Lecture on Trading at KSE

By Dr. Nisar Ahmad

Assistant Professor
Secondary Market
• The trading of already issued securities takes
place in secondary market
• Secondary markets helps the primary
markets as they increase the liquidity of
existing securities
• Secondary markets exists for trading of
common stocks, bonds, and puts and calls,
• Secondary markets include brokers market,
dealers markets
Broker Market
• This is also called stock exchange or
• It is an association of brokers and works
like an auction market
• All investor must deal through brokers
• No investors is allowed to directly buy or
sell shares from/to other investors
• Brokers charge commission on transactions
they make for their clients
Dealer Market
• National Association of Security Market
Dealers is a dealers market
• Unlike brokers, dealers(also called market
makers) buy and sell securities for themselves
• Every market maker deals in number of
securities and keeps a specific quantity of a
given security
• He stands to buy and sell a given security at
the same time
Brokerage Operation
 Brokerage firms earn commissions
on executed trades, profits from
securities sold from inventory,
underwriting fees and administrative
account fees
 Full-service brokers offer order
execution, information on markets and
firms, and investment advice
 Discount brokers offer order execution
Types of Accounts
 Cash account: A Cash account is a brokerage account in which securities are
paid for in full. Investor pays 100% of purchase price for securities
 Margin account: A Margin account is a brokerage account in which, subject
to limits, securities can be bought and sold short on credit. Investor borrows
part of the purchase price from the broker
 Asset management account: automatic reinvestment of excess cash balances
in money market fund
 Trading accounts can also be differentiated by the ways they are managed.
 Advisory account - You pay someone else to make buy and sell decisions
on your behalf.
 Wrap account - All the expenses associated with your account are
“wrapped” into a single fee.
 Discretionary account - You authorize your broker to trade for you.
 Asset management account - Provide for complete money management,
including check-writing privileges, credit cards, and margin loans.
Fees and Costs
 Brokerage commissions differ by
security, broker, and investor
 Institutional investors have greatest
negotiating power
 Dividend reinvestment plans permit
reinvestment of dividends in
additional stock
 Avoids commissions, administrative fees
Trading
TradingatatStock
StockExchange
Exchange
To buy and sell shares at stock exchanges, investors
have to open accounts with brokerage houses
In Pakistan, most of the brokerage houses require
initial deposit of Rs.100,000, some allow deposit of
Rs.50,000
There are 200 member of KSE
Getting Started
(a)Open
(a) Openaabrokerage
brokerage
ortrading
or tradingaccount
account

(c)Buy
(c) Buy100
100Shares
Shares
(b)Deposit
(b) DepositRs.50,000
Rs.50,000
ofABC
of ABCCo.
Co.
intoaccount
into account
atRs.60
at Rs.60per
pershare
share

(d)Pay
(d) PayCommission,
Commission,
SayRs.50
Rs.50 (e)Rs.44,000
(e) Rs.44,000Cash
Cash
Say
ininAccount
Account
Rs.6,000
Rs. 6,000Stock
Stock
InInAccount
Account
Trading at Stock Exchange
After opening an account, an investor can trade by
placing orders through phone, or internet (live
accounts)
Orders placed for purchase of shares are called bid
order
Orders placed for sale of shares are called offer orders
Type of Orders
Broadly classified: Two types of orders
Limit Orders
Market Orders
Limit Orders

• When an investor specifies the price at which he is

willing to buy or sell, such orders are called Limit
order
• Limit orders are sorted on the basis of price and then
on first come and first serve basis
• Bid orders with highest bid price are placed at the top
• Offer orders with the lowest offer prices are placed at
the top
Orders Sorting
• Orders with similar prices are sorted on the basis of
first come first serve
• Orders at the top are fulfilled first
• Limit orders are fulfilled only when matching price is
available i.e. a bid order of 100 shares at Rs.30 each
will have to wait until someone offers his shares at
Rs.30
• Limit orders are fulfilled neither below nor above the
price at which they are placed
• Quantity matching is not necessary
Example Orders Sorting
1. A bid order of 5000 shares of NML is placed with
Rs.70 a share

