topic 2 investment analysis

INTRODUCTION

In Topic 1, we looked at the definition of investment, types of investments and financial markets. In this topic, we will look at transaction procedures in the stock market. After we have discussed transaction procedures, we will move on to various orders that exist in share market transactions. Finally, we will discuss margin trading or loan facility to buy shares.

TRANSACTION PROCEDURES IN BURSA MALAYSIA

Its 9am on Sunday and you are at home reading the newspapers. In the business section, you read that an established cosmetic company is expecting an increase in profit. You are interested in buying shares in this company but do not have a clue as to how to go about it. What is the first step that you should take?

2.1

TTooppiicc

22 Transactions

in the Share Market

LEARNING OUTCOMES

By the end of this topic, you should be able to:

1. Explain the transaction procedures in the Bursa Malaysia;

2. Differentiate the types of orders;

3. Assess the mechanics of margin trading; and

4. Explain the terms used in share trading transactions.

TOPIC 2 TRANSACTIONS IN THE SHARE MARKET 14

The first step that you need to do is open a CDS Account and a Trading Account with a remisier or a dealer from a licensed broker. Before proceeding with the transaction procedures in the share market, let us clearly understand what a remisier and a dealer are.

The trading account looks like any ordinary bank account where there are debit and credit columns. All purchases are recorded on the credit side and all sales are registered on the debit side. All transactions in the Bursa Malaysia do not involve any physical transfer of share scripts between buyer and sellers. It is all done electronically. Having decided to purchase shares, the investor will then contact his remisier and place a buy order. The order will specify the number as well as the price of the purchase. Next, the order will be entered into the Bursa Malaysia automated trading system or WinScore. The purchase will usually be completed if there is a seller willing to sell below or at the same price offered by the buyer. If there is more than one buyer, then the security will be sold to the highest bidder. If there is more than one seller, the purchase will be fulfilled by the seller with the lowest offer price. The completed transaction will indicate the number of shares and the matched price. The broker will then send details of any transaction to the investor in the form of a contract note. The note will have information such as brokerage, stamp duty and clearing fees. The contract note will serve as an indication that the transaction bid or offer was successful. The buyers account will then be credited with the number of shares on the third day after the successful order. This is known as T+3. The buyer will own the shares upon payment to the broker. The buyer cannot trade in these shares before payment is made without the permission of the broker. The buyer is not allowed to cancel the purchase since the bid was successful. If he fails to settle the payment, the broker can sell off the shares. Since the buyers account has to be credited or recorded on the third day, it is important for the other party of the transaction, that is the seller, to have the shares in his account two days after the successful order. This is known as T+2. Sometimes, the buyer may sell the shares before the payment is made. This is known as ccontra transaction. If the selling price is higher than the purchase price,

A rremisier is an agent who handles individual investors while a ddealer is an agent who handles institution investors.


the buyer has made a profit. Then, the broker will pay the buyer this profit. If a loss has been made, the client has to pay the broker the difference. Bursa Malaysia has specified the minimum bids that can be used for any transaction. This minimum bid is the change in price of a share that can be offered or bid. For example, a share with a market price of RM5.50 can only be offered or bid with a change in price of five sen. A buyer may bid to buy at RM5.55 or RM5.60 but not at RM5.53. Notice the price change is at a minimum of five sen and not three sen. Details of other price ranges can be obtained from the Bursa Malaysia website.

TYPES OF ORDERS

Remember in the earlier section, we noted that having decided to buy a share, you must place a buy order with the remisier. In a stock market transaction, there are five types of orders:

(a) Market Order

(b) Limit Order

(c) Stop Order

(d) Good Till Cancel Order

(e) Day Order

2.2

1. Based on your understanding of the transaction procedures in a share market, use a mind map to explain the roles of buyer, seller, remisier and the share market.

2. Visit other share market websites such as the Hong Kong Stock Market at http://www.asiadragons.com/hong_kong/finance/ stock_market/ and the New York Stock Market at http://www.nyse.com/ and determine whether their trading procedures are the same as that of the Bursa Malaysia procedures.

