WEEK 4: Trading Securities, Risk, and Return Flashcards
memorize terms
Trading long vs short
Long: own the security positive outlook
Short: sell security without owning it, negative outlook
covered vs uncovered sales
Covered sale: sell a security you already own, write a call option
Uncovered sale (naked): sell the security without owning it first - very risky
types of trading
Day trading: intraday trading (few minutes, hours, or day), profit from short-term price fluctuations
Intermediate training (swing trading): days to months, actively trading
Long-term trading (position trading): several months or years, stay here for a while, infrequent
Bid-Ask
Bid - highest current price someone is willing to buy the security
Ask - lowest current price someone is willing to sell the security
Last - most recent transaction
Spread = difference between bid and ask price
Change = last price quote compared to previous day close
As you get more liquid securities thousands of people want to buy/sell, spread gets closer
Smaller the spread, the more liquid the security, can quickly buy/sell
quote levels
Level 1 - shows best bid best offer
Level 2 - shows depth of best bids/offers, usually 5-10 orders
Level 3 - shows up to 20 bids and offers
Order types
market order (immediate fill), limit order (fills if execution meets price condition), stop order (price triggers the trade order)
market order
fill order immediately at the next available price, go buy it at the market, used during market hours in liquid markets
limit orders
no guarantee of a fill, order fills only if security can be bought or sold at the specified price or better, small stocks
stop orders
allow investor to place a buy or sell order ahead of time, with price being the order’s trigger
Stop orders: order to buy or sell a stock once the market price reaches that level, when triggered the stop order becomes a market order
Going on vacation and cannot watch your shares
Stop limit orders: once market price triggers the stop, the order becomes a limit order (filling at the limit price or better)
trade time limitations and conditions
Day order: active until end of trading day
Good-till-canceled: active until completely filled or canceled by the trader
All or none: trade executive 100% (no partial buys or sell); the order is in effect until canceled
Fill or kill: entire trade 100% filled, otherwise canceled immediately
Immediate or cancel: any portion of trade filled, the canceled immediately
trade settlements
Stocks, bonds and mutual funds: Required to settle two business days after the trade
On settlement day, certificate and money exchange hands
Government securities and options: Settlement is one business day after trade
physical certificate vs book entry
Physical certificate: issuer records investor as owner, hard-copy
book entry: street name registration, broker-dealer registered as owner on issuer’s book, investor is the beneficial owner
types of accounts
cash account: 100% settlement made in cash
margin: allows investor to use leverage in purchasing security
option: options must be traded in an options account
margin accounts
margin offers investors trading leverage. cash + margin = security settlement. investor pays interest on margin loan
margin rules
minimum account balance, $2000 or 100% of purchase price, Federal reserve Board sets initial margin %, broker-dealer establishes maintenance margin. if account falls below maintenance margin, investor will get a margin call and must add cash or sell
order authority
discretionary/solicited: broker-dealer or advisor has the authority to decide what to buy and how to purchase
non-discretionary/unsolicited: investor makes the buy/sell decisions
expected risk vs expected return
cash equivalents, short-term, intermediate, long term-bonds, large-cap, mid-cap, small-cap equities, alternative investments
unsystematic risk
factors that are unique to the individual firm (micro)
systematic risk
factors that influence the entire market (macro)
types of unsystematic risk
business, financial, credit (default), liquidity, marketability, industry, prepayment, call risk
types of systematic risk
business cycle, interest rate, inflation, reinvestment, country, political, regulatory, currency risk
risk reduction by diversification
holding 15-30 diversified assets effectively eliminates unsystematic risk
market/systematic risk cannot be diversified away
equity risk premium
long-term equity returns are greater than bonds because you are rewarded for holding systematic risk. you are not rewarded for unsystematic risk because you can diversify it away
concentrated positions
review allocation and holistic asset holdings and rebalance as appropriate, tax-efficient selling, apply option strategies to spread income tax allocation over several tax periods.
simple vs compound interest
simple: interest applied to only the beginning contribution
compounding: interest and dividends applied to beginning contribution plus annual additions
time-weighted return
not affected by the timing of the portfolio cash flows. simply measures portfolio return during period
- total return
- annualized return over holding period
- arithmetic/geometric average return
dollar-weighted return
accounts for the timing and amount of the portfolio cash flows
- internal rate of return (IRR)
total return (HPR)
includes all returns on investments including capital gains and distributions (interest/dividends)
(endPrice + cash distribution - beginPrice)/(beginPrice)
annualized HPR
Given quarterly returns: (1 + HPR1 ) x (1 + HPR2 ) x (1 + HRP 3 ) x (1 + HPR n )] -1
Given 3-year HPR: (1 + HPR1 )(1/N) -1
arithmetic returns
sum of the series of returns and divide by number of returns
- best used when forecasting a future return because offers estimate of return in that next period
- used for portfolio optimization data inputs
geometric returns
average compounded growth rate of the investment portfolio, calculated by taking the nth root of the product of the returns
- useful in explaining how much a portfolio would have grown over a period
internal rate of return (IRR)
measures investment performance considering all beginning, intermediate, and ending cash flows, the return is the rate that makes NPV = 0, often used as part of a portfolio manager performance assessment
after-tax return
as an investor, you are concerned about the return you get to keep after taxes
= investment return * (1 - marginal tax rate)
tax-equivalent yield
tax-free yield: taxable yield * (1 - marginal tax rate)
tax-equivalent yield: tax-free yield/(1-marginal tax rate)
nominal yield
coupon rate
current yield
total annual cash flows/current price
yield to maturity (YTM)
internal rate of return on all cash flows
- assumes bond is held to maturity
- discount rate % that equates the PV of all interest and return of principal payment to price of bond
yield to call (for callable bonds)
IRR on all cash flows up to the first date the bond could be called
real rate of return
quantified the actual return of an investment after adjusting for impact of inflation
real rate = [(1+nominal rate)/(1+inflation rate)]-1
