3. Investment Planning. 14. Buying and Selling Securities Flashcards
Investing in stock is a relatively complex concept for most people. In the past, it was more common for people to have a home or their money in the bank as their only investments. However, this viewpoint changed, and in the last few decades people have turned to other avenues of investing, such as stocks, bonds, Treasury Bills, and mutual funds. The majority of investments that were taken out of banks were put in mutual funds. In the late 1990s, as the Internet boom took off, many people tried investing on their own through discount and online brokers. When the Internet boom went bust, some of the more risk-averse investors shied away from stock investments or at least became more dependent on professional investment advice. Today, brokers are not strictly employed in brokerage firms. Investors can have their brokerage service needs met on the Internet, at a local bank, and through mutual fund companies.
The Buying and Selling Securities module, which should take approximately four hours to complete, will explain the purchase and sale of securities through a brokerage account.
Upon completion of this module you should be able to:
* List various brokerage services,
* List the specifications of transaction orders,
* Describe how margin accounts are used for purchases and short sales, and
* Describe the aggregation of multiple margin transactions.
AUDIO
When a security is bought or sold, many financial intermediaries are likely to be involved. Although it is possible for two investors to trade with each other directly, the most common transaction employs the services provided by brokers, dealers, and markets. A broker acts as an agent for an investor and is compensated via commission.
Many individual investors find it easy and convenient to deal with brokerage firms with many offices that are connected by private wires with their own headquarters and, through the headquarters, with the major markets. This helps investors to be part of the market via the brokerage firms, and, throughout the market’s ups and downs, make or lose money. All transactions are handled by brokers.
To ensure that you have a solid understanding of the buying and selling of securities, the following lessons will be covered in this module:
* Brokerage Services
* Order Specifications
* Margin Accounts
* Aggregation
Brokerage firm - where investors can meet their security transaction needs
Brokerage account - can hold stocks, bonds, mutual funds
Investors can pay full price or buying on margin (using borrowed funds)
Purpose of this module:
* List various brokerage account options
* Discuss the strategies behind various order types
* Compare and contrast between cash and margin accounts
Goal of the module: become familiar with brokerage account options available to you and your clients
Section 1 - Brokerage Services
There are three general categories of brokers: full-service brokers, discount brokers, and deep discount brokers. In addition, you can also deal directly, that is, over the phone or in person, with your broker, or you can do your trading online without ever interacting directly with a broker. The differences between them center on advice and cost. The difference in cost can be substantial.
To ensure that you have a solid understanding of brokerage accounts, the following topics will be covered in this lesson:
* The Brokerage Account
* Asset Management Account
* Brokerage Reports
Upon completion of this lesson, you should be able to:
* Describe a brokerage account,
* Describe an asset management account, and
* Describe brokerage reports.
Section 1 – Brokerage Services Summary
When opening a brokerage account, an investor must consider the amount of advice he or she will need going forward. More expensive full service brokers will offer extensive advice for transactions. They may also offer products such as wrap accounts that make investing simple for hands-off investors. Active investors who enjoy the challenge of making their own investment decisions may choose less expensive alternatives such as discount brokers or online brokers.
In this lesson, we have covered the following:
* The brokerage account acts as a reservoir for the investor’s investment assets including stocks, bonds, cash and other securities. The amount of advice given for transactions is proportionate to the amount of commission paid.
- Asset management accounts are offered by some brokerage firms as a way to manage all of an investor’s financial needs including financing (loan payments), credit (credit card), cash (checking account) and investments (brokerage account).
- Research reports are provided by most full-service and some discount brokers to customers with the brokerage firm’s security analyst’s rationale and recommendations for buying, holding or selling individual securities.
- Wrap accounts align a professionally managed portfolio with personal investment needs. There are a variety of types including ones that are purely consultative, to ones that only hold mutual funds, to ones that are aligned with the brokerage firm’s recommended strategies.
Section 2 – Order Specifications
When an investor is ready to make a trade, he or she will contact a broker with the order specifications. In discussing order specifications it will be assumed that the investor’s order involves common stock. These specifications include:
* The name of the security,
* Whether the order is to buy or sell shares,
* The size of the order,
* How long the order is to be outstanding, and
* What type of order is to be used.
