Buying and Selling Securities

Question 1

Brokerage Services

Answer 1

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 or even through an app without ever interacting directly with a broker. The differences between them center on advice and cost. The difference in cost can be substantial both explicit cost (trading fees) and implicit costs (bid-ask spreads).

Question 2

The Brokerage Account

Answer 2

Just as a bank account represents money you have on deposit at a bank, a brokerage account represents money or investments you have at a brokerage firm. For most investors, this account includes securities and possibly some cash.

When an investor wants to buy or sell securities, all that the investor has to do is open an account with a brokerage firm and provide the broker with order specifications. After the initial forms have been signed, everything else can be done by mail or telephone or via the Internet. Transactions will be posted to your account just as they would to a bank account. For example, you can deposit money, purchase securities using money from the account, and add the proceeds from security sales to the account. Brokers exist (and charge fees) to make security transactions as simple as possible.

Additional applications and reviews are necessary prior to clients being able to trade options and penny stocks.

Question 3

Asset Management Account

Answer 3

The brokerage account can also include other investments. If there are enough different investments, combining these different accounts into an all-in-one account, called an asset management account, might be best.

An asset management account is a comprehensive financial services package offered by a brokerage firm that can include a checking account; a credit card; a money market mutual fund; loans; automatic payment on any fixed debt (such as mortgages); brokerage services (buying and selling stocks or bonds); and a system for the direct payment of interest, dividends, and proceeds from security sales into a money market mutual fund.

The major advantage of such an account is that it automatically coordinates the flow of funds into and out of your money market mutual fund. For example, interest and dividends received from securities owned are automatically “swept” into the money market mutual fund. If you write a check for an amount greater than what is held in your money market mutual fund, securities from the investment portion of your asset management account are automatically sold, and the proceeds “swept” into the money market fund to cover the check.

Question 4

Brokerage Research Reports

Answer 4

Most full-service and some discount brokers provide customers access to research reports prepared by the brokerage firm’s security analysts and/or investment banking group. These reports cover the direction of the economy as a whole. They also look directly at individual companies, analyzing the companies’ prospects and concluding with recommendations of buy, hold, or sell. Buy indicates a positive recommendation, sell a negative recommendation, and hold a neutral recommendation. The exact terminology and definitions of a brokerage firm’s recommendations vary from firm to firm.

These reports provide you with the logic behind the recommendation. Even if you don’t buy the recommended stocks, the reports are of value to read because they show you the logic that leads an analyst to recommend that a stock be bought or sold. These research reports can easily be accessed online or through apps through the firms’ websites.

Question 5

Wrap Accounts

Answer 5

A wrap account is an investment portfolio managed by professional money managers. The key regulatory difference is that the client is paying a fee (typically based on assets under management for advice, not trade execution). The allocation mix of the portfolio may be determined through the advice of a financial planner or by the investor himself. The wrap account is used for transacting, reporting, and administering all paperwork. A nominee called the custodian holds the investments on your behalf.

Benefits of a wrap service include access to investments at wholesale prices, efficient administration, and sophisticated reporting. Some also provide the option for investors to manage their own portfolio or allow planners to manage it on their behalf.

Wraps were billed as a simple way to access professional money management while simultaneously aligning an investment adviser’s interests with your own. In exchange for an annual fee equal to a percentage of your assets, a broker would create an investment plan, find professional money managers to execute it, and waive all commissions for any trading that took place in your account. This better aligns the interest of the investment professional and the client. For example, it reduces the risk of “churning” or placing unnecessary trades to generate a commission. In addition, as successful investments are made and the account value grows, so does the advisory fee, rewarding the investment professional as well as the client.

Today, there are a wide variety of wrap accounts offered at not only brokerage firms, but also banks, mutual fund companies and private consulting firms.

Wrap accounts offer investors who do not have the competence or time to actively manage their portfolios access to professional money management. Hands-on investors who enjoy doing their own research, can make asset-allocation decisions, and have the time necessary to monitor and adjust their portfolios would not invest in wrap accounts.

Question 6

Order Size

Answer 6

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.

It is worth noting, many clients still think of their trades in terms of dollars which needs to be translated to the estimated number of shares, depending on the price per share and the amount the investor would like to purchase in dollar terms.

Question 7

Day Orders

Answer 7

The broker attempts to fill the order only during the day in which it was entered. If the order is not filled by the end of the day, it is canceled. If the investor does not specify a time limit, the broker will treat an order as a day order.

