Chapter

2
Buying and Selling Securities

Fundamentals
of Investments
Valuation & Management
second edition
Charles J. Corrado Bradford D.Jordan

McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu

 2-2

First you buy a stock.

First you buy a stock.
If it goes up, sell it. If it doesn’t go up, don’t buy it.
– Will Rogers

McGraw Hill / Irwin  2002 by The McGraw-Hill Companies, Inc. All rights reserved.
 2-3

Buying and Selling Securities

This chapter covers the basics of the
Goal investing process.
 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.
McGraw Hill / Irwin  2002 by The McGraw-Hill Companies, Inc. All rights reserved.
 2-4

Getting Started
Open a brokerage
or trading account

Deposit money
into account Buy securities

Withdraw money Sell securities

from account

Close account
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 2-5

Choosing a Broker
 Brokers are traditionally divided into three
groups.
 full-servicebrokers
 discount brokers
 deep-discount brokers

 These three groups can be distinguished by the

level of service provided, as well as the
resulting commissions charged.

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 2-6

Choosing a Broker
Commissions Level of
# of shares ($50/share) 200 500 1000 Service
Full-Service Brokers Provides
A.G. Edwards $150 $200 $300 extensive
Merrill Lynch investment
advice
Discount Brokers
Charles Schwab $100 $125 $150
Fidelity Brokerage Maintains
Deep-Discount Brokers account and
Olde Discount $50 $75 $100 executes
Quick & Reilly buy/sell
orders only
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 2-7

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.
McGraw Hill / Irwin  2002 by The McGraw-Hill Companies, Inc. All rights reserved.
 2-8

Choosing a Broker
Broker Commission for Simple Trade
Charles Schwab $29.95, up to 1000 shares
 http://www.schwab.com
Fidelity Investments $25, up to 1000 shares
 http://www.fidelity.com
CSFBdirect $20, up to 1000 shares
 http://www.csfbdirect.com
E*Trade $14.95, up to 5000 shares
 http://www.etrade.com
TD Waterhouse $12, up to 5000 shares
 http://www.tdwaterhouse.com
Ameritrade $8, no share limits
 http://www.ameritrade.com
McGraw Hill / Irwin  2002 by The McGraw-Hill Companies, Inc. All rights reserved.
 2-9

Work the Web

 Which online broker is the best?

See ratings at:
http://www.gomez.com

McGraw Hill / Irwin  2002 by The McGraw-Hill Companies, Inc. All rights reserved.
 2 - 10

Security Investors Protection Corporation

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 $100,000 cash
maximum.
 Note that SIPC does not guarantee the value of
any security.
McGraw Hill / Irwin  2002 by The McGraw-Hill Companies, Inc. All rights reserved.
 2 - 11

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.
 Your account agreement will probably specify that
any disputes will be settled by arbitration and that
the arbitration is final and binding.
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 2 - 12

Work the Web

 To learn more about dispute

resolution, visit:
http://www.nasd.com

McGraw Hill / Irwin  2002 by The McGraw-Hill Companies, Inc. All rights reserved.
 2 - 13

Brokerage Accounts
Cash account
A brokerage account in which all
transactions are made on a strictly cash
basis.
Margin account
A brokerage account in which, subject to
limits, securities can be bought and sold on
credit.

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 2 - 14

Margin Accounts
 In a margin purchase, the portion of the value
of an investment that is not borrowed is called
the margin.
 The portion that is borrowed incurs an interest
that is based on the broker’s call money rate,
which is the rate brokers pay to borrow bank
funds for lending to customer margin accounts.

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 2 - 15

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 $24,000 Margin loan $ 6,000
Account equity 18,000
Total $24,000 Total $24,000
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 2 - 16

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.
McGraw Hill / Irwin  2002 by The McGraw-Hill Companies, Inc. All rights reserved.
 2 - 17

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 $40,000 Margin loan $20,000
Account equity 20,000
Total $40,000 Total $40,000
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 2 - 18

Margin Accounts
Example: Margin Requirements
 After your purchase, the share price of stock A falls to
$35 per share.
Assets Liabilities & Account Equity
800 A shares $28,000 Margin loan $20,000
Account equity 8,000
Total $28,000 Total $28,000

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

Therefore, you are subject to a margin call.
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 2 - 19

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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 2 - 20

A Note on Annualizing Returns

 To compare investments, we will usually need
to 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
where m is the number of holding periods in a year.

