PHILLIPS MORRIS COS-NYSE:MO Bid (size) Ask(size) 19.63(1000) 19.69(631) Deep market T.ROWE PRICE ASSOC-NASDAQ Stock Market:TROW Bid(size) Ask(size) 32.81(5) 33.13(1) Relatively thin market Stock Quotes from freerealtime.com • If you would like to buy Phillips Morris Stock, which price should you look at? The price under bid or under ask? • If you would like to sell Phillips Morris Stock, which price should you look at? The price under bid or under ask? • What does the size measure? • How do you measure the depth of the market?
EVALUATING MARKET DEPTH How Many Buyers and Sellers? • Round Lot: 100 shares of stock • Bid Size: number of round lots sought by current buyers at any moment • MO: Bid size 1000 the bid price of $19.63 is good for 1000*100 = 100,000 shares • Ask Size: number of round lots for sale at any moment • MO: Ask size 631 the ask price of $19.69 is good for ____*100 = _______ shares • Measure of Price Stability: gauges supply and demand and identifies upward or downward pressure on price
Inverted Bid-Ask Spread Again • Inverted bid-ask spread: The quoted bid price is higher/ lower than the quoted ask price • If the bid size is only 100 shares, an eager seller of 10,000 shares might end up with accepting a lower price. • Which scenario do you think that the inverted bid-ask spread most likely occur? • The bid size is very large compared with the ask size. • The bid size is very small compared with the ask size.
Stop-Loss Order You own 100 shares of AOL,which is currently selling for $50 per share. Because you believe that the stock price could decline rapidly at any time, you place a stop-loss order to sell at $40. (You do not want to hold the stock anymore if its price goes below that specified price. You would like to stop your loss from holding that stock.) If the stock price does in fact drop to $40, your 100 share will be sold at the best price available at that time.In other words, once the price falls to the price you specified, the stop-loss order is converted to a market order to sell at the best price available. Your 100 shares will be sold at the best price available at that time. If the market price declines to $38 by the time your stop-loss order comes up, you will receive less than $40 per share, that is, you’ll end up with selling your stock for $39 per share ExampleStop, Stop-Loss Order
Stop-Loss Order What happens if the market price stays above $40 per share? You will have lost nothing as a result of placing the order because the stop order will never be initiated. ExampleStop, Stop-Loss Order
Stop Order to Buy An investor may place a stop order to buy 100 shares of MSFT, currently selling for $70 per share, once its price rises to $75. (the stop price) When to use this type of order? Limit losses on short sales. Buy a stock just as its price begins to rise. ExampleStop, Stop-Loss Order
Stop-Limit Order You own 100 shares of MSFT stocks, which is currently selling for $50 per share. Because you believe that the stock price could decline rapidly at any time, you place a stop-limit order to sell at $40. If the stock price does in fact drop to $40, your 100 share will be sold at $40 0r better. There would be no risk of getting less than $40 unless the price of the stock kept right on falling. In that case, as is true for any limit order, you might miss the market altogether and end up with stock much less than $40.Say, price from $50 to $41 to $39 and to $30; you’ll end up with stock for $30 per share. ExampleStop-Limit Order
More • What kind of order is it? • Buy 100 shares of Walt Disney at the current ask price • Buy 500 shares of Walt Disney at $35 or less • Automatically expires if it cannot be executed during the trading session in which it is entered • Stays active until it is executed or canceled by the investor • In some instances, broker set a time limit of 30-60 days • Either fill the entire order or do not fill it at all • Immediately fill the entire order or completely cancelled • Why bother to use all-or-none or fill-or-kill order? • The potential for paying higher brokerage commissions on orders that are executed in piecemeal fashion.
Defined-benefit plans: Defined-contribution plans: Retirement Plans • Company agrees to pay fixed dollar amount based on years worked and salary level • Company assumes market risk on invested funds • Employee pays in set amount per pay period • Employee chooses investment options • Employee is responsible for investment performance
Dollar-Cost Averaging Again Dollar-Cost Averaging: Strategy of investing a fixed amount in a security at regular intervals; ideal for defined contribution savings plans • It’s a passive buy-and-hold strategy.
How Does Dollar-Cost Averaging Work? • Invest $400 per month to buy Citi’s stock. • Investment horizon: 1 year • Three different market environments are shown: Rising, Falling, and directionless but highly volatile market • The average cost per share is always lower than the average price per share.
