© 2009 mcgraw-hill ryerson limited 3-1 chapter 3 buying and selling securities getting started...

© 2009 McGraw-Hill Ryerson © 2009 McGraw-Hill Ryerson LimitedLimited

3-3-11

Chapter 3Chapter 3

Buying and Buying and Selling SecuritiesSelling Securities

• Getting startedGetting started• Brokerage accountsBrokerage accounts• Short salesShort sales• Investor objectives, Investor objectives, constraints, and strategiesconstraints, and strategies


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Getting StartedGetting Started

(c) Buy 100 Shares of Disney

at $60 per share

(c) Buy 100 Shares of Disney

at $60 per share

(e) $3,950 Cashin Account

$6,000 Stock In Account

(e) $3,950 Cashin Account

$6,000 Stock In Account

(d) Pay Commission,Say $50

(d) Pay Commission,Say $50

(b) Deposit $10,000into account

(b) Deposit $10,000into account

(a) Open a brokerageor trading account

(a) Open a brokerageor trading account


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Choosing a BrokerChoosing a Broker Brokers are traditionally divided into three groups:Brokers are traditionally divided into three groups:

1.1. full-service brokersfull-service brokers2.2. discount brokersdiscount brokers3.3. deep-discount brokersdeep-discount brokers

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

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

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

Online investing has really changed the brokerage industry.Online investing has really changed the brokerage industry. slashing brokerage commissionsslashing brokerage commissions providing investment informationproviding investment information Customers place buy and sell orders over the InternetCustomers place buy and sell orders over the Internet


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Choosing a BrokerChoosing a Broker


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Canadian Investor Protection FundCanadian Investor Protection Fund Canadian Investor Protection Fund (CIPF):Canadian Investor Protection Fund (CIPF):

Insurance fund covering investors’ brokerage Insurance fund covering investors’ brokerage accounts with member firms.accounts with member firms.

Most brokerage firms belong to the CIPF, which Most brokerage firms belong to the CIPF, which insures each account for up to $1,000,000 for losses insures each account for up to $1,000,000 for losses of securities, commodity and futures contracts.of securities, commodity and futures contracts.

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

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


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Broker-Customer RelationsBroker-Customer Relations There are several important things to remember when you There are several important things to remember when you

deal with a broker:deal with a broker: Any advice you receive is Any advice you receive is notnot guaranteed. guaranteed. Your broker works as your agent and has a legal duty to act Your broker works as your agent and has a legal duty to act

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

commissions.commissions. Your account agreement will probably specify that any Your account agreement will probably specify that any

disputes will be settled by arbitration and that the disputes will be settled by arbitration and that the arbitration is final and binding.arbitration is final and binding.


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Brokerage AccountsBrokerage Accounts A A Cash accountCash account is a brokerage account in which is a brokerage account in which

securities are paid for in full.securities are paid for in full.

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

(more on selling short later)


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Margin AccountsMargin Accounts

In a In a margin purchasemargin purchase, the , the portionportion of the value of an of the value of an investment that is investment that is not borrowednot borrowed is called the is called the marginmargin. Of . Of course, the portion that is borrowed incurs an interest charge.course, the portion that is borrowed incurs an interest charge. This interest is based on the broker’s This interest is based on the broker’s call money rate.call money rate. The call money rate is the rate brokers pay to borrow The call money rate is the rate brokers pay to borrow

money to lend to customers in their margin accounts.money to lend to customers in their margin accounts.

Example: Margin Accounts, The Balance SheetExample: Margin Accounts, The Balance Sheet You buy 1,000 Wal-Mart shares at $24 per share. You buy 1,000 Wal-Mart shares at $24 per share. You put up $18,000 and borrow the rest. You put up $18,000 and borrow the rest. Amount borrowed = $24,000 – $18,000 = $6,000Amount borrowed = $24,000 – $18,000 = $6,000 Margin = $18,000 / $24,000 = 75%Margin = $18,000 / $24,000 = 75%


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Example: Margin Accounts,Example: Margin Accounts,The Balance SheetThe Balance Sheet

AssetsAssets Liabilities and Account Liabilities and Account EquityEquity

1,000 Shares, WMT1,000 Shares, WMT $24,000$24,000 Margin LoanMargin Loan $6,000$6,000

Account EquityAccount Equity $18,000$18,000

TotalTotal $24,000$24,000 TotalTotal $24,000$24,000


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Margin AccountsMargin Accounts

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

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

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


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Example: The Workings of Example: The Workings of a Margin Account, Ia Margin Account, I

