Buying and Selling Securities

“Don’t Gamble! Take all your savings and buy some good stock and hold it till it goes up. If it don’t go up, don’t buy it.”

– Will Rogers

In formulating investment objectives, the individual must balance return objectives with risk tolerance. Investors must think about risk and return. Investors must think about how much risk they can

handle.

Your risk tolerance is affected by Your ability to take risk Your willingness to take risk

Resources. What is the minimum sum needed? What are the associated costs?

Horizon. When do you need the money?

Liquidity. How high is the possibility that you need to sell the asset quickly?

Taxes. Which tax bracket are you in?

Special circumstances. Does your company provide any incentive? What are your regulatory and legal restrictions?

Investment management. Should you manage your investments yourself?

Market timing. Should you try to buy and sell in anticipation of the future direction of the market?

Asset allocation. How should you distribute your investment funds across the different classes of assets?

Security selection. Within each class, which specific securities should you buy?

Most people are inclined to think security selection is the more important element for successful investing.

Research shows asset allocation is the more important determinant of portfolio returns: ~ 90% of portfolio performance stems from asset allocation. ~10%of portfolio performance comes from security selection.

How is this possible? Well, consider the Crash of 2008. Bonds outperformed stocks in 2008 Even those elusive “skilled stock pickers” might underperform

You will probably have access to a company-sponsored retirement plan such as a 401(k).

In a typical plan, you (the employee) decides how much money to contribute to the plan through payroll deductions.

Generally, your employer also makes contributions to the plan. For example, your company could make dollar-for-dollar matching

contributions up to a certain percentage of your salary. Even after your contributions hit the maximum amount your employer

will match, you can still contribute additional funds. The amount of your total contribution is limited by the Internal Revenue

Service (IRS).

The investing approach applies to your retirement plan. You decide your percentage allocations to asset classes (like stocks, bonds,

and T-bills, foreign or domestic).

The primary benefit of company-sponsored plans is that money you deposit into the account lowers your taxable income. So, your tax bill is lower, and your net “out of pocket” cost is lower. For example, if you are in the 25 percent tax bracket and decide to deposit

$12,000 next year, your net out of pocket cost is only $9,000. Why? You will pay $3,000 (.25*$12,000) less in taxes than you would if you

had not made this deposit.

You must pay taxes on the withdrawals you make during retirement.

The essential difference between IRAs lies in taxes (“Pay me now, or pay me later.”)

Roth Individual Retirement Account (Roth IRA) Today, you invest after-tax money. Therefore, you pay no taxes when you make withdrawals. So, capital gains and dividends accumulate tax-free.

“Tax-Deferred” or Traditional IRAs You do not pay taxes on money you place into this

account. When money is removed from this account, you pay

taxes.

Roth IRAs benefit younger investors in a low tax bracket.

Brokers are now divided into three groups:1. full-service brokers2. discount brokers3. deep-discount brokers

These three groups can be distinguished by the level of service provided, as well as the level of commissions charged.

As the brokerage industry becomes more competitive, the differences among broker types continues to blur.

Another important change is the rapid growth of online brokers, also known as e-brokers or cyberbrokers.

Online investing has really changed the brokerage industry.

slashing brokerage commissions providing investment information Customers place buy and sell orders over the Internet

Security Investors Protection Corporation (SIPC): Insurance fund covering investors’ brokerage accounts with member firms.

Most brokerage firms belong to the SIPC, which insures each account for up to $500,000 in cash and securities, with a $250,000 cash maximum.

Important: The SIPC does not guarantee the value of any security (unlike FDIC coverage).

Rather, SIPC protects whatever amount of cash and securities that were in your account, in the event of fraud or other failure.

There are several important things to remember when you deal with a broker:

Any advice you receive is not guaranteed. Your broker works as your agent and has a legal duty

to act in your best interest. However, brokerage firms make profits from

brokerage commissions.

Your account agreement will probably specify that any disputes will be settled by arbitration and that the arbitration is final and binding.

A Cash account is a brokerage account in which securities are paid for in full.