Question 8

Week and Month Orders

Answer 8

Expire at the end of the respective calendar week or month during which they were entered, provided that they have not been filled by then.

Question 9

Open Orders, or “Good-till-canceled” (GTC) orders

Answer 9

Remain in effect until they are either filled or canceled by the investor. However, during the time period before the order has been filled, the broker may periodically ask the investor to confirm the order.

Question 10

Fill-or-kill orders/FOK orders

Answer 10

These orders are canceled if the broker is unable to fully execute them immediately.

Question 11

Discretionary orders

Answer 11

Allows the broker to set the specifications for the order. The broker may have virtually complete discretion, in which case he or she decides on all the order specifications, or limited discretion, in which case he or she decides only on the price and timing of the order.

Question 12

Order Types

Answer 12

Market orders
Limit orders
Stop orders
Stop limit orders

Question 13

Market Orders

Answer 13

The most common type of order is the market order. Here the broker is instructed to buy or sell a stated number of shares immediately. In this situation the broker is obligated to act on a “best-efforts” basis to get the best possible price, that is, as low as possible for a purchase order, or as high as possible for a sell order at the time the order is placed.

It is important to be aware that an investor placing a market order can be certain that the order will be executed (for securities with normal trading volume), but will be uncertain of the price. There is generally good information available beforehand concerning the likely price at which a market order will be executed based on the bid and ask of the security. Not surprisingly, market orders are day orders because they typically execute immediately.

Question 14

Limit Orders

Answer 14

Here the investor specifies a limit price when the order is placed with the broker. If the order is for purchasing shares, then the broker must execute the order at a price that is less than or equal to the limit price. If the order is to sell shares, then the broker is to execute the order only at a price that is greater than or equal to the limit price.

Thus, for limit orders to purchase shares the investor specifies a ceiling on the price, and for limit orders to sell shares the investor specifies a floor on the price. In contrast to a market order, an investor using a limit order cannot be certain that the order will be executed. Hence there is a trade-off between these two types of orders. The trade off is immediacy of execution with uncertain price versus uncertain execution with bounded price.

Question 15

Stop Orders

Answer 15

Two special kinds of orders are stop orders, also known as stop-loss orders, and stop-limit orders. The investor specifies a stop price for a stop order. If it is a sell order, the stop price must be below the market price at the time the order is placed. Conversely, if it is a buy order, the stop price must be above the market price at the time the order is placed. If later someone else trades the stock at a price that reaches or passes the stop price, then the stop order becomes, in effect, a market order. Hence a stop order can be viewed as a conditional market order.

Continuing with the ABC Corporation example, a stop sell order of common stock at $20 would not be executed until a trade involving others had taken place at a price of $20 or lower. Conversely, a stop buy order at $30 would not be executed until a trade involving others had taken place at a price of $30 or more. If the price did not fall to $20, then the stop sell order would not be executed. Similarly, if the price did not rise to $30, the stop buy order would not be executed. In contrast, a limit order to sell at $20 or a limit order to buy at $30 would be executed immediately, because the current market price is $25.

Question 16

Stop Limit Orders

Answer 16

The stop limit order is a type of order that is designed to overcome the uncertainty of the execution price associated with a stop order. With a stop limit order the investor specifies not one but two prices, a stop price and a limit price. When someone else trades the stock at a price that reaches or passes the stop price, then a limit order is created at the limit price. Hence a stop limit order can be viewed as a conditional limit order.

Continuing with the ABC Corporation example, the investor could place a stop limit order to sell ABC stock where the stop price is $20 and the limit price is $19. In effect, a limit order to sell ABC stock at a price of $19 or higher would be activated for the investor only if others trade ABC at a price of $20 or less. Conversely, the investor could enter a stop limit order to buy ABC stock where the stop price is $30 and the limit price is $31. In this case, a limit order to buy ABC stock at a price of $31 or lower would be activated for the investor only if others trade ABC at a price of $30 or more.

Note that if the stop price is reached, execution is assured for a stop order but not for a stop limit order. Continuing with the ABC Corporation example, the industrial accident may cause the stock price to fall to $12 so rapidly that the stop limit order to sell (where the stop price was $20 and the limit price was $19) might not have been executed, whereas the stop order (where the stop price was $20) would have been executed at $16. Hence there is a trade-off between these two types of orders that is very similar to the trade-off between market and limit orders. Once activated, the stop order provides certain execution at an uncertain price, whereas a stop limit order provides uncertain execution at a bounded price.

