I’ll bet you’re thinking that I’ve switched from math to a football game. No such luck. However, the calls made in investing arelike the plans made by the quarterback. But football games can’t wait for days or weeks to see the results of the call. And, similarly, a spread in bond prices may act like a point spread prediction of a sportscaster; the investor is more leery when the spread is too great. Okay, enough of the analogies.
A putis a contract that allows the owner of a particular stock to sellthat stock if it reaches a particular price in a designated amount of time. A callis a contract that gives someone the right to purchase a given stock at a particular
price — if it reaches that price in a designated amount of time. An investor uses a straddleif he contracts for an equal number of puts and calls with the same price and the same expiration date (playing it both ways). And a spreadis the difference between the amount in the contract and the current asking price.
Puts are used by investors who are looking for a profit from a rise in the stock prices, and calls are used by investors who expect a profit from a fall in the stock prices. Confusing? Well, just remember that it’s more confusing than the rules for football, but less confusing than the rules for soccer.
Suppose you establish a margin account with your broker. You arrange to purchase 100 shares of your favorite stock, which is now selling for $70 per share. The brokerage house sends you a bill for 50% of the cost of the stock, which you pay. You agree to pay 7% interest on the difference until the stock goes up 10% in value (which ends up taking four months). As soon as the stock increases in value by 10%, you sell the stock and pay back the broker.
How much money do you make on this transaction?
First of all, you determine how much money is being borrowed at 7%. One hundred shares of stock at $70 per share is 100 ×$70 = $7,000. Because you paid 50% of this bill and borrowed the rest, you paid $3,500 and borrowed the other $3,500. The interest on $3,500 at 7% is about $20.42. (Computing inter- est on loans is covered in detail in Chapter 12.) You pay this amount of inter- est monthly for the four months until the stock goes up to the level you want.
If the stock’s value increases by 10%, it’s then worth the original amount mul- tiplied by the original 100% plus the increase of 10%: $7,000 ×110% = $7,000 × 1.10 = $7,700. (You can find out more about percent increases in Chapter 3.) You pay your broker $3,500, the amount borrowed. So your net profit is the
$7,700 selling price of the stock minus the cost of the stock minus the interest payments. In other words, your net is: $7,700 – $7,000 – 4($20.42) = $700 –
$81.68 = $618.32. You usually also have to pay broker fees, but you still end up with a nice profit.
Paying a commission
You pay bankers, mechanics, and accountants for their expertise. Likewise, you can expect to pay a stockbroker for advice, guidance, and other services provided by the brokerage firm. Until a few years ago, stock was bought in lots of 100 (multiples of 100); those that weren’t purchased in lots of 100 were deemed odd lots.In this case, a price differential was then applied to the odd lots to make up for the inconvenience of not dealing with nice, round num- bers. In other words, the broker received the usual commission, based on the purchase price, and an extra charge was added on for the strange number of stocks purchased.
Nowadays, any number of stocks can be purchased, and the commission is a percentage of the purchase price. Different brokerages have different com- mission scales, but most charge somewhere between 1% and 3% of the pur- chase price. The more stock you purchase and the greater the price you pay, the smaller the percentage you’re charged.
Table 11-2 is a possible commission schedule. The number of stocks being purchased is multiplied by the cost per share to determine the purchase price.The maximum commission is $500 and is paid for any transaction whose price is $50,000 or more.
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Chapter 11: Understanding and Managing Investments
Table 11-2 Percent Commission Based on Purchase Price
Purchase $ 0–1,000 1,001–5,000 5,001–20,000 20,001–50,000 +50,001
% Commission 3% 2.5% 2% 1.5% ($500 max.)
What’s the commission paid on the purchase of 250 shares of stock that cost
$47.90 per share?
The purchase price is 250 ×$47.90 = $11,975. An $11,000 purchase puts you in the 2% category. So the commission is $11,975 ×2% = $11,975 ×0.02 = $239.50.
Investing in the public: Buying bonds
A bondis a way of investing in a corporation, university, or some other public project. Essentially, you’re lending money to the institution with the expecta- tion of getting back your principal plus some interest. In most cases, the bond and interest are all paid back at the end of the agreed-upon time period.
In some cases, however, the bond is discounted— the interest is deducted from the amount loaned and is paid to the bondholder up front.
Most bonds are arranged for with your stockbroker. You can purchase trea- sury bonds or savings bonds at a bank, but the others are negotiated through a brokerage firm.
Bonds are different from stocks, because a stockholder is actually a part- owner of the enterprise when they hold the stock certificates. A bondholderis just a lender. Many issues of bonds are available on the principal exchanges, which means that the stockbroker is aware of and can make recommenda- tions as to their availability and advisability.
Bonds come in all shapes and sizes and arrangements of payments. You have tax-free bonds, zero coupon bonds, premium bonds, and discount bonds. You decide with your broker how you want to arrange your profit — equally over the term of the bond, more upfront, or more toward the end. The variations are many.
Check out this example to see how to calculate bond interest: Suppose you invest $10,000 in bonds at a 5% annual rate of interest. The agreement stipu- lates that the company make semi-annual interest payments until the bond is repaid. How much interest is paid each year?
The annual interest of 5% on $10,000 earns 0.05 ×$10,000 = $500 each year;
half is paid each six months. Not too bad!