C HAPTER 2

1. CHAPTER2 Buying and Selling Securities Chapter Sections: Getting Started Brokerage Accounts Short Sales Investor Objectives, Constraints, and Strategies We are going to focus on margin accounts and selling short.

2. Brokerage Firms • Full Service (Traditional) • Companies such as Merrill Lynch and Morgan Stanley that provide investment recommendations • Discount • Companies such as Schwab that traditionally left the stock picking to the investor but now have their own stock rating / recommendation services • Deep-discount (a.k.a. Internet brokers) • Companies that have emphasized technology to reduce brokerage costs dramatically What can you expect to pay for each? What kind of service can you expect from each?

3. Brokerage Firms (continued) • Commissions – Then and Now • Traditionally, virtually all brokerage firms made their money from commissions • Full-service brokers – $70 to $100+ per trade • Discount – $45  $29  $19  $13  $9 per trade • Deep-discount – $5 to $18 per trade or less! • Mutual fund companies! Examples: Fidelity & Vanguard (Both offer free commissions on their own funds) • A couple of companies experimented with $0 commissions • One failed and the other now charges $5 per trade Wait a minute! How can a brokerage firm make any money with a $0 commission? In fact, how can a company make money with $5 or $7 per trade?

4. Brokerage Firms (continued) • The following disclaimer is placed on each trade confirmation from Scottrade SCOTTRADE INC. RECEIVES REMUNERATION FOR DIRECTING ORDERS TO PARTICULAR BROKER/DEALERS OR MARKET CENTERS FOR EXECUTION. SUCH REMUNERATION IS CONSIDERED COMPENSATION TO THE FIRM AND THE SOURCE AND AMOUNT OF ANY COMPENSATION RECEIVED BY THE FIRM IN CONNECTION WITH YOUR TRANSACTION WILL BE DISCLOSED UPON REQUEST Remember this slide from Chapter 5?

5. Brokerage Firms (continued) • Alternative Methods of Paying Your Broker • As the competition for your business as gotten fiercer • The methods of charging investors for investment services have gotten more “creative” • Merrill Lynch experimented with charging $3,000 per year for unlimited trades • (They do not have that program anymore) • There are many other methods The new, modern-day-a-go-go-way to soak customers… uh, I mean, charge for brokerage services is called “Wealth Management.”

6. Brokerage Firms (continued) • Wealth Management Account • a.k.a. Wrap account, Financial advisor account • Instead of charging per transaction, the brokerage firms tacks on a yearly 1% or 2% “wealth management” fee • Do you remember the mutual fund F shares? • These types of programs are being pushed by all the major full-service brokerage firms • There are many flavors of this program The latest wrinkle to this method is the new “performance-based wealth management” program.

7. Brokerage Firms (continued) • Performance-based Wealth Management • Only pay your advisor when you make money! • The advisor receives 10% to 20% of your earnings when you make money • The advisor receives nothing when you lose money (or do not make anything) • It is a variation of the way hedge funds charge their shareholders • Currently marketed to “high-net worth investors” • Example: Dunham & Associates • http://www.dunham.com/ Although it sounds tempting, the reality is that you have the potential to pay far, far more for your investment services using this method.

8. ANTI-Brokerage Firms • Dividend Reinvestment Plans • a.k.a. DRIPs, Direct low-cost investment plans • Bypass the middleman! • Many of the large, well-established companies offer their own DRIPs • Some are totally free – some are close to free • There are many other DRIP programs available • NAIC – www.better-investing.org (now uses Foliofn.com) DRIPs are low-cost, yes. But they are not perfect. How would you like having to sift through 18 different statements? Some charge a monthly fee to allow you to keep all your DRIPs in one place. Many traditional brokerage firms now offer DRIPs.

9. Cash Account • Cash Account • A brokerage account in which all transactions are made on a strictly cash basis • Cash accounts are the simplest arrangements requiring no credit check of the customer by the brokerage firm Once you have established a good relationship, most brokerage firms will allow you to purchase shares of stock even if you do not have enough cash in the account. This is because stock transactions settle in three business days. You have three business days to get the money into the account. Some of the deep-discount Internet brokers (example: Scottrade) do not allow this. (Conversely, when you sell a stock, it takes three business days to receive the money.)

