StocksQuest Lesson #3: Selling Short and Buying on Margin Selling Short ~ Selling short occurs when investors sell stocks they don t actually own, they do this by borrowing stocks instead of buying stocks. There is the potential for great reward in this practice but there is also a great deal of risk. Example: Selling Short of Apple, Inc. You borrow shares of Apple, Inc. from a broker at 50 per share. You sell the shares for 5,000. You wait for the price of Apple to fall. When the price of Apple reaches 25 per share you purchase shares for 2,500. You then return the shares to the broker and keep the 2,500 difference in price minus commissions and fees. You sell the You profit if You lose if You borrow shares at stock price stock price the 50 price drops. rises. at 50 per getting 5,000 share from your broker. you owe your broker. 50 How Selling Short Works Step 1 Open an account with a broker. (To sell short, you start by opening an investment account with a broker. It helps a lot if you have good information or good instincts about the future price of the stock you are going to sell short.) Step 2 Borrow shares of stock from the broker. Step 3 Sell the shares of stock that you borrowed and get the money. Step 4 Wait for the price of the stock to drop. Step 5 Buy the same number of shares of stock at the lower price. Step 6 Return the shares to the broker. (Brokers generally charge interest per day on the value of the stocks that you borrowed and will also charge a commission for executing the transaction.) Step 7 Count the money that you made. (After all the fees and commissions are paid you get to keep the difference in money.) 25 75 Your cost to pay back the shares. 2,500 7,500 Your profit or loss. 2,500 Profit 2,500 Loss
Covering the short position ~ buying shares back is called covering the short position, because your cost to return the shares you borrowed is less than it costs to borrow them and you make a profit. What are the Risks? ~ The risks in selling short occur when the price of the stock goes up, not down, or when the process takes a long time. Timing ~ The timing is important because your paying your broker interests on the stocks you borrowed. The longer the process goes on the more you pay and the more the interest expense erodes your eventual profit. Rising Value ~ The rise in a stock s value is an even greater risk. Because if it goes up instead of down, you will be forced sooner or later to pay more to cover your short position than you made from selling the stock. Squeeze Play ~ Sometimes short sellers are caught it what is known as the squeeze. This happens when a stock that has been shorted by a large number of investors starts to rise. The short sellers then try to purchase the number of stocks they need to return to their brokers while still trying to make a profit. The scramble among short sellers to cover their positions results in heavy buying that drives the price of the stock even higher, which narrows the margin of profit for short sellers who wait too long to buy. Buying Warrants Warrants ~ Warrants are a way to wager on future prices though using warrants is very different from selling short. Warrants guarantee, for a small fee, the opportunity to buy stock at a fixed price during a specific period of time. Investors usually buy them if they think a stock s price is going up. Example: Buying a Warrant of Union-Pacific Railroad You might believe that the price of Union-Pacific Railroad is going to go up so you might pay 1 per share for the right to buy Union-Pacific stock at 10 within 5 years. If the price goes up to 14 and you exercise (use) your warrant, you save 3 on every share you buy. You can then sell the shares at the higher price to make a profit (14-(10+1) =3), or 300 on shares. Companies sell warrants if they plan to raise money by issuing new stock or selling stocks they hold in reserve. After a warrant is issued, it can be listed in the stock columns and traded like other investments. A wt after a stock table entry means the quotation is for a warrant, not the stock itself. If the price of the stock is below the set price when the warrant expires, the warrant is worthless. But since warrants are fairly cheap and have a relatively long lifespan, they are traded actively.
Directions: Fill in the table below to demonstrate understanding of selling short. Answer the questions that follow. You sell the You profit if You lose if You borrow shares at stock price stock price the 63 price drops. rises. at 63 per share from your broker. you owe your broker. getting Your cost to pay back the shares. Your profit or loss. + Profit - Loss 1. How does selling short work? 2. How do you cover the short position? 3. Why is timing so important when selling short? 4. How can investors be caught in what is known as the Squeeze? 5. Based on your threshold of risk would you ever attempt to sell short, why or why not? 6. If you had to choose between selling short or buying a warrant which would you do and why?