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

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

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


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Workings of a Margin AccountWorkings of a Margin Account


800 Shares of WHOA 800 Shares of WHOA @ $50@ $50

$40,000$40,000 Margin LoanMargin Loan $20,000$20,000

Account EquityAccount Equity $20,000$20,000

TotalTotal $40,000$40,000 TotalTotal $40,000$40,000


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Example: The Workings of Example: The Workings of a Margin Account, IIa Margin Account, II

After your purchase, shares of WHOA fall to $35.After your purchase, shares of WHOA fall to $35. New margin = $New margin = $8,0008,000 / $ / $28,00028,000 = 28.6% = 28.6% It is less than the margin (It is less than the margin (28.6% < 30% )28.6% < 30% ) Therefore, you are subject to a Therefore, you are subject to a margin callmargin call..


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Example: The Workings of Example: The Workings of a Margin Account, IIa Margin Account, II


800 Shares of WHOA 800 Shares of WHOA @ $35@ $35

$28,000$28,000 Margin LoanMargin Loan $20,000$20,000

Account EquityAccount Equity $$8,0008,000

TotalTotal $28,000$28,000 TotalTotal $$28,00028,000


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Example: The Effects of Margin, I.Example: The Effects of Margin, I.

You have $30,000 in a margin account that requires 60% initial You have $30,000 in a margin account that requires 60% initial margin. You can buy $50,000 of stock with this account (why?).margin. You can buy $50,000 of stock with this account (why?).

Your borrowing rate from your broker is 6.00%.Your borrowing rate from your broker is 6.00%. Suppose you buy 1,000 shares of TD Bank, for $50/share.Suppose you buy 1,000 shares of TD Bank, for $50/share. Assume no dividends, and that your borrowing rate is still 6.00%, Assume no dividends, and that your borrowing rate is still 6.00%,

what is your return if in one year, stock is selling for $60 per share.what is your return if in one year, stock is selling for $60 per share. Your investment is worth $60,000.Your investment is worth $60,000. You owe 6% on the $20,000 you borrowed: $You owe 6% on the $20,000 you borrowed: $1,2001,200.. If you pay off the loan with interest, your account balance is: If you pay off the loan with interest, your account balance is:

$60,000 – $21,200 = $38,800.$60,000 – $21,200 = $38,800. You started with $30,000.You started with $30,000. Therefore, your return is $8,800 / $30,000 = 29.33%.Therefore, your return is $8,800 / $30,000 = 29.33%. Suppose TD stock was selling for $40 per share instead of $60 per Suppose TD stock was selling for $40 per share instead of $60 per

share? What is your return?share? What is your return?


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Example: The Effects of MarginExample: The Effects of Margin

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

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

Your investment is now worth $36,000.Your investment is now worth $36,000. Therefore, your return is $6,000 / $30,000 = Therefore, your return is $6,000 / $30,000 =

20.00%. 20.00%. Suppose TD is selling for $40 per share instead of Suppose TD is selling for $40 per share instead of

$60 per share. What is your return in this case?$60 per share. What is your return in this case?


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Example: How Low Can it Go?Example: How Low Can it Go? Suppose you want to buy 200 shares of Anheuser Suppose you want to buy 200 shares of Anheuser

Busch (BUD) at $50 per share.Busch (BUD) at $50 per share. Total cost: $10,000, You have only $6,000—so Total cost: $10,000, You have only $6,000—so

you must borrow $4,000. you must borrow $4,000. Suppose your broker requires a maintenance Suppose your broker requires a maintenance

margin of 30%.margin of 30%.

Your initial margin is $6,000/$10,000 = 60%.Your initial margin is $6,000/$10,000 = 60%.At what price will you receive a margin call?At what price will you receive a margin call?


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Example: How Low Can it Go? Answer.Example: How Low Can it Go? Answer.

