Reflective Questions

1. Can you compare a cash account to a margin account?

A securities transaction through a dealer member must be made in either a cash
account or a margin account. Clients with regular cash accounts are expected to
make full payment for purchases or full delivery for sales on or before the
settlement date. The settlement date is specified in the contract, generally
according to the following industry rules:
 Government of Canada Treasury bills—on the day that the transaction takes
place
 All other securities—one business day after the transaction takes place
In contrast, margin accounts are used by clients who wish to buy or sell securities
on partial credit. In such cases, the client pays only a portion of the purchase price
and the investment dealer lends the balance to the client, charging interest on the
loan.
The difference between cash accounts and margin accounts is important. When a
client opens a cash account, the investment dealer does not grant credit. The
explicit understanding is that the client will pay for the security in full on the
settlement date. With a margin account, on the other hand, it is understood that the
firm is granting credit based on the market value and quality of the securities held
in the account.
2. What does the word ‘margin’ refer to?
The word margin refers to the amount of funds the investor must personally
provide. The margin plus the loan provided by the dealer member together make up
the total amount required to complete the transaction. Two types of margin
positions are possible:
 A long margin position allows investors to partially finance the purchase of
securities by borrowing money from the dealer. Investors buy on margin with
the expectation that the price of the security will rise.
 A short margin position allows investors to sell borrowed securities in the
expectation that the price will fall, allowing the investor to buy back the
shares at a lower price for a profit.
Not every dealer member allows margin accounts, and those that do must obtain an
authorized Margin Account Agreement Form from the client before any business is
transacted
3. Can you describe the two types of margin positions possible?
Long margin positions and short margin positions. When a long position is
established on margin, sufficient funds (or securities with excess loan value) must
be in the account to cover the purchase. The dealer member lends some of these
funds to the client, and the client is responsible for the balance. Therefore, margin
refers to the amount put up by the client. The minimum margin required equals the
initial cost of the transaction minus the loan amount. The sum of the margin and the
loan must always be equal to the original purchase price, at a minimum. If the price
of the security falls, the value of the loan drops accordingly. The client must then
immediately provide additional funds in the account to cover the shortfall up to the
original purchase price. This requirement to deposit additional money is known as a
margin call.
Short selling is defined as the sale of securities that the seller does not own and can
only be done in a margin account. Profits are made whenever the initial sale price
exceeds the subsequent purchase cost. This is unlike a long position, where the
investor purchases a security and then holds it in the hope of eventually selling it at
a higher price. With short selling, the order of the transactions is reversed: the
investor sells the security first, and then waits in the hope of eventually buying it
back at a lower price. Because the seller does not own the securities sold, the seller
in effect creates a short position, during which the seller still owes the securities.
The subsequent purchase eventually compensates for this deficit. Short selling is
generally carried out in the belief that the price of a stock is going to fall, and the
investor who sells it short will be able to buy it back later at a lower price. If that
subsequent purchase is lower than the investor’s original sale price, the investor
has made a profit.
4. What are securities eligible for reduced margin?
CIRO produces a quarterly list of “securities eligible for reduced margin”. Inclusion
in the list is restricted to those securities that demonstrate both sufficiently high
liquidity and sufficiently low price volatility, based on specific price risk and liquidity
risk measures.
5. Can you explain what a margin call is?
The sum of the margin and the loan must always be equal to the original purchase
price, at a minimum. If the price of the security falls, the value of the loan drops
accordingly. The client must then immediately provide additional funds in the
account to cover the shortfall up to the original purchase price. This requirement to
deposit additional money is known as a margin call. Margin calls must be paid
without delay If the security has fallen in price and the client fails to meet the
margin call, the dealer can sell the security without notice or consent, and the client
will suffer a loss.
6. Can you describe why a price drop on the shares you hold in your
long margin account would lead to a net margin deficiency?
 7. Can you name and explain three margin risks?
 Margin increases market risk: Borrowing to buy securities magnifies the
outcome, either in a positive or negative way.
 Loan and interest must be repaid: The client must pay interest during the
period that the security is margined and must repay the loan at the end,
regardless of the value of the security.
