Security Trading

1
Security Trading

• Objectives
• Margin Account
• Short Sale
• Summary

2
Objectives

• Margin Account Trading
• Why do investors use margin account?
• How does margin borrowing affect return and risk?
• Short Sale
• What purpose does short sale serve?
• How does short sale work?
• How does short sale constraint affect stock
  return?

3
Margin Account Trading

• Definition
• Account Values
• Asset total holding of securities including cash
• Liability the amount of money owed to others
• Either cash (margin borrowing) or stock (short
  sale)
• Equity the investors net worth Asset -
  Liability
• Stock Value the market value of stock holding
• Margin equity as a percentage of stock value
• Initial Margin Requirement initial margin gt 50
• Set by Board of Governors of the Federal Reserve
  System
• Maintenance margin minimum amount of equity
  before additional funds to be put into the
  account
• Margin call notice from broker for additional
  funds
• Margin Interest interest charge on capital
  borrowed

4
Margin Account Trading

• Holding Period Return
• E.g., you invest 10,000 and receive 1,000 of
  dividends at the end of the year. The market
  value of your stocks at the end of the year is
  11,000.
• Q whats your return for the year?
• A the holding period return is

5
Margin Account Trading

• Un-leveraged Investment
• Invest no more than the capital you have
• Q You open an account with 6,000. IBM stock
  price is 100.
• If you invest all your money in IBM
• What is your HPR if IBM appreciates to 130 in a
  year?
• What is your HPR if IBM depreciates to 80 in a
  year?
• A Since this is a unleveraged position, your
  return is the same as the stock price
  appreciation/depreciation
• Appreciation
• Depreciation

6
Margin Account Trading

• Q Same condition as previous case, but you buy
  100 shares
• What is your HPR if IBM appreciates to 130 in a
  year?
• What is your HPR if IBM depreciates to 80 in a
  year?
• A 100 shares cost 10,000, you have to borrow
  4,000 (at 9)
• Initial Position
• Asset stock value 10,000
• Liability 4,000, Equity Asset Liability
  6,000
• Initial Margin Equity/Stock Value 60
• Final Position when P 130
• Asset stock value 100130 13,000
• Liability 4,000(19) 4,360, Equity
  8,640
• Final Position when P 80
• Asset 8,000, Liability 4,360, Equity
  3,640

7
Margin Account Trading

• Effects of Margin on Return and Risk
• Higher risk
• Makes more in good times
• Loses more in bad times
• Higher return
• Margin amplifies the expected return

8
Margin Call

• Margin Call (for Margin Account)
• If equity falls below maintenance margin (25-30
  typical), a margin call for more fund or for
  liquidation is issued
• Assuming 30 maintenance margin
• What is the margin call price one year later?
• Solve the above equation Pc 62.29
• What is the margin call price today?
• Liability 4,000 (instead of 4,360), so Pc
  57.14
• What is the margin call price if the maintenance
  margin 40?
• What happens to the investor receiving a margin
  call?
• either deposit more fund (increase the equity),
  or
• sell some stock (lowers the stock value)

9
Margin Call - Risks

• Margin calls happen when your bets go wrong (at
  least short-term)
• The higher the leverage, the higher the chance of
  getting margin calls
• Need to come up with cash (liquidity) - fast
• Can not profit from your position if you sell
  stock
• May trigger liquidity crisis
• Try to use Rev/repos if you can
• Tough luck, if you cant come up with cash
• This is where LTCM failed

10
Short Sale

• What purpose does short sale serve?
• Gives speculators a tool to profit from bear
  market
• Q Jane believes IBM is going to drop from 100
  to 90, what should she do?
• A Jane borrows IBM shares and sells them at
  100. She waits to buy back the shares at 90 to
  make 10 profit per share.
• Allows arbitrageurs to enforce price convergence
  of similar securities
• Q On Shenzhen Stock Exchange (China), one
  observes that A share has P/E ratio 55, and B
  share P/E ratio 39. What profitable opportunity
  does this price divergence provide?
• A If possible short A share/buy B share to make
  16 dollar profit on 1 earning.
• Provides investors with a vehicle to hedge its
  portfolio
• Q An investor holds a diversified portfolio with
  huge capital gains, but is afraid of a market
  drop. What should she do?
• A sell short a market index portfolio like
  Spider (SPY)

11
Short Sale
100

• How Does Short Sale Work?
• Mr Owner buys 1 share of IBM
• Mr owner has the rights of
• Voting
• Dividend
• Short Creation
• Short borrows share from Owner
• Short owes Owner a share (IOU)
• Short sells the share to Ms Long
• Ms Long has the rights of
• Voting
• Dividend
• Mr Owner is still entitled to
• Dividend
• All deals are facilitated by brokers

IBM
Mr Owner
1 share
IOU dividend
Morgan Stanley Dean Witter facilitates all the
deals
1 share
100
Mr Short
Ms Long
1 share
12
Short Sale

• How does Short Sale Work?
• Profit/Loss (so called P/L in industry)
• Long position on one share of stock
• P1 is the ending price
• P0 is the beginning price
• D1 dividend during the period paid in the end
• Short position on one share of stock short
• Q Whats your profit if you short 200 share of a
  stock at 34, and cover it at 30, while it pays
  a 1 dividend?
• A
• You receive 20034 6,800 at time 0
• You pay 2001 200 dividends to the one you owed
  share to
• You pay 20030 6,000 to buy the share and pay
  it back.

13
Short Sale

• Return and Margin Call
• Q You deposit 50,000 in the brokerage acct, and
  sell short 1000 share of IBM at 100
• What is your initial margin?
• What is your investment return if IBM falls to
  70?
• What is the margin call price if 2 dividends are
  paid?
• A Both the margin and return depend on equity
• Initial margin
• Return
• Assuming maintenance margin of 30

14
Short Sale - Constraints

• Cost of Borrowing
• Broker fees
• Low rebate rates on your collateral cash
• Scarcity of shares to borrow (stock on special)
• After IPOs
• Prior to rumored mergers/acquisitions (acquirers
  stock is hard to borrow)
• Risk of involuntary closing a short position
• Borrowed stock can be recalled, and the broker
  may not find a substitution

15
Wrap-up

• Margin account to profit in the up market
• Margin trading increases both the expected return
  and the level of risk
• Short sale to profit in the down market
• Short sale provides a mechanism for hedging and
  downward market speculation
• Short sale constrained stocks typically exhibit
  underperformance