Chapter 2: Buying and Selling Securities
I. Regulation of Brokers in the Securities Markets
Securities and Exchange Commission (SEC) and the Justice Department are primarily
responsible for enforcing securities laws.
However, the principle of self-regulation is imbedded in the policies of the SEC. The
1934 Act mandates that exchanges are responsible for identifying violations of the 1934
Act and through its surveillance and enforcement roles. (See, The Rulemakers)
Stock Watch monitors every trade on a real-time basis throughout the trading day and
analysts watch for suspicious signals from the market - like sudden fluctuations in the
price of a stock that can't be explained.
They use sophisticated systems to uncover insider trading, market manipulation or any
unusual trading pattern that could indicate violations of rules or laws.
The Division of Enforcement prosecutes cases involving misconduct on the Trading Floor
and in the marketplace, including insider trading and market manipulation cases.
Improper sales practice constitutes the single largest component of enforcement activity.
The Financial Industry Regulatory Authority (FINRA) is an independent agency charged
with regulating the securities industry and the NASDAQ market.
Responsibilities include dispute resolution, disclosure and investor protection,
enforcement, and market regulation.
Electronic surveillance enables regulation analysts to reconstruct unusual trading patterns
and create a complete audit trail of all market makers.
These capabilities facilitate the efforts of analysts to investigate insider-trading and other
FIN 330: Chapter 2, page 1
II. Types of Accounts
Cash Account – Investor pays broker full amount for securities whenever a purchase is
Margin Account – A brokerage firm allows a customer to borrow funds to purchase
securities. The securities are retained as collateral. The investor pays interest at the “call
money” rate plus 1½ - 2%. The Fed and NYSE (or NASD) regulates margin
requirements, which vary depending on the volatility of the purchased asset.
Wrap – Complete money management services for wealthy client. A money manager is
provided by the brokerage firm. The firm then executes orders for the money manager
and monitors account performance for the client. Due to abuse in the industry (excessive
fees), wrap accounts have gotten a bad rap.
Asset Management – Complete checking, cash management, loan and investment services.
Beneficial for investors who don=t want to bother with managing their own money.
DPP – Direct Purchase Plans allows companies to sell stock directly to investors. (See,
Power and Money). Investors avoid broker fees, but companies can attach their own fees.
DRIPs – Dividend Reinvestment Plans allow investors to avoid costs of reinvesting
dividends. Some plans discount the price, and some charge a fee. Dividends are still
recognized as taxable income. (See, Direct Investing and What are DRIPS)
FIN 330: Chapter 2, page 2
III. Margin Trading
Margin account: Account where investor borrows funds from the broker to buy stock. The
margin amount is the amount the investor must put up. The borrowed is the balance. The
margin amount plus the borrowed amount equals the total market value. As the price
changes, the value of the margin amount will change, but not the value of the borrowed
Street name account: Securities are held in the broker=s account, known as the street
name account. When buying on margin, if the value of the securities fall and the investor
cannot come up with additional funds then securities are sold from this account. The
broker is never at risk.
Call money rate: The short-term, money-market interest rate charged brokers by the
banks. The broker charges the customer this rate plus 1 ½ % - 2%.
Initial margin (IM): Regulated by the Federal government under regulation T. The initial
margin is the percentage that the investor must initially deposit. Since 1974 it is 50% for
stocks, 30% for bonds, 8% for Treasuries.
Restricted account: When the equity value falls below the initial margin requirement the
account is restricted. The investor may not make additional margin purchases.
Maintenance margin (MM): The percentage that the margin amount can fall to before
there is a margin call. For equity securities, it is currently 25%. Brokerages may require a
greater amount, especially during volatile markets.
Margin call: A call for the deposit of additional funds when the price falls to the
maintenance margin level.
FIN 330: Chapter 2, page 3
Margin percentage: (P x Q – B)/ (P x Q)
This is the percentage margin that the investor has at any point in time. When the price of
securities goes down, the value of securities (P x Q) drops but the amount borrowed (B)
is unchanged. Thus the margin falls. Eventually, if it drops to the maintenance margin
level, new money must be deposited.
(P) Price = $80; (Q) number of shares = 200
(IM) Initial margin = 60%;
(MM) maintenance margin = 25%
1. What is market value initially?
P x Q =$80 x 200 =16,000
2. What is the initial margin in dollars?
(P x Q) x IM = 16,000 x .6 = $9,600
3. How much is borrowed?
(P x Q) x (1-IM) = 16,000 x .4 = $6,400
4. At what price will a margin call occur?
P* = B/ (1-MM) Q
= $6,400/ (1- .25)200 = $42.67
5. Show that this price is truly the maintenance margin price
FIN 330: Chapter 2, page 4
Short-selling, or “going short” means selling stock that you don=t own by borrowing the
shares from another investor and selling to a third party.
The practice is executed through the broker who borrows the stock from another client.
The other client never knows these shares have been loaned. The broker can only borrow
from shares held in a “street account”
The “up-tick” rule (eliminated on July 6, 2007): You can only short a stock on an up-tick
Up-tick: 42 ... 42 2 short sale at 42 2
Zero-plus tick: 42 ... 42 2 ... 42 2 ditto
Short Seller 1 Share
Lender’s Share buyer
1 share Short Seller
Lender’s $10 gain Share Seller
FIN 330: Chapter 2, page 5