,000

Buying on Margin

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The Account Balance Sheet (Example: Page 43) Uh, Oh! Your shares falls to $35

The company was caught artificially inflating earnings!

Margin = $8,000 / $28,000 = 28.6%

(continued)


800 Shares @ $35/shr $28,000 Margin Loan $20,000

Account Equity $8,000

Total $28,000 Total $28,000

Buying on Margin

Your brokerage’s maintenance margin is 30%. Margin call!

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Long Stock Purchases Long Purchase

a.k.a. “Buying long,” “Going long” A transaction in which investors buy securities in

the hope that they will increase in value and can be sold at a later date for profit

This is the type of transaction that people commonly think of when they hear that someone bought stock Buying long is the most common form of

transaction Expectation of dividends or capital appreciation or

both “Buy low, sell high”

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Long Stock Purchases Long Purchase Example

You purchase one share of common stock for $20 The market price rises to $30

Congratulations! You made $10 on a $20 investment! That is a 50% increase.

Of course, if the price dropped to $10, you lost $10, or ½ of your investment – a 50% decrease.

(continued)

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Selling Short Short Selling

a.k.a. “Selling short,” “Shorting the stock,” “Going short”

The sale of borrowed securities, their eventual repurchase by the short seller, and their return to the lender

It is the opposite of “buying long” You are hoping that the price goes down

“Sell high, buy low” Selling short must take place in a margin account

Since you are borrowing the stock you sell from the brokerage firm

You are gonna’ love this!

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Selling Short Short Selling (continued)

Here is how it works: You borrow the stock from another shareholder

(without their knowledge) and sell it on the market You receive money for selling stock that you do not own!

You wait for the stock price to go down You then buy back the shares at a lower price

Pocketing the difference The shareholder you borrowed the shares from

never knows that the shares were borrowed The brokerage firm does all the financial sleight-of-hand

By the way, you must pay any dividends the company declares to the investor who bought the shares that you sold short…

(continued)

Doesn’t it sound as though it should be illegal!?

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Here is how it works:

(continued)

If the price goes down, you have made money. If the price goes up, you have lost money. It is the opposite of buying long.

Borrowsharesfrom

someone

Borrowsharesfrom

someone

Sell theshares in the market

Sell theshares in the market

Buyshares

from themarket

Buyshares

from themarket

Returnthe

shares

Returnthe

shares

Today: In the Future:

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Selling Short Short Selling Example:

You sell a stock short for $20 You receive $20 from the sale of the stock

Even though the stock was not yours. You borrowed it from someone else

The stock price goes down to $10 You buy back the stock at $10

“Closing out the transaction” You give the stock back to the person you borrowed

it from You get to keep the $10 difference

(continued)

Congratulations! You just made $10 on a $0 investment! Well, not quite…

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Selling Short Short Selling Example:

You can not really make $10 on a $0 investment It is a margin account, remember? You borrowed the stock that you sold

The rules for a margin account still apply You must put up at least 50%

“50% of what?” 50% of what you borrowed! (Huh? What?) 50% of the proceeds from the sale of the borrowed

stock – You borrowed the stock that you sold Again, the brokerages use the Account Balance

Sheet to keep track of the investor’s margin

(continued)

Examples of margin requirements accounting to follow in a bit.

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Selling Short Short Selling Example Revisited:

You sell a stock short for $20 You receive $20 from the sale of the stock

Even though the stock was not yours. You borrowed it from someone else

The stock price goes up to $40 You buy back the stock at $40

Remember, you borrowed it You must replace it at some future date You must buy it back

(continued)

Uh-oh! You just lost $20 on your short transaction!

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When you buy long, you can only lose the purchase price of the stock Buy a stock for $20, it goes to zero, you lost $20 Once a stock reaches $0, it can not go any lower

But when you sell short, there is no limit to the amount of money you can lose (theoretically) Why? Because there is no limit to the price of a

stock The price can always go higher

(continued)

“He who sells what isn’t his’n, Must buy it back or go to prison.”

