Page 1

The Complete Guide to Investing



Tutorial 1

Introduction to Investing

Tutorial 2

Accounts & Margin

Tutorial 3

Corporate Bonds

Tutorial 4

Municipal Securities

Tutorial 5

U.S. Government Securities

Tutorial 6

Investment Companies

Tutorial 7


Tutorial 8

Brokerage Firms

Tutorial 9

Qualified Plans & Retirement

Tutorial 10


Tutorial 11

Investor Education & Resources

We want your feedback. Please email us at the address below with any suggestions for updates to this guide. This would include any further explanation on existing topics or new topics that you would find helpful. This guide will always be a work in progress and we strive to add topics that the public requests.



tutorial 1, these are the topics we will discuss:

I. Common Stock II. Preferred Stock III.Market Value IV.Categories of Stock V. Stock Ratios and Returns VI.Stock Splits VII.NYSE/Listed Securities VIII.Trading Hours IX.Types of Traders X. Order/Transaction Priority XI.Types of Orders XII.Qualifiers XIII.Ticker Tape XIV.Short Sales XV.Over the Counter/NASD XVI.Quotations XVII.NASDAQ XVIII.NASD XIX.Trade Settlements XX.How to read a quote XXI.PE (Price to Earnings Ratio)


Common Stock Stock is issued by a corporation so they can raise funds to either expand or continue business operations. Stock in a privately held corporation is owned by very few investors. Stock in a publicly held corporation can be purchased by the public. Publicly held shares are either traded on an exchange, the most famous being the New York Stock Exchange (NYSE) or the over the counter (OTC) market like NASDAQ. If a stock symbol has three letters or less, it is traded on an exchange. (for example: C-Citigroup, Inc., BABoeing & WMT-Walmart) and if the symbol is four or five letters, it is traded OTC (for example: MSFT-Microsoft). Stocks traded by the public are very liquid, which means they are easy to buy and sell. Stock is known as an equity security because it represents ownership or equity in the corporation. Common stock is the most basic type of equity security and gives the buyer the right to participate in the earnings and assets of the company as well as voting rights and any dividends that are paid by the corporation. Preferred Stock Companies also issue preferred stock. The advantage of preferred stock is that it usually pays a stated dividend. The par value is normally $100, so that the dividend can be expressed as a percentage of par (IE: 5 Âź% preferred). There is also a market value to the stock and it trades, however, the value normally does not fluctuate as much as common stock. Preferred stock holders have no voting rights. Market Value The market value of a stock is the price listed multiplied with the number of shares that an individual owns. (For example: An investor owns 100 shares of a $50 stock, the market value is $5,000) Market value can fluctuate many times during a single day of trading and is dependent on supply and demand. Categories of Stock Blue Chip-High grade, high quality companies, major corporations, usually well established and have a track record of paying dividends and increasing earnings. An example would be General Electric (GE) Defensive-Businesses which seem resistant to recession for example utility companies. Income-Pays a higher than average dividend. Investors who seek consistent income that is higher than average would buy income stocks. Growth-Market share, earnings and sales are expanding at a rate faster than average. Dividends are usually small because earnings are being reinvested back into the company for growth. Many technology companies are growth stocks.


Seasonal-Earnings fluctuate with the calendar and changing seasons. Retail stores are often seasonal. Cyclical-Businesses such as automobile manufacturing and steel are cyclical. Earnings and stock price tend to fluctuate with the business cycles. Not the same as seasonal because the business cycle is not always in a one year cycle. Stock Ratios and Returns Dividends-When a company realizes profits, the board may vote to distribute dividends. Cash Dividends-Cash dividends are the most common paid in regular intervals. Stock Dividends-The board may also decide to distribute more shares of stock as a dividend. This is distributed in equal percentage. Settlement Date-A settlement date is used to determine who is entitled to a specific dividend. Regular Way Settlement-A transaction that settles regular way will settle on the 3rd business day following the date of the trade. This is how most common stocks transactions are settled. U.S. Notes and bonds settle next business day and money market securities settle same day. Dividend Disbursement Declaration Date-When a dividend payment is approved by the board, they must notify the NASD 10 days prior to the record date, which is selected by the corporation. Ex-Dividend Date-This is 2 days prior to the record date. We established earlier that regular way settlement takes 3 business days from the date of the trade. So, the investor that bought the stock before the ex-date would receive the dividend, while the investor who bought on the exdate would not receive the dividend. Record Date-The date that determines who is the owner of the stock for purposes of dividend disbursement. Payable Date-The date the dividend is paid to the stock holder of record.


