Chapter 3

Securities
Markets

McGraw-Hill/Irwin

Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

3.2 How Securities are

Traded

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Types of Orders
Market order: execute immediately at the best price
Limit order: buy or sell at a specified price or better
Could place a buy limit at $15.95 or a sell limit order at $15.96.

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Types of Orders
Stop loss order: becomes a market sell order when the
trigger price is encountered.
You own stock trading at $40, and place a stop loss at $38. The stop loss
becomes a market order to sell if the stock price hits $38.

Stop buy order: becomes a market buy order when the

trigger price is encountered.
You shorted stock trading at $40, and place a stop buy at $42. The stop buy
becomes a market order to buy if the stock price hits $42.

Other types:
Discretionary order: gives the broker the power to buy and sell for your
account at the broker's discretion.
Time dimension on orders (other than market orders):
IOC: immediate or cancel, Day: by default, GTC: good until canceled (usually 60
days max)
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Video Recap
http://www.youtube.com/watch?v=vENGp8Ivo8E&feature=relmfu

Questions
At what price does a Market Order get filled?
A Limit Buy Order is higher or lower than the current
price?
A Stop Buy Order is higher or lower than the current
price?
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Q1. You bought a stock at $50. Current price is $52. You

are worried about a huge loss. You put in a ___________
order at $45.

1.
2.
3.
4.

Stop-loss
Market order
Limit order to sell
I dont know

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Q2. You placed a stop-loss order at $20. Given the

market prices, will your order be executed?
Marriott

Bid

Ask

19.95

20.05

1. Yes, at $19.95 or
below
2. Yes, at $20.05
3. No, since ASK is
above $20
4. I dont know
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Q3. You placed a limit sell order at $55.63. Given the

market prices, will your order be executed?
Marriott

Bid

Ask

55.25

55.50

1. Yes, at $55.63 or
better
2. No, since BID is
below $55.63.
3. No, since ASK is
below $55.63
4. I dont know
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3.7 Trading Costs

Commission: fee paid to broker for making the transaction
Spread: cost of trading with dealer
Bid: price dealer will buy from you
Ask: price dealer will sell to you
Spread: ask bid
Total Trading Cost = Commission + Spread

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3.8 Margin Trading

http://
www.youtube.com/watch?v=0SGGSqOZhps&feature=related

Questions:
Definition: What is buying on margin?

Why buy a stock on margin?

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Margin Definitions
Initial Margin Requirement (IMR): the minimum % of
initial investor equity.
In the US: 50% for stocks.
1-IMR = maximum % amount investor can borrow

Maintenance margin requirement (MMR): the

minimum % of equity before additional funds must be
put into the account
In the US: 25% exchange mandate minimum.

Equity = Value of trade

= Position value borrowed money
- interest on loan + additional cash
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Margin Call
Margin call: notification from broker to add
additional funds or have your position liquidated.
A declining stock price reduces the investor's equity.

Equity
MMR
Market Value
A margin call will occur when:
(Market Value Borrowed )
MMR
Market Value
Market Value
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Borrowed
1 MMR
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Margin Trading
Margin Trading: Initial Conditions
X Corp
Stock price = $70
50%
Initial Margin (IMR)
40%
Maintenance Margin (MMR)
1000
Shares Purchased
Initial Position
Stock

$70,000 Borrowed
Equity

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$35,000
$35,000

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Margin Trading
Stock price falls to $60 per share (1000 shares)
New Position
Stock

$60,000

Borrowed
Equity

$35,000
$25,000

Margin% = $25,000 / $60,000 = 41.67%

*This calculation assumes the interest rate for the borrowed funds equals
zero.

Margin Call: How far can the stock price fall before
a margin call? (MMR = 40%)
Market Value = Borrowed / (1 MMR)
Market Value = $35,000 / (1 0.40) = $58,333
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Margin Trading
With 1000 shares, the stock price at which we
receive a margin call is $58,333 / 1000 = $58.33
New Position at
margin call
Stock

$58,333

Borrowed

$35,000

Equity

$23,333

% Margin = $23,333 / $58,333 = 40%

How much cash must you put up?
To restore the IMR of 50% you will need
equity = 50% x $58,333 = $ 29,167
You have equity = $23,333
so you owe = $29,167-$23,333 = $5,834
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Margin Trading
Why purchase on margin?
Stock=$100. Investor invests $10,000, borrows another
$10,000. Pays 9% interest.

30% increase

Loan
Value
owed
$26,000 $10,900

Return w/
Margin
51%

Return w/o
Margin
30%

No change

$20,000 $10,900

-9%

0%

30% decrease $14,000 $10,900

-69%

-30%

Price

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Q4. Dee Trader buys 300 shares of Internet Dreams at $40

per share. She borrows $4000 from the broker to pay for
the purchase. Interest rate on the loan is 8%. Compute
(a) Margin in her account when she first buys the stock
(b) If share price falls to $30 per share by the year end, what
is her margin?
(c) What is the rate of investment for her?
1.
2.
3.
4.
5.