 Margin calls must be paid without delay: If the security has fallen in
price and the client fails to meet the margin call, the dealer can sell the
security without notice or consent, and the client will suffer a loss.
8. Can you describe the process short selling in a margin account?
Short Selling—Simplified Steps
I. Your client calls you and instructs you to sell 10,000 shares of ABC short.
II. Your firm lends the ABC shares to your client, who immediately instructs you
to sell them into the market.
III. The proceeds from the short sale are deposited in the client’s account.
IV. The client deposits the required margin into the account.
V. The share price of ABC falls, and your client wants to close the position. You
buy ABC back on the client’s behalf at the lower price and return the stock to
your firm.
9. Can you describe why a price drop on the shares you sold short in
your short margin account would lead to excess margin?
 10. What is the limit on short sales and why?
There is no limit on the amount of time that a short sale position may be
maintained, provided that the stock does not become delisted or worthless. As well,
the position remains open as long as equivalent amounts of the shorted security
can be borrowed by the short seller’s dealer, and as long as adequate margin is
maintained in the short account. For short sales of listed securities, borrowing can
be arranged between dealers to facilitate the delivery required by the short sale.
11. Under what conditions would a short seller be forced to cover
her short position?
In some cases, the short seller may be unable to borrow enough stock from the
investment dealer to maintain or carry a short position. In such cases, the client
must buy the necessary shares to cover the short sale. This transaction must be
done regardless of the short seller’s intention to buy back the shorted security or
market price of the shorted security. There is also an issue with short selling shares
that are thinly traded. It can be difficult to borrow sufficient stock with low
marketability to maintain a short position for a prolonged period. Short sellers
generally look for shares of companies that have a large number of shares
outstanding and that are widely held by many shareholders.
12. Can you name and explain the seven risks of short selling?
I. Borrowing shares: It may be difficult to borrow a sufficient quantity of the
security sold short to maintain the short sale.
II. Adequate margin: The short seller must maintain adequate margin in the
short account as the price of the shorted security fluctuates.
III. Liability: The short seller is liable for any dividends or other benefits paid
during the period that the account is short.
IV. Buy-in requirements: If an adequate margin cannot be maintained by the
client, the investment dealer must buy back the stock to close the short sale.
Similarly, if the borrowed stock is called by its owner, the client may be
unable to borrow other stock to replace it.
V. Insufficient information: It is difficult to obtain up-to-date information on
total short sales on a security. (The exchanges do not report short positions
on a daily basis, and no data is available on unlisted short sales.)
 VI. Price action: The price of a shorted security may become volatile when a
number of short sellers try to cover their short sales at the same time,
creating a buying rush.
VII. Unlimited risk: There is a possibility of unlimited loss if a shorted stock
starts a dramatic rise in price. Unlike a typical investor who can lose no more
than the security’s purchase price, there is no maximum to the loss that a
short seller can incur, because there is no limit to how high the price of a
stock can advance.
VIII. Regulatory risk: The risk that the regulators may ban short selling for
certain types of stocks. The most obvious example of this was during the
credit crisis. The SEC, for example, banned short sales of banks and other
financial institutions. When such a ban is put in place, short sellers may be
forced to cover their positions (creating an upward spike in prices) at a loss.
13. Can you describe how order types are categorized?
TYPES OF ORDERS: There are various types of orders that may be involved in a
stock transaction, including market, limit, day, good til, on-stop sell, on-stop buy,
and professional. All of these types are discussed in detail below:
MARKET ORDER: A market order is an order to buy or sell a specified number of
securities at the prevailing market price. All orders not bearing a specific price are
considered market orders. Generally, the buyer can expect to pay the ask price, and
the seller can expect to accept the bid price.
LIMIT ORDER: A limit order is an order to buy or sell securities at a specific price or
better. The advantage to a limit order is that the order will be executed only if the
market reaches that price or better. The downside to a limit order is that there is no
certainty that the order will be filled.
DAY ORDER: A day order is an order to buy or sell that expires at the end of the
day, if it is not executed on the day it is entered. All orders are considered to be day
orders unless otherwise specified.