Question 17

Margin Purchases

Answer 17

With a cash account, an investor who purchases a security must pay the entire cost of the purchase with cash. However, with a margin account, the investor must come up with cash for only a percentage of the cost and can borrow the rest from the broker. The amount borrowed from the broker as a result of such a margin purchase is referred to as the investor’s debit balance. The interest charged on loans advanced by a broker for a margin purchase is usually calculated by adding a service charge (for example, 1%) to the broker’s call money rate. In turn, the call money rate is the rate paid by the broker to the bank that loaned the broker the cash that ultimately went to the investor to pay for part of the purchase.

Cost to borrow money for a margin account = Call Rate + Spread

For example, the bank may loan money to the broker at a rate of 10%, and then the broker may loan this money to the investor at a rate of 11%. The call money rate will change over time as the prevailing market interest rates change. Thus, the interest rates that investors are charged for loans changes accordingly.

The securities purchased by the investor serve as collateral on the loan made by the broker. In turn, the broker uses these securities as collateral on the loan made by the bank. Thus the broker is acting as a financial intermediary in the lending process by facilitating a loan from the bank to the investor. Sometimes, however, the broker will use the brokerage firm’s own funds to make the loan. Nevertheless, the investor will still be treated as if a bank was behind the loan.

Question 18

Initial Margin Requirement

Answer 18

The minimum percentage of the purchase price that must come from the investor’s own funds is known as the initial margin requirement. Regulations T, U, G, and X prescribed in accordance with the Securities Exchange Act of 1934, gives the Federal Reserve Board the responsibility for setting this percentage when either common stocks or convertible bonds are being purchased. However, the exchanges on which purchase orders are filled are allowed to set a percentage higher than the one set by the Federal Reserve Board, and brokers are allowed to set it even higher. Thus, hypothetically, the Federal Reserve Board could set the initial margin requirement at 50%, the New York Stock Exchange could then make it 55%, and the broker could ultimately make it 60%.

For example, Amy purchases 100 shares of Widget Corporation on margin for $50 per share. With an initial margin requirement of 60%, Amy must pay the broker $3,000 (0.6 x 100 shares × $50 per share). The remainder of the purchase price, $2,000 [(1.0 - 0.6) x 100 shares × $50 per share], is funded by a loan from the broker to the investor.

Asset = price per share × the number of shares purchased
Margin loan = (1 - initial margin requirement) × the purchase amount
Account Equity = initial margin requirement × the purchase amount

ASSET LIABILITIES & ACCOUNT EQUITY
100 shares of Widget Corp. = $50 (100 shares) $5,000 Margin loan = 40%($5,000) = $2,000
Account Equity = 60%($5,000) = $3,000
Total Assets = $5,000 Total Liabilities and Equity = $5,000

The balance sheet illustrates the investor’s balance sheet immediately after the margin purchase. The investor has assets of $5,000 corresponding to the value of Widget stock. Those assets are partially offset by liabilities of $2,000 representing the margin loan, leaving $3,000 in equity. Also, the 100 shares of Widget are being kept as collateral on the loan of $2,000 to the investor.

Question 19

Actual Margin

Answer 19

The actual margin in the account of an investor who has purchased stocks is calculated as:

Actual Margin=market value of assets−loan / market value of assets

The daily calculation of the actual margin in an investor’s account is known as having the account marked to the market. Upon examination of the above equation it can be seen that at the time of the margin purchase, the actual margin and the initial margin are the same. However, subsequent to the purchase, the actual margin can be either greater than or less than the initial margin.

Continuing with the Widget Corporation example, if the Widget stock fell to $25 per share from $50 per share, then the actual margin would drop to 20%=[($2,500−$2,000)/$2,500].

Question 20

Maintenance Margin Requirement

Answer 20

o prevent an occurrence where the broker has to bear an amount on account of the investor, brokers require investors to keep the actual margin in their accounts at or above a certain percentage. This percentage is known as the maintenance margin requirement. It is set by the exchanges, not by the Federal Reserve Board, and brokers have the right to set it as high as they want. As of 1998, the New York Stock Exchange had set this percentage for common stock and convertible bond purchases at 25%.

