CH.2 Buying and Selling Securities
CH.2 Buying and Selling Securities
CH.2 Buying and Selling Securities
Fundamentals of Investments
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We begin by describing how you go about buying and selling securities such as stocks and bonds. Then we outline some important considerations and constraints to keep in mind as you get more involved in the investing process.
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2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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Getting Started
Open a brokerage or trading account Deposit money into account
Buy securities
Sell securities
Close account
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2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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Choosing a Broker
The first step in opening an account is choosing a broker . brokers are traditionally divided into three groups : Full service brokers Discount brokers Deep discount brokers What distinguish the three groups is the level of service they provide and the resulting commissions they charge .
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2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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Choosing a Broker
With deep discount broker : essentially the only services provided are account maintenance and order execution that is " buying and selling " With full service broker will provide investment advice regarding the types of securities and investment strategies that might be appropriate for you to consider ( or avoid ) , the large brokerage firms do extensive research on individual companies and securities and maintain lists of recommended securities .a full service broker will even manage your account for you if you wish . With discount broker , with fall somewhere between the two cases , offering more investment counseling than the deep discounters and lower commissions than the full service brokers .
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2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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Online broker
The most important recent change in the brokerage industry is the rapid growth of online brokers , also known as e- brokers or cyber brokers . with an online broker , you place buy and sell orders over the internet using a web browser . online brokers will almost surely become the dominant form because of their enormous convenience and the low commission rates.
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2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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Choosing a Broker
# of shares ($50/share)
Commissions 200 500 1000 Level of Service Provides extensive investment advice Maintains account and executes buy/sell orders only Full-Service Brokers A.G. Edwards $150 $200 $300 Merrill Lynch Discount Brokers Charles Schwab $100 $125 $150 Fidelity Brokerage Deep-Discount Brokers Olde Discount $50 $75 $100 Quick & Reilly
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Choosing a Broker
However, as the brokerage industry becomes more competitive, the differences among the broker types seem to be blurring. Another important change is the rapid growth of online brokers, also known as e-brokers or cyberbrokers. Online investing has fundamentally changed the discount and deep-discount brokerage industry by slashing costs dramatically.
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2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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Choosing a Broker
Broker Charles Schwab
http://www.schwab.com
Commission for Simple Trade $29.95, up to 1000 shares $25, up to 1000 shares
Fidelity Investments
http://www.fidelity.com
CSFBdirect
http://www.csfbdirect.com
E*Trade
http://www.etrade.com
TD Waterhouse
http://www.tdwaterhouse.com
Ameritrade
http://www.ameritrade.com
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Broker-Customer Relations
There are several important things to keep in mind when dealing 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. On the other hand, brokerage firms are in the business of generating brokerage commissions. Finally , in the unlikely event of a significant problem , your account agreement will probably specify very closely that you must waive your right to sue or seek a jury trial , instead you are going to agree that any disputes will be settled by arbitration and that arbitration is final and binding .
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2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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Brokerage Accounts
Cash account A brokerage account in which all transactions are made on a strictly cash basis. So securities can be purchased to the extent that sufficient cash is available in the account .
Margin account A brokerage account in which, subject to limits, securities can be bought and sold on credit.
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2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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Margin Accounts
Those securities purchased on credit using money loaned to you by your broker ,such a purchase is called a margin purchase . the interest rate you pay on the money you borrow is based on the broker's call money rate , which is the rate the broker pays to borrow the money , so you pay some a mount over the call money rate , called the spread , which depend on your broker and the size of the loan .
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2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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Margin Accounts
Margin : the portion of the value of an investment that is not borrowed . In general , when you purchase securities on credit , some of the money is yours and the rest is borrowed . the amount that is yours called the margin . Margin is usually expressed as a percentage , for example : If you take 7000 $ of your own money and borrow an additional 3000 $ from your broker , your total investment will be 10,000 $ , 7000 $ from you ,and the margin is 10,000 /7000 =70%
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2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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Margin Accounts
Example: The Account Balance Sheet
You want to buy 1000 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%
Assets Liabilities & Account Equity
1000 WM shares
Total
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$24,000
$24,000
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Margin Accounts
In a margin purchase, the minimum margin that must be supplied is called the initial margin. The maintenance margin is the minimum margin that must be present at all times in a margin account.
