Investments: Analysis and Behavior

Chapter 3- Buying and Selling

Equities

©2008 McGraw-Hill/Irwin

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Learning Objectives

Know the costs of trading securities. Be able to place a buy or sell order. Be able to compute margin debt and returns for long and

short positions. Implement a dollar cost average strategy.

Examine the Initial Public Offer market.

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Buying 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 price Ask size: the number of shares offered at the ask price

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Quote from specialist market

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Quote from dealer market

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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 kill Day order Good ‘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 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 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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Illusions 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 information How 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 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 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 declining

If 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 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

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Leverage, 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 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 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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Most shorts are done on margin

Since the first thing you do in selling short is to sell stock you don’t own, you would not need to put up any cash of your own for the position.

You are required to put cash in a margin account that is no less than 50% of the sale proceeds. So, selling short is usually a margin position

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Short 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:

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Short 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.

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Dollar-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 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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Underwriting 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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Underwriting revenue of top investment banks Issue Amount (billions) 2005 Market Share

2004 Market Share

J.P. Morgan $3.09 7.1% 6.9%

Citigroup 3.09 7.1 7.4

Goldman Sachs 2.39 5.5 5.7

Deutsche Bank 2.36 5.4 4.9

Credit Suisse F.B. 2.22 5.1 5.4

Morgan Stanley 2.22 5.1 6.0

UBS 2.19 5.0 5.0

Merrill Lynch 2.04 4.7 4.5

Lehman Brothers 1.69 3.9 4.1

Banc of America Sec. 1.66 3.8 4.3

Top 10 Totals $22.93 52.7% 54.2%

Industry Totals $43.48 100.0% 100.0%

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Group of underwriters

Syndicate manager

Underwriter’s allotment

Dealers agreement

Tombstone ads

For Large Issues, a Syndicate is Used

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Securities Act of 1933

Registration Statement

Filing Date

Cooling-Off Period

Preliminary Prospectus

Red Herring

Effective Date

Deficiency Letter

Due Diligence

Final Prospectus

Meanwhile, the underwriter puts on a Road Show Presentations to large,

institutional investors

Assess demand

Helps to determine the best offer price

SEC Requirements IPOs

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See IPO Central at Hoovers OnlineSee IPO Central at Hoovers Online

www.hoovers.comwww.hoovers.comPublic Date,

2005Name (Ticker) Offer Price

First Day Open/ Close Price

Price as of December 15, 2005

30-Nov Actions Semiconductor Co., Ltd. (ACTS) $8.00 $7.90/$8.00 $7.30

22-Nov Union Drilling, Inc. (UDRL) $14.00 $13.61/$14.41 $14.48

22-Nov Brookdale Senior Living Inc. (BKD) $19.00 $23.10/$25.43 $28.52

18-Nov Under Armour, Inc. (UARM) $13.00 $31.00/$25.30 $27.39

18-Nov Dover Saddlery, Inc. (DOVR) $10.00 $10.06/$10.25 $10.00

15-Nov Vimicro International Corporation (VIMC)

$10.00 $10.01/$8.36 $8.76

9-Nov Saifun Semiconductors Ltd. (SFUN) $23.50 $31.18/$35.30 $28.62

2-Nov Newkirk Realty Trust, Inc. (NKT) $16.00 $15.05/$15.05 $15.73

2-Nov Cbeyond Communications, Inc. (CBEY) $12.00 $12.00/$12.00 $12.07

Check Out IPOs

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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!