Chapter 2 Notes: Markets, Orders, and Margin Trading (Vocabulary)

Primary and Secondary Markets

• Primary markets issue initial public offerings (IPOs).

• Secondary markets trade securities after issuance (IPOs).

• Securities dealers buy (at bid price) and sell (at ask price) for their own accounts.

• A dealer is a market maker who offers to buy from sellers and sells to buyers.

• Market makers transfer ownership on organized exchanges (e.g., NYSE, "Big Board"). NYSE merged with Euronext and other U.S. exchanges (total of 10 exchanges in the U.S.).

• Listing requirements: A company must apply to have its stock listed to be accepted for trading. The company must meet exchange listing requirements; otherwise it is not listed, and if listed but violated, the stock would be delisted.

- Securities not listed on an exchange are traded over-the-counter (OTC).

OTC, Nasdaq, and Market Structure

• OTC is made up of Nasdaq, a communication system for price quotations. All major unlisted stocks (e.g., Microsoft, Intel) are traded on Nasdaq stock markets.

• Third Market: OTC market for securities listed on an exchange. With online trading, the distinction between organized exchanges and OTC markets is diminishing. Most large blocks (10,000 shares) are traded on the Third Market. Institutional investors are usually the main participants.

• Designated Market Maker (DMM): Supervises trading in a company’s stock to ensure smooth trading. If trading becomes volatile, the DMM buys/sells for their own account to maintain liquidity.

- Dealer Markets: Roughly 35,000 securities trade on OTC. Thousands of brokers register with the SEC as security dealers.

Electronic Trading Networks (ECNs) and Market Efficiency

• Electronic Communication Networks (ECNs) allow participants to post market and limit orders over computer networks. BATS is one leading ECN.

• ECN advantages:-

  • Orders can be crossed/matched automatically without broker intervention, eliminating the bid-ask spread that would otherwise be incurred. Trades cross at a modest cost, typically less than a penny per share.

  • Speed: trades can be executed quickly.

  • Anonymity for investors.

• Trading terminology:-

  • Round lot: 100 shares

  • Odd lot: less than 100 shares

  • Bid: price at which a securities dealer offers to buy a stock

  • Ask: price at which a securities dealer offers to sell a stock

  • Spread: difference between bid and ask prices; a source of profit for the dealer

- Equilibrium price: price that equates supply and demand

Market Participants and Trading Terms

• Financial analyst, securities analyst, or investment analyst: analyzes financial statements, interviews management, uses other information to estimate earnings and issue buy/sell recommendations. These are not brokers/dealers.

• Broker: an agent who handles buy/sell orders for an investor.

• Registered representative: a person who buys/sells securities for customers; a broker.

• Long position: owning assets for income and potential price appreciation; investor bullish (prices up).

- Short position: selling borrowed assets for possible price decline; investor bearish (prices down).

Types of Orders

• Market order: buy or sell at the going market price immediately.-

  • Example: Buy 700 shares of ABCD; Sell 300 shares of ABCD.

• Limit order: specify the maximum price to buy or the minimum price to sell.-

  • Example: Buy 700 shares at $15; Sell 700 shares at $10.

• Day order: order canceled at the end of the trading day if not executed.

• Good-till-cancelled (GTC) order: remains active until executed or canceled by the investor.

- A market order or limit order could be a day or a GTC order.

Stop Orders and Stop-Loss Orders

• Stop order to sell: after purchasing, you may place a stop order to sell; may be at a higher or lower price. Once the stock reaches that price, the stop order becomes a market order.

• Stop-loss order: to limit potential losses; specifies a price below cost at which the broker is authorized to sell.-

  • Example: Buy at $50; stop-loss at $45 limits loss to $5 per share. If price falls to $45, it becomes a market order and is sold.

- You may also place a stop or stop-based order above the purchase price to lock in gains; e.g., buy at $50, sell stop at $60; if price hits $60, it becomes a market order and is sold. This also limits potential profits.

Margin Trading: Long Margin

• Definition: A margin account allows a bullish investor to buy securities with borrowed money (called money or call money). The investor pays interest on the borrowed funds at a rate (call rate) typically 1–3 percentage points above the rate the broker pays for the money.

• Margin Requirement (MR): The maximum amount of credit the investor may receive. The Federal Reserve System (FRS) or equivalent sets/monitors MR.

• Why use margin? Leverage: it magnifies returns if the investment goes up.

• Example: Compare a 100-share purchase at $50 on cash vs. margin with MR = 50%.

  • Cash purchase return if price rises to $60: \frac{60-50}{50} = 0.20 = 20\%.

