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 • Existing owner sells to another party • Issuing firm doesn’t receive proceeds and is not directly involved
Public Offerings • Public offerings: registered with the SEC and sale is made to the investing public • Initial Public Offerings (IPOs)
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 • 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 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 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 • 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 • 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 X Corp $70 50% Initial Margin 40% Maintenance Margin 1000 Shares Purchased Initial Position Stock $70,000 Borrowed $35,000 Equity 35,000
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 How far can the stock price fall before amargin call? (1000P - $35,000)* / 1000P = 40% P = $58.33 * 1000P - Amt Borrowed = Equity
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 Z Corp 100 Shares 50% Initial Margin 30% Maintenance Margin $100 Initial Price Sale Proceeds $10,000 Margin & Equity 5,000 Stock Owed 10,000
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 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 • 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 • 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)