Dollar-Cost Averaging • Findings • The more volatile the better. • The average cost of shares purchased by regular investors will always be than the average share price. • Neither will dollar-cost averaging ensure a profit or protect against a loss in declining market, nor will it prevent a loss if it is discontinued when the value of an account is less than its cost. • The success of the dollar-cost averaging depends on the investor making regular purchases irrespective of the market conditions.
Problem-Buying on Margin • I would like to buy 1000 shares of stock at $10 per share, but I only have $5000. How can I do? • Buy on marginI can open a margin account with initial margin 50%. • Margin Account = account that holds securities purchased with a combination of cash and borrowed funds • At the beginning, my margin account will have 1000 shares worth at $10 per share-a combination of $5000 cash and borrowed funds $5000.
Problem-Buying on Margin • If the price goes up to $20 per share, what is my margin now? • I have 1000 shares worth at $20 per share now, and my original loan to finance these 1000 shares is $5000. Therefore, my margin will become ($20000-$5000)/$20000= 75%.
Problem-Buying on Margin • If the price goes down to $7 per share, what is my margin now? • I have 1000 shares worth at $7 per share now, and my original loan to finance these 1000 shares is $5000. Therefore, my margin will become ($7000-$5000)/$7000= 28.57%. • If the maintenance margin(the absolute minimum amount of margin (equity) that an investor must maintain in the margin account at all times) is set equal to 30%, I will receive a margin call from my broker to bring the equity up to the initial margin level within 3 business days. If not brokerage will liquidate position to bring account’s equity back up to 50%.
Problem-Buying on Margin • Stock purchases with 50% initial margin trigger a 30% maintenance margin call following a ____% decline in price. • Initial purchase price:P0 Margin debt = 0.5* P0 • To ensure 30% initial margin, total debt must be less than or equal to 70% of the current market price,P, of any stock purchased on margin. That is, Debt 0.7*P • 0.5* P00.7*P 0.5/0.7 P/ P0 0.714 P/ P0 0.714 must be less than or equal to the ratio of the current market price divided by the initial purchase price. Alternatively, a stock purchased with 50% initial margin could fall by as much as 28.6% (=(P- P0)/ P0 =(0.714 P0 - P0)/ P0 =-0.286 P0 / P0 =-0.286=-28.6%)
Buying on Margin-Summary Table 4.4 Panel A Investment results with an initial purchase of 1,000 shares at $10 using 50% initial margin.
More Practice-Buy on Margin • If the initial margin requirement is 40%, an investor buying 100 shares at $100 per share must furnish equity of _______ • Initial purchase price * shares purchased * initial margin =
More Practice-Buy on Margin • The purchase of a stock at 50 with 50% initial margin would result in a margin call (for 30% initial margin) if the stock falls in price to_____ • Margin debt = 0.5* P0 Margin debt = • To ensure 30% initial margin, total debt must be less than or equal to 70% of the current market price,P, of any stock purchased on margin. That is, Debt 0.7*P
How to Profit from Falling Prices • How can an investor profit from the impending decline in a company’s stock price if he/she does not presently own companies with poor and deteriorating fundamentals? • Short sale
SELLING SHORT • Sale of borrowed stock on margin • “Cover the short”: returning borrowed shares after repurchase • Short sales expose trader to unlimited upward risk • Shorted stock skyrockets • Cost of margin calls to maintain short • Short interest(number of shares sold short)—bearish sentiment for issue • Short interest ratio: short interest expressed in terms of % of day’s trading volume; number of shares sold short relative to the daily trading volume in a stock • High bullish/ bearish sentiment?
Margin Call Risk For Short Sellers Initial margin 50%, maintenance margin 30% Debt = Initial Debt + Debt = (P – 0.5PO) + (P – PO) Debt = 2P – 1.5PO Debt0.7P after simplification 1.153 P/PO
Margin Call Risk For Short Sellers • The current market price of a stock sold short can be no more than 15.3% higher(=(P- P0)/ P0 =(1.153 P0 - P0)/ P0 0.153 P0 / P0 =.153=15.3%) than the original price before a 30% maintenance marginal call is triggered.
Selling Short on Margin-Summary Table 4.4 Panel B Investment results with an initial short sale of 1,000 shares at $10 using 50% initial margin.
Problem-Short Sale • A short sale of 1,000 American Online at 65 that is covered at 60 results in a total : • Proceeds from short sale: • Cost to buy back stocks: • Results:
Prescriptions For Limiting Short-Selling Risk • Timing • Careful selection • Limit short positions to no more than 20% of portfolio • Disciplined trading—limit losses to 20% price appreciation