  • Margin purchase return with 50% MR: \frac{60-50}{25} = 0.40 = 40\%.

  • Magnification factor = 1/MR = 1/0.50 = 2; margin increases both potential gains and potential losses.

• Margin Percent and Maintenance Margin:

  • Margin Percent = (Equity / Market Value) × 100

  • Equity = Market Value − Call Money (the amount borrowed)

  • Maintenance Margin Requirement (MMR): The minimum margin percentage required; varies by brokerage.

  • Margin Call: occurs when equity falls to or below MMR; investor must deposit additional equity.

• Margin Call calculation example:

  • Suppose you buy 200 shares at $50; MR = 0.50; MMR = 0.25.

  • Call Money = (200 × $50) × 0.50 = $5,000.

  • Margin Call price per share: solve for price P where equity/market value = MMR:

  • Equity = 200P − 5,000; Market Value = 200P.

  • Requirement: (200P − 5,000) / (200P) = 0.25 \rightarrow 1 − 5,000/(200P) = 0.25 \rightarrow 5,000/(200P) = 0.75 \rightarrow 200P = 5,000/0.75 = 6,666.67 \rightarrow P^* \approx $33.33.

  • Margin Call price per share: \approx $33.33.

- Key takeaway: Margin amplifies both gains and losses; maintenance margin prevents excessive leverage.

Margin Trading: Short Sales

• Definition: A short sale involves selling stock short by a bearish investor in anticipation of a price decline. Typically the seller does not own the stock and borrows it from the broker (using cash and/or other securities as collateral) to sell to a buyer who hopes the price will fall.

• Short Sales Against The Box: Selling short stock that is already owned by the short seller as a hedge; locking in existing profits; closing the position later by delivering the stock.

• Short sale example (illustrative):

  • 100 shares of ABC sold short at $70 per share.

  • The broker loans out the shares and replaces them later; the short seller deposits collateral to meet the initial margin requirement (MR).

  • MR of 50% implies collateral cash/securities valued at $3,500 (because 100 × $70 × 0.50).

  • The broker may also use the proceeds from the short sale ($7,000) as additional collateral.

  • The broker charges commissions on initiating the short sale and on covering and on the buyer.

  • The short seller hopes the price falls to repurchase at a lower price, delivering to the broker and repaying the loan.

- Short-selling: Mechanics for gains/losses and commissions depend on price movement and financing costs.

Short Selling: Maintenance Margin and Margin Calls (Shorts)

• NYSE maintains higher minimum Maintenance Margin Requirement (MMR) on short transactions than on long transactions.

• Margin calls occur when the equity in the short account falls below the MMR; investor must deposit more collateral.

• Short sale margin call calculation example:

  • Suppose the initial value is $7,000 and initial margin is $3,500 (MR = 50%). If MMR = 30%, the margin call price threshold is:

  • Margin Call = (Initial Market Value + Initial Margin) / [n × (1 + MMR)]

  • Here: (7,000 + 3,500) / [100 \times (1 + 0.30)] = 10,500 / 130 \approx $80.77 per share.

  • A margin call would occur if the stock price rises to about $80.77.

• Reasons for short selling:

  • Speculation on price declines

  • Hedging against potential losses in other positions

- Tax planning: harvest losses or manage taxable gains year-to-year

Chapter 2 Problems and Solutions (Selected Examples)

• Problem 1 (Margin return on a margin purchase):

  • A stock sells for $10 per share. You purchase 100 shares for $10 each. After a year, the price rises to $17.50. Margin requirement is 25%.

  • Solution: Return on margin purchase is

  • \text{Return} =\frac{P^t - P^0}{P_0 \times \text{MR}} =\frac{17.50 - 10}{10 \times 0.25} =\frac{7.50}{2.5} = 3.0 = 300\text{%.}

  • Note: The denominator uses the amount of investor equity invested (cash outlay) rather than the full stock value.

• Problem 3 (Cash vs Margin return with price change):

  • You purchase 100 shares at $100; margin requirement is 40%. If you sell at $112 and you purchased with cash (no margin): profit per share is $12.

  • If purchased on margin (40% MR): return is

  • \text{Return} =\frac{112 - 100}{40} =\frac{12}{40} = 0.30 = 30\%.

• Problem 4 (Investor A vs Investor B on margin and cost of borrowing):

  • Investor A (cash): buys 100 shares at $35 = $3,500; holds for one year; sells at $40.

  • Investor B (margin): margin requirement 60%, borrowed funds cost 8% per year.

  • a) Interest cost for Investor A: none (cash purchase).

