Buying and Selling Equities

1

• Buying and Selling Equities
• (chapter 3)

2
Buying and Selling

• Stock Price Quotes
• Bid
• The highest price a market maker is willing to
  pay (and is lower than the ask).
• Ask
• The lowest price a market maker is willing to
  accept to sell.
• Bid-Ask Spread
• Gap between the ask and the bid quotes.
• Profit to the market maker

• Market depth
• How many people are buying and selling? How much
  can I buy or sell without moving the price?
• Bid size the number of shares offered at the bid
  price
• Ask size the number of shares offered at the ask
  price

3
Buy now, or wait for a better price?

• Market order (executed immediately)
• Buy (or sell) now at market price
• Buy 50 shares of Home Depot at market
• Sell 100 shares of Apple Computer at market
• Limit order (may take awhile to execute, or
  never)
• Buy when the price gets a little better
• How long to wait?
• Fill or kill
• Day order
• Good til canceled
• Sell 100 shares of IBM at 82.70 or better,
  today
• Buy 200 shares of Dell at 30.72 or better, fill
  or kill
• When would these trades execute?

4
Place an order to trade when certain price levels
are reached (before the emotions set in!)

• Stop order
• Placing an order to sell a stock after the price
  has risen to a specified price.

• Stop-loss order
• Placing an order to sell when a stock falls to a
  specific price.

5
Pitfalls to Trading

• Active trading (day trading)
• Induces the same emotions as casinos try to
  elicit.
• Investment decisions are more likely to be
  influenced by emotions and psychological biases.
• The allure of active trading is strong.
• People who believe they have superior information
  or skill feel like they should benefit by trading
• Trading costs are important! (commissions and
  bid-ask spread)

6
Illusions

• Illusion of Knowledge
• The illusion that more information creates more
  knowledge and better predictions
• Does telling you what the last five rolls of a
  dice help you predict what the next roll will be?
• The internet is full of information
• How much is true?
• Can you turn this info into wisdom?
• Illusion of Control
• People often believe that they have influence
  over the outcome of uncontrollable events.
• People seem to believe that they have greater
  odds of winning the lottery with their own
  numbers than randomly picked numbers.
• These illusions may cause investors to trade too
  much and eventually experience lower returns!

7
Impact on Return

• A study of 1,607 investors which moved from
  discount broker to online broker.

• Before going online
• average turnover was 70
• beat the market by 2.4 per year
• After going online
• turnover jumped to 120
• under performed the market by 3.5 per year

Brad Barber and Terrance Odean, 2002, Online
Investors Do the Slow Die First? Review of
Financial Studies, 15, 455-487.
8
Buying Stocks Using Debt

• Cash account
• Most investors use a cash account. The fund the
  account with cash and then use the cash to buy
  stocks.
• Margin account
• You can borrow money from the brokerage firm to
  buy more stock.
• You must start with no less than 50 of the
  position as your equity (called initial margin)
• If the stock price falls, it is your equity that
  is declining
• If your margin falls below 20, you will be asked
  (a margin call) to sell or add more cash.
  (minimum maintenance margin level)

9
Computing your equity in a margin position

• Consider that you borrowed 10,000 to buy 20,000
  of stock.
• If the value of the stock increases to 25,000,
  what is your margin?
• If the value of the stock declines to 15,000,
  what is your margin?

10
Leverage, the reason to use margin

• Using margin magnifies the realized return.
• Example
• buy 200 shares at 40 per share (8,000 total)
• Use 4,000 or your own money and borrow 4,000.
• What is your return if the stock rises to 44? (a
  10 increase)
• Solution
• Profit is (44 - 40) 200 800
• Return is 800 / 4,000 20
• A 20 return from a stock that increased 10!

11
Leverage, the reason NOT to use margin

• Using margin magnifies the realized return.
• Example
• buy 200 shares at 40 per share (8,000 total)
• Use 4,000 or your own money and borrow 4,000.
• What is your return if the stock falls to 34? (a
  15 decline)
• Solution
• Loss is (34 - 40) 200 -1,200
• Return is -1,200 / 4,000 -30
• A -30 return from a stock that declined -15!

12
Profiting from falling stock prices

• The simple rule of buy low, sell high works
  well when prices are increasing.
• When prices are falling, can you sell high, buy
  low?
• Can only be executed on an uptick.