A Margin account is a brokerage account in which, subject to limits, securities can be bought and sold short on credit.

In a margin purchase, the portion of the value of an investment that is not borrowed is called the margin.

Of course, the portion that is borrowed incurs an interest charge.

This interest is based on the broker’s call money rate. The call money rate is the rate brokers pay to borrow money to lend to

customers in their margin accounts.

Assets

Liabilities and Account Equity

1,000 Shares, WMT $ 24,000 Margin Loan $ 6,000

Account Equity $ 18,000

Total $ 24,000 Total $ 24,000

2-14

• You buy 1,000 Wal-Mart shares at $24 per share.

• You put up $18,000 and borrow the rest.

• Amount borrowed = $24,000 – $18,000 = $6,000

• Margin = $18,000 / $24,000 = 75%

In a margin purchase, the minimum margin that must be supplied is called the initial margin.

The maintenance margin is the margin amount that must be present at all times in a margin account.

When the margin drops below the maintenance margin, the broker can demand more funds. This is known as a margin call.

Assets

Liabilities and Account Equity

800 Shares of WHOA @ $50/share

$ 40,000 Margin Loan $ 20,000

Account Equity $ 20,000

Total $ 40,000 Total $ 40,000

2-16

• Your margin account requires: • an initial margin of 50%, and• a maintenance margin of 30%

• A Share in Miller Moore Equine Enterprises (WHOA) is selling for $50. • You have $20,000, and you want to buy as much WHOA as you can.

• You may buy up to $20,000 / 0.5 = $40,000 worth of WHOA.

Assets

Liabilities and Account Equity

800 Shares of WHOA @ $35/share

$ 28,000 Margin Loan $ 20,000

Account Equity $ 8,000

Total $ 28,000 Total $ 28,000

2-17

• After your purchase, shares of WHOA fall to $35.

• New margin = $8,000 / $28,000 = 28.6% < 30%

• Therefore, you are subject to a margin call.

You have $30,000 in a margin account, 60% initial margin required.

You can buy $50,000 of stock with this account (why?).

Your borrowing rate from your broker is 6.00%.

Suppose you buy 1,000 shares of IBM, for $50/share.

Assume no dividends, and that your borrowing rate is still 6.00%, what is your return if:

In one year, IBM stock is selling for $60 per share?

In one year, IBM stock is selling for $60 per share, but you did not borrow money from your broker?

IBM stock is selling for $60 per share.

Your investment is worth $60,000.

You owe 6% on the $20,000 you borrowed: $1,200.

If you pay off the loan with interest, your account balance is: $60,000 – $21,200 = $38,800.

You started with $30,000.

Therefore, your return is $8,800 / $30,000 = 29.33%.

Suppose IBM stock was selling for $40 per share instead of $60 per share? What is your return?

IBM stock is selling for $60 per share, but you did not borrow from your broker.

You started with $30,000, which means you were able to buy $30,000 / $50 = 600 shares.

Your investment is now worth $36,000.

Therefore, your return is $6,000 / $30,000 = 20.00%.

Suppose IBM is selling for $40 per share instead of $60 per share. What is your return in this case?

Suppose you want to buy 300 shares of Ford Motor Company (F) at $55 per share.

Total cost: $16,500 You have only $9,900—so you must borrow $6,600.

Your initial margin is $9,900/$16,500 = 60%.

Suppose your maintenance margin is 40%. At what price will you receive a margin call?

$36.67.0.60

22

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$6,600 P

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Borrowed Amount P

in results ,P price, stock critical the for Solving

P Shares of Number

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To compare investments, you should express returns on a per-year, or annualized, basis.

Such a return is often called an effective annual return (EAR).

(1 + EAR) = (1 + holding period return)m

(m is the number of holding periods in a year)

You buy Qwest (Q) at $60 and sell it 4 months later for $63.

There were no dividends paid, and suppose the prices above are net of commissions.

What is your holding period percentage return and your EAR?

15.76%.about or (1.1576),

0.05) (1

Return) Percentage Period Holding (1 EAR 1

0.0560

3

60

60 - 63 Return Percentage Period Holding

3

m

Note that there are three “4-month” periods in one year.