10. Margin Account • Margin Account • A brokerage account in which, subject to limits, securities can be bought and sold on credit • If you open a margin account, the brokerage firm will do a credit check to determine your credit worthiness • Since you will be borrowing money from them The interest rate you pay on money borrowed from your broker is called the margin rate. It is actually a very good interest rate. It is often the prime rate plus 1 or 2 percentage points or 2 or 3 points above the current money market rates, depending on how much you borrow.

11. Buying on Margin • A margin account allows you to perform Margin Trading • a.k.a. “Buying on margin” “leveraged account” • The use of borrowed funds to purchase securities; magnifies returns by reducing the amount of equity that the investor must put up • Margin • The portion of the value of an investment that is not borrowed (Shouldn’t it be the other way ‘round?) • The amount of equity stated as a percentage in the investment • Example: 75% margin, 25% borrowed

12. Why Buy on Margin? • Buying on margin allows the investor to use financial leverage • The use of debt financing to magnify investment returns • Buying on margin also allows an investor to tap into the equity in their account • Without actually selling their investments • And generating commissions and taxable transactions Buying on margin is much like buying a house. When you purchase a house, you do not come up with the total amount. You put up 10% or 20% down and finance the rest. Stocks require at least 50% down.

13. Buying on Margin (continued) • Margin Requirement • a.k.a. Initial margin • The minimum amount of equity that must be a margin investor’s own funds; set by the Federal Reserve Board • Currently the margin requirement is 50% • You must put up at least 50% of your own funds • This allows you to purchase the same amount of stock with less money • Margin Loan • a.k.a. Debit Balance • The amount of your account borrowed

14. Buying on Margin (continued) • Buying on Margin Example • You put up $10 and borrow $10 from your broker • Initial Margin = 50%; Margin Loan = $10 • You purchase one share of common stock for $20 • The market price rises to $30 Congratulations! You made $10 on a $10 investment! That is half of what you had to come up with when you simply purchased the stock outright with your own money. Instead of a 50% return on your investment, you received a 100% return on your investment.

15. Buying on Margin (continued) • Buying on Margin Example Revisited: • You put up $10 and borrow $10 from your broker • You purchase one share of common stock for $20 • Same as before, but this time… • The market price drops to $10 Oops! Only ½ of the money was yours! You borrowed the rest. You have lost your entire investment. Buying on margin magnifies your gains and your losses. Margin buying was one of the major contributing factors to the Crash of 1929. At the time, the margin requirement was only 10%. For this reason, the above scenario is prohibited today and our intrepid investor would have had a “margin call” long ago.

16. Buying on Margin (continued) • Margin Trading (continued) • Because margin trading is inherently more risky, margin accounts are more highly scrutinized by brokerage firms • Restricted account • A margin account whose equity is less than the initial margin requirement; the investor may not make further margin purchases and must bring the margin back to the initial margin requirement when the securities are sold Information technology has made the brokerage firm’s job of scrutinizing margin clients much easier. Now, the computer spits out a list of customers that are restricted.

17. Buying on Margin (continued) • Margin Trading (continued) • Maintenance margin • The absolute minimum amount of margin (equity) that an investor must maintain in the margin account at all times – typically 25% to 35% (25% min) • Margin call • Notification of the need to bring the equity of an account whose margin is below the maintenance level up to the initial margin level or to have enough margined holdings sold to reach this standard If the investor does not meet the margin call in sufficient time (typically 72 hours), the brokerage firm is authorized to sell enough of the securities to meet the margin call. “Never meet a margin call!”

18. Buying on Margin (continued) • Margin Trading (continued) • Of course, if your investments do very well, then you can use the excess margin you create in your margin account to purchase additional stock without having to come up with more money • Excess margin • More equity than is required in a margin account • Pyramiding • The technique of using excess margin from paper profits in margin accounts to partly or fully finance the acquisition of additional securities What do you think of this strategy?

19. Buying on Margin (continued) • Margin Trading (continued) • Paying interest on the margin loan also adds yet another drag on your investment returns • Your margined investments must meet or exceed the margin interest rate in order for you to just break even! Commissions and interest! Now you know why your broker is always so happy to take your calls.

20. Buying on Margin (continued) • Margin Trading (continued) • “So, why would I buy on margin?” • The easy answer is, “You shouldn’t” • The risks are not worth the potential reward • In my humble opinion… • However, there is a valid, logical reason for having a margin account • A margin account allows you to temporarily borrow against your investments without having to sell them • You do not incur commission costs and … • You do not trigger capital gains taxes, but … • You do pay interest! Discussion: Do you think you would want to margin securities?

