How Securities are Traded

1
Chapter 3

• How Securities are Traded
• How firms issue securities
• How securities are traded Trading basics
• Trading cost
• Order type
• Buying on margin
• Short sales

2
Primary vs. Secondary Security Sales

• Primary
• New issue
• Key factor issuer receives the proceeds from the
  sale
• Secondary
• Existing owner sells to another party
• Issuing firm doesnt receive proceeds and is not
  directly involved

3
Public Offerings

• Public offerings registered with the SEC and
  sale is made to the investing public
• Initial Public Offerings (IPOs)

4
Private Placements

• Private placement sale to a limited
• number of sophisticated investors not
• requiring the protection of registration
• Dominated by institutions
• Very active market for debt securities
• Not active for stock offerings

5
Costs of Trading

• Commission fee paid to broker for making the
  transaction
• Spread cost of trading with dealer (NOT an
  explicit cost, it is not a fee, but will affect
  your return)
• Bid price dealer will buy from you
• Ask price dealer will sell to you
• Spread ask - bid

6
Types of Orders

• Instructions to the brokers on how to
• complete the order
• Market order executed immediately at current
  market prices
• Limit order An order specifying a price at (or
  better than) which an investor is willing to buy
  or sell
• Limit buy buy at price same or below the
  stipulated limit price
• Limit sell Sell at price same or above the
  stipulated limit price

7
Types of Orders

• Stop order trade is not executed unless stock
  hits a price limit
• Stop-loss orders
• Def A stock is to be sold if its price falls
  below a price limit
• Idea sell to stop further loss
• Stop-buy orders
• Def a stock should be bought when price rises
  above a limit
• Idea limit loss from short sales
• Idea 2dont want to lose opportunity to buy
  before prices goes even higher

8
Margin Trading

• Using only a portion of the proceeds for an
  investment
• Borrow remaining component
• Margin
• The net worth (Equity) of the investors account
• Margin Asset-Liability ( borrowed funds or
  stocks)
• marginEquity/Value of stock
• The idea for margin requirement The of decline
  of your stock value before equity value drops to
  zero. It serves as a cushion for the lender.

9
Stock Margin Trading

• Maintenance margin minimum percentage of margin
  in trading before additional funds must be put
  into the account
• Initial margin maintenance margin when first
  purchasing the stock
• Margin call notification from broker you must
  put up additional funds

10
Margin Trading - Initial Conditions

• X Corp 70
• 50 Initial Margin
• 40 Maintenance Margin
• 1000 Shares Purchased
• Initial Position
• Stock 70,000 Borrowed 35,000
• Equity
  35,000

11
Margin Trading - Maintenance Margin

• Stock price falls to 60 per share
• New Position
• Stock 60,000 Borrowed 35,000
• Equity
  25,000
• Margin 25,000/60,000 41.67
• If sock price falls 41.67, equity will be wiped
  out (equity value will be zero).

12
Margin Trading - Margin Call

• How far can the stock price fall before amargin
  call?
• (1000P - 35,000) / 1000P 40
• P 58.33
• 1000P - Amt Borrowed Equity

13
Short Sales

• Purpose to profit from a decline in the price
  of a stock or security
• Mechanics
• Borrow stock through a dealer
• Sell it and deposit proceeds and margin in an
  account
• Closing out the position buy the stock and
  return to the party from which is was borrowed
• MarginEquity / Values of stocks owned

14
Short Sale - Initial Conditions

• Z Corp 100 Shares
• 50 Initial Margin
• 30 Maintenance Margin
• 100 Initial Price
• Sale Proceeds 10,000
• Margin Equity 5,000
• Stock Owed 10,000

15
Short Sale - Maintenance Margin

• Stock Price Rises to 110
• Sale Proceeds 10,000
• Initial Margin 5,000
• Stock Owed 11,000
• Net Equity 4,000
• Margin (4000/11000) 36
• If stock price rises 36, equity will be zero.

16
Short Sale - Margin Call

• How much can the stock price rise before a margin
  call?
• (15,000 - 100P) / (100P) 30
• P 115.38
• Initial margin plus sale proceeds

17
Warning

• Dont short!
• Short has unlimited potential loss
• Short is against the long term trend (positive
  return for investing)
• Stay away from
• Small cap, fast growing, high valuation (Netflix)
• Potential turning around company (Ford)
• Potential taken over target

18
Short candidates

• Stocks with a broken business model (BBI, DTV,
  BKS)
• and struggling in competition (Dell, MOT,NOK)
• and with a high valuation
• and with a large Cap. (small cap stocks can rise
  very fast and kill the shorts)