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Buying and Selling Buying and Selling EquitiesEquities(chapter 3)(chapter 3)

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Buying and SellingBuying and Selling Stock Price Quotes

- Bid The highest price a market maker is willing to pay (and is lower than the ask).

- Ask The lowest price a market maker is willing to accept to sell.

- Bid-Ask Spread Gap between the ask and the bid quotes. Profit to the market maker

Market depth - How many people are buying and selling? How much can I buy or

sell without moving the price?Bid size: the number of shares offered at the bid priceAsk size: the number of shares offered at the ask price

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Buy now, or wait for a better price?Buy now, or wait for a better price? Market order (executed immediately)

- Buy (or sell) now at market price- “Buy 50 shares of Home Depot at market”- “Sell 100 shares of Apple Computer at market”

Limit order (may take awhile to execute, or never)- Buy when the price gets a little better- How long to wait?

Fill or killDay orderGood ‘til canceled

- “Sell 100 shares of IBM at $82.70 or better, today”- “Buy 200 shares of Dell at $30.72 or better, fill or kill”

When would these trades execute?

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Place an order to trade when certain price levels are Place an order to trade when certain price levels are reached (before the emotions set in!)reached (before the emotions set in!)

Stop order- Placing an order to sell a

stock after the price has risen to a specified price.

Stop-loss order- Placing an order to sell

when a stock falls to a specific price.

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Pitfalls to TradingPitfalls to Trading Active trading (day trading)

- Induces the same emotions as casinos try to elicit.

- Investment decisions are more likely to be influenced by emotions and psychological biases.

The allure of active trading is strong.- People who believe they have superior

information or skill feel like they should benefit by trading

Trading costs are important! (commissions and bid-ask spread)

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IllusionsIllusions Illusion of Knowledge

- The illusion that more information creates more knowledge and better predictions

Does telling you what the last five rolls of a dice help you predict what the next roll will be?

The internet is full of informationHow much is true?Can you turn this info into wisdom?

Illusion of Control- People often believe that they have influence over the outcome of

uncontrollable events. People seem to believe that they have greater odds of winning the lottery

with their own numbers than randomly picked numbers.

These illusions may cause investors to trade too much and eventually experience lower returns!

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Impact on ReturnImpact on Return

Before going online:- average turnover was 70%- beat the market by 2.4% per

year After going online:

- turnover jumped to 120%- under performed the market by

3.5% per year

Brad Barber and Terrance Odean, 2002, “Online Investors: Do the Slow Die First?” Review of Financial Studies, 15, 455-487.

A study of 1,607 investors which moved from discount broker to online broker.

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Buying Stocks Using DebtBuying Stocks Using Debt

Cash account- Most investors use a cash account. The fund the account

with cash and then use the cash to buy stocks.

Margin account- You can borrow money from the brokerage firm to buy

more stock.

- You must start with no less than 50% of the position as your equity (called initial margin)

- If the stock price falls, it is your equity that is decliningIf your margin falls below 20%, you will be asked (a margin call) to

sell or add more cash. (minimum maintenance margin level)

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Computing your equity in a margin positionComputing your equity in a margin position

Consider that you borrowed $10,000 to buy $20,000 of stock.- If the value of the stock increases to $25,000, what is your margin?

- If the value of the stock declines to $15,000, what is your margin?

%6060.0000,25$

000,10$000,25$

ityPercentEqu

ValueStock

DebtValueStock

ValueStock

EquityityPercentEqu

%3.3333.0000,15$

000,10$000,15$

ityPercentEqu

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Leverage, the reason to use marginLeverage, the reason to use margin

Using margin magnifies the realized return.

Example: - buy 200 shares at $40 per share ($8,000 total)

- Use $4,000 or your own money and borrow $4,000.

- What is your return if the stock rises to $44? (a 10% increase)

Solution:- Profit is ($44 - $40) × 200 = $800

- Return is $800 / $4,000 = 20%

- A 20% return from a stock that increased 10%!

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Leverage, the reason NOT to use marginLeverage, the reason NOT to use margin

Using margin magnifies the realized return.

Example: - buy 200 shares at $40 per share ($8,000 total)

- Use $4,000 or your own money and borrow $4,000.

- What is your return if the stock falls to $34? (a 15% decline)

Solution:- Loss is ($34 - $40) × 200 = -$1,200

- Return is -$1,200 / $4,000 = -30%

- A -30% return from a stock that declined -15%!

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Profiting from falling stock pricesProfiting from falling stock prices

Selling short (or short selling)- By executing a short sale, the investor

sell stock that they do not own (by borrowing it from the brokerage).