SNo Bid Q Price Offer Q Price

1 5000 70.00 - -
2. Another investor bids 100 shares of NML at Rs.
71.01

SNo Bid Q Price Offer Q Price

1 100 70.01 - -
5000 70.00
3. An order for sale of 3000 shares of NML at Rs. 72 is
placed
SNo Bid Q Price SN Offer Q Price
o

1 100 70.01 1 3000 72

2 5000 70.00
4. A purchase order of 700 share at Rs. 70.01 is placed

SNo Bid Q Price SN Offer Q Price

o

1 100 70.01 1 3000 72

2 700 70.01
3 5000 70.00
5. Someone offers 1000 shares of NML at Rs.70.01 a
share
S Bid Q Price SN Offer Q Price
N o
o
1 5000 70.00 1 200 70.01
3000 72.00

6. A bid order to buy 1000 shares at market is placed

SNo Bid Q Price SN Offer Q Price
o

1 5000 70.00 1 2200 72.00

Market Orders
Orders that are to be executed immediately at currently
placed limit orders
If a market order is not completely fulfilled from the
top limit order, it is fulfilled from the next limit order
in the sequence
Types of limit orders
Stop Loss order: The stock has to be sold if its price falls
bellow stipulated level
Allow investor to avoid unexpected losses
Also useful in very uncertain markets
At PSX, maximum variation in prices is 5% per day
One can place stop loss order at 3% and avoid the 2%
loss, if anything abnormal happens with the stock
Stop-Buy Orders: Specifies that a stock should be bought
when price of a security rises above a limit
It is usually used with short-sell to limit possible losses
from short position
At PSX, orders have a validity of one day
Settlement
• Orders executed at PSX are settled within 3 working
days
• This requirement is called T+2 days
• Purchaser delivers the cash to his broker who delivers
it to the seller’s broker
• Brokers net out their transactions each day and only
net quantity is transferred or received
• Investors may keep shares in CDC account or may
keep physical shares
 Buying on Margin
 In a margin purchase, the portion of the value of an investment
that is not borrowed is called the margin.
 Of course, the portion that is borrowed incurs an interest charge.
This interest is based on the broker’s call money rate.
The call money rate is the rate brokers pay to borrow money to
lend to customers in their margin accounts.
 When investors buy shares they have easy access to a source of
debt, called brokers call loan or buying on margin.
 Broker may have funds, if not, the broker borrows from financial
institutions Intra-day trades do not have margin cost
 Greater up-side potential, but also greater downside risk
Margin Financing
 Margin: the portion of the purchase price contributed by
investor
Margin requirements: suppose if margin is 50%
Then investor must provide at least Rs.10000 for
purchasing Rs.20000 worth of shares
Assume: purchased 200 shares of FFC at Rs.100 each
with Rs.10000 of equity and the rest for debt
Margin = Equity/Value of stock
10000/20000= .5 or 50%
What will happen if price of FFC drops to Rs.70
Margin Financing and Falling prices
of securities
 If FFC price falls to Rs70, loss to the investor
will be (200x30) = 6000. His margin will now
be:
 (10000-6000)/(200x70) = 4000/14000 = 28%
 The investor will be asked to deposit Rs.3000 so
that his equity increases and the margin reaches
the 50% mark again i.e (4000+3000)/14000 =
7000/14000 = 50%
Example: Margin Accounts,
The Balance Sheet
• You buy 1,000 Wal-Mart shares at $24 per share.
• You put up $18,000 and borrow the rest.
• Amount borrowed = $24,000 – $18,000 =
$6,000
• Margin = $18,000 / $24,000 = 75%
In a margin purchase, the minimum margin that must
be supplied is called the initial margin.
The maintenance margin is the margin amount that
must be present at all times in a margin account.
When the margin drops below the maintenance
margin, the broker can demand more funds. This is
known as a margin call.
 Example: The Workings of
a Margin Account, I
• Your margin account requires:
• an initial margin of 50%, and
• a maintenance margin of 30%
• A Share in Miller, Moore and Associates (WHOA) is selling for $50.
• You have $20,000, and you want to buy as much WHOA as you can.
• You may buy up to $20,000 / 0.5 = $40,000 worth of WHOA.
 Example: The Workings of
a Margin Account, II
•After your purchase, shares of WHOA fall to $35.
• New margin = $8,000 / $28,000 = 28.6% < 30%
• Therefore, you are subject to a margin call.
Example: The Effects of Margin, I.
 You have $30,000 in a margin account that requires 60% initial
margin.
 You can buy $50,000 of stock with this account (why?).
 Your borrowing rate from your broker is 6.00%.
 Suppose you buy 1,000 shares of IBM, for $50/share.
 Assume no dividends, and that your borrowing rate is still 6.00%, what
is your return if:

 In one year, IBM stock is selling for $60 per share?

 In one year, IBM stock is selling for $60 per share, but you did not
borrow money from your broker?
Example: The Effects of Margin, II.
 IBM stock is selling for $60 per share.

 Your investment is worth $60,000.

 You owe 6% on the $20,000 you borrowed: $1,200.
 If you pay off the loan with interest, your account
balance is: $60,000 – $21,200 = $38,800.
 You started with $30,000.

 Therefore, your return is $8,800 / $30,000 = 29.33%.

 Suppose IBM stock was selling for $40 per share instead
of $60 per share? What is your return?
Example: The Effects of Margin, III
 IBM stock is selling for $60 per share, but you did not borrow
from your broker.

 You started with $30,000, which means you were able to buy
$30,000 / $50 = 600 shares.

 Your investment is now worth $36,000.

 Therefore, your return is $6,000 / $30,000 = 20.00%.

 Suppose IBM is selling for $40 per share instead of $60 per share.
What is your return in this case?
Example: How Low Can it Go?
Suppose you want to buy 200 shares of at $50 per
share.
Total cost: $10,000
You have only $6,000—so you must borrow $4,000.
Suppose your broker requires a maintenance margin of
30%.

Your initial margin is $6,000/$10,000 = 60%.

At what price will you receive a margin call?

Example: How Low Can it Go?
Answer.
This will happen when the price of Anheuser
Busch drops to $28.57. How so? Well,

Note that the 50 in the

last equation and the
current stock price of
50 is a coincidence.
A Note on Annualizing Returns
To compare investments, you should express returns
on a per-year, or annualized, basis.

Such a return is often called an effective annual return

(EAR).

(1 + EAR) = (1 + holding period pct. return)m

Example: Annualizing Returns
You buy Boeing (BA) at $34 and sell it 3 months
later for $38.
There were no dividends paid, and suppose the
prices above are net of commissions.
What is your holding period percentage return and
your EAR?
38 - 34 4
Holding Period Percentage Return    0.117647
34 34

1  EAR  (1  Holding Period Percentage Return) m

 (1  0.117647) 4
Note that there are four “3-month”
periods in one year.
 (1.560338) , or about 56%.
Practice Problem
5-1 a. Consider an investor who purchased a stock at
$100 per share. The current market price is $125.
a. At what price would a limit order be placed to
assure a profit of $30 per share?
b. What type of stop order would be placed to ensure a
profit of at least $20 per share?

5-2 Assume an investor sells short 200 shares of stock
at $75 per share. At what price must the investor cover
the short sale in order to realize a gross profit of
$5,000? $1,000?
5-3 Assume that an investor buys 100 shares of stock
at $50 per share and the stock rises to $60 per share.
What is the percentage return on the investor’s cash
outlay, assuming an initialmargin requirement of 50
percent? 40 percent? 60 percent?
5-4 Assume an initial margin requirement of 50
percent and a maintenance margin of 30 percent.
An investor buys 100 shares of stock on margin at $60
per share. The price of the stock subsequently drops to
$50.
a. What is the actual margin at $50?
b. The price now rises to $55. Is the account restricted?
c. If the price declines to $49, is there a margin call?
d. Assume that the price declines to $45. What is the
amount of the margin call? At $35?
Hypothecation and Street Name
Registration
Hypothecation is the act of pledging securities as a
collateral against a loan.
This is needed so that the securities can be sold by the
broker if the customer is unwilling or unable to meet a
margin call.