GOOD TIL ORDER: There are two good til order types that an investor can place: a
good til date (GTD) order or a good til cancelled (GTC) order. A GTD order expires on
a date specified by the investor. A GTC order expires 90 calendar days from entry on
the TSX, unless the investor decides to cancel the trade sooner than the expiry
date.
ON-STOP SELL ORDER: An on-stop sell order, also known as a stop loss order, is
an order that is specifically used in connection with a sell order where the limit price
is below the existing market price. The order is triggered when the stock drops to
the specified level. The purpose is to reduce the amount of loss that might be
incurred or to protect at least part of a paper profit when a stock’s price declines.
ON-STOP BUY ORDER: An on-stop buy order, also known as a stop buy order, is
the opposite of an on-stop sell order – that is, an order to buy a stock at or above a
certain price. On-stop buy orders are used for two reasons: To protect a short
position when the stock’s price is rising. To ensure that a stock is purchased while its
price is rising.
PROFESSIONAL (PRO) ORDER: A fundamental trading regulation to protect the
public relates to the priority given to client orders. If the order of a client competes
with a non-client order at the same price, the client’s order is given priority of
execution over the non-client order. A non-client order is an order for an account in
which a partner, director, officer, advisor, or other employee of a dealer member
holds a direct or indirect interest or an arbitrage order. This rule is applied within
dealer members in its dealings with clients to ensure that a client’s order has
priority over a professional (PRO) order.
14. What is the definition of price spread?
The difference between the bid and ask price. Also known as the dealer’s spread.
15. Can you describe a market order?
A market order is an order to buy or sell a specified number of securities at the
prevailing market price. All orders not bearing a specific price are considered market
orders. Generally, the buyer can expect to pay the ask price, and the seller can
expect to accept the bid price.
16. Can you describe a limit order?
A limit order is an order to buy or sell securities at a specific price or better. The
advantage to a limit order is that the order will be executed only if the market
reaches that price or better. The downside to a limit order is that there is no
certainty that the order will be filled.
17. Can you compare a day order to a good through order?
A day order is an order to buy or sell that expires at the end of the day, if it is not
executed on the day it is entered. All orders are considered to be day orders unless
otherwise specified. There are two good til order types that an investor can place: a
good til date (GTD) order or a good til cancelled (GTC) order. A GTD order expires on
a date specified by the investor. A GTC order expires 90 calendar days from entry on
the TSX, unless the investor decides to cancel the trade sooner than the expiry
date.
18. What is the purpose of an on-stop sell order, and how does it
work?
An on-stop sell order, also known as a stop loss order, is an order that is specifically
used in connection with a sell order where the limit price is below the existing
market price. The order is triggered when the stock drops to the specified level. The
purpose is to reduce the amount of loss that might be incurred or to protect at least
part of a paper profit when a stock’s price declines.
19. Can you create an example of an on-stop buy order?
On-Stop Buy Order (Example 1): ABC stock is currently trading at $30 per share.
Your client decides that she would like to buy it, but only if it moves up to $35. By
entering the order as an on-stop buy at $35, the order is not triggered until the
stock trades at $35 or above. On-Stop Buy Order (Example 2): ABC stock is currently
trading at $30 per share. Your client decides to short it at that price. However, he
would like to limit his loss to $5 per share, so he enters an on-stop buy order at $35.
The on-stop buy order is triggered only if the price of ABC stock trades at $35 or
above. The on-stop buy order offers the client insurance in one respect. If the share
price rises instead of falls, the client’s position in ABC will be closed out, limiting the
potential loss.
20. Why are client orders given priority over non-client orders?
A fundamental trading regulation to protect the public relates to the priority given
to client orders. If the order of a client competes with a non-client order at the same
price, the client’s order is given priority of execution over the non-client order. A
non-client order is an order for an account in which a partner, director, officer,
advisor, or other employee of a dealer member holds a direct or indirect interest or
an arbitrage order. This rule is applied within dealer members in its dealings with
clients to ensure that a client’s order has priority over a professional (PRO) order.