If an account’s actual margin falls below the maintenance margin requirement, the account is under-margined. Accordingly, the broker will issue a margin call, and request the investor to either:

deposit cash or securities into the account
pay off part of the loan, or
sell some securities currently held in the account and use the proceeds to pay off part of the loan.
Any of these actions will raise the numerator or lower the denominator, thereby increasing the actual margin. If the investor does not act, or cannot be reached, then, in accordance with the terms of the account, the broker will sell some or all of the securities from the account in order to restore the actual margin to (at least) the maintenance margin requirement.

Question 21

Margin Account - Rate of Return

Answer 21

The use of margin purchase trading allows the investor to engage in financial leverage. That is, by using debt to fund part of the purchase price, the investor can increase the expected rate of return of the investment. However, there is a complicating factor in the use of margin: the effect on the risk of the investment.

Consider the Widget Corporation as an example. If Amy believes that the stock will rise by $15 per share over the next year, then the expected rate of return on a cash purchase of 100 shares of Widget at $50 per share will be 30%, assuming that no cash dividends are paid.

For the cash account:
Holding Period Return=P1+D−P0/P0=$6,500+0−$5,000/$5,000=30%

A margin purchase, on the other hand, would have an expected return of 42.7%, where the interest rate on margin loans is 11% and the initial margin requirement is 60%. Thus, Amy has increased the expected rate of return from 30% to 42.7% by the use of margin.

For the margin account:
Holding Period Return=P1−P0−Margin Cost/Initial Equity=$6,500−$5,000−$220/$3,000=42.7%

Question 22

Short Selling

Answer 22

Most investors hope to buy securities first and sell them later. However, with a short sale this process is reversed. The investor sells a security first and buys it back later.

Borrowing stock certificates for use in the initial trade, then repaying the loan with certificates obtained in a later trade, accomplishes a short sale. Note that the loan here involves certificates, not dollars and cents, although it is true that the certificates at any point in time have a certain monetary value. This means that the borrower must repay the lender by returning certificates, not dollars and cents, although it is true that an equivalent monetary value, determined on the date the loan is repaid, can be remitted instead as it will be used to buy the requisite number of shares. It also means that there are no interest payments to be made by the borrower.

Question 23

Short Selling - Rules

Answer 23

Any order for a short sale must be identified as such. Prior to July 6, 2007, the Securities and Exchange Commission had ruled that short sales may not be made when the market price for the security is falling, on the assumption that the short seller could exacerbate the situation, cause a panic, and profit from an assumption inappropriate for an efficient market with astute, alert traders. The precise rule, was known as the up-tick rule, and stated that a short sale must be made on a plus (or “up”)-tick (for a price higher than that of the previous trade) or on a zero-plus tick (for a price equal to that of the previous trade but higher than that of the last trade at a different price). The uptick rule in the United States was eliminated by the SEC effective July 6, 2007.

However, after the financial crisis of 2008, the alternative uptick rule was reinstituted. The rule is much less strict and is aimed to allow long security holders to exit before short selling may occur. This rule is triggered at a 10% decline in a single day and is much more obscure than the original rule that was present for all short sale trades at all times.

The borrowed securities may come from:

the inventory of securities owned by the brokerage firm itself
the inventory of another brokerage firm
the holdings of an institutional investor (such as a pension fund) that is willing to lend its securities, or
the inventory of securities held in street name by the brokerage firm for investors who have margin accounts with the firm.
The life of the loan is indefinite, meaning that there is no specific time limit on it. If the lender wants to sell the securities, then the short seller will not have to repay the loan if the brokerage firm can borrow shares elsewhere, thereby transferring the loan from one source to another. However, if the brokerage firm cannot find a place to borrow the shares, then the short seller will have to repay the loan immediately. Interestingly, only the brokerage firm knows the identities of the borrower and the lender. The lender does not know who the borrower is and the borrower does not know who the lender is.

Often, the question comes up as to why a security holder would allow their shares to be lent out for short selling. This is clearly a conflict with the long security holder’s view. The simple answer is twofold:

A margin account generally allows for securities that are in it to be lent out on a contractual basis. This is called hypothecation.
You can earn money by lending shares out. Paid lending allows owners of highly shorted or hard to borrow securities to earn a return by lending their shares. This return can be minimal or significant based on the short interest in the market

