Chapter 3
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Chapter 3. How Securities are Traded How firms issue securities How securities are traded Trading basics Trading cost Order type Buying on margin Short sales. Primary vs. Secondary Security Sales. Primary New issue Key factor: issuer receives the proceeds from the sale Secondary

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Chapter 3

Chapter 3

How Securities are Traded

How firms issue securities

How securities are traded Trading basics

Trading cost

Order type

Buying on margin

Short sales


Primary vs secondary security sales

Primary vs. Secondary Security Sales

  • Primary

    • New issue

    • Key factor: issuer receives the proceeds from the sale

  • Secondary

    • Existing owner sells to another party

    • Issuing firm doesn’t receive proceeds and is not directly involved


Public offerings

Public Offerings

  • Public offerings: registered with the SEC and sale is made to the investing public

  • Initial Public Offerings (IPOs)


Private placements

Private Placements

Private placement: sale to a limited

number of sophisticated investors not

requiring the protection of registration

  • Dominated by institutions

  • Very active market for debt securities

  • Not active for stock offerings


Costs of trading

Costs of Trading

  • Commission: fee paid to broker for making the transaction

  • Spread: cost of trading with dealer (NOT an explicit cost, it is not a fee, but will affect your return)

    • Bid: price dealer will buy from you

    • Ask: price dealer will sell to you

    • Spread: ask - bid


Types of orders

Types of Orders

Instructions to the brokers on how to

complete the order

  • Market order: executed immediately at current market prices

  • Limit order: An order specifying a price at (or better than) which an investor is willing to buy or sell

    • Limit buy: buy at price same or below the stipulated limit price

    • Limit sell: Sell at price same or above the stipulated limit price


Types of orders1

Types of Orders

  • Stop order: trade is not executed unless stock hits a price limit

    • Stop-loss orders:

      • Def: A stock is to be sold if its price falls below a price limit

      • Idea: sell to stop further loss

    • Stop-buy orders:

      • Def: a stock should be bought when price rises above a limit

      • Idea: limit loss from short sales

      • Idea 2:don’t want to lose opportunity to buy before prices goes even higher


Margin trading

Margin Trading

  • Using only a portion of the proceeds for an investment

  • Borrow remaining component

  • Margin:

    • The net worth (Equity) of the investor’s account

    • Margin =Asset-Liability ( borrowed funds or stocks)

  • % margin=Equity/Value of stock

  • The idea for margin requirement: The % of decline of your stock value before equity value drops to zero. It serves as a cushion for the lender.


Stock margin trading

Stock Margin Trading

  • Maintenance margin: minimum percentage of margin in trading before additional funds must be put into the account

  • Initial margin: maintenance margin when first purchasing the stock

  • Margin call: notification from broker you must put up additional funds


Margin trading initial conditions

Margin Trading - Initial Conditions

X Corp$70

50%Initial Margin

40%Maintenance Margin

1000Shares Purchased

Initial Position

Stock $70,000 Borrowed $35,000

Equity 35,000


Margin trading maintenance margin

Margin Trading - Maintenance Margin

Stock price falls to $60 per share

New Position

Stock $60,000 Borrowed $35,000

Equity 25,000

Margin% = $25,000/$60,000 = 41.67%

If sock price falls 41.67%, equity will be wiped out (equity value will be zero).


Margin trading margin call

Margin Trading - Margin Call

How far can the stock price fall before amargin call?

(1000P - $35,000)* / 1000P = 40%

P = $58.33

* 1000P - Amt Borrowed = Equity


Short sales

Short Sales

Purpose: to profit from a decline in the price of a stock or security

Mechanics

  • Borrow stock through a dealer

  • Sell it and deposit proceeds and margin in an account

  • Closing out the position: buy the stock and return to the party from which is was borrowed

  • % Margin=Equity / Values of stocks owned


Short sale initial conditions

Short Sale - Initial Conditions

Z Corp100 Shares

50%Initial Margin

30%Maintenance Margin

$100Initial Price

Sale Proceeds$10,000

Margin & Equity 5,000

Stock Owed 10,000


Short sale maintenance margin

Short Sale - Maintenance Margin

Stock Price Rises to $110

Sale Proceeds$10,000

Initial Margin 5,000

Stock Owed 11,000

Net Equity 4,000

Margin % (4000/11000) 36%

If stock price rises 36%, equity will be zero.


Short sale margin call

Short Sale - Margin Call

How much can the stock price rise before a margin call?

($15,000* - 100P) / (100P) = 30%

P = $115.38

* Initial margin plus sale proceeds


Warning

Warning

  • Don’t short!

    • Short has unlimited potential loss

    • Short is against the long term trend (positive return for investing)

    • Stay away from:

      • Small cap, fast growing, high valuation (Netflix)

      • Potential turning around company (Ford)

      • Potential taken over target


Short candidates

Short candidates

  • Stocks with a broken business model (BBI, DTV, BKS)

  • and struggling in competition (Dell, MOT,NOK…)

  • and with a high valuation

  • and with a large Cap. (small cap stocks can rise very fast and kill the shorts)


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