This will happen when the price of Anheuser Busch This will happen when the price of Anheuser Busch drops to $28.57. How so? Well, drops to $28.57. How so? Well,

$28.57.140

4000

200X0.30) - (200

$4,000 P

here, So

Level)Margin eMaintenanc*Shares ofNumber - Shares of(Number

BorrowedAmount P

in results ,P price,stock critical for the Solving

P Shares ofNumber

BorrowedAmount PShares ofNumber LevelMargin eMaintenanc

*

*

*

*

*


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Hypothecation and Street Name Hypothecation and Street Name RegistrationRegistration

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

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

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


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Other Account Issues, I.Other Account Issues, I. Trading accounts can also be differentiated by the ways they Trading accounts can also be differentiated by the ways they

are managed.are managed. Advisory accountAdvisory account - You - You paypay someone else to make buy someone else to make buy

and sell decisions on your behalf.and sell decisions on your behalf. Wrap accountWrap account - All the expenses associated with your - All the expenses associated with your

account are “wrapped” into a single fee.account are “wrapped” into a single fee. Discretionary accountDiscretionary account - You - You authorize authorize your broker to your broker to

trade for you.trade for you. Asset management accountAsset management account - Provide for complete money - Provide for complete money

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

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

One alternative is to buy securities directly from the issuer. One alternative is to buy securities directly from the issuer. Another alternative is to invest in Another alternative is to invest in mutual fundsmutual funds..


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Short Sales, I.Short Sales, I.

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

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

Borrowsharesfrom

someone

Borrowsharesfrom

someone

Sell theShares in the market

Sell theShares in the market

Buyshares

From themarket

Buyshares

From themarket

Returnthe

shares

Returnthe

shares

Today In the Future


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Short Sales, II.Short Sales, II. An investor with a long position benefits from price An investor with a long position benefits from price

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

An investor with a short position benefits from price An investor with a short position benefits from price decreases.decreases. Also easy to understandAlso easy to understand You sell today at $83, and buy later at $27, you profit.You sell today at $83, and buy later at $27, you profit. Sell high, buy lowSell high, buy low


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Example: Short Sales, I.Example: Short Sales, I.

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

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

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

AssetsAssets

Liabilities and Liabilities and Account EquityAccount Equity

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

Initial Margin Initial Margin DepositDeposit

$ 1,500$ 1,500 Account EquityAccount Equity $ 1,500$ 1,500

TotalTotal $ 4,500$ 4,500 TotalTotal $ 4,500$ 4,500


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Example: Short Sales, II.Example: Short Sales, II. Sears stock falls to $20 per share.Sears stock falls to $20 per share. Sold at $30, value today is $20, so you are "ahead" Sold at $30, value today is $20, so you are "ahead"

by $10 per share, or $1,000.by $10 per share, or $1,000. Also, new margin: $Also, new margin: $2,5002,500 / $ / $2,0002,000 = 125% = 125%

AssetsAssetsLiabilities and Liabilities and

Account EquityAccount Equity

Sale Proceeds Sale Proceeds $ 3,000$ 3,000 Short PositionShort Position $ $ 2,0002,000

Initial Margin Initial Margin Deposit Deposit

$ 1,500$ 1,500 Account EquityAccount Equity $ $ 2,5002,500



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Example: Short Sales, III.Example: Short Sales, III. Sears stock price rises to $40 per share.Sears stock price rises to $40 per share. You sold short at $30, stock price is now $40, you are You sold short at $30, stock price is now $40, you are

"behind" by $10 per share, or $1,000. "behind" by $10 per share, or $1,000. Also: new margin = $Also: new margin = $500500 / $ / $4,0004,000 = 12.5% < 40% = 12.5% < 40%

Therefore, you are subject to a margin call.Therefore, you are subject to a margin call.

AssetsAssets Liabilities and Liabilities and

Account EquityAccount EquitySale Proceeds Sale Proceeds $ 3,000$ 3,000 Short PositionShort Position $ $ 4,0004,000

Initial Margin Initial Margin DepositDeposit

$ 1,500$ 1,500 Account EquityAccount Equity $ $ 500500



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More on Short SalesMore on Short Sales

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

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

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


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Short Selling Report from Short Selling Report from TheThe TSXTSX


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Investment ObjectivesInvestment Objectives Fundamental Question: Why invest at all?Fundamental Question: Why invest at all?

We invest today to have more tomorrow.We invest today to have more tomorrow. Investment is simply deferred consumption.Investment is simply deferred consumption. We choose to wait because we want more to spend later.We choose to wait because we want more to spend later.

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

© 2009 McGraw-Hill Ryerson Limited

3- 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?

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?


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Useful Internet SitesUseful Internet Sites www.bearmarketcentral.com (a reference for short selling) (a reference for short selling) www.moneycentral.msn.com (a reference for risk aversion)(a reference for risk aversion) www.sharebuilder.com (a reference for opening a brokerage (a reference for opening a brokerage

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

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

money rate)money rate)

© 2009 mcgraw-hill ryerson limited 3-1 chapter 3 buying and selling securities getting started...

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