Buying And Selling SecuritiesPresentation Transcript
Chapter Sixteen Buying and Selling Securities
Describe how stocks are bought and sold and how to select a brokerage firm.
Explain how to order securities transactions and read newspaper price quotations for stocks, bonds, and mutual funds.
Understand how to obtain and use investment information.
Learning Objectives (continued)
Given the risks associated with an investment, determine whether one’s required rate of return is exceeded by its potential return.
Recognize the risks associated with the trading techniques of margin buying and selling short.
Brokerage Firm – specializes in facilitating the purchase and sale of negotiable securities, such as stocks, bonds, and mutual fund shares.
Securities Markets and Brokerage Firms
Primary Market – exists anywhere issuers and buyers of new offerings of stocks and bonds are bought together.
Secondary Market (or Aftermarket) – where the trading of previously purchased securities takes place.
Initial Public Offerings (IPOs) – new issues of stock.
Investment Banking Firms – serve as intermediaries between companies issuing stocks and bonds and the investing public in the primary markets.
Figure 16.1: Flow of Stocks and Bonds in Primary Markets
Stockbroker (or Account Executive) – licensed to buy and sell securities on behalf of the brokerage firm’s clients.
Stockbrokers arrange the transactions between buyers and sellers.
Figure 16.2: Flow of Securities in Secondary Markets
Organized Stock Exchanges
Organized Stock Exchange (or Stock Market) – a market where agents of buyers and sellers bring together supply and demand for securities.
Listed Securities – securities that have been approved by the exchange for sale on its trading floor.
Member Firms – have purchased a seat on the exchange, which gives them the legal right to buy and sell securities on the exchange.
New York Stock Exchange
Founded in 1792, this by far, the largest exchange in the world with the most stringent requirements for listing
Corporations must have the following to list on the NYSE
minimum earnings of $2.5 million before taxes
net assets of at least $16 million
minimum of 1.2 million shares publicly held
market value of outstanding stocks of no less than $18 million
minimum of 2000 shareholders owning at least 100 shares each to be listed
American Stock Exchange
The American Stock Exchange (ASE or AMEX), is the second-largest exchange in the United States
The AMEX lists primarily smaller and younger companies than the NYSE Its listing requirements are less stringent than those of the NYSE
Regional Stock Exchanges
Regional Stock Exchanges trade securities mainly of interest to investors living in certain geographic areas.
Over-the-Counter (OTC) Market – buyers and sellers negotiate transaction prices through a sophisticated telecommunications network connecting brokerage firms.
NASDAQ – provides prices on securities offered by more than 4000 small domestic and foreign companies.
Electronic Communications Networks
Electronic Communications Networks (ECNs) – look for matching buy and sell orders and execute the trades, eliminating the need for most middlemen from transactions.
Full-Service General Brokerage Firms
General Brokerage Firm – offers a full rage of services to customers.
Cash Account – requires an initial deposit and specifies that full settlement is due to the brokerage firm within three business days after a buy or sell order has been given.
Broker’s Commissions and Fees
A brokerage firm might charge 2.8 percent on a transaction amounting to less than $800, 1.8 percent on transactions between $800 and $2500, 1.6 percent on amounts between $2500 and $5000, and 1.2 percent on amounts exceeding $5000.
Round Lots – standard units of trading of stock and $1000 or $5000 par value for bonds.
Odd Lots – transactions of any number of shares that is less than its normal trading unit.
Discount Brokers – charge commissions to execute trades that are about 40 to 80 percent less than the fees charged by full-service brokers.
Day Trading – occurs when an investor buys and sells stocks quickly throughout the day with the hope that the price will move enough to cover transaction costs and earn some profits.
The Process of Trading Stocks
Specialist – a person on the floor of the exchange who handles trades of that particular stock in an effort to maintain a fair and orderly market.
Figure 16.2: Flow of Securities in Secondary Markets
Types of Stock Orders
Market Order – instructs the stockbroker to execute an order at the prevailing market price.
Limit Order – instructs the stockbroker to buy or sell a stock at a specific price.
Stop Order – instructs a stockbroker to sell your shares of stock at the market price if a stock declines to or goes below a specified price.
Fill-or-Kill Order – instructs the stockbroker to buy or sell the stock at the market price immediately or else cancel the order.
Day Order – valid only for the remainder of the trading day during which it was given to the brokerage firm.
Week Order – remains valid until the close of trading on Friday of the current week.
Time Limits (continued)
Month Order – effective until the close of trading on the last business day of the current month.
Good-til-Cancelled (GTC) Order (also called open order) – remains valid until executed by the stockbroker or canceled by the investor.
Reading Newspaper Price Quotations
Mutual Fund Quotations
Figure 16.3: How Stocks Are Quoted
Figure 16.4: How Bonds Are Quoted
Figure 16.5: How Mutual Funds Are Quoted
Securities and Market Indexes
Securities Market Indexes – measure the average value of a number of securities chosen as a sample to reflect the behavior of a more general market.
The Dow Jones Industrial Average
The (DJIA) is the most widely reported of all indexes, having been used continuously since 1884.
In determining the DJIA, the prices of only 30 actively traded blue-chip stocks are followed.
“ Points” changes in the index are not actual dollar changes in the value of the stocks.
The average is calculated by adding the closing prices of the 30 stocks and dividing by a number adjusted for splits, spin-offs, and dividends.
Standard & Poor’s Indexes
The popular Standard & Poor’s (S&P) 500 index reports price movements of 500 stocks of large, established, publicly traded firms.
It includes stocks of 400 industrial firms, 40 financial institutions, 40 public utilities, and 20 transportation companies.