21. Buying on Margin (continued) • Margin Trading (Examples:) • Stock selling for $50 • You put up $30 and borrow $20 • ( $50 - $20 ) / $50 = 60% • Stock price rises to $80 • ( $80 - $20 ) / $80 = 75% • Stock price falls to $25 • ( $25 - $20 ) / $25 = 20% −Uh, Oh! Margin Call! Value of Security – Margin Loan Margin = ─────────────────── Value of Security

22. Buying on Margin (continued) • The Account Balance Sheet • Traditionally, with margin accounts, the brokerage firms would create an Account Balance Sheet to keep track of the account • It is all computerized now • Those of you with accounting experience will recognize this as… • Assets = Liabilities + Equity • The balance sheet also makes it easier to calculate the margin • Margin = Account Equity / Total Assets

23. Buying on Margin (continued) • The Account Balance Sheet (Example: Page 43) • You purchase 800 shares at $50 • You put up $20,000 & borrow the rest ($20,000) • Margin = $20,000 / $40,000 = 50%

24. Buying on Margin (continued) • The Account Balance Sheet (Example: Page 43) • Uh, Oh! Your shares falls to $35 • The company was caught artificially inflating earnings! • Margin = $8,000 / $28,000 = 28.6% Your brokerage’s maintenance margin is 30%. Margin call!

25. Long Stock Purchases • Long Purchase • a.k.a. “Buying long,” “Going long” • A transaction in which investors buy securities in the hope that they will increase in value and can be sold at a later date for profit • This is the type of transaction that people commonly think of when they hear that someone bought stock • Buying long is the most common form of transaction • Expectation of dividends or capital appreciation or both • “Buy low, sell high”

26. Long Stock Purchases (continued) • Long Purchase Example • You purchase one share of common stock for $20 • The market price rises to $30 Congratulations! You made $10 on a $20 investment! That is a 50% increase. Of course, if the price dropped to $10, you lost $10, or ½ of your investment – a 50% decrease.

27. Selling Short You are gonna’ love this! • Short Selling • a.k.a. “Selling short,” “Shorting the stock,” “Going short” • The sale of borrowed securities, their eventual repurchase by the short seller, and their return to the lender • It is the opposite of “buying long” • You are hoping that the price goes down • “Sell high, buy low” • Selling short must take place in a margin account • Since you are borrowing the stock you sell from the brokerage firm

28. Selling Short (continued) • Short Selling (continued) • Here is how it works: • You borrow the stock from another shareholder (without their knowledge) and sell it on the market • You receive money for selling stock that you do not own! • You wait for the stock price to go down • You then buy back the shares at a lower price • Pocketing the difference • The shareholder you borrowed the shares from never knows that the shares were borrowed • The brokerage firm does all the financial sleight-of-hand • By the way, you must pay any dividends the company declares to the investor who bought the shares that you sold short… Doesn’t it sound as though it should be illegal!?

29. Borrow shares from someone Sell the shares in the market Buy shares from the market Return the shares Today: In the Future: Selling Short (continued) • Short Selling (continued) • Here is how it works: If the price goes down, you have made money. If the price goes up, you have lost money. It is the opposite of buying long.

30. Selling Short (continued) • Short Selling Example: • You sell a stock short for $20 • You receive $20 from the sale of the stock • Even though the stock was not yours. You borrowed it from someone else • The stock price goes down to $10 • You buy back the stock at $10 • “Closing out the transaction” • You give the stock back to the person you borrowed it from • You get to keep the $10 difference Congratulations! You just made $10 on a $0 investment! Well, not quite…

31. Selling Short (continued) • Short Selling Example: • You can not really make $10 on a $0 investment • It is a margin account, remember? • You borrowed the stock that you sold • The rules for a margin account still apply • You must put up at least 50% • “50% of what?” • 50% of what you borrowed! (Huh? What?) • 50% of the proceeds from the sale of the borrowed stock – You borrowed the stock that you sold • Again, the brokerages use the Account Balance Sheet to keep track of the investor’s margin Examples of margin requirements accounting to follow in a bit.