To ensure that you have a solid understanding of order specifications, the following topics will be covered in this lesson:
* Order Size
* Time Limit
* Order Type
Upon completion of this lesson, you should be able to:
* Identify the size of orders, in terms of number of shares,
* Identify the time limit specifications as specified by investors, and
* List the types of orders.
Describe the terminology for Order Size
When buying or selling common stock, the investor places an order involving a round lot, an odd lot, or both.
* In general, round lot means that the order is for 100 shares, or a multiple of 100 shares.
* Odd lot orders generally are for 1 to 99 shares.
* Orders that are for more than 100 shares, but are not a multiple of 100, should be viewed as a mixture of round and odd lots. Thus, an order for 259 shares should be viewed as an order for two round lots and an odd lot of 59 shares.
PRACTITIONER ADVICE:
A block trade is for 10,000 shares. This is typically carried out by institutional traders who make large volume transactions throughout the trading day.
Match the corresponding order size with the number of shares.
Round Lot
Odd Lot
Mixed Lot
Block trade
* 65 shares
* 10,000 shares
* 369 shares
* 200 shares
- Round Lot - 200 shares
- Odd Lot - 65 shares
- Mixed Lot - 369 shares
- Block trade - 10,000 shares
Section 2 – Order Specifications Summary
Every investor makes transactions for securities through brokerage firms, as this is the most convenient form of dealing with the market. Investors specify the name of the security, whether the order is to buy or sell stocks, the size of the order, how long the order is to be outstanding, and what type of order is to be used.
Example
You can outsmart yourself sometimes. A stock was trading at $19.13 per share. The investor wanted to keep the broker honest and put in a limit order to buy for 19 instead of putting in a market order. The stock continued to rise up to $60 per share and the limit order was never executed. If the investor had just executed the market order, he would have profited from the rise in the share price. That is the risk of submitting a limit buy order for a price lower than the current market price for the stock.
In this lesson, we have covered the following:
* Order size: Determines the number of shares that the investor wants to buy or sell. The investor places an order involving round lots that are grouped into 100 or multiples of 100 shares, odd lots that contain 1 to 99 shares, or both, containing 100 or more shares but not a multiple of 100.
* The time limit must be specified by the investor on his or her order. This is the timeframe within which the broker attempts to fill the order, which can be the same day in which it was entered; until the order is filled or canceled; or as specified by the broker at his discretion.
* Order type includes market orders, limit orders, stop orders, and stop-limit orders.
Jose places an order with his broker to buy 400 shares of XYZ Corp to be executed by the end of the day at $49/share or less. Which of the following is true about Jose’s order? (Select all that apply)
* It is an odd lot
* It is a round lot
* It is a day order
* It is a fill or kill order
* It is a limit order
It is a round lot
It is a day order
It is a limit order
* Since the size was a multiple of 100, the order was a round lot.
* Execution within the same day is a day order.
* The specified ceiling price of $49/share makes it a limit order.
When an investor specifies a time limit on the order, it indicates the:
* Time that the exchange is open
* Amount of price movement allowed by the investor
* Time to fill the order
* Commission based on the time it takes to fill the order
Time to fill the order
* The investor needs to specify a time limit within which the broker should attempt to fill the order.
Natasha wanted to purchase shares of a stock once it hit a certain price, but she is afraid the price of the stock may move too quickly. What type of order should she request?
* Market order
* Stop-buy order
* Limit order
* Stop-limit order
Stop-limit order
* Natasha can use a stop-limit order to activate a market order at a certain price, and then limit the transaction from going beyond an unwanted price.
Which orders are cancelled if the broker is unable to fully execute them immediately?
* Good-till-canceled
* Open
* Fill-or-kill
* Discretionary
Fill-or-kill
* Fill-or-kill orders are those that get cancelled if the broker is unable to fully execute them immediately.
Section 3 – Margin Accounts
Investors with cash accounts pay in full for their security purchases, with the payment due within three business days of the transaction. Investors with margin accounts borrow a portion of the purchase price from the broker. A cash account with a brokerage firm is like a regular checking account, whereby deposits must cover withdrawals. A margin account, on the other hand, is like a checking account that has overdraft privileges. So when more money is needed than is in the account, the broker automatically makes the loan within limits.