Mon 6 13 20

Tue 7 14 21


Thu 2 9 16 23

1 8 15 22

Fri 3 10 17 24

Sat 4 11 18 25

Let's say the record date is the 9th. If the trade date is on the 2nd, then the trade will settle


5 12 19 26

on Monday the 7th. Since the 7th is before the record date, this investor would be entitled to the dividend. Stock Splits A stock split increases the number of shares and reduces the market price proportionately. This is a forward split. This is often done when the board of directors feel the price is too high for investors. Example: A 3 for 2 stock split means that for every 2 shares of stock held by the investor, he/she will now have 3. Here is an easy way to calculate this: Left

Right 100 shares 3 for

At $60 2 split

1.To figure the new shares-Multiply the numbers on the left side (100x3) and then divide it by the numbers on the right bottom quadrant (2). So, 100x3/2=150 shares is what the investor will have after the split. 2.To figure the new price-multiply the numbers on the right side (60x2) then divide it by the number on the left bottom quadrant (3). So, 60x2/3=$40 per share will be the new price after the split. Note that the market value does not change in a split of this nature (100 shares x $60=$6,000 and 150 shares x $40=$6,000) however, the investor now has more shares (150 compared to 100). Reverse Stock Split-would have the opposite effect, however, you can use the same formula above to calculate it. New York Stock Exchange/Listed Securities Organized exchanges provide a centralized location for buyers and sellers to determine securities prices. This is done by auction where sellers shout out offering prices and buyers shout out bid prices. The best bid (highest) and the best offering (lowest) prevail and this sets the price of the security. Prices continually fluctuate as buyers and sellers execute their orders. The New York Stock Exchange (NYSE) is the largest and most well known exchange, however, others include the American Stock Exchange (AMEX), the Philadelphia Stock Exchange (PhX), the Pacific Stock Exchange (PSE), Midwest Stock Exchange (MWE), the Boston Stock Exchange (BSE) and others. Access to the trading floor of the NYSE is restricted to members of the exchange. Members are individuals who have purchased a “seat” on the exchange. A member firm which employs an individual who owns a seat, or owns a seat themselves. Commonly referred to as “the Big Board”, the NYSE was founded in 1872 .


Listing Requirements Here are the requirements for a stock to be listed on the NYSE: 1.Have at least 1.1 million shares held publicly 2.Have at least 2,000 round lot (round lot=100 shares usually) shareholders 3.Have pre-tax earnings of at least $2.5 million 4.Have an average monthly trading volume of 100,000 shares for the most recent six month period 5.Have a national interest (IE: shareholders in a wide geographical area) 6.Have a common stock market value of at least $16 million The trading floor of the NYSE is a large area that contains telephones, computers and trading posts, where all the buying and selling takes place. Each of the trading posts are assigned a number of securities to trade. Above each post there is an indicator which shows the stocks traded at that particular post. Each post also has an indicator that shows what the last executed price of each stock traded at and whether or not it was an uptick (price increase) or downtick (price decrease). Orders to buy or sell are given to the retail broker by his/her client. This order is then transmitted to the firm's clerk on the trading floor. The order then goes from the clerk to a floor broker for execution. Trading Hours Normal trading hours are from 9:30 AM EST until 4:00 PM EST Types of Traders The Specialist-maintains an orderly market in stocks which he trades. The Specialist executes orders for his own account (as principal) as well as public orders from floor brokers (as agent). He can not place orders for his own account ahead of public orders. The Floor Broker-Executes orders for clients of the brokerage firm (known as retail customers) and his firm's own trading account. The Two Dollar Broker-Executes orders for various floor brokers in instances when he/she is too busy to execute all of the orders. He will charge a fee for services, which used to be $2 and hence the name. The Registered Floor Trader-Normally only trades for his own account and rarely executes public orders.