Tickets for orders for the accounts of partners, directors, officers, investment
advisors, and specified employees (in some cases) must be clearly labelled PRO, N-
C (non-client), or EMP (employee). Under the preferential trading rule, this type of
order is executed after a client’s order if both orders compete at the same price for
the same security.
MARGIN ACCOUNT TRANSACTIONS
1. What happens if the investor’s margined stock falls in price? Will the investor be
allowed to keep the position?
In a margin transaction, if the investor’s account falls below a certain level as a
result of adverse price moves, the investor will be required to deposit more margin.
If the investor fails to do so or is unable to do so, the dealer will close the position
the investor initiated.
For long positions, the investor’s shares will be sold out.
For short positions, the investor’s shares will be bought back.
2. I thought the loan value plus margin would be based on the current market
value?
Your analysis is incorrect. The loan value is based on the current market value, but
the loan plus margin is ALWAYS based on the original value of the transaction. If this
weren’t the case then it would never be worth an investor’s time to buy on margin.
At the original price, Jill buys 1,000 shares at $10. She is eligible for a loan of 50%
(or $5,000) and therefore her margin requirement is $5,000 ($5,000 loan + $5,000
margin = $10,000 original transaction value).
If the stock price increases to $12, the broker is willing to loan 50% of the market
value or $6,000. The investor’s margin requirement drops to $4,000 ($6,000 loan +
$4,000 margin = $10,000 original transaction value).
If the stock drops in price to $2, the broker is willing to loan 50% of the market
value or $1,000. Her margin requirement increases to $9,000 ($1,000 loan value +
$9,000 margin = $10,000 original transaction value).
Intuitively this makes sense. As the market price increases, the investor should be
turning a profit and not contributing more and more money. As the market price
decreases, the investor would be turning a loss and should be contributing more
money to keep the transaction alive.
3. Will I need to memorize the margin loan values and minimum credit balance
values for my exam?
No, you will not need to remember those values. That information is not
examinable.
4. When do the dealers determine that your account is undermargined?
The dealer recalculates your account balance each night after the market closes. If
your account does not meet the minimum requirements for margin maintenance,
the dealer issues you a margin call.
5. Is cash the required security or collateral for a margin account?
There has to be some kind of security provided that can count as margin. In many
cases, rather than cash, margin can be satisfied with other securities already owned
by the investor. This subject is covered in full in the Conduct and Practices
Handbook.
6. What’s the difference between a long and short position?
A long position is created when you buy shares and are now an owner. The position
is closed when you decide to sell those shares.
A short position is created when you borrow shares from your broker and sell them
in the market and the proceeds are placed in your account. The position is closed
when you decide to buy back the shares, thus returning them to the broker.
7. Where do the shares for a short sale come from?
The securities come either from the firm’s inventory, an alternate firm’s inventory or
from the inventory of securities held in street name by the brokerage firm. Only the
brokerage firm knows the identities of the borrower and lender of securities. Part of
your agreement with the brokerage firm for securities in street name is that the
broker can use the securities for such purposes.
8. How is it that the dealer can lend client shares to short sellers?
Most shares are actually registered in the dealer’s name even though a client is the
beneficial owner. When you open an account, often one of the conditions is that you
grant the dealer the opportunity to loan your shares to those who are interested in
selling short. No matter what occurs in the market, the dealer will always ensure
that the shares are returned to the original owner when required.
9. How do I as a short seller turn a profit on a short sale?
If I loaned you 1,000 shares of stock XYZ and you sold those shares in the market
when the share price was $10, you would receive proceeds in the amount of
$10,000. If the stock then dropped in value to $9 per share and you decided to close
your position, you would have to buy back 1,000 shares so you can return them to
me, since I loaned you the shares. To buy back the shares, it would cost you $9,000.
So once you buy back the shares, and hand them over to me, you are left with
$1,000 in your account.
10. Why is a short seller obligated to pay dividends?
Let’s say you are the short seller and I’m the one you’re borrowing shares from to
initiate the short sale. Once I hand over my shares to you and you sell them in the
market, the individual who buys the shares becomes the shareholder of record.