(a) 33.3%, (b) 55.6%, No, (c) 58.5%

(a) 66.7%, (b) 55.6%, No, (c) -37.5%
(a) 33.7%, (b) 55.6%, No, (c) -61.0%
(a) 66.7%, (b) 55.6%, No, (c) -41.5%
(a) 66.7%, (b) 55.6%, No, (c) -61.0%

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3.9 Short Sales

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Short Sales: Mechanics

1. Borrow stock from a broker/dealer, must
post margin
2. Broker sells stock. Deposits proceeds
and margin into a margin account
You are not allowed to withdraw the proceeds until
you cover.

3. Covering or closing out the position:

Buy the stock.
Return the stock title back to the party from which
it was borrowed

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Short Sales
Required initial margin: usually 50%
more for low priced stocks
Liable for any cash flows: Dividend on stock
Short sales were banned during the 2008
financial crisis.

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Short Sales: Example

You sell short 100 shares of stock priced at $60
per share.
The proceeds of $6000 must be pledged to
broker.
You must also pledge 50% margin.
You put up $3000. Now you have $9000
invested in margin account.
After you enter into a short sale:
Equity = Value of Short Trade
= Initial Margin Account
- Market Value of Stock Position
- Dividends paid after opening trade
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Short Sales: Example

At what price does a Margin Call occur?
Maintenance margin requirement (MMR) is 30% of
market value

Equity
MMR
Market Value

Price at margin call:

(Total Margin Account Market Value)

MMR
Market Value
Total Margin Account
9000
Market Value

6923
1 MMR
(1 0.3)
Price at margin call: $6,923 / 100 shares = $69.23
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Short Sales: Example

The amount to restore to initial margin?
Market Value = Total Margin Account / (1 + MMR)
Market Value = $9,000 / (1 + 0.30) = $6,923

Restore (50% initial margin):

Necessary equity: ($6,923 * 0.5) = $3461.5
Current equity: Total Margin Account - Market Value
$9,000-$6,923 = $2,077
Difference:
$3461.5 - $2077 = $1,384.5

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Summary: Round Trip

A Round Trip is a purchase and a sale
Long position
Buy first and then sell later
Bullish

Short position
Sell first and then buy later
Bearish

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Q5. You sell short 300 shares of Microsoft which are

currently selling at $30 per share. You post the 50%
margin required on the short sale. If you earn no interest
on the funds in your margin account, what will be your
rate of return after one year if Microsoft is selling at $27?
(Ignore any dividends)
1.
2.
3.
4.
5.

10%
20%
30%
40%
None of the above

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More Practice

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Q6. You placed a limit buy order at $55.37. Given the

market prices, will your order be executed.
Marriott

Bid

Ask

55.25

55.50

1. Yes, at $55.50
2. Yes, since BID is
below $55.37.
3. No, since ASK is
above $55.37
4. I dont know
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Q7. You placed a stop-loss order at $55 when the

current price is $62. How much would you receive
if the price drops to $50 ?
1.
2.
3.
4.

$50
$55.
$54.87
Cannot tell from
the information

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Q8. An investor puts up $5,000 but borrows an equal

amount of money from their broker to double the amount
invested to $10,000. The broker charges 7% on the loan.
The stock was originally purchased at $25 per share and in
one year the investor sells the stock for $28. The investor's
rate of return was ____.
1.
2.
3.
4.
5.

24%
18.5%
17%
8.5 %
None of the above
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Q9. You are bullish on Telecom stock. The current market

price is $50 per share and you have $5000 of your own to
invest. You borrow an addition $5000 from your broker at
8% interest rate per year and invest $10000 in the stock.
(a) If share price increases by 10%, compute the rate of
return.
(b) How far must the price fall for you to get a margin call if
MMR is 30%? Assume price fall happens immediately.
1.
2.
3.
4.
5.

(a) 12%, (b) $35.71

(a) 20%, (b) $35.71
(a) 12%, (b) $71.43
(a) 20%, (b) $71.43
None of the above
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Q10. On Jan 1, you sold short one round lot (i.e. 100
shares) of Zenith stock at $14 per share. On Mar 1, a
dividend of $2 per share was paid. On Apr 1, you
covered the short sale by buying the stock at a price of
$9 per share.
You paid 50 cents per share in
commissions for each transaction. What is the value of
your account on Apr 1?
1.
2.
3.
4.
5.

$200
$400
$250
$450
None of the above

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Q11. An investor buys $16,000 worth of a stock priced at

$20 per share using 60% initial margin. The broker
charges 8% on the margin loan and requires a 35%
maintenance margin. The stock pays a $0.50 per share
dividend in one year and then the stock is sold at $23
per share. What was the investor's rate of return?
1.
2.
3.
4.
5.

23.83%
17.50%
19.67%
25.75%
None of the above

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