ACTIVITY 2.1


Let us discuss each type of order further. (a) MMarket Order Market order is an instruction that an investor gives to the broker to buy or

sell at the prevailing market price. This type of order is risky as the difference in price can be very far from the price anticipated by the investor.

(b) LLimit Order To protect against too great a price range, an investor can set limits to the

price the broker can use. In a limit buy order, the investor sets the highest price that he is willing to pay

for a stock. If the market price of the stock is thought to be too high and does not fall below this limit, then the buy order will not be executed. If the price is lower than the limit buy order, the broker should buy at the best price.

In a limit sell order, the investor sets the lowest price he is willing to sell a

particular stock. In this case, the stock will not be sold if there is no buyer willing to pay the stated price.

(c) SStop Order Stop order is an instruction to protect an investor from profit or limit losses.

It is used when the investor thinks the price is going to fall and he needs to protect his investment. For example, an investor buys some shares for RM3 each and the price is now RM4. He gains a profit of RM1.00 and wants to protect it. Thus, he places a stop loss order of RM3.75. If the price falls to RM3.75, the broker will try to sell the share. Sometimes, the broker may not be able to complete the transaction at that price and may sell it at a lower price. The risk in this type of arrangement is that the price drop is temporary. The price may go up again and the investor will lose the opportunity to get higher returns once the share is sold.

A stop order can be combined with a limit order. For example, the above

investor can issue a stop order of RM3.75 and a limit sell order of RM3.50. If there is no buyer willing to buy at RM3.50, then the stock will not be sold.

(d) GGood Till Cancel Order Good till cancelled is an order that is valid until the client instructs it to be

cancelled. (e) DDay Order Day order is an order that will be valid for a day. It will not be carried to

the next trading day.


Visit Bursa Malaysia website at http://www.bursamalaysia.com or any broker companys website and list other order(s) that is(are) not discussed in this section.

MARGIN TRADING

This loan is provided by the broker. The loan amount is based on an agreed percentage of the value of the shares. Interest will be charged on the amount of the loan as well as the length of time the loan was used. Table 2.1 shows a margin trading situation using an example of purchasing five lots of shares at a price of RM3 per share. The amount of cash flow needed is RM1,500. The investor is given a margin facility of 40% of the investment value. Therefore the investor needs to come up with RM900 of his own funds. Margin facility can effectively increase an investors return. It provides a leverage effect on the returns. Panel A on Table 2.1 shows the effect on the returns if the price of the shares rises to RM5. If the investor sells the shares at that price, the amount of cash he will receive is RM2,500 (500 x RM5). From the sale, he has to pay interest as well as the principal amount that he borrowed. The net cash flow from the sale is RM1,840 (RM2,500 RM600 RM60) and after deducting his initial capital, the net cash flow from the investment is RM940 (RM1,840 RM900). The rate of return for the investment is just the net cash flow from the investment divided by the initial capital [(RM940 900) x 100]. Therefore, if the price rises to RM5, then the rate of return for this investor is 104.44%. However, the leverage effect can be risky to an investor. If the price falls to RM2, Panel A shows that the rate of return is negative 62.22%. The use of margin trading is similar to a firm that uses debt to finance an operation. It adds risk to the investor.

Margin trading is a loan facility that an investor can use to buy stocks.

2.3

1. Explain why it is risky to place a market order.

2. Explain what kind of order an investor can make if he is not a risk taker.

EXERCISE 2.1


Look at Panel B where the investor buys shares without the margin trading. With RM900, the investor will only be able to purchase three lots of shares. If the price rises to RM5, the rate of return is only 66.67%. However, if the price falls to RM2, the rate of return is negative 33.3%, which is lower than 62.22% as compared to the rate of return when margin trading is used.

Table 2.1: Calculation of Share Trading with and without Margin Trading A: Trade with Margin Trading


B: Trade without Margin Trading

2.3.1 Margin Call

The value of investment can change if the price of the share changes. Thus, the broker needs to protect himself against any default by the customer. The broker can insist on a maintenance margin against the value of an investment.