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 2 - 21

Hypothecation and Street Name Registration

Hypothecation
Pledging securities as a collateral against a
loan, 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
An arrangement under which a broker is the
registered owner of a security.
The account holder is the “beneficial
owner.”
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 2 - 22

Other Account Issues

 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 simply authorize your
broker to trade for you.
 Asset management account - Provide for complete
money management, including check-writing
privileges, credit cards, and margin loans.
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 2 - 23

Other Account Issues

 To invest in financial securities, a brokerage
account is not a necessity.
 One alternative is to buy securities directly from
the issuer.
 Another alternative is to invest in mutual funds.

McGraw Hill / Irwin  2002 by The McGraw-Hill Companies, Inc. All rights reserved.
 2 - 24

Short Sales
Short sale
A sale in which the seller does not actually
own the security that is sold.
Borrow Buy
Return
shares Sell the shares
the
from shares from
shares
broker market

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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 2 - 25

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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 2 - 26

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 $ 3,000
Initial margin deposit 1,500 Account equity 1,500
Total $4,500 Total $4,500
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 2 - 27

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 $ 2,000
Initial margin deposit 1,500 Account equity 2,500
Total $4,500 Total $4,500

 New margin = $2,500 / $2,000 = 125%

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 2 - 28

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 $ 4,000
Initial margin deposit 1,500 Account equity 500
Total $4,500 Total $4,500

 New margin = $500 / $4,000 = 12.5% < 40%

Therefore, you are subject to a margin call.
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 2 - 29

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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 2 - 30

Work the Web

 There are many sites devoted to the

fine art of short selling. Try:
http://www.bearmarketcentral.com

McGraw Hill / Irwin  2002 by The McGraw-Hill Companies, Inc. All rights reserved.
 2 - 31

Risk and Return

 In formulating investment objectives, the
individual must balance return objectives with
risk tolerance.

McGraw Hill / Irwin  2002 by The McGraw-Hill Companies, Inc. All rights reserved.
 2 - 32

Work the Web

 How risk-averse are you?

Take a test at:
http://www.investorama.com/calc

McGraw Hill / Irwin  2002 by The McGraw-Hill Companies, Inc. All rights reserved.
 2 - 33

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?
McGraw Hill / Irwin  2002 by The McGraw-Hill Companies, Inc. All rights reserved.
 2 - 34

Work the Web

 Can you open a brokerage account

with no money? See:
http://www.sharebuilder.com
http://www.buyandhold.com

McGraw Hill / Irwin  2002 by The McGraw-Hill Companies, Inc. All rights reserved.
 2 - 35

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?
McGraw Hill / Irwin  2002 by The McGraw-Hill Companies, Inc. All rights reserved.
 2 - 36

Strategies and Policies

 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?
McGraw Hill / Irwin  2002 by The McGraw-Hill Companies, Inc. All rights reserved.
 2 - 37

Chapter Review
 Getting Started
 Choosing a Broker
 Online Brokers

 Security Investors Protection Corporation

 Broker-Customer Relations

McGraw Hill / Irwin  2002 by The McGraw-Hill Companies, Inc. All rights reserved.
 2 - 38

Chapter Review
 Brokerage Accounts
 Cash Accounts
 Margin Accounts

 A Note on Annualizing Returns

 Hypothecation and Street Name Registration

 Other Account Issues

McGraw Hill / Irwin  2002 by The McGraw-Hill Companies, Inc. All rights reserved.
 2 - 39

Chapter Review
 Short Sales
 Basics of a Short Sale
 Some Details

 Investor Objectives, Constraints, and

Strategies
 Risk and Return
 Investor Constraints

 Strategies and Policies

McGraw Hill / Irwin  2002 by The McGraw-Hill Companies, Inc. All rights reserved.