Now what happens if the company decides to pay dividends? They will pay
dividends to the shareholder of record. The problem for you is you borrowed shares
from me to initiate your short sale. In other words, I still own those shares. I only
loaned them to you. So when the company is going to pay dividends, I’m going to
be asking for my fair share of dividends. One of the prices that a short seller may
face is paying the dividends that the original owner of the shares (who loaned you
the shares) deserves. Of course, the payment is offset on paper by the fact that the
stock drops in price by the amount of the dividend per share paid to investors, so
the short sale profit increases by that amount.
11. Why would a dealer have to close an investor’s short sale position?
In order to carry out a short sale, the short seller must have stock they can borrow
because they must sell stock in the market to initiate the transaction. If there is not
stock to borrow, there can be no short sale to initiate. If the original owner of the
shares you borrowed now wants to sell their shares, the dealer may not be able to
find replacement shares to help support your short sale transaction. As such, the
short sale investor would have to close the position in order to return the stock to
the original owner who wants to sell his or her shares.
12. Can you please explain in more detail what the minimum credit balance
requirement is for short sales?
The minimum credit balance refers to the total value that must be in your account.
When you short sell a stock, the result is that the proceeds from the sale are
deposited into your account. These proceeds help to cover part of the minimum
credit balance in your account. Any remaining shortfall is considered to be margin –
you have to make up that margin from your own pocket.
For example, you sell short 100 shares of FED Company. The current price of FED
is $5 per share and the stock is not eligible for reduced margin. The minimum credit
balance for this transaction is $750. In other words, you must have $750 in your
account to carry this transaction.
When you sell short 100 shares, you receive $500. So this $500 goes into your
account. However, the minimum balance is $750. That means the margin for this
transaction (i.e., the amount you must contribute out of your own pocket) would be
$250 ($750 minimum balance required - $500 proceeds from short sale = $250
margin requirement).
13. Can you please explain using an example why the client would pay interest on a
higher amount if he or she withdraws the excess margin from the account?
Using an example from the text, assume the investor originally contributed $1,170
(M) and the dealer originally loaned $780 (L) – M represents Margin and L represents
Loan:
L + M = Original Cost
$1,170 + $780 = $1,950
When the price of the stock increased, the dealer’s revised loan value increased
from $780 to $1,125. That means the new margin requirement drops to only $825.
So you have two choices:
Leave the excess margin in the account, in which case the formula looks like the
following:
$1,170 + $780 = $1,950
Notice that by leaving the excess margin in the account, the loan value is still $780
and that’s what you pay interest on. Since you haven’t changed the amount of your
margin contribution, there is no reason for the value of the loan you borrowed to
change.
Remove $345 from your original $1,170:
($1,170 - $345) + L = $1,950
$825 + L = $1,950
Because you lowered your margin contribution to the minimum requirement of
$825, the amount you are borrowing from your broker must now increase to $1,125.
By withdrawing the excess margin, you must now pay interest on a loan of $1,125.
14. Is there a maximum time limit for a short sale?
There is no theoretical time limit on a short sale. The only time a short sale cannot
continue is if there is no longer any stock to borrow and the short sale position has
to be closed.
TRADING AND SETTLEMENT PROCEDURES
15. What happens when an order to buy stock is transmitted to the exchange?
A market order is transmitted to the exchange and one of two things will happen.
Either the trade will be executed somewhere between the bid and ask price if
another participant is willing to sell, or if there are no interested parties, the order
would be executed at the ask price. The ask price represents the lowest price at
which the market maker is willing to sell shares.
HOW SECURITIES ARE BOUGHT AND SOLD
16. When I enter a market order with my broker, does my purchase get filled at the
bid price?
The bid price is the highest price anyone is willing to pay for shares. When you enter
a market order, you are not entering a bid price. You are basically telling your broker
that you want to buy shares at the best price that can be obtained. Having stated
that, imagine that I’m a seller who calls his broker and says, “Sell 100 shares of XYZ
at $50 or better.”
Let’s say that’s the lowest price anyone is willing to sell XYZ at, so my order
becomes the current ask price. You then call your broker and enter a market order
to buy 100 shares of XYZ. If the bid is $49 and the ask is $50, chances are your
order will be filled at $50, since $50 is the best price you are going to get from a
seller at the present time. Of course, by the time your order is entered, if the ask
price of $50 is no longer the lowest available ask, you may get filled at a higher
price.
