Trading in Securities 1.

Open an account with a Broker Account Opening Form Bank Account CNIC Initial Deposit Types of Account Regular Account Margin Account Regular Account

A cash account with a brokerage firm is like a bank account. Deposits (cash and proceeds from selling securities) must cover withdrawals (cash and cost of purchasing securities) Margin Account A margin account is like a bank account that has overdraft privileges. If more money is needed than in the account, a loan (within limits on its size) is automatically made by the brokers When opening a margin account with the brokerage firm, an investor must sign a hypothecation agreement, known as customers agreement. This agreement grants the brokerage firm the right to pledge the investors securities as collateral for the loan, provided the securities were purchased using margin account. Margin The percent of cost a buyer pays in cash for a security, borrowing the balance from the broker. 2. Account with Central Depository Company Broker)

Sub-Account (An investor account with CDC through Investor Account Services. (Investor independent CDC Accounts)

3.

Placing an Order Market Order Limit Order Stop Loss Order

Market Order: The most common type of order is the market order. With this order, the investor trusts the fair pricing function of the marketplace. The broker is to buy or sell at the best price prevailing at the moment. The key element of a market order is that the order is to be executed as soon as possible. Limit Order: Sometimes an investor is not willing to trade at the market price, preferring to set his or her own price and not trade until that price is obtainable. Limit order must specify a price and a time limit. The time limit is most commonly either for the day or good till canceled (GTC). Day orders expire at the close of business if they are not executed. GTC orders remain open either until they are executed or the investor cancels them. Limit orders are useful, but they should be used reasonably. A limit order with a limit price distant from the prevailing market price is said to be away from the market. Limit order must specify a price and a time limit. Stop Order: A Stop Order specifies a price and time limit, just like a limit order. The difference is that a stop order is only executed if a specified price, called the stop price is touched. Stop orders become market order when the stop price is reached. Therefore, it is possible for the actual sales price to be different from the stop price. The most important use of a stop order is to protect a profit and minimize losses. There is no cost to placing a stop order or raising the stop price; you only pay a brokerage commission when a trade occurs. Stop orders become market order when the stop price is reached. The most important use of a stop order is to protect a profit.

Other Orders: Although much less common than the three discussed so far, a number of other types of orders might be placed. One cancels the others All or none

Fill or kill Stop limit Market if triggered order (MIT) Good till cancel (GTC) 4. Settlement T+2 ( Trading Plus Two Days) Stop Loss You own 200 shares of Shamrock Enterprises that you bought at $25 a share. The stock is now selling for $45 a share. a. If you put in a stop loss order at $40, discuss your reasoning for this action. b. If the stock eventually declines in price to $30 a share, what would be your rate of return with and without the stop loss order? (a) (b). I am satisfied with the profit resulting from the sale With the stop loss: ($40 - $25)/$25 = 60% Without the stop loss: ($30 - $25)/$25 = 20% Q. The stock of the Michele Travel Co. is selling for $28 a share. You put in a limit buy order at $24 for one month. During the month, the stock price declines to $20, then jumps to $36. Ignoring commissions, what would have been your rate of return on this investment? What would be your rate of return if you had put in a market order? What if your limit order was at $18 Limit order @ $24: When market declined to $20, your limit order was executed $24 (buy), then the price went to $36. Rate of return = ($36 - $24)/$24 = 50%. of the 200 shares at $40.

Assuming market order @ $28: Buy at $28, price goes to $36 Rate of return = ($36 - $28)/$28 = 28.57%. Limit order @ $18: Since the market did not decline to $18 (lowest price was $20) the limit order was never executed. a. Consider an investor who purchased a stock at $100 per share. The current market price is $125. At what price would a limit order be placed to assure a profit of $30 per share? b. What type of stop order would be placed to ensure a profit of at least $20 per share? (a) A limit order to sell is placed above the current market price. If the limit order is set at $130, the investor will realize a gross profit of at least $30 (ignoring transaction costs) (b) A sell stop order is placed below the market price. If the stop order is placed at $120, the investor should realize a profit of approximately $20 per share. Technically, to be certain of $20 per share, the stop order probably would have to be set slightly above $120 because a stop price is actually an activator that initiates a market order when the specified price is reached. Margin Trading Assume that an investor buys 100 shares of stock at $50 per share and the stock rises to $60 per share. What is the gross profit, assuming an initial margin requirement of 50 percent? 40 percent? 60 percent? 100 shares at $50 per share is a total cost of $5000. At 50% margin, the investor must put up $2500. Sales Price Purchase Price Gross Profit 6000 5000 1000