When opening a margin account with a brokerage firm, an investor must sign a hypothecation agreement. This agreement grants the brokerage firm the right to pledge the investor’s securities as collateral for bank loans, provided that the securities were purchased using a margin account.
With a margin account an investor may undertake certain types of transactions that are not allowed with a cash account. These transactions are known as margin purchases and short sales.
To ensure that you have a solid understanding of margin accounts, the following topics will be covered in this lesson:
* Margin Purchases
* Short Sales
* Securities Lending
Upon completion of this lesson, you should be able to:
* Describe margin purchases,
* Describe short sales, and
* Describe security lending.
PRACTITIONER ADVICE:
People often confuse the term margin. When someone talks about buying securities on margin, he or she often refers to margin as the money that is borrowed. The margin portion actually refers to the equity (the portion that is paid for already). So if there was a $10,000 stock purchase with a 60% initial margin requirement, investors must put down $6,000 and borrow $4,000, not the other way around.
Antonio bought a 100-share block of Tomorrow’s Toys Corp. for $20/share. The initial margin is 65%. If the price of the stock goes to $30/share, what is the actual margin on Antonio’s account?
* 65%
* 66.67%
* 23.33%
* 76.67%
76.67%
* Initial purchase was for $2,000.
* At 65% initial margin, $1,300 was paid in cash and $700 was a loan.
* When assets increase to $3,000, the loan is still $700 and the equity is $2,300.
* The actual margin = $2,300/$3,000
* =76.67%.
An investor just bought 1,000 shares of IBM from her broker on margin. The initial margin requirement was 50%, and the firm adheres to a strict maintenance margin requirement of 30%. The total cost of the transaction, including the commission, was $100,128. ($100 per share and $128 commission).
1. At what price per share will the investor receive a margin call from her broker?
2. If the price should suddenly fall to $60 per share, how much additional cash will be needed to meet the margin call?
- The break-point formula yields the lowest possible price where the margin level is still acceptable. Any price below this however, will result in a margin call.
This break-point form is: [(1 - I.M.) / (1 - M.M)] x Ps
Where:
I.M. = initial margin requirement (%)
M.M. = maintenance margin requirement (%)
Ps = purchase price of the stock
[(1 - .50) / (1 - .30)] x $100.128
= $71.52
Any closing price below $71.52 will generate a margin call.
-
Formula is: Market value x (1 - M.M,) = maximum debt allowable.
Then subtract this amount from current debt amount to determine margin call.
= $60,000, multiplied by (1 - .30)
= $42,000 = maximum debt allowable.
The current debt amount was 50% of the original transaction of $100,128 or $50,064.
Therefore, the margin call = $50,064 - $42,000 = $8,064.
Example (Cash Account vs. Margin Account)
If Donna buys 100 shares of Toothwhite Co. for $50/share using a cash account, she would pay $5,000 for them.
* If she buys those shares in a margin account with an initial margin of 60%, then she would pay $__ ____??____ __ for them.
* If the price went to $60/share, then Donna’s return for the cash account is __ ____??____ __.
* But if she bought the shares in a margin account, then her return would be __ ____??____ __.
- If she buys those shares in a margin account with an initial margin of 60%, then she would pay $3,000 for them.
- If the price went to $60/share, then Donna’s return for the cash account is ($6,000 - $5,000)/$5,000 = 20%.
- But if she bought the shares in a margin account, then her return would be ($6,000 - $5,000)/$3,000 = 33%.
- Therefore, through leverage, Donna can earn a greater return on her margin account.
If the maintenance margin is 40%, would an investor receive a margin call if the price went up to $120/share? Equity is $4,000.
* Yes
* No
Yes
* Actual Margin = Equity ÷ Margin Value
* = $4,000 ÷ $12,000
* = 33.3%.
* Since 33.3% is less than 40% a margin call will be made for the account.
Describe Actual and Maintenance Margin
It is maintenance margin that protects the brokerage firm from losing money in situations where the initial margin has not been sufficient to cover the extreme volatility of stock prices. In order to examine the use of maintenance margin in short sales, the actual margin in a short sale will be defined as:
Actual Margin = (short sale proceeds+initial margin) −loan / loan
For short sales, the loan is the current value of the assets held in the account (current price X number of shares).
