2

Buying and
Selling Securities

2-1

Brokerage Types
Broker Type

Service Level Commissions

Full Service
Discount
Deep
Discount

High
Medium
Low

High
Medium
Low

Online e-broker

Varies;
unbundled

Low/varies

2-2

Broker-Customer Relations

Advice not guaranteed

SIPC insured
Your broker = your agent

Legal duty to act in your best interest

Best Execution

Brokerage firms profit from

commissions
Disputes settled by final and binding
arbitration
2-3

Securities Investor Protection

Corporation

Securities Investor Protection Corporation (SIPC): Insurance

fund covering investors brokerage accounts when member firms
go bankrupt or experience financial difficulties.

Most brokerage firms belong to the SIPC, which insures each

account for up to $500,000 in cash and securities, with a
$100,000 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.

2-4

Brokerage Accounts

Cash account = a brokerage account in

which securities are paid for in full

Margin account = a brokerage account

in which, subject to limits, securities can
be bought and sold short on credit.

2-5

Margin Accounts

Margin = the portion of the value of

an investment that is not borrowed

Borrowed portion incurs interest

Call money rate

Rate brokers pay to borrow money to

lend to customers in their margin
accounts
2-6

Example: Margin Accounts,

The Balance Sheet
You buy 1,000 Pfizer (PFE) 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%

Liabilities and
Account Equity

EX 2.1

Assets
1,000 Shares, PFE $ 24,000
Total

$ 24,000

Margin Loan

$ 6,000

Account Equity

$ 18,000

Total

$ 24,000

2-7

Margin Accounts

Initial Margin = the minimum margin that

must be supplied in a margin purchase

Minimum = 50% set by Federal Reserve

Broker can require more

Maintenance margin = amount that must be

present at all times in a margin account.

Margin Call = broker demands more funds to

bring margin amount back up to the
maintenance margin.
2-8

Example: The Workings of

a Margin Account, I
Initial margin = 50%

Maintenance margin = 30%

Miller Moore Equine Enterprises (WHOA) is selling for $50.

With $20,000 you can buy $20,000 / 0.5 = $40,000 worth of
WHOA or 800 shares
Liabilities and
Account Equity

Assets
800 Shares of
WHOA @ $50/share
Total

$ 40,000

$ 40,000

Margin Loan

$ 20,000

Account Equity

$ 20,000

Total

$ 40,000

2-9

Example: The Workings of

a Margin Account, II

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

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

You are subject to a margin call.

Liabilities and
Account Equity

Assets
800 Shares of
WHOA @
$35/share
Total

$ 28,000

$ 28,000

Margin Loan

$ 20,000

Account Equity

$ 8,000

Total

$ 28,000
2-10

Margin and Leverage

Suppose you buy 1,000 shares of Coca-Cola (KO) at
$50 per share. You put up 60% initial margin and
borrowed the remainder at 6% per year (call money
rate plus the spread).

If a year later, KO is trading at $60 per share:

What is your return on this investment?

What would be your return if you had not invested on
margin?

What if KO is trading at $40 per share?

2-11

Margin & Leverage: Sell at $60

2-12

Margin & Leverage: Sell at $40

2-13

Margin & Leverage

Margin provides leverage

which magnifies profits and losses

2-14

Example: How Low Can it Go?

Suppose you want to buy 300 shares of Pepsico,

Inc. (PEP) at $55 per share.

Total cost: $16,500

You have only $9,900so 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?

2-15

Margin Call

Let P* be the critical margin call price:

Amount borrowed
=B
$6,600
Number of shares = N
300
Value of stock
=V
55 x P*
Account equity
= AE 55 x P* - $6,600
Maintenance margin = MM 40%
P*

Amount Borrowed

Number of shares
1 Ma int enance Margin

2.1

2-16

Margin Call Price

P*

Amount Borrowed

Number of shares
1 Maintenance Margin
$6,600
P*

300
1 .40

$22
P*
$36.667
.60

2-17

Annualized Returns
Effective Annual Rate (EAR)

EAR (1 HPR ) 1
M

Where:
HPR = Holding Period Return
M = Number of Holding Periods per year

2-18

Annualizing Returns on a Margin

Purchase

You buy 1,000 shares of Costco at $60 per share

You put up 50% initial margin and borrowed the
remainder at 11% per year (call money rate of 9%
plus a 2% spread)
Three months later, Costco is selling for $63 per
share and you decide to close out your position
What is your annualized return?