Question 24

Short Selling - Cash Dividends

Answer 24

What happens when XYZ Company declares a cash dividend and subsequently pays the dividend to its stockholders? Before the short sale, Brock would receive a check for cash dividends on 100 shares of stock. After depositing this check in its own account at a bank, Brock would write a check for an identical amount and give it to Mr. Lane. Thus neither Brock nor Mr. Lane has been made worse off by having the shares held in street name. After the short sale, XYZ will see that the owner of those 100 shares is no longer Brock but is now Mr. Jones. Thus XYZ will now mail the dividend check to Mr. Jones, not to Brock. However, Mr. Lane will still be expecting his dividend check from Brock. Indeed, if there were a risk that he would not receive it, he would not have agreed to have his securities held in street name. Brock would like to mail him a check for the same amount of dividends that Mr. Jones received from XYZ, that is, for the amount of dividends that Mr. Lane would have received from XYZ had he held his stock in his own name. If Brock does mail Mr. Lane such a check, then it will be losing an amount of cash equal to the amount of dividends paid. What does Brock do to avoid incurring this loss? It makes Ms. Smith, the short seller, give it a check for an equivalent amount.

Consider all the parties involved in the short sale now. Mr. Lane is content because he has received his dividend check from his broker. Brock is content because its net cash outflow is still zero, just as it was before the short sale. Mr. Jones is content because he received his dividend check directly from XYZ. What about Ms. Smith? She should not be upset with having to reimburse Brock for the dividend check given by Brock to Mr. Lane, because the price of XYZ Company’s common stock can be expected to fall by an amount roughly equal to the cash dividend, thereby reducing the dollar value of her loan from Brock by an equivalent amount.

Question 25

Short Selling - Initial Margin Requirement

Answer 25

Since a short sale involves a loan, there is a risk that the borrower (in the example, Ms. Smith) will not repay the amount borrowed. In such a situation, the brokerage firm would be left without the 100 shares that the short seller, Ms. Smith, owes the firm. Either the brokerage firm, Brock, is going to lose money or else the lender, Mr. Lane, is going to lose money. This loss is prevented by not giving the cash proceeds from the short sale, paid by Mr. Jones, to the short seller, Ms. Smith. Instead, they are held in her account with Brock until she repays her loan. But by holding the proceeds, the brokerage firm is not assured that the loan will be repaid.

Using the example, assume that the 100 shares of XYZ were sold at a price of $100 per share. In this case, the proceeds of $10,000 from the short sale are held in Ms. Smith’s account, but she is prohibited from withdrawing them until the loan is repaid.

The chart provided here shows the investor’s balance sheet immediately after the short sale. The investor’s assets total $16,000, made up of the cash proceeds from the short sale and the initial margin. The investor has liabilities of $10,000 representing the market value of the stock, leaving $6,000 in equity.

ASSETS LIABILITIES AND NET WORTH
Cash proceeds of short sale = 100 × $100 = $10,000 Market value of short sold stock = 100 × $100 = $10,000
Initial Margin = 60% ($10,000) = $6,000 Equity = 60% ($10,000) = $6,000
Total Assets = $16,000 Total Liabilities and Net Worth = $16,000

Thus by the use of margin requirements, Brock can protect itself from experiencing losses from short sellers who do not repay their loans. In this example, Ms. Smith must not only leave the short sale proceeds with her broker, but she must also give her broker initial margin applied to the amount of the short sale. If the initial margin requirement was 60%, she must give her broker $6,000 (= 0.6 × $10,000) in cash.

Now imagine that at some date after the short sale, XYZ stock rises by $20 per share. In this situation, Ms. Smith owes Brock 100 shares of XYZ with a current market value of $12,000 (100 shares × $120 per share), but she has only $10,000 in her account. If she skips town, Brock will have collateral of $10,000 (in cash) but a loan of $12,000, resulting in a loss of $2,000.

ASSETS LIABILITIES AND NET WORTH
Cash proceeds of short sale = 100 × $100 = $10,000 Margin value (current FMV) of short sold stock = 120 × $100 = $12,000
Initial Margin = 60% ($10,000) = $6,000 Equity = $16,000 - $12,000 = $4,000
Total Assets = $16,000 Total Liabilities and Net Worth = $16,000

Question 26

Short Selling - If the maintenance margin is 40% in the example above, would you receive a margin call if the price went up to $120/share?

Answer 26

Actual margin = Equity/Margin Value = $4,000/$12,000 = 33.3%. Since 33.3% less than 40%, a margin call will be made for the account.

Question 27

Actual and Maintenance Margin

Answer 27

Actual Margin=(short sale proceeds+initial margin)−loan / loan

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.