Gross Profit Percentage 1000/2500 = 40% At 40% margin, the investor must put up $2000, resulting in a gross profit percentage relative to equity of $1000/$2000 = 50%

At 60% margin, the investor must put up $3000, resulting in a gross profit percentage relative to equity of

$1000/$3000 = 33.3% Margin The initial margin requirement is 60 percent. You have $40,000 to invest in a stock selling for $80 a share. Ignoring taxes and commissions, show in detail the impact on your rate of return if the stock rises to $100 a share and if it declines to $40 a share assuming (a) you pay cash for the stock, and (b) you buy it using maximum leverage. (a). Assume you pay cash for the stock: Number of shares you could purchase = $40,000/$80 = 500 shares. (1) If the stock is later sold at $100 a share, the total shares proceeds would be $100 x 500 shares = $50,000. Therefore, the rate of return from investing in the stock is as follows:
$50 ,000 $40 ,000 25 .00 % $40 ,000

(2)If stock is later sold at $40 a share, the total shares proceeds would be $40 x $500 shares = $20,000. Therefore, the rate of return from investing in the stock would be

(b). Assuming you use the maximum amount of leverage in buying the stock, the leverage factor for a 60 percent margin requirement is = 1/percentage margin requirement = 1/.60 = 5/3. Thus, the rate of return on the stock if it is later sold at $100 a share = 25.00% x 5/3 = 41.67%. In contrast, the rate of return on the stock if it is sold for $40 a share: = -50.00% x 5/3 = -83.33%. Margin call A request by an investors broker for additional capital for a security bought on margin if the investors equity value declines below the required maintenance margin.

Q. Suppose you buy 100 share of ABC stock at $50 per share total cost =5000 borrowing 50% or 2500. And suppose the maintenance margin is 30%. If the stock price goes to 60 per share then your contribution is 6000-2500 =3500 In terms of equity percentage 3500/6000 = 58.33% If the stock price goes to 40 per share it would be =4000-2500 In terms of equity percentage 1500/4000 =37.50 =1500

What would be stock price before there is a margin call?

Margin

Market Value - Debit Balance Market Value

.30(100 shares * price) = (100 shares * price) -2500 30 share * price = (100 shares * price) -2500 -70 shares * price = -2500 Price = -2500 /-70 Price = 35.71429 Q. Lauren has a margin account and deposits $50,000. Assuming the prevailing margin requirement is 40 percent, commissions are ignored, and The Gentry Shoe Corporation is selling at $35 per share: a. How many shares of Gentry Shoe can Lauren purchase using the maximum allowable margin? b. What is Laurens profit (loss) if the price of Gentrys stock (1) Rises to $45? (2) Falls to $25?

c. If the maintenance margin is 30 percent, to what price can Gentry Shoe fall before Lauren will receive a margin call?

(a). Since the margin is 40 percent and Lauren currently has $50,000 on deposit in her margin account, if Lauren uses the maximum allowable margin her $50,000 deposit must represent 40% of her total investment. Thus, $50,000 = .4x then x = $125,000. Since the shares are priced at $35 each, Lauren can purchase $125,000 / $35 = 3,571 shares (rounded). (b). Total Profit = Total Return - Total Investment (1) If stock rises to $45/share, Laurens total 3,571 shares x $45 = $160,695. Total profit = $160,695 - $125,000 = $35,695 return is:

(2)

If stock falls to $25/share, Laurens total 3,571 shares x $25 = $89,275. Total loss = $89,275 - $125,000 = -$35,725.

return is:

(c)

Margin

Market Value - Debit Balance Market Value

where Market Value = Price per share x Number of shares. Initial Loan Value = Total Investment - Initial Margin. = $125,000 - $50,000 = $75,000 Therefore, if maintenance margin is 30 percent:
.30 (3,571 shares x Price) - $75,000 (3,571 shares x Price

.30 (3,571 x Price)

= (3,571 x Price) - $75,000.