When the margin drops below the maintenance margin, the broker may demand for more funds. This is known as a margin call. Note : there is little initial margin requirement for government bonds . on the other hand , margin is not allowed at all on certain other types of securities .
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2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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Margin Accounts
Example: Margin Requirements
Your account requires an initial margin of 50% and a maintenance margin of 30%. Stock A is selling at $50 per share. You have $20,000, and you want to buy as much of stock A as you possibly can. You may buy up to $20,000 / 0.5 = $40,000 worth of shares. Assets Liabilities & Account Equity
800 A shares
Total
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$40,000
$40,000
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Margin Accounts
Example: Margin Requirements
After your purchase, the share price of stock A falls to $35 per share. Assets 800 A shares Total
Liabilities & Account Equity $28,000 $28,000 Margin loan Account equity Total $20,000 8,000 $28,000
New margin = $8,000 / $28,000 = 28.6% < 30% Therefore, you are subject to a margin call.
2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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Maintenance margin
Maintenance margin : the minimum margin that must be present at all times in a margin account .this level is established by the broker , and depend on what you are buying as example for low priced and very volatile stocks , the house margin ( maintenance margin ) can be as high as 100% meaning no margin at all . Atypical maintenance margin will be 30% , if your margin falls below 30% ,then you may be subject to a margin call : demand for more funds that occurs when the margin in an account drops below the maintenance margin . If you do not comply ,your securities may be sold , the loan will be repaid out of the proceeds , and any remaining amount will be credited to your account .
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2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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Margin Accounts
Margin is a form of financial leverage.
When you borrow money to make an investment, the impact is to magnify both your gains and your losses.
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Short Sales
Short sale A sale in which the seller does not actually own the security that is sold.
Borrow shares from broker
Sell the shares
Note that an investor who buys and owns shares of stock is said to be long in the stock or to have a long position.
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2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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Short Sales
An investor with a long position benefits from price increases.
On the other hand, an investor with a short position benefits from price decreases.
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Short Sales
Example: Short Sales
You want to short 100 Sears shares at $30 per share. Your broker has a 50% initial margin and a 40% maintenance margin on short sales. Worth of stock borrowed = $30 $100 = $3,000
Assets Liabilities & Account Equity
Proceeds from sale $3,000 Short position Initial margin deposit 1,500 Account equity Total $4,500 Total
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Short Sales
Example: Short Sales continued
Scenario 1: The stock price falls to $20 per share.
Assets Liabilities & Account Equity
Proceeds from sale $3,000 Short position Initial margin deposit 1,500 Account equity Total $4,500 Total
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Short Sales
Example: Short Sales continued
Scenario 2: The stock price rises to $40 per share.
Assets Liabilities & Account Equity
Proceeds from sale $3,000 Short position Initial margin deposit 1,500 Account equity Total $4,500 Total
New margin = $500 / $4,000 = 12.5% < 40% Therefore, you are subject to a margin call.
2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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Short Sales
You can calculate the critical price on a short sale ( the highest price before you get a margin call) as follows : P* = (initial margin deposit + short proceeds ) / number of shares _______________________________ 1 + maintenance margin For example : suppose you shorted 1000 shares at 50 $ , the initial margin is 50 % and the maintenance margin is 40 % . what is the critical stock price , and how do you interpret it ? P* ={ (25000 + 50000 ) / ( 1000 shares ) } / (1 + 40 % ) P* = 53.57 $
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Short Sales
Short interest 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 limit to how high the stock price may rise.
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2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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Investor Constraints
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?
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2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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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?
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2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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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?
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2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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Chapter Review
Getting Started
Choosing a Broker Online Brokers Security Investors Protection Corporation Broker-Customer Relations
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Chapter Review
Brokerage Accounts
Cash Accounts Margin Accounts A Note on Annualizing Returns Hypothecation and Street Name Registration Other Account Issues
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Chapter Review
Short Sales
Basics of a Short Sale Some Details