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Selling Short Calculating the margin on short sales

Example: If the stock were sold short at $20, you would have to deposit $10

Margin = ($10 + $20 - $20 ) / $20 = $10 / $20 = 50%

(continued)

Margin deposit + Short sale proceeds - Value of security Margin = –––––––––––––––––––––––––––––––––––––––––––

Value of Security

Again, the Account Balance Sheet makes the calculation easier.

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The Account Balance Sheet (Example: Page 49) You sell short 100 shares of Texas Instruments at

$30 You receive $3,000 from the sale (100shrs * $30) Margin = $1,500 / 3,000 = 50%

(continued)


Proceeds from sale

of Texas Instruments

$3,000 Short position $3,000

Initial margin deposit $1,500 Account Equity $1,500

Total $4,500 Total $4,500

Selling Short

Margin = Account Equity / Short Position

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The Account Balance Sheet (Example: Page 50) The stock price of Texas Instruments falls to $20 The short position falls to $2,000 (100shrs * $20) Margin = $2,500 / $2,000 = 125%

(continued)


Proceeds from sale



Initial margin deposit $1,500 Account Equity $2,500


Selling Short

This side does not change (unless you deposit more $$$)

The short position fell and the account equity rose. You made money because the stock price fell.

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The Account Balance Sheet (Example: Page 50) Uh, Oh! What if the stock price of TI rises to $40? The short position rises to $4,000 (100shrs * $40) Margin = $500 / $4,000 = 12.5%

(continued)


Proceeds from sale



Initial margin deposit $1,500 Account Equity $500


Selling Short

Uh, oh! Your brokerage’s maintenance margin is 40%. Margin call!

Recall, this side does not change

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Selling Short Margin Call Price Level – page 52

Example: If you sold 100 shares short at $20, your proceeds are $2,000, you deposited $1,000 and the maintenance margin = 25%

Price = [ ($1,000 + $2,000 ) / 100 ] / ( 1 + 0.25) = ($3,000 / 100 ) / 1.25 = $30 / 1.25 = $24

(continued)

( margin deposit + short sale proceeds ) / number of sharesPrice = –––––––––––––––––––––––––––––––––––––––––––––

1 + maintenance margin

Selling short is very risky. The brokerage firm will keep a close eye on you.

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Selling Short Short Squeeze

When the market is going down, momentum investors will often short stocks to try to take advantage of the down momentum

This pushes the market down even further But eventually, the short shares must all be repurchased

The subsequent up movement of the market is often dramatic as short sellers cover their positions

Short interest The amount of stock shares that have been sold short

(continued)

In August of 2002, short interest was the highest it had ever been in the history of the United States stock markets. That gave me great

comfort because it meant that the market downturn was close to an end.

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Actually, there used to be a valid reason for shorting a stock

“Shorting against the box” Shorting stock that you already owned It allowed you to essentially sell the stock without

creating a taxable transaction until you closed out the transaction with your own stock For example, you could sell the stock short in December,

receive the money and then deliver your shares in January, effectively postponing the taxes for another year

The IRS removed this loophole in 1997

(continued)

My advice? Never short a stock!

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Careers in Stocks Registered Representative

a.k.a. Stockbroker, Financial Representative, Account Executive, Financial Planner

Background check No shenanigans with other peoples’ money

Must take Series 7 and Series 66 Series 7 is difficult, 6 hours, 2 months of studying Series 66 is much easier, 2 to 4 weeks study

Must be sponsored by a brokerage firm Some brokerages exist simply to sponsor people

Expect to pay a fee to them for the privilege of being sponsored

Many brokerages now sponsoring new recruits!

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CHAPTER 2 – REVIEW

Buying and Selling Securities

Chapter Sections:Getting StartedBrokerage AccountsShort SalesInvestor Objectives, Constraints, and Strategies

Next: Miscellaneous Topics in Investing: Account Types, REITs, Real Estate, Precious Metals, Hard Assets, etc.

1 C HAPTER 2 Buying and Selling Securities Chapter Sections: Getting Started Brokerage Accounts...

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