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Chap. 5 How Securities are Traded • • • • Buying and selling securities Buying on Margin Short Selling Regulations and the Securities and Exchange Commission • William Pugh 9/23/2002 Buying and Selling Securities • On the NYSE, and sometimes now NASDAQ, an investor usually issues an order to buy or sell “at market”. This market order, means the investor will accept the best price available at the time. A certain trade but maybe at an uncertain price. • In contrast, some investors hope to improve the price they accept by placing limit orders. Limit orders state a price to be met or bettered. Sell at 25 means accept offers at $25 a share or higher. The trouble with limit orders is that often they never execute (trade). Buying and Selling Securities Buying and Selling Securities • A stop order is a variation on the limit order: here the investor wishes to limit a loss. If you buy a stock a $30, you may put in a “stop” at $27 (10% below). Usually the stop triggers a market order at 27. A sale at 27 is not assured. • A stop buy is used to stop losses on a short sale. • Stop orders are mostly used by technical analysts or trend followers, who believe that a stock moving in a certain direction tends to continue in that direction. • On the NASDAQ, a price quote will be bid-ask prices, the ask price being the best (lowest) asking price from among the many dealers making a market in that security. The ask will also have a size (in 100s), which is the number of share currently being offered at that price. • Example under the new decimalization • price 20.25 20.38 size 44 10 Buying and Selling Securities Buying on Margin • On the NYSE, etc., a price quote will appear to be a similar bid-ask from a dealer, but in fact will more likely reflect the best limit orders from other investors. • In the absence of reasonable limit orders, the price would reflect the specialist’s bid or ask price. • When you leave your securities with the broker, it is called “in street name”. The company has no record that you are a shareholder. • Need to open a margin account rather than just a simple cash account. • This account usually requires higher initial investment. • Margin is essentially a “down payment”, where you borrow the rest of a security’s purchase price. The margin is safe part of your position, and is often referred to as your account’s equity. • The rest of the purchase price is borrowed 1 Buying on Margin Buying on Margin • You borrow from the broker, pay interest, there is no required repayment period. • Interest is tax deductible (against investment income). • Example: you purchase 100 shares of Intel at $40 a share. You use $2,400 of your own money and $1,600 borrowed money. • For short-term HPR, we will ignore interest. • Initially margin is $2,400/$4,000 = 60%. • Initial margin requirements are set by the Federal Reserve. Minimum 50% for stocks. • You could have purchased the 100 shares for as little $2,000 down. • Using debt provides your account with leverage. Leverage increases potential gains and losses, thus also your risk. • Leverage is inverse of the actual margin • L = 1/.60 = 1.67 (no units) Buying on Margin Buying on Margin • Example of leverage: Suppose Intel falls from $40 to $36/share. This would be 10% loss in a cash account. • With leverage, your equity shrinks from $2,400 to $3,600 - $1,600 = $2,000 a loss of $400, but on a smaller investment of $2,400. • LHPR = -$400/$2,400 = -16.7% = 1.67 * -10% • Leverage increases return and risk by the amount of the leverage number. LHPR = L*HPR • Actual margin = current equity/ current value and which varies over time. • If your actual margin falls below a certain maintenance margin, you get a margin call. This is because your equity (marginable securities) serves as collateral, and if the collateral falls in value you must send the broker more cash or securities (or sell some securities). • Example: Intel falls to $22 MM set to .30 • AM = ($2,200 - $1,600)/$2,200 = .27 margin call Short Selling Short Selling • A way to make a profit on a falling security. • Example: Borrow 100 shares of Intel from another brokerage account and sell at $40 a share on the open market. • Soon the shares fall to $22, you buy 100 shares on the open market (cover your short position) and use these shares to repay your share loan. • Profit: $18 a share or $1,800. • Must trade using a margin account which gives other speculators the right to borrow your shares for short selling. • In theory, shares never need be returned (no deadline at least). • Must compensate the other margin account for any dividends lost while his/her shares are lent to you. • Can only sell on an uptick (in price): can’t short if the stock is currently falling. Maybe not ETFs 2 Short Selling • Are short-sellers antisocial, evil or just plain unAmerican? • Short-sellers tend to be sophisticated investors and studies show that they are often right • Not over the last eight years though. • Shortsellers also serve a role in not letting some stock prices get too high. Helps market efficiency. • Helps market liquidity. SEC • Eventually regulated investment companies (1940), and investment advisors (1940) • SPIC: a sort of FDIC for brokerage accounts. Protects against losses due to brokerage closure, lost securities. • Regulates Insider trading offenses. This is where someone profits from trading using inside information - info not available to the public. • Insiders allowed to trade using public information, but must report trades to the SEC. Securities and Exchange Commission (SEC) • Established in 1933, after the great stock market crash. First goal: require new issuers to disclose all relevant facts about the company - that is, tell the truth. (e.g. prospectus) • Still legal to issue awful stocks and bonds, just can’t t lie that they are not awful. Due diligence • 1934 extended disclosure to secondary markets (existing shares, etc.) No lies in annual reports. Circuit Breakers • Trading halts that go into affect to help control large moves in various stock indexes such as the S&P500 and the DJIA. Essentially shuts down some or all trading for 30 minutes to the rest of the day. Reaction to 1987 crash. • CB Rules seem to change every year or so. • Assignment: Chap 5 • Questions: 1, 3, 4, 13, 15 • Problems 1-3, 4a,b, 6 3