2-19

Annualized Return

Loan with interest = $30,000 x (1.11).25

3 months = 1/4 of a year = 0.25
Annualized Return = (1+HPR)4 -1
There are 4 HPs in a year
2-20

Hypothecation and Street Name

Registration

Hypothecation:

Pledging securities as collateral against a loan

Securities can be sold by the broker if the
customer fails to meet a margin call.

Street name registration:

Broker = registered owner of a security

Account holder = beneficial owner.

2-21

Trading Account Management

Advisory account

You pay someone else to make buy and

sell decisions on your behalf.

Wrap account

All the account expenses are wrapped into

a single fee.

2-22

Trading Account Management

Discretionary account

You authorize your broker to trade for you.

Asset management account

Provides complete money management,

including check-writing privileges, credit
cards, and margin loans.

2-23

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

Borrow
Borrow
shares
shares
from
from
someone
someone

Sellthe
the
Sell
Shares
Shares
inthe
the
in
market
market
Today

Buy
Buy
shares
shares
inthe
the
in
market
market

Return
Return
the
the
shares
shares

In the Future

2-24

Long Positions
When an investor buys and owns shares
of stock, he holds a Long Position.

A long position benefits from price

increases.

You buy today at $34, and sell later at $57,

you profit!

Buy low, sell high

2-25

Short Positions
When an investor sells shares that he does not
own, he holds a Short Position.

Shorting the stock

A short position benefits from price decreases.
You sell today at $83, and buy later at $27, you
profit.
Sell high, buy low
Buy low, sell high in reverse

2-26

Example: Short Sales

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

Your broker has a 50% initial margin and a
40% maintenance margin on short sales.
Liabilities and
Account Equity

Assets
Sale Proceeds

$ 3,000

Short Position

$ 3,000

Initial Margin Deposit $ 1,500

Account Equity

$ 1,500

Total

Total

$ 4,500

$ 4,500

2-27

Example: Short Sales

TI stock falls to $20 per share.

Shorted at $30, value today is $20, so you are "ahead" by $10
per share, or $1,000.
New margin: $2,500 / $2,000 = 125%

Liabilities and
Account Equity

Assets
Sale Proceeds

$ 3,000

Short Position

$ 2,000

Initial Margin Deposit

$ 1,500

Account Equity

$ 2,500

$ 4,500

Total

$ 4,500

Total

2-28

Example: Short Sales

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

Assets
Sale Proceeds

Liabilities and
Account Equity
$ 3,000

Short Position

$ 4,000

Initial Margin Deposit $ 1,500

Account Equity

Total

Total

$ 4,500

$ 4,500

500

2-29

More on Short Sales

Short interest is the amount of common

stock held in short positions.
A bearish indicator

With a short position,

No theoretical limit to how high the stock
price may rise
No limit to potential losses
2-30

Investment Objectives

Basic Question: Why invest at all?

Invest today to have more tomorrow

Deferred consumption
Choose to wait to have more to spend
later

Individual risk-return trade-off:

How much risk can you handle?

2-31

Investment Strategies and Policies

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?

2-32

Investor Constraints

Resources: What is the minimum sum needed?

What are the associated costs?

Horizon: When do you need the money?

Liquidity: Will you need to sell the asset quickly?

Taxes: Which tax bracket are you in?

Special circumstances

2-33

Useful Internet Sites

www.finra.org (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 building a portfolio
search the site for Build your first stock portfolio)
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)

2-34

2
Chapter End

Buying and
Selling Securities

2-35