In some cases, there are short sales in which the stock price goes up to such a degree that the maintenance margin requirement is violated and the account is thereby under-margined. One more case is where the stock price goes up but not to such a degree that the maintenance margin requirement is violated. In this case, the initial margin requirement has been violated, which means that the account is restricted.
Maintenance margin, in other words, is charged over and above the initial margin, especially in times of volatile markets. This is required to be able to cover the actual margin requirements of an order.
Exam Tip: While it is likely that you will be tested on margin calls and requirements from the long side, it is highly unlikely you will be tested on margin calls/requirements on short transactions.
Mei sells short 200 shares of Wheels-R-Us at $50 per share. The initial margin is 60% and the maintenance margin is 50%. If the price per share goes to $57, would Mei receive a margin call from her broker?
* Yes
* No
Yes
- The short sale proceeds = $10,000
Initial margin = $6,000
Therefore, the loan amount = $11,400
The actual maintenance is 40.35%.
Mei will receive a margin call and she has to either add cash or securities, or buy back stock to pay off part of her short position.
Section 3 – Margin Accounts Summary
Investors can purchase securities with cash or may borrow from brokerage firms to buy securities on margin. With margin accounts, investors are required to make down payments on their margin purchases, maintain minimum levels of collateral in their margin accounts, and pay interest on margin loans. Investors can also be involved in short selling of securities. Margin allows the investor to maximize his or her gain through leverage, but it also exposes him or her to greater risks.
In this lesson, we have covered the following:
- Margin purchases involve purchase of securities by borrowing from brokerage firms to buy securities on margin. The investors are required to maintain a margin requirement with respect to actual margin and initial margin, engage in financial leverage, and pay interest on margin loans.
- Short sales involve the sale of securities that are not owned, but rather are borrowed by the sellers. The borrowed securities must ultimately be purchased in the market and returned to the lenders. A short seller must deposit the proceeds of the short sale and initial margin with his or her broker. The short seller must also maintain a minimum actual margin level in his or her margin account or face a margin call.
PRACTITIONER ADVICE:
Remember, leverage works both ways. A margin account can maximize an investor’s return but also increase the risk exposure.
When opening a margin account with a brokerage firm, which agreement must an investor sign?
* Commission-waiver
* Hold-harmless
* Limit order
* Hypothecation
Hypothecation
* When opening a margin account with a brokerage firm, an investor must sign a hypothecation agreement. This agreement grants the brokerage firm the right to pledge the investor’s securities as collateral for bank loans, provided that securities are purchased using a margin account.
* Most brokerage firms also expect investors to allow them to lend their securities to others who wish to sell them short.
The minimum percentage of the purchase price that must come from the investor’s own funds is known as the:
* Maintenance margin
* Margin account
* Initial margin requirement
* Debit balance
Initial margin requirement
* The minimum percentage of the purchase price that must come from the investor’s own funds is known as the initial margin requirement.
VJ suspects that Hermes Wireless’ share price will decline in the near future. He would like to sell it for its current price and buy it back later when it is cheaper. When an investor sells a security first and buys it back later, it is known as:
* Margin selling
* A short sale
* Discounting
* A wash
A short sale
* Most investors buy securities first and sell them later.
* But with short selling, investors sell securities first and then buy them back later.
* If VJ short sells Hermes Wireless shares, he will be borrowing the securities to sell to someone, then when the prices drop, he will buy the shares back and return the shares to the original lender.
A broker buys 500 shares of IBM stock at $80 per share on margin. The initial margin is 50% and the maintenance margin requirement is 30%. To what price may the IBM stock fall before the broker receives a margin call?
* $57.14
* $55.08
* $48.00
* $52.85
$57.14
* The maintenance margin is 30% = $12,000 (500 x 80 x 0.30).
* The initial margin provides a price movement of ± 50% i.e. up to $20,000. Therefore, beyond a price volatility of ± $12,000, the broker is likely to give an additional margin call.
* When the total value of the stock falls to $28,000 (initial investment – maintenance margin), the broker will ask for a margin call. So he calls for the highest price that allows him not to go beyond $28,000.
* At the price of $57.14 (500 x 57.14 = 28,570) the broker is likely to give margin call, since the total value of the shares is only $28,570.