Although not as popularly reported as the DJIA, the S&P 500 more accurately reflects daily transactions of the investing public thanks to its greater breadth of representation.
New York Stock Exchange Composite
This index includes all stocks traded on the NYSE.
It provides a comprehensive measure of the price movements and value changes of those stocks.
NASDAQ Composite Index
The NASDAQ Composite Index takes into account virtually all U.S. stocks (about 8000) traded in the over-the-counter market in the automated quotations system of the National Association of Securities Dealers.
It provides a measure of companies not as popular or as large in size as those traded on the New York Stock Exchange.
Wilshire 5000 Index
The Wilshire 5000 index represents the total market value (trillions of dollars) of the more than 6500 most actively traded stocks.
Japan’s best-known barometer of stock prices represents the activity of 300 stocks.
Because this market is open at night in the United States, U.S. investors often check the Nikkei Dow in the morning to gain a hint of what might happen that day.
General Economic Conditions and Financial News
It is vital that one stay abreast of the economic conditions and current financial events.
Information about Industries
Economic events can significantly influence entire industries, such as aerospace, apparel, automobiles, beverages, chemicals, construction, pharmaceuticals, electronics, finance, foods, machinery, and metals.
They may even depress the stock of a very profitable company .
Industry-Oriented Investment Publications
You can find Industry Information in the following investment publications and advisory services
The Outlook (published by Standard & Poor’s)
Value Line Investment Survey (Value Line Publishing)
The Monthly Economic Letter (Citibank)
Industrial Manual (Moody’s).
These publications can be found in large libraries (especially at colleges) and in brokerage firms.
Information about Specific Companies and Funds
Investors should buy only when they have a clear, simple understanding of why the value of their investment is likely to rise
Before buying any securities, one should thoroughly research a company
The focus of the analysis should be on the company’s:
quality of management
Companies issue an annual report once a year that summarize the firm’s financial activities for the year.
It includes information on sales, earnings, profit, legal problems and it offers a forecast of it future.
Investors use these reports to compare results from recent years and to find out about management’s views of the immediate future
When a company issues any new security, it must file a prospectus with the Securities and Exchange Commission.
It describes the corporation’s:
any anticipated legal matters that could affect the company
potential risks of investing in the firm
Online Investment Information Is Extensive
Basic Investment Information websites
The Motley Fool (www.fool.com)
Electronic Data Gathering and Retrieval (Edgar) project (www.edgar- online.com)
Standard & Poor’s Financial Information Services (www.standardandpoors.com)
Value Line (www.valueline.com).
Online Investment Information Is Extensive (continued)
Online Investment Screening – One can conduct in-depth research on stocks, bonds, and mutual funds using screening tools on the Internet such as www.quicken.com and www.kiplinger.com
Portfolio tracking – permits you to enter the symbol of the stocks you own and the number of shares held that you wish to follow and the software automatically updates the value of your portfolio.
Vaulable websites include www.quicken.com, www.moneycentral.com and www.investorguide.com
Online Investment Information Is Extensive (continued)
Financial Calculators – available on various websites including www.financenter.com and www.usatoday.com.
Beware of On-Line Investment Scams – see the Securities and Exchange Commission website (www.sec.gov) for suggestions to avoid investment scams.
Investors Should Begin with the Return on U.S. Treasury Bills
Real Rate of Return – a zero return on investment after inflation and income taxes.
Alpha – statistic that quantifies the difference between an investments expected return and its actual recent performance, given its risk.
Use Beta to Estimate the Risk of the Investment
Beta – value that is a measure of an investment’s volatility compared with a broad market index for similar investments.
Estimate the Market Risk
Market Risk (or Systematic Risk) – the risk associated with the effects of the overall economy on securities markets.
Calculate the Required Rate of Return
Estimate of the required rate of return on an investment
= T-bill rate + (beta [x] market risk)
Calculate the Potential Rate of Return on the Investment
Potential Rate of Return – calculates the approximate compound yield.
Compare the Required Rate of Return with the Potential Rate of Return on the Investment
The potential return for any investment over a period of years can be determined by adding anticipated income (from dividends, interest, rents, or other sources) to the future value of the investment and subtracting its original cost
Margin Buying and Selling Short are Risky Trading Techniques
This estimate involves the estimate of the required rate of return on an investment given its risk to the investment’s potential projected rate of return.
Margin Trading is Buying Stocks on Credit
Margin Account – requires making a deposit of substantial cash or securities and permits the purchase of other securities using credit granted by the brokerage firm.
Margin Buying – allows the investor to apply leverage that magnifies returns.
Margin Rate – the percentage of the value (or equity) in an investment that is not borrowed.
A Margin Call Makes Matters Worse
Margin Call – a representative of the firm tells the investor to immediately either provide more collateral (money) or face having the investment liquidated.
Selling Short is Selling Stocks Borrowed From Your Broker
Buying Long – buying a security with the hope that it will go up in value.
Selling Short – investors sell securities they do not own (borrowing them from a broker) and later buy the same number of shares of the security at a lower price (returning them to the broker).
Golden Rules of Personal Finance
Use a discount broker to pay the lowest brokerage fees on securities transactions.
When trading stocks, use limit and stop orders to protect your profits and reduce your losses.
Stay abreast of general economic conditions and financial news so you can use that information to your advantage when buying and selling securities.
Golden Rules of Personal Finance (continued)
Use on-line investment screening software and portfolio tracking services to help make good buying and selling decisions.
Before putting money in an investment, always calculate your required rate of return given its risk as well as the investment’s potential rate or return.
Do not engage in the risky practices of day trading, short selling, and margin buying.