Question

A) Describe margin and short selling. What are the key differences between the two strategies?

Which of the above strategy is riskier? Why?

B) Differentiate between

1) Cash accounts and margin accounts

2) Stop-loss and stop buy orders

Answer 1

(A)- An investor buys a securityon margin when he pays only a portion of price of security and the rest is paid by broker. Broker reatins the possession of the security as a collateral until the investor pays in full. In case of default, securities are kept by the broker.This is known as margin buying. When an investor sellsthe securities purchased on margin, it is known as margin selling. Example in an investment of $2000, $500 is invested by investor and the rest $1500 is paid by the broker. This is margin buying.

Short selling is the type of trading when an investor sells the shares that he does not own. A brokey or investment firm lends the security to theinvestor for selling.The investor then repurchases the stocks and return to the broker or investment firm the amount of shares that where worth at the time of borrowing. If the price of the security falls, investor is able to buy that amount of shares at a lesser price and the difference is his profit.

The key difference between the two strategies is that in margin selling, some amount of equity is invested by the investor in the stock sold whereas in short selling , investor does not own any amount in the securities sold. Those securities are purely based on borrowed sum.

Margin selling is more riskier. For example, when the above investment of $2000 of shares are sold and the price of these shares rise up to $4000, an investor loses only the $2000 ( $4000 - $2000 borrowed sum) when the securities are sold through short selling. But when sold through margin selling the investor loses both his equity of $500 as well as the difference of $2000. So losses are of $2500

(b)

1- Cash account is the account where the investor keeps the money for investment purposes and the margin account is the account which is kept by the broker and investor is supposed to keep initial margin to cover for the losses.

2- Stop loss orders are the sell orders which suspend the execution until a trade occurs at or below the stop price which helps the seller to save him from the losses. Stop buy orders arethe orders which are valid only after price rises above the stop price