Chapter 9 - Equity Securities: Equity Transactions (Done) Flashcards
Compare a cash account to a margin account.
- Cash Account: In a cash account, you can only trade using the money you have deposited. You cannot borrow funds from your brokerage to trade.
- Margin Account: In a margin account, you can borrow funds from your brokerage to buy securities. This allows you to buy more than you could with just your deposited funds. However, it also involves paying interest on the borrowed funds and additional risk.
What does the word “margin” refer to?
Margin refers to the amount of money that an investor borrows from a brokerage firm to buy securities. It also refers to the collateral deposited by the investor with the brokerage.
Describe the two types of margin positions possible.
- Long Margin Position: This is when an investor borrows money to purchase more shares than they could with their own funds alone. The investor profits if the share price increases.
- Short Margin Position: This is when an investor borrows shares to sell them, hoping to buy them back at a lower price. The investor profits if the share price decreases.
What are securities eligible for reduced margin?
Securities eligible for reduced margin are typically highly liquid and have a low volatility. Examples include government bonds and blue-chip stocks. The specific criteria can vary depending on the brokerage and regulatory guidelines.
Explain what a margin call is.
A margin call occurs when the value of an investor’s margin account falls below the broker’s required minimum value, known as the maintenance margin. The investor must deposit more funds or sell some of the assets to bring the account back to the required level.
Describe why a price drop on the shares you hold in your long margin account would lead to a net margin deficiency.
If the price of the shares you bought on margin drops, the value of your holdings decreases, but your debt to the brokerage remains the same. This can lead to the equity in your account falling below the maintenance margin, resulting in a net margin deficiency and potentially triggering a margin call.
Name and explain three margin risks.
- Market Risk: The value of the securities can decline, resulting in losses that exceed the initial investment.
- Interest Rate Risk: The cost of borrowing funds on margin can increase if interest rates rise.
- Margin Call Risk: If the account value drops below the maintenance margin, you may need to quickly deposit additional funds or sell assets, potentially at a loss.
Describe the process of short selling in a margin account.
To short sell, you borrow shares from your brokerage and sell them on the open market. Your goal is to buy them back later at a lower price. If the price drops, you can buy the shares back for less than you sold them for, return the borrowed shares to the brokerage, and keep the difference as profit.
Describe why a price drop on the shares you sold short in your short margin account would lead to excess margin.
If the price of the shares you sold short drops, the value of your short position increases because you can buy back the shares at a lower price. This increases the equity in your account, leading to excess margin, which is the amount by which your equity exceeds the maintenance requirement.
What is the limit on short sales and why?
There is generally no theoretical limit on the losses that can occur from short selling because the price of a stock can rise indefinitely. However, regulations may limit short selling to prevent market manipulation and excessive speculation.
Under what conditions would a short seller be forced to cover her short position?
A short seller may be forced to cover her short position if the broker issues a margin call due to insufficient margin in the account. Additionally, if the lender recalls the borrowed shares, the short seller must buy back the shares to return them.
Name and explain the seven risks of short selling.
- Unlimited Losses: Potential losses are unlimited as there is no cap on how high a stock’s price can rise.
- Margin Calls: Rising stock prices can lead to margin calls, requiring additional funds.
- Short Squeeze: If many short sellers try to cover their positions simultaneously, it can drive the stock price up sharply.
- Regulatory Risks: Short selling may be subject to changing regulations that can impact its feasibility.
- Dividend Payments: Short sellers must pay dividends on borrowed shares, adding to the cost.
- Borrowing Costs: Borrowing shares can be costly, especially if the stock is hard to borrow.
- Market Risk: General market volatility can impact the profitability of short positions.
Describe how order types are categorized.
Order types can be categorized based on their conditions and execution requirements, such as market orders, limit orders, stop orders, and stop-limit orders. Each type specifies how and when the order should be executed.
What is the definition of price spread?
Piece spread refers to the difference between the bid price (the highest price a buyer is willing to pay) and the ask price (the lowest price a seller is willing to accept) for a security.
Describe a market order.
A market order is an order to buy or sell a security immediately at the best available current price. It guarantees execution but not the price.