Street name registration is an arrangement under

which a broker is the registered owner of a security.
(You, as the account holder are the “beneficial
owner.”)
Short Sales, .Other Account Issues
• Short Sale is a sale in which the seller does not
actually own the security that is sold.

Borrow
Borrow Sellthe
Sell the Buy
Buy Return
Return
shares
shares Shares
Shares shares
shares the
the
from
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the Fromthe
From the
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someone
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Today: In the Future:

Note that an investor who buys and owns shares of stock is said to be “long the stock” or
to have a “long position.”
Short Sale Process
Short Sales
 An investor with a long position benefits from price increases.
 Easy to understand
 You buy today at $34, and sell later at $57, you profit!
 Buy low, sell high

 An investor with a short position benefits from price decreases.

 Also easy to understand
 You sell today at $83, and buy later at $27, you profit.
 Sell high, buy low
Example: Short Sales,
 You short 100 share of Sears shares at $30 per share.
 Your broker has a 50% initial margin and a 40% maintenance
margin on short sales.
 Value of stock borrowed that will be sold short = $30 × $100
 = $3,000
Example: Short Sales, II
Sears stock falls to $20 per share.
Sold at $30, value today is $20, so you are "ahead" by $10 per
share, or $1,000.
Also, new margin: $2,500 / $2,000 = 125%
Example: Short Sales, III
 Sears stock rises to $40 per share.
 You sold short at $30, stock price is now $40, you are
"behind" by $10 per share, or $1,000. (He who sells what
isn’t his’n…..)
 Also: new margin = $500 / $4,000 = 12.5% < 40% Therefore,
you are subject to a margin call.
More on Short Sales
•Short interest is the amount of common stock held in short positions.

• In practice, short selling is quite common and a substantial volume of stock sales
are initiated by short sellers.