1,071.3 x Price = (3,571 x Price) - $75,000 -2,499.7 x Price Price = $30.00 Q. you bought 300 shares of Kayleigh Milk Co. for $30 a share with a margin of 60 percent. Currently, the Kayleigh stock is selling for $45 a share. Assuming no dividends and ignoring commissions, (a) compute the rate of return on this investment if you had paid cash and (b) your rate of return with the margin purchase. (a). Assuming that you pay cash for the stock: = -$75,000

Rate of Return

($45 x 300) - ($30 x 300) 13,500 - 9000 50 % ($30 x 300) 9000

(b). Assuming that you used the maximum leverage in buying the stock, the leverage factor for a 60 percent margin requirement is = 1/margin requirement = 1/.60 = 1.67. Thus, the rate of return on the stock if it is later sold at $45 a share = 50% x 1.67 = 83.33%. Q. Suppose you buy a round lot of Maginn Industries stock on 55 percent margin when the stock is selling at $20 a share. The broker charges a 10 percent annual interest rate, and commissions are 3 percent of the total stock value on both the purchase and sale. A year later, you receive a $0.50 per share dividend and sell the stock for 27. What is your rate of return on the investment? Profit = Ending Value - Beginning Value + Dividends - Transaction Costs - Interest Beginning Value of Investment = $20 x 100 shares = $2,000 Your Investment = margin requirement + commission. = (.55 x $2,000) + (.03 x $2,000) = $1,100 + $60 = $1,160 Ending Value of Investment = $27 x 100 shares = $2,700 Dividends = $.50 x 100 shares = $50.00

Transaction Costs (Commission)

= (.03 x $2,000) + (.03 x $2,700) = $60 + $81 = $141

Interest = .10 x (.45 x $2,000) = $90.00 Therefore: Profit = $2,700 - $2,000 + $50 - $141 - $90 = $519 The rate of return on your investment of $1,160 is: $519/$1,160 = 44.74% Q. Ali has purchased 1000 shares of PTCL stock at Rs.36 per share for a total purchase price of Rs.36,000. He has a deposited Rs.18,000 with his broker to meet the 50% margin requirement, borrowing the remainder. The margin requirement is 30%. a. b. c. What is his initial equity? What is his equity in the account if the stocks price What is his equity in the account if the stock price falls rises to Rs.40 per share. to Rs.30 per share? is a margin call on his

d. What is the minimum value of securities before there account?

Rs. 36,000 18,000 = 18,000 Equity in account = =50% Rs. 40,000 18,000 = 22,000

Equity in account = =55%

Rs. 30,000 18,000 = 12,000

Equity in account = =40%

Margin

Market Value - Debit Balance Market Value

Price per share = 25.714 Q. Razia has purchased 200 shares of FFC that is currently trading for Rs.100 per share. She has purchased this stock using a 50% margin, borrowing Rs.10,000 for the purchase price of Rs.20,000. The stock paid no dividend. She has incurred a 1% commission when buying and selling the stock, and the margin loan is at a rate of 8% per year. What is the return on her investment if she sells the share after one year at: a. b. c. Sales Cost of Sales Purchase Commission on Purchase interest on loan commission on sale Profit 20,000 200 800 250 21,250 3,750 Rs. 125 per share Rs. 100 per share Rs. 90 per share 25,000

Q. Suppose you decide that the Bear Company is selling at too high a price at its current $50 per share price. You are convinced that the price of Bear Stock will fall in the next couple of months, so you decide to sell 100 shares of Bear Stock short. Ignoring transaction costs, if the Bear company does not pay dividend and if you do not have to use a margin account, what is you profit or loss if the stocks price goes to a. b. $40 and you buy at that price to cover your short? $55 and you buy at that price to cover your short?