32. Selling Short (continued) • Short Selling Example Revisited: • You sell a stock short for $20 • You receive $20 from the sale of the stock • Even though the stock was not yours. You borrowed it from someone else • The stock price goes up to $40 • You buy back the stock at $40 • Remember, you borrowed it • You must replace it at some future date • You must buy it back Uh-oh! You just lost $20 on your short transaction!

33. Selling Short (continued) • Short Selling (continued) • When you buy long, you can only lose the purchase price of the stock • Buy a stock for $20, it goes to zero, you lost $20 • Once a stock reaches $0, it can not go any lower • But when you sell short, there is no limit to the amount of money you can lose (theoretically) • Why? Because there is no limit to the price of a stock • The price can always go higher “He who sells what isn’t his’n, Must buy it back or go to prison.”

34. Selling Short (continued) • Calculating the margin on short sales • Example: If the stock were sold short at $20, you would have to deposit $10 Margin = ($10 + $20 - $20 ) / $20 = $10 / $20 = 50% Margin deposit + Short sale proceeds - Value of security Margin = ––––––––––––––––––––––––––––––––––––––––––– Value of Security Again, the Account Balance Sheet makes the calculation easier.

35. Selling Short (continued) • The Account Balance Sheet (Example: Page 49) • You sell short 100 shares of Texas Instruments at $30 • You receive $3,000 from the sale (100shrs * $30) • Margin = $1,500 / 3,000 = 50% Margin = Account Equity / Short Position

36. Selling Short (continued) • The Account Balance Sheet (Example: Page 50) • The stock price of Texas Instruments falls to $20 • The short position falls to $2,000 (100shrs * $20) • Margin = $2,500 / $2,000 = 125% This side does not change (unless you deposit more $$$) The short position fell and the account equity rose. You made money because the stock price fell.

37. Selling Short (continued) • The Account Balance Sheet (Example: Page 50) • Uh, Oh! What if the stock price of TI rises to $40? • The short position rises to $4,000 (100shrs * $40) • Margin = $500 / $4,000 = 12.5% Recall, this side does not change Uh, oh! Your brokerage’s maintenance margin is 40%. Margin call!

38. Selling Short (continued) • Margin Call Price Level – page 52 • Example: If you sold 100 shares short at $20, your proceeds are $2,000, you deposited $1,000 and the maintenance margin = 25% Price = [ ($1,000 + $2,000 ) / 100 ] / ( 1 + 0.25) = ($3,000 / 100 ) / 1.25 = $30 / 1.25 = $24 ( margin deposit + short sale proceeds ) / number of shares Price = ––––––––––––––––––––––––––––––––––––––––––––– 1 + maintenance margin Selling short is very risky. The brokerage firm will keep a close eye on you.

39. Selling Short (continued) • Short Squeeze • When the market is going down, momentum investors will often short stocks to try to take advantage of the down momentum • This pushes the market down even further • But eventually, the short shares must all be repurchased • The subsequent up movement of the market is often dramatic as short sellers cover their positions • Short interest • The amount of stock shares that have been sold short In August of 2002, short interest was the highest it had ever been in the history of the United States stock markets. That gave me great comfort because it meant that the market downturn was close to an end.

40. Selling Short (continued) • Short Selling (continued) • Actually, there used to be a valid reason for shorting a stock • “Shorting against the box” • Shorting stock that you already owned • It allowed you to essentially sell the stock without creating a taxable transaction until you closed out the transaction with your own stock • For example, you could sell the stock short in December, receive the money and then deliver your shares in January, effectively postponing the taxes for another year • The IRS removed this loophole in 1997 My advice? Never short a stock!

41. Careers in Stocks • Registered Representative • a.k.a. Stockbroker, Financial Representative, Account Executive, Financial Planner • Background check • No shenanigans with other peoples’ money • Must take Series 7 and Series 66 • Series 7 is difficult, 6 hours, 2 months of studying • Series 66 is much easier, 2 to 4 weeks study • Must be sponsored by a brokerage firm • Some brokerages exist simply to sponsor people • Expect to pay a fee to them for the privilege of being sponsored • Many brokerages now sponsoring new recruits!

42. CHAPTER2 – REVIEW Buying and Selling Securities Chapter Sections: Getting Started Brokerage Accounts Short Sales Investor Objectives, Constraints, and Strategies Next: Miscellaneous Topics in Investing: Account Types, REITs, Real Estate, Precious Metals, Hard Assets, etc.