Chapter McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 2 Buying and Selling Securities

2-2 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

2-3 Buying and Selling Securities This chapter covers the basics of the 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.

2-4 Getting Started (c) Buy 100 Shares of Disney at $60 per share (c) Buy 100 Shares of Disney at $60 per share (e) $3,950 Cash in Account $6,000 Stock In Account (e) $3,950 Cash in Account $6,000 Stock In Account (d) Pay Commission, Say $50 (d) Pay Commission, Say $50 (b) Deposit $10,000 into account (b) Deposit $10,000 into account (a) Open a brokerage or trading account (a) Open a brokerage or trading account

2-5 Individual Brokerage Accounts Try and think of your account as a balance sheet at the brokerage… First you open the account –Assets:Liabilities Cash $10,000 Equity $10,000 Then you buy Disney –Assets:Liabilities Cash $3,950A/P $50 Stock $6,000 Equity (Disney 100 shares$9,950 at $60 per share)

2-6 Choosing a Broker, I. Brokers are now divided into three groups: 1. full-service brokers 2. discount brokers 3. deep-discount brokers These three groups can be distinguished by the level of service provided, as well as the level of commissions charged.

2-7 Choosing a Broker, II. 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 Why even use a broker? –NYSE and NASDAQ are clubs and only members can trade –You access the “floor” through the broker’s platform –Technically you trade through an agent not directly

2-8 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. 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.

2-9 Broker-Customer Relations 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.

2-10 Brokerage Accounts 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. (more on selling short later)

2-11 Margin Accounts 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.

2-12 Example: Margin Accounts, The Balance Sheet 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 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%

2-13 Margin Accounts 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.

2-14 Example: The Workings of a Margin Account, I Assets Liabilities and Account Equity 800 Shares of $50/share $ 40,000 Margin Loan$ 20,000 Account Equity$ 20,000 Total$ 40,000 Total$ 40,000 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.

2-15 Margin Account Gain Your stock has risen in price to $58, what is your gain AssetsLiabilities and Equity 800 Shares of WHOA Margin Loan$ $58/share $ 46,400 Equity$ 26,400 Total$ 46,400 Your gain is the change in the Equity account: $26,400 - $20,000 = $6,400 Your return is the gain in your account divided by your original investment $6,400 / $20,000 = 32% This is twice the return of the stock

2-16 Margin Account Loss Your stock has fallen in price to $39, what is your loss AssetsLiabilities and Equity 800 Shares of WHOA Margin Loan$ $39/share $ 31,200 Equity$ 11,200 Total$ 31,200 Your loss is the change in the Equity account: $11,200 - $20,000 = -$8,800 Your return is the gain in your account divided by your original investment -$8,800 / $20,000 = 44% This is twice the loss of the stock

2-17 How Low Can it Go? Again you start with 800 shares of WHOA at $50 per share. –Total cost: $40,000 –You put up $20,000—so borrow $20,000. Your initial margin is $20,000/$40,000 = 50%. Suppose your maintenance margin is 35%. At what price will you receive a margin call? The price can fall to $38.46 before you receive a maintenance call

2-18 How Low Can it Go? Continued What can you do if you get a maintenance call? –You can do nothing…the brokerage firm will then sell your shares in the market place at the best available price This way there is sufficient value to cover the loan –You can add more cash to your account to bring it back to the initial maintenance margin In this case if the price of WHOA falls to $38.46 you must add sufficient cash to your account to hit the 50% margin again If the value of the stock is $30,768 and you have borrowed $20,000 you equity stake is only $10,768. Required margin: $30,768 x 0.50 = $15,384 Required additional cash $15,384 - $10,768 = $4,616

2-19 Name on the Stock – Collateral for Loan When you go through a broker typically the stock is purchased in the name of the broker and you are the beneficiary owner Margin shares owned by a brokerage firm for a client are in STREET NAME (the street name of the broker, i.e., A.G. Edwards) Thus the broker can sell the stocks without your consent if you fail to post additional funds when you get a maintenance call Technically the shares are used a collateral against your borrowed dollars The process of using stocks as collateral is known as HYPOTHECATION

2-20 Short Sales, I. 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. Borrow shares from someone Borrow shares from someone Sell the Shares in the market Sell the Shares in the market Buy shares From the market Buy shares From the market Return the shares Return the shares TodayIn the Future

2-21 Short Sales, II. 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

2-22 Example: Short Sales, I. You short 100 share of Sears shares at $30 per share. Your broker has a 50% initial margin and a 30% 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, you must put 50% of the proceeds or $1,500 cash Assets Liabilities and Account Equity Sale Proceeds$ 3,000 Short Position (100 Shares) $ 3,000 Initial Margin Deposit$ 1,500 Account Equity $ 1,500 Total$ 4,500 Total $ 4,500

2-23 Example: Short Sales, II. 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 / $2,000 = 125% Assets Liabilities and Account Equity Sale Proceeds$ 3,000 Short Position (100 Shares) $ 2,000 Initial Margin Deposit$ 1,500 Account Equity $ 2,500 Total$ 4,500 Total $ 4,500

2-24 Example: Short Sales, III. Sears stock price rises to $35 per share. You sold short at $30, stock price is now $35, you are "behind" by $5 per share, or $500. Also: new margin = $1,000 / $3,500 = 28.57% < 30% Therefore, you are subject to a margin call. AssetsLiabilities and Account Equity Sale Proceeds$ 3,000 Short Position (100 shares) $ 3,500 Initial Margin Deposit$ 1,500 Account Equity $ 1,000 Total$ 4,500 Total $ 4,500

2-25 How High Can it Go Again you start with 100 shares of Sears at $30 per share. –Total cost: $3,000 –You put up $1,500 cash above proceeds—you borrow 100 shares. Your initial margin is $1,500/$3,000 = 50%. Suppose your maintenance margin is 30%. At what price will you receive a margin call? –The price can rise to $34.16 before you receive a maintenance call

2-26 More on Short Sales 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. Therefore brokerage firms require a deposit so that you have an equity stake in the transaction. And because you lose your equity position before the brokerage firm, you suffer all the loss. There was a an up-tick rule for short selling but this regulation has been eliminated. It required that the last price change be positive before you could execute a short sale.

2-27 Investment Objectives Fundamental Question: Why invest at all? –We invest today to have more tomorrow. –Investment is simply deferred consumption. –We choose to wait because we want more to spend later. 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.

2-28 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?

2-29 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?

2-30 Useful Internet Sites (a reference for dispute resolution) (a reference for short selling) (a reference for short interest) (a reference for risk aversion) (a reference for opening a brokerage account) (another reference for opening a brokerage account) (a risk tolerance questionnaire from Merrill Lynch) (a reference for current broker call money rate) finance.yahoo.com (a reference for short sales on particular stocks)finance.yahoo.com

2-31 Chapter Review, I. 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

2-32 Chapter Review, II. Short Sales –Basics of a Short Sale –Some Details Investor Objectives, Constraints, and Strategies –Risk and Return –Investor Constraints –Strategies and Policies