- Later, after the price falls (hopefully!) the stock is repurchased (called covering the short) and given back to the broker.

Lucent Technologies Share Statistics

Shares Outstanding: 4.44B

% Held by Insiders: 0.15%

% Held by Institutions: 33.40%

Shares Short (as of 10-May-05)3: 175.38M

Short Ratio (as of 10-May-05)3: 3.6

Shares Short (prior month)3: 164.40M

The simple rule of “buy low, sell high” works well when prices are increasing.

When prices are falling, can you “sell high, buy low?”

Can only be executed on an uptick.

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Short ExampleShort Example

Short 100 shares at $60 using 50% margin- Total proceeds: $60 × 100 = $6,000- Amount borrowed of own money used = $3,000

What is the equity margin and return if the price rises to $66?- Loss = ($60 - $66) × 100 = -$600- Return = -$600 / $3,000 = -20%- Margin:

ValueStockCurrent

ValueStockCurrentCashSoldwhenValueStock

ValueStockCurrent

EquityEquityPercentage

%4.36364.010066$

10066$000,3$000,6$

EquityPercentage

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Short ExampleShort Example

What is the equity margin and return if the price falls to $50?- Profit = ($60 - $50) × 100 = -$1,000- Return = $1,000 / $3,000 = 33.3%- Margin:

At what stock price would a margin call occur (in the maintenance margin is 20%?

P = $75 Short Squeeze: when prices rise, investors short often have to

cover their short, which involves buying stock, and causing more increases in price.

%8080.010050$

10050$000,3$000,6$

EquityPercentage

100

100000,3$000,6$20.0

P

P

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Dollar-Cost AveragingDollar-Cost AveragingIf you buy stock over time, you will be some shares at a low price and some at a high price as the price fluctuates.

A Rising Market A Falling Market A Volatile Market

Monthly Share Shares Share Shares Share Shares

Investment Price Purchased Price Purchased Price Purchased

$400 $4.00 100 $50.0

0 8 $40.00 10

400 8.00 50 25.00 16 25.00 16

400 8.00 50 25.00 16 16.00 25

400 10.00 40 20.00 20 10.00 40

400 12.50 32 20.00 20 8.00 50

400 12.50 32 20.00 20 4.00 100

400 16.00 25 16.00 25 4.00 100

400 20.00 20 16.00 25 8.00 50

400 20.00 20 10.00 40 10.00 40

400 25.00 16 5.00 80 16.00 25

400 40.00 10 5.00 80 25.00 16

400 40.00 10 4.00 100 50.00 8

Totals $4,800 $216.00 405 $216. 450 $216.0 480

Average price $18.00 $11.85 $18.0 $10.67 $18.00 $10.00

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Issuing New SecuritiesIssuing New Securities

New securities are issued with the help of investment banks (or underwriter)

New issues are sold on the primary market first, and subsequently sell on the secondary market.- The secondary markets are the security

exchanges.

The selling of shares for the first time in a new company is called a initial public offering (IPO)

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UnderwritingUnderwriting Investment banks: advise or underwrite new

issues; distribute shares to institutional investors through road shows

Firm-commitment underwriting: investment bankers buy entire issue and assume risk

Best-efforts underwriting: investment agrees to make its best effort at placing shares; issuing firm assumes risk

All-or-none offerings: investment bank tries to sell entire issue or sale is cancelled

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Group of underwriters

Syndicate manager

Underwriter’s allotment

Dealers agreement

Tombstone ads

For Large Issues, a Syndicate is UsedFor Large Issues, a Syndicate is Used

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Who gets IPO shares?Who gets IPO shares?

Hot Issue Market- During some periods, over 50 news firms go public every month.

- Many investors want these shares

- Initial returns are high

Cold market- During other periods, less than 10 IPOs are issued in a month.

Who gets shares?- Those who want shares ask their broker.

- When more shares are sought, than are being issued, priority tends to go to the large shareholders and the broker’s best clients.

- If you are a small-money investor and receive shares of an IPO, look out, it may be a lemon!

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Learning objectivesLearning objectives

Know the bid-ask spread and market depth.Discuss the market, limit and stop orders.Discuss the following pitfalls to trading: hyperactive trading, online brokerage and trading activity, the illusion of knowledge, the illusion of controlDiscuss buying on margin; know how to calculate the change in the value of the margin account (see slides 9, 10 and 11) Discuss the short selling; know how to calculate the short selling return as in example in slides 13 and 14Know the underwriting process for IPOs; know the definitions p. 79 to 83 text

End of chapter questions 3.1 to 3.8