Lucent Technologies Share Statistics
Shares Outstanding 4.44B
Held by Insiders 0.15
Held by Institutions 33.40
Shares Short (as of 10-May-05)3 175.38M
Short Ratio (as of 10-May-05)3 3.6
Shares Short (prior month)3 164.40M

• Selling short (or short selling)
• By executing a short sale, the investor sell
  stock that they do not own (by borrowing it from
  the brokerage).
• Later, after the price falls (hopefully!) the
  stock is repurchased (called covering the short)
  and given back to the broker.

13
Short Example

• Short 100 shares at 60 using 50 margin
• Total proceeds 60 100 6,000
• Amount borrowed of own money used 3,000
• What is the equity margin and return if the price
  rises to 66?
• Loss (60 - 66) 100 -600
• Return -600 / 3,000 -20
• Margin

14
Short Example

• What is the equity margin and return if the price
  falls to 50?
• Profit (60 - 50) 100 -1,000
• Return 1,000 / 3,000 33.3
• Margin
• At what stock price would a margin call occur (in
  the maintenance margin is 20?
• P 75
• Short Squeeze when prices rise, investors short
  often have to cover their short, which involves
  buying stock, and causing more increases in price.

15
Dollar-Cost Averaging
If you buy stock over time, you will be some
shares at a low price and some at a high price as
the price fluctuates.
A Rising Market A Rising Market A Falling Market A Falling Market A Volatile Market A Volatile Market
Monthly Share Shares Share Shares Share Share Shares
Investment Price Purchased Price Purchased Price Price Purchased
400 4.00 100 50.00 8 40.00 40.00 10
400 8.00 50 25.00 16 25.00 25.00 16
400 8.00 50 25.00 16 16.00 16.00 25
400 10.00 40 20.00 20 10.00 10.00 40
400 12.50 32 20.00 20 8.00 8.00 50
400 12.50 32 20.00 20 4.00 4.00 100
400 16.00 25 16.00 25 4.00 4.00 100
400 20.00 20 16.00 25 8.00 8.00 50
400 20.00 20 10.00 40 10.00 10.00 40
400 25.00 16 5.00 80 16.00 16.00 25
400 40.00 10 5.00 80 25.00 25.00 16
400 40.00 10 4.00 100 50.00 50.00 8
Totals 4,800 216.00 405 216. 450 216.0 216.0 480
Average price 18.00 11.85 18.0 10.67 18.00 18.00 10.00
16
Issuing New Securities

• New securities are issued with the help of
  investment banks (or underwriter)
• New issues are sold on the primary market first,
  and subsequently sell on the secondary market.
• The secondary markets are the security exchanges.
• The selling of shares for the first time in a new
  company is called a initial public offering (IPO)

17
Underwriting

• Investment banks advise or underwrite new
  issues distribute shares to institutional
  investors through road shows
• Firm-commitment underwriting investment bankers
  buy entire issue and assume risk
• Best-efforts underwriting investment agrees to
  make its best effort at placing shares issuing
  firm assumes risk
• All-or-none offerings investment bank tries to
  sell entire issue or sale is cancelled

18
For Large Issues, a Syndicate is Used

• Group of underwriters
• Syndicate manager
• Underwriters allotment
• Dealers agreement
• Tombstone ads

19
Who gets IPO shares?

• Hot Issue Market
• During some periods, over 50 news firms go public
  every month.
• Many investors want these shares
• Initial returns are high
• Cold market
• During other periods, less than 10 IPOs are
  issued in a month.
• Who gets shares?
• Those who want shares ask their broker.
• When more shares are sought, than are being
  issued, priority tends to go to the large
  shareholders and the brokers best clients.
• If you are a small-money investor and receive
  shares of an IPO, look out, it may be a lemon!

20
Learning objectives
Know the bid-ask spread and market depth. Discuss
the market, limit and stop orders. Discuss the
following pitfalls to trading hyperactive
trading, online brokerage and trading activity,
the illusion of knowledge, the illusion of
control Discuss buying on margin know how to
calculate the change in the value of the margin
account (see slides 9, 10 and 11) Discuss the
short selling know how to calculate the short
selling return as in example in slides 13 and
14 Know the underwriting process for IPOs know
the definitions p. 79 to 83 text End of chapter
questions 3.1 to 3.8