A maintenance margin is a level to which the investment value can drop before the investor has to increase his contribution to the investment.

The cosmetic companys shares that you read about in Sundays newspaper cost RM3 per share. You are interested in purchasing five lots, and it will cost you RM1,500. If you do not have sufficient cash to purchase the shares, how would you finance your investment?

SELF-CHECK 2.1


Let us look at Table 2.2 for a clearer picture.

Table 2.2: Margin Call

Panel A of Table 2.2 shows the initial position of the investor in a margin trading situation (based on 2.3 example). The investment value is financed partly by the loan from the broker and the investors own funds known as equity value. Lets say that the broker needs a 30% maintenance margin. This means that the equity portion of the investment must not fall below 30% of the total investment value. Panel B is the position if the share price increases to RM5. Notice that the loan figure is still the same while the equity figure has increased from RM900 to RM1,900. The investor is safe at this level of share price.


Panel C is a position where the price of the share drops to RM1.72 and consequently the equity value falls. The equity value has dropped by 30% of the total investment value. If the price falls any further, the equity portion is going to be less than 30%. This is shown in Panel D. A price drop of RM1.60 will cause the equity value to drop to 25% of the total investment value. Therefore, the investor needs to contribute some cash to meet the maintenance margin. This contribution of the new cash is known as a margin call. Panel E is the position when the cash has been collected from the investor. The investment will now comprise RM800 worth of stocks and RM57.14 cash. The new cash is then included in the equity of the investor. This will raise the equity level to 30%. Please take note that the investor had actually borrowed 40% of the initial investment value. Sometimes, it is easier to determine the price that the share can drop to before a margin call is made. This drop in price can be obtained through the equation below:

Loan

Initial Value - (Initial Value Maintenance Margin)

RM600RM1.71 = RM3.00

RM1, 500 - (RM1500 0.3)

Price drop = BuyingPrice

The broker will make a margin call if the share price drops below RM1.71.

OTHER TRADING TRANSACTIONS JARGON

There is some interesting jargon that market players use in share trading transactions. If an investor is buying and intends to hold the share for a while, then he is regarded as being in a llong position. An investor is said to be in a sshort position if he is not interested in a share, or if he has any, he intends to sell it.

A bull trend is a condition where the market is on the rise. If an investor feels bullish, then he may think that a share may increase in price and it is a good time to buy. AA bear trend is a market that is on the decline. AA bearish situation is when investors think it is time to sell or may also indicate that it is not the time to enter the market. Short selling is a situation where we sell shares that we do not own. This is done when there is a forecast that the price of a share is going to fall. The procedure is to borrow shares and sell them. Then wait for the price to fall after which we will

2.4


buy them at a lower price. The shares are then returned to the lender. The difference between the selling and buying price is the profit made. This move is very risky and involves a lot of speculation. If it is done on a large scale, it may also upset the situation in the market. Some exchanges may ban this type of transaction. Visit the Bursa Malaysia website at http://www.bursamalaysia.com and list other transaction jargons that used in share trading transactions.

An account is needed before an investor can trade in shares.

Different kinds of orders can be made during trading, which can be suited to the requirements of the investor.

Investors can use margin trading for the purpose of funding an investment. Margin trading has a leverage effect.

Share A is selling at RM3. You only have RM15,000 to invest. Thefirst alternative is to use only your funds to buy the shares. Thesecond alternative is to arrange a margin trading with your broker.You can borrow up to 50% of your investment value. The interestrate is 8%.

(a) How many units of shares can you buy with the firstalternative?

(b) How many units of shares can you buy with the secondalternative?

(c) If the price goes up to RM3.80, how much return can you getfrom your investment from each alternative?

(d) With the margin trading, calculate how far the price could dropbefore you get a margin call. The broker insists on a 30%maintenance margin.

EXERCISE 2.2


Although it is risky, it can also maximise an investors rate of return.

Terms used in share market trading include:

Long position

Short position

Bull trend

Bear trend.

topic 2 investment analysis

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