  • b) Interest cost for Investor B: borrowed amount = 40% of $3,500 = $1,400. Interest = $1,400 × 0.08 = $112.

  • c) If both sell at $40 after a year, capital gain on the stock is $4,000 − $3,500 = $500 for both.

  • Investor A percentage return: \frac{500}{3,500} \times 100 \simeq 14.3\%.

  • Investor B percentage return: net gain = $500 − $112 = $388. Total equity invested: $3,500 − $1,400 = $2,100.

  • Investor B percentage return: \frac{388}{2100} \times 100 \simeq 18.5\%.

• Problem 4, Cont’d: Why do percentage returns differ if the stock rises the same amount?

  • Answer: Investor B borrowed 40% of the cost, so leverage increases the percentage return despite the interest cost.

• Problem 6 (Short selling with low price stock)

  • Ms. Tejal Gandhi short sells SmallCap Inc. at $4 per share (shorts on this stock cannot be executed on margin because price is relatively low; must put up the entire value of the stock when sold short).

  • a) If the price rises to $8, loss on the position is $4 per share; percentage loss = $4 / $4 = 100%.

- b) If the price rises to $10, loss on the position is $6 per share; percentage loss = $6 / $4 = 150% (short seller would need to add funds as the price increases).

Assignments (From Lecture)

• Fundamental problems pp. 54

- Problems P. 55–56: 1.a, 1.c, 3.a, 4.b and 4.c, 6

Summary of Key Formulas and Concepts

• Equity in a margin account: \text{Equity} = \text{Market Value} - \text{Call Money}

• Margin Percent: \text{Margin Percent} =\frac{\text{Equity}}{\text{Market Value}} \times 100

• Margin Call threshold for a long position: solve for price P* in

  • Equity = MarketValue − CallMoney; Margin = Equity / MarketValue = MMR

  • \frac{(nP^) - \text{CallMoney}}{nP^} = \text{MMR}
    \rightarrow P^* =\frac{\text{CallMoney}}{n(1 - \text{MMR})}

• ### Short sale maintenance margin logic: Margin Call threshold is when

  • Example: If initial value is $7,000, initial margin is $3,500, and MMR = 30%,

  • Margin Call price per share \approx\frac{7,000 + 3,500}{100 \times (1 + 0.30)} \approx 80.77

- Returns with leverage (examples above) illustrate how MR and MMR affect gains and losses in margin and short positions.

Real-World Relevance and Implications

• Margin accounts enable investor leverage, increasing potential returns but also magnifying risk and potential losses; mismanagement can lead to margin calls and forced liquidations.

• Short selling provides a mechanism to profit from declines, but it entails risk of unlimited losses and requires collateral; margin requirements and maintenance margins constrain risk.

• ECNs, market makers, and Third Market dynamics influence liquidity, price discovery, execution speed, and cost structure for trades.

- Understanding stop orders, limit orders, and market orders is critical for managing execution certainty vs. price protection.

Notes on Ethics and Practicality

• Margin trading magnifies both gains and losses, potentially leading to significant financial risk for individuals and institutions.

• Short selling involves risks including sudden price spikes (short squeezes) and borrowing costs; ethical considerations center on market manipulation and disclosure.

- Regulatory frameworks (e.g., MR/MMR, margin calls) are designed to protect investors and maintain market stability.

Quick Reference: Key Terms

• IPO, IPOs; Secondary market; Market maker; DMM; List/Delist; OTC; Nasdaq; 3rd Market; ECN (e.g., BATS)

• Bid, Ask, Spread; Round lot; Odd lot; Equilibrium price

• Market order, Limit order, Day order, GTC order; Stop order; Stop-loss order

• Margin, Call Money, MR, MMR, Margin Call

• Long position, Short position; Short against the box

- Problems: margin return, cash vs margin returns, leverage effects, short sale risk

Appendix: Quick Formulas

• Margin Call price per share for long position:
  
  P^* =\frac{\text{Call Money}}{n(1 - \text{MMR})}

• Margin Percent:
  
  \text{Margin Percent} =\frac{\text{Equity}}{\text{Market Value}} \times 100 , \text{ where } \text{Equity} = \text{Market Value} - \text{Call Money}

• Example long margin return (cash vs margin):-

  • Cash return: \frac{P^t - P^0}{P_0}

  • Margin return: \frac{P^t - P^0}{P_0 \times \text{MR}}

• Short sale payoff and maintenance: complex, but generally involve-

  • Proceeds from short sale, collateral requirements, and eventual buy-to-cover costs plus interest on borrowed funds.