17. Can you give me examples of an on-stop sell and on-stop buy order?
On-stop sell: you buy 100 shares of XYZ at $20 per share and set an on-stop sell at
$18. If the market falls to $18, your shares are automatically sold to close your
position. This automatic sale limits to an extent the loss on your position.
On-stop buy: you sell short 100 shares of XYZ at $15 per share and set an on-stop
buy at $17. If the market rises to $17, 100 shares are automatically bought back in
order to close the position. This automatic sale limits to an extent the loss on your
position.
18. What is the point of using an on-stop sell order?
The basic concept is to protect an investor once he or she has made an investment.
An on-stop sell order protects an investor when he or she purchases stock.
For example, let’s say you are interested in buying XYZ Inc. at $10 a share. You
noticed a chart pattern that suggests a probability of higher prices, but at the same
time you know that the stock shouldn’t drop more than a dollar based on your
research. So you enter an on-stop sell order at $9. You can now go mind your own
affairs without having to worry about monitoring the stock much. If the stock drops
to your on-stop sell price, an order is executed to sell your shares at a small loss.
Many investors do not use on-stop sell orders. The feeling is that the investor can
get out of the market when the time is needed. Unfortunately, a lot of emotions can
get in the way of making a sound decision when the stock starts to drop and you are
losing money. It’s not uncommon for someone without an on-stop sell order, for
example, to watch the stock drop to $9, know that they should get out, but continue
to hold the stock hoping to recover some of the money lost. In the meantime, the
stock then drops to $8. So now the investor is really worried, but holds on in the
hopes of gaining back some of what was lost. But then the stock drops to $7. Now
the investor has lost 30% of the investment, panics, and sells. Entering an on-stop
sell order could have saved a lot of time, stress and money. On-stop sell orders are
not perfect, of course, but can be a benefit to your trading performance.
On-stop sell orders are also used to lock in profits.
For example, the stock you bought at $10 jumps to $15. So you cancel your $9 on-
stop sell order and enter a new on-stop sell order for $13.50. Again, you can mind
your own affairs and take your eye off the stock, knowing that if a big turnaround
occurs, your on-stop sell order will get you out of the market and protect some of
the profit you have made. An on-stop buy order works in reverse to an on-stop sell
order. For the investor who has sold short at $15, for example, he or she can enter
an on-stop buy order at $16. The investor is hoping the price of the stock will drop
but is protected from an adverse move. If the price of the stock rises to $16, an
order is entered to close the transaction. This protects the investor from more
serious losses. Just like a trailing on-stop sell order that follows the market higher to
lock in profits, you can also use a trailing on-stop buy order to follow the market
lower to lock in profits on a short sale.
19. Can you give me an example of the benefits of using an on-stop sell?
Example: you bought the stock at $15. Today it trades at $30 but you are going on
vacation for three months and would like to try and hang on to as much of that gain
without sacrificing further growth. So you set an on-stop sell order at $27.
Two scenarios to consider:
1. You are enjoying your vacation and the stock price starts to slide. When the
price falls back to $27, the on-stop sell order is triggered and your shares are
sold automatically. When you get back from your vacation, you see the stock
has fallen all the way back to $18 per share. Luckily, your profit on the stock
was approximately $27 - $15 = $12 per share.
2. You are enjoying your vacation and the stock price starts to slide. The price
falls back to $28 but then continues to climb higher over the next few
months. When you get home, the stock is trading at $40. You still own the
shares because the on-stop sell order you placed was never triggered. Your
current paper profit is $40 - $15 = $25 per share.
The on-stop sell order is an order designed to help protect you from further losses
but, because of its function, also can help you lock in profits on a transaction. In the
example above, the investor had a stock worth $30 at the time the vacation started.
The investor was willing to suffer a loss of $3 per share on the price down to $27,
but wasn’t willing to go any lower than that, so an on-stop sell order was placed on
the position.
20. What is an open order?
An open order is an order placed by a client but has not been filled yet.