a. Sales Purchase Profit b. Sales Purchase Loss

5000 4000 1000

5000 5500 500

Q. You are sure that the stock of Dippy company will drop from its present price of $40. You decide to sell 100 shares of Dippy company stock short. Now suppose that you must pay your broker 1% in transaction costs for all purchases and sales. If Dippy company pays a dividend of $1 per share, what is your profit or loss if you buy the stock back at a. b. c. a. Sales Purchase Gross Profit Commission on Sales Commission on Purchase Dividend Profit $4,000 3500 500 40 35 100 325 $35 $40 $45

B Sales Purchase Gross Profit $4,000 4000 0

Commission on Sales

40

Commission on Purchase Dividend Loss C Sales Purchase Gross Profit/loss Commission on Sales

40 100 -180

$4,000 4,500 -500 40

Commission on Purchase Dividend Loss

45 100 -685

Q. You decide to sell short 100 shares of Charlotte Horse Farms when it is selling at its yearly high of 56. Your broker tells you that your margin requirement is 45 percent and that the commission on the purchase is $155. While you are short the stock, Charlotte pays a $2.50 per share dividend. At the end of one year, you buy 100 shares of Charlotte at 45 to close out your position and are charged a commission of $145 and 8 percent interest on the money borrowed. What is your rate of return on the investment?

Profit on a Short Sale = Begin.Value - Ending Value - Dividends -Trans. Costs - Interest

Beginning Value of Investment = $56.00 x 100 shares = $5,600 (sold under a short sale arrangement) Your investment = margin requirement + commission = (.45 x $5,600) + $155 = $2,520 + $155 = $2,675 Ending Value of Investment = $45.00 x 100 = $4,500 (Cost of closing out position) Dividends = $2.50 x 100 shares = $250.00 Transaction Costs = $155 + $145 = $300.00 Interest = .08 x (.55 x $5,600) = $246.40 Therefore: Profit = $5,600 - $4,500 - $250 - $300 - $246.40 = $303.60 The rate of return on your investment of $2,675 is: $303.60/$2,675 = 11.35% Q. Assume an initial margin requirement of 50 percent and a maintenance margin of 30 percent. An investor buys 100 shares of stock on margin at 60 per share. The price of the stock subsequently drops to $50. What the actual margin at $50? The price now rises to $55. Is the account restricted? If the price declines to $49, is there a margin call? Assume that the price declines to $45. What is the amount of the margin call? At $35? The initial margin is 50% of $6000, or $3000. The other $3000 is borrowed from the broker.

(a)

$5000 - $3000 Actual Margin = $5000 = 40% In a restricted account, the actual margin is between the initial margin (i.e., 50%) and the maintenance margin (i.e., 30%). The actual margin is now: $5500 - $3000 B = $5500

= 45.5% Therefore, the account is restricted. A margin call results when the actual margin declines below the maintenance margin. At a stock price of $49, the actual margin is:

$4900 - $3000 C actual margin = $4900 = 38.8%

Because the actual margin is not below the maintenance margin of 30%, there is no margin call.

(d)

At a stock price of $45, the actual margin is

$4500 - $3000 actual margin = $4500

= 33.3%

There is no margin call at a price of $45. At $35, however, the actual margin is

$3500 - $3000 actual margin = $3500

= 14.3%

The amount of the margin call is calculated as:

(x + $3500) - $3000 .3 = ---------------------(x + $3500)

= $785.71

Q. Assume an investor sells short 200 shares of stock at $75 per share. At what price must the investor cover the short sale in order to realize a gross profit of $5000? $1000. To realize a gross profit of $5000 on 200 shares sold short at $75, the investor must cover at (ignoring transaction costs):

200($75) = $15,000 X

= $ 5000 profit

X is $10,000, which must be divided by 200 shares.

ANSWER: $50 per share For a profit of $1000, the calculation is:

$15,000 X

$ 1000

X is $14,000, which again must be divided by 200 shares.

ANSWER: $70 per share.