Hypothecation is the act of pledging securities as a collateral against a loan.

This pledge is needed so that the securities can be sold by the broker if the customer is unwilling or unable to meet a margin call.

Street name registration is an arrangement under which a broker is the registered owner of a security. (You, as the account holder are the “beneficial owner.”)

Trading accounts can also be differentiated by the ways they are managed.

Advisory account - You pay someone else to make buy and sell decisions on your behalf.

Wrap account - All the expenses associated with your account are “wrapped” into a single fee.

Discretionary account - You authorize your broker to trade for you.

Asset management account - Provide for complete money management, including check-writing privileges, credit cards, and margin loans.

To invest in financial securities, you do not need an account with a broker.

One alternative is to buy securities directly from the issuer.

Another alternative is to invest in mutual funds.

Note that an investor who buys and owns shares of stock is said to be “long the stock” or to have a “long position.”

• Short Sale is a sale in which the seller does not actually own the security that is sold.

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Today In the Future

An investor with a long position benefits from price increases.

Easy to understand You buy today at $34, and sell later at $57, you profit! Buy low, sell high

An investor with a short position benefits from price decreases.

Also easy to understand You sell today at $83, and buy later at $27, you profit. Sell high, buy low

You short 100 share of Sears shares at $30 per share.

Your broker has a 50% initial margin and a 40% maintenance margin on short sales.Value of stock borrowed that will be sold short = $30 × $100 = $3,000

Value of stock borrowed that will be sold short = $30 × $100 = $3,000

Assets

Liabilities and Account Equity

Sale Proceeds $ 3,000 Short Position $ 3,000

Initial Margin Deposit $ 1,500 Account Equity $ 1,500

Total $ 4,500 Total $ 4,500

2-30

Sears stock falls to $20 per share.

Sold at $30, value today is $20, so you are "ahead" by $10 per share, or $1,000.

Also, new margin: $2,500 / $2,000 = 125%

AssetsLiabilities and

Account Equity

Sale Proceeds $ 3,000 Short Position $ 2,000

Initial Margin Deposit

$ 1,500 Account Equity $ 2,500

Total $ 4,500 Total $ 4,500

2-31

Sears stock price rises to $40 per share.

You sold short at $30, stock price is now $40, you are "behind" by $10 per share, or $1,000. (He that sells what isn’t his’n, must buy it back—or go to prison.)

Also: new margin = $500 / $4,000 = 12.5% < 40% Therefore, you are subject to a margin call.

Assets Liabilities and

Account Equity

Sale Proceeds $ 3,000 Short Position $ 4,000

Initial Margin Deposit $ 1,500 Account Equity $ 500

Total $ 4,500 Total $ 4,500

2-32

Short interest is the amount of common stock held in short positions.

In practice, short selling is quite common and a substantial volume of stock sales are initiated by short sellers.

Note that with a short position, you may lose more than your total investment, as there is no theoretical limit to how high the stock price may rise.

Problems 12, 16

Margin eMaintenanc1 Shares of NumberProceeds)/ Short Deposit Margin Initial P

*

www.nasd.com (a reference for dispute resolution)

www.bearmarketcentral.com (a reference for short selling)

www.nasdaq.com (a reference for short interest)

www.moneycentral.msn.com (a reference for risk aversion)

www.sharebuilder.com (a reference for opening a brokerage account)

www.buyandhold.com (another reference for opening a brokerage account)

www.individual.ml.com (a risk tolerance questionnaire from Merrill Lynch)

www.money-rates.com (a reference for current broker call money rate)

finance.yahoo.com (a reference for short sales on particular stocks)

Getting Started

Choosing a Broker Online Brokers Security Investors Protection Corporation Broker-Customer Relations

Brokerage Accounts

Cash Accounts Margin Accounts A Note on Annualizing Returns Hypothecation and Street Name Registration Other Account Issues

Short Sales

Basics of a Short Sale Some Details

Investor Objectives, Constraints, and Strategies

Risk and Return Investor Constraints Strategies and Policies