Buying and Selling Securities

1
Chapter 2

• Buying and Selling Securities

2
Key Concepts and Skills

• Broker-customer relationship
• Brokerage account options
• Margin trading and short sales

3
Broker Basics

• No advice is guaranteed
• Principal-Agent relationship
• Broker is an agent
• SIPC Protection totals 500,000
• Cash maximum of 100,000
• Securities

4
Brokerage Accounts

• Cash Account
• brokerage account in which securities are paid
  for in full
• Margin Account
• brokerage account in which securities can be
  bought and sold short on credit
• Borrowed portion incurs interest based on the
  brokers call money rate

5
Buying on Margin

• Investor buys part of the purchase price of the
  stock from a broker
• Margin portion of purchase price contributed by
  the investor
• Investor borrows from broker, broker borrows from
  a bank
• Initial margin requirement 50 or 2,000,
  whichever is greater

6
Margin Terms

• Margin
• Initial margin
• Maintenance margin
• Margin call
• Hypothecation
• Street name

7
Margin Example

• You buy 1,000 Wal-Mart shares at 24 per share.
  You put up 18,000 and borrow the rest. What is
  your margin?
• Assets Liabilities
• 1,000 shares 24,000 Margin Loan 6,000
• Equity 18,000
• Total 24,000 24,000
• Margin Equity/Value of shares 18/24 75

8
Margin Example

• Suppose the price of Wal-Marts stock drops to
  20. What is your margin now?
• Assets Liabilities
• 1,000 shares 20,000 Margin Loan 6,000
• Equity 14,000
• Total 20,000 20,000
• Margin Equity/Value of shares 14/20 70

9
Margin Example

• What if Wal-Marts stock continues to plummet
  and hits 5. What is your new margin?
• Assets Liabilities
• 1,000 shares 5,000 Margin Loan 6,000
• Equity -1,000
• Total 5,000 5,000
• Once the value of the stock drops below your
  equity becomes negative.

10
Maintenance Margin

• Guards against the possibility that your equity
  is less than the loan you borrowed

11
Maintenance Margin

• Suppose the maintenance margin was 30 for the
  previous example. At what price (P) would you
  receive a margin call.
• Number of shares Value of loan
• P price per share
• 1,000P - 6,000 .3 or 30
• 1,000P
• P Once the price of the stock drops below
  this value, you will receive a margin call.

12
Margin Review

• Margin Equity in account
  
• Value of stock
• Maintenance margin
• Set to protect against negative equity positions

13
Wal-Mart Margin Scenarios Revisited

• Examine the payoffs for each share price
  scenario. Assume you borrowed 6,000 at 8 per
  year.

Margin trading exaggerates both profits and
losses.
14
Short Sales

• Investor sells and then buys back the shares
• Investors can profit from a decline in a
  securitys price
• Borrow shares to sell them
• Repay any dividends and buy shares to replace the
  share originally borrowed
• Sufficient cash and/or securities must be in your
  account to cover margin requirements

15
Short Sale Example

• You are bearish on eBay and contact your broker
  for a short sale at 100/share. The broker has a
  50 margin requirement for short sales. Assume
  1,000 shares.
• Assets Liabilities Equity
• Cash 100,000 eBay (shares owed) 100,000
• T-bills 50,000 Equity 50,000
• Total 150,000 150,000
• Margin 50/100 50

16
Short Sale Example

• Suppose eBays stock falls to 70.
• You buy 1,000 shares at 70, to replace the
  shares you borrowed (spending 70,000).
• You borrowed and sold shares worth 100,000
• Your profit 30,000

17
Short Sale Margin Call

• Your broker has a short position maintenance
  margin of 30. Above what price level would you
  receive a margin call?
• Equity 150,000 - 1,000P .3
• Value owed 1,000 P
• Solving for P, if the price goes above
  per share, you will receive a margin call from
  your broker.

18
Short Sale Cash Flows

• Short seller pays the broker commission
• Broker borrows shares and sells them
• Share price goes down

• Broker buys shares at new price
• Profit goes to short seller

19
Quick Quiz

• What is a margin account?
• What effect does margin trading have on profits
  and losses?
• What is the sentiment of an investor who wishes
  to book a short sale?