Buying on Margin Buying on Margin ~ Is a practice that allows investors to borrow some of the money they need to buy stock. Investors who want to buy stock but don t want to pay full price can leverage their purchase by buying on margin. They set up a margin account with a broker, sign a margin agreement (or contract), and maintain a minimum balance. Then they can borrow up to 50% of the price of the stock and use the combined funds to make their purchase. Investors who buy on margin pay interest on the loan portion of their purchase, but don t have to repay the loan itself until they sell the stock. Any profit is theirs. They don t have to share it. Step 1 ~ Open a margin account with a broker. (Margin accounts normally require a minimum deposit of 2,000 in cash or eligible securities, however the more buying/borrowing power you want when buying on margin will require a larger deposit into your margin account.) Step 2 ~ Sign a margin agreement or contract with the broker. (The margin agreement outlines the margin minimums, the brokerage firm s policies on margin calls, interest rates and commission fees.) Step 3 ~ Maintain a minimum balance on your margin account. Money may need to be added to your margin account to accommodate margin calls (specifically if the value of your investment drops below 75%). Step 4 ~ Sell the stock as it increases in price, repay the broker, keep the profit. (All interest and commission fees must be subtracted from the sale before you receive the proceeds.) Example #1 Buying on Margin ~ If you want to buy 200 shares of stock selling for 40 a share, the total cost would be 8,000. Buying on margin, you put up 4,000 and borrow the remaining 4,000 from your broker. If the stock price rises to 60 and you decide to sell, the proceeds amount to 12,000. You repay your broker the 4,000 you borrowed; you have recovered your 4,000 initial investment and put 4,000 in your pocket (minus the interest and commissions). That s almost a % profit on your original 4,000 investment. Had you used all your own money and laid out 8,000 for the initial purchase, you would have made only a 50% profit: a 4,000 return on an 8,000 investment. Leveraging your Stock Investment Leverage ~ leverage is speculation. It means investing with money borrowed at a fixed rate of interest in the hope of earning a greater rate of return. < Like the lever, the simple machine that provides its name, leverage lets the users exert a lot of financial power with a small amount of their own cash. Companies use leverage called trading on equity when they issue both stocks and bonds. Their earnings per share may increase because they ve expanded operations with the money raised by bonds. But they must use some of those earnings to repay the interest on the bonds.
Margin Minimums ~ to open a margin account, you must deposit 2,000 in cash or eligible securities (securities your broker considers valuable). That s the minimum margin requirement. All margin trades have to be conducted through that account, combining your own money and money borrowed from your broker. Closing the Barn Door ~ the government and its regulatory agencies, the SEC (Securities Exchange Commission) are good at figuring out ways to prevent financial disasters after they happen. The rules and regulations that govern stock trading, for example, were devised in the wake of two major stock market crashes. Margin Calls ~ Despite its advantages, buying on margin can be very risky. For example, the stock you buy could drop so much that selling it wouldn t raise enough to repay the loan to your broker. To protect themselves in cases like this, brokers issue a margin call if the value of your investment falls below 75% of its original value. That means you have to put additional money into your margin account. If you don t want to meet the call, or can t afford to, you must sell the stock, pay back the broker in full and take the loss even if you think the stock will rise again. Example #2 Margin Calls ~ If shares you bought for 8,000 declined to 5,600 the value would be less than 75% of the investment price. To meet the margin requirement of 6,000 (75% of 8,000), you would have to add 400 to your account to bring it back within the acceptable limits. Brokerage firms may set their own margin levels, but they can t be less than the 75% required by the Federal Reserve. During crashes, or dramatic price decreases in the market, investors who are heavily leveraged because they ve bought on margin can t meet their margin calls. The result is panic selling to raise cash, and further declines in the market. That is one of the reasons the SEC instituted Regulation T, which limits the leveraged portion of any margin purchase to 50%. Directions: Read the diagram on the next page to see a visual illustration of how Buying on Margin works. Then answer the following questions to complete this stocks activity. 1. How is Buying on Margin different than Selling Short? 2. What is it called when companies use leverage to raise money? 3. What are two ways brokerage firms who lend money to investors insure that they will be repaid? A. B.
How It Works You open a margin You Profit You Lose if Account- 5,000 if stock price stock price of your own money You purchase Rises Drops and 5,000 of your 1,000 shares Broker s money at 10 each 10 15 7.50 The value of your Investment 5,000 10,000 2,500 Your Broker s Investment 5,000 5,000 5,000 4. What does SEC stand for and what does it do? Your Break Even Point Margin Call 5. According to the diagram how much does the stock price have to rise in order to make a profit? 6. At what price would an investor lose money? 7. At what price point will the broker make a margin call on the investor? 8. What is the investor s break even point? 9. If your broker makes a margin call and you cannot meet the call what will you have to do?