• Note that with a short position, you may lose more than your total investment, as
there is no theoretical limit to how high the stock price may rise.
 Long Vs Short Position of an
Investor
l A normal transaction (investor is long the position)—A
security is bought, and owned,
because the investor believes the price is likely to rise.
Eventually, the security is sold
and the position is closed out. First you buy, then you sell.
l Reverse the transaction (investor is short the position)—
What if the investor thinks that
the price of a security will decline? If he or she owns it,
you might be wise to sell. If the
security is not owned, the investor wishing to profit from
the expected decline in price
You open a margin account at Chas Pigeon, a
discount broker. You subsequently short
Exciting.com at $286, believing it to be
overpriced. This transaction is done on margin,
which has an annual interest rate cost of 9 percent.
Exactly 1 year later Exciting has declined to $54 a
share, at which point you cover your short
position. You pay brokerage costs of $20 on each
transaction you make.
Required:
a. The margin requirement is 50 percent. Calculate
your dollar gain or loss on this position, taking into
account both the margin interest and the
transaction cost to sell.
b. Calculate the percentage return on your
investment (the amount of money you put up
initially, counting the brokerage costs to buy).
(a) The margin requirement is 50%.
 Amount investor puts up = .50 x 28,600 =
$14,300
Amount investor borrows = .50 x 28,600 = $14,300
 Gross profit = $28,600 - $5,400 = $23,200
Net Profit = $23,200 – [$14,300 X .09] - $20 = $21,893
Gross pr. - Int. costs - transactions costs to buy the
stock back
(b)initial investment = $14,300 + $20 (trans. cost to
short) = $14,320
% return on investment = $21,893 / $14,320 = 1.5288,
or 153% (rounded
Class Activity
Using your same brokerage account as in Problem 5-1
(same margin rate and transaction costs), assume that
you buy IBM at $156 a share, on 60 percent margin.
During the year IBM
pays a dividend of $1.30 per share. One year later you
sell the position at $233. Treat the brokerage cost to
sell in calculating the gain or loss, and the brokerage
cost to buy as part of your investment.
a. Calculate the dollar gain or loss on this position.
b. Calculate the percentage return on your investment
(a) initial cost of 100 shares = $15,600 + $20.
Initial investment put up by investor buying on 60%
margin = .6 ($15,600) = $9,360 + $20 = $9,380
Margin cost for one year = $6,240 X .09 = $561.60
Dollar gain = $23,300 – $15,600 - $561.60 + 130 - 20
= $7,248.40
(b) % return on investment = $7,248.40 / $9,380
= .7728
= 77.28%
QUIZ
An investor buys 100 shares of Altria at $82 per share on
margin. The initial margin requirement is 50 percent, and
the maintenance margin is 30 percent.
a. The price of Altria drops to $61 per share. What is
the actual margin now?
b. The price of Altria declines further to $59.50. Show
why a margin call is generated, or is not warranted.
c. The price declines yet again to $55.25. Show by
calculations why a margin call is generated.
d. Using the information in (3), how much cash must
be added to the account to bring it into compliance with
the margin requirements?
Broker-Customer Relations
There are several important things to remember when
you deal with a broker:
Any advice you receive is not guaranteed.
Your broker works as your agent and has a legal duty to
act in your best interest.
However, brokerage firms make profits from brokerage
commissions.
Your account agreement will probably specify that any
disputes will be settled by arbitration and that the
arbitration is final and binding.
KSE 100 Index
 Index is a statistical tool that measures
percentage changes in a variable
 The KSE-100 Index was introduced in
November 1991 with base value of 1,000 points.
 The Index comprises of 100 companies selected
on the basis of sector representation and highest
market capitalization
KSE-100 Index introduced in
November, 1991

– Most recognized index of the KSE
– Representation from all sectors of the KSE
and includes the largest
companies on the basis of their market
capitalization
– Represents over 85% of the market
capitalization of the Exchange.
– Proposed to be migrated to Free-Float
methodology shortly
The selection criteria for stock inclusion in
the recomposed KSE 100 Index are:
SECTOR RULE

Out of the 33 Sectors, 32 companies are selected i.e.

one company from each sector
 Largest market capitalization in each of the 34 sector of the
Exchange, excluding Open – end Mutual Fund sector;
 CAPITALIZATION RULE

 The remaining 68 companies are taken up on the basis

of market capitalization of companies in descending order.
Close-end Mutual Fund Tobacco Chemical

Modaraba Refinery Paper & Board

Leasing Companies Power Generation & Vanapati & Allied

Distribution
Inv. Banks / Inv. Cos. / Sec. Leather & Tanneries
Oil & Gas Marketing
Cos
Companies Foods & Personal Care
Commercial Banks Products
Oil & Gas Exploration
Insurance Companies Glass & Ceramics
Engineering Miscellaneous
Textile Spinning
Automobile Assembler
Textile Weaving
Automobile Parts &
Textile Composite
Accessories
Woollen Cables & Electric Goods
Synthetics & Rayon Transport
Jute Technology & Communication
Sugar & Allied Fertilizer
Cement Pharmaceutical
KSE 100 Index
• Suppose we have the following 3 companies in our
index:

• Suppose Rs.1070000 is equal to 1000 points

Index = 1000x(Mkt cap / Base Mkt ca)
Nest day the prices change and we have the following
data:

Index = 1104000/107000 = 1.031x1000 = 1031

Interpretation
• The index improved from 1000 points to
1031 point
• Means that the improvement is 31 points in
1000 point or 3.1 percent in 100 as
compared to the base period
• In other words, the share prices of
companies in the 100 index have risen by
3.1 percent as compared to prices in the
base period