Order/Transaction Priority


Many orders arrive at the trading post at approximately the same time. A priority of orders has been set to determine which orders are executed first. 1.Price-The best bid (highest) and best offer (lowest) comes first. For Example, an order to buy 100 shares of IBM at $120 would be executed before bids at 119 7/8. An offer to sell XYZ at 33 ½ would be before offers at 33 5/8. 2.Time-If all bidders or offerers are equal in price, the order arriving first to the post has priority. 3.Size-If both price and time are equal, then size takes precedence. Types of Orders Market Orders-Most common order. A market order assures an execution if the stock is trading, however, it does not guarantee a price. It will be executed at the best available price at the time the order is submitted to the floor. Unless the stock is very volatile or thinly traded, market orders are usually executed within 1/8 to ¼ from the quoted price. Limit Orders-When the client needs to purchase or sell a security at a specific price or better, a limit order is used. The risk here is that the order will never be executed at all if it does not reach that specified limit price or better. Limit orders are either a day order, which automatically cancels if not executed by the end of that trading day or good til canceled (GTC) also known as open orders, which remains in effect until executed or canceled. In today's market, GTC orders generally are good for 60 days or until executed or canceled previous to that. Limit orders are placed at a price above (sells) or below (buys) the current market price. So, if XYZ was trading for $30 per share, you could put a sell limit at $32, so if it climbs up $2 more, the trade would be executed. If ABC was at $100 per share, you could put a buy limit at $98, so if it drops $2 more, the trade would execute and you would buy the stock at $98. Stop Orders- or “stop loss” orders are used when an investor wants to limit a loss or protect a profit. Unlike a regular limit order, a Buy Stop is entered above the current market price of the stock. A Sell Stop would be placed below the current market price. When the limit is reached, the order is “triggered” and becomes a regular market order and the customer is then filled at the next available price like any other market order. Let's say an investor purchased 500 shares of XYZ stock at $25. Obviously, she expects the value of the stock to rise, but to protect herself, she decides to place a sell stop order. She has determined that she is willing to accept a 2 ½ point loss, so she enters the following order. Sell 500 XYZ at 22 ½ STOP GTC. If the price of XYZ should drop to 22 ½, her order is triggered and would be most likely executed somewhere in the 22 ½ range. She has effectively limited her potential loss. The same order can be used to protect a profit. Using the same investor, her XYZ shares have risen in value to $30. In order to protect this profit, a sell stop is entered at $28, usually allowing her to keep at least part of her profit in the event the stock price declines.

Stop Limit Orders-are like regular stop orders, except they do not become market orders


when the trigger price is reached. Instead, they become a regular limit order and are only executed at the limit price or better. For this reason, when the order is entered, the investor must choose a “stop price” and a “limit price”. Sometimes, they are the same. Sell 500 XYZ at 32 STOP, 32 LIMIT means it will trigger at 32 but only execute at 32 or better. Qualifiers Order qualifiers allow the investor additional control over executions. Here are some of the more popular qualifiers: All or None-The entire order must be executed at once or not at all. Immediate or Cancel-As much of the investor's order must be filled at his limit immediately and any remaining portion is canceled. Fill or Kill-The entire order must be executed immediately or the entire order is canceled. At the Close- (on the close)-Orders will be executed as close to the close of the market as possible. The order does not guarantee the absolute last order of the day. Used with a market order. At the Opening-Order must be executed at the opening price for the stock or it's canceled. Ticker Tape Trades of listed stocks are reported to the Consolidated Tape System. This is the electronic ticker tape you probably have seen running across the TV screen on CNBC. Tape A shows NYSE transactions and tape B shows ASE and regional exchanges or NASDAQ OTC. The updates move across from left to right and displays the stock's ticker symbol followed by the price and the number of shares. If a round lot (100 shares) is traded, only the price is shown. So, a trade of 100 IBM at 120 would display as: IBM 120 Between 200 and 9900, the zeros are dropped and a small “s” is inserted, then the price. Some examples include: IBM 2s120 (200 shares at 120) IBM 8s120 (800 shares at 120) IBM 10s120 (1000 shares at 120)


The volume is displayed in full for trades of 10,000 or more shares. IBM 10,000s120 (10,000 shares at 120) IBM 14,500s120 (14,500 shares at 120) A series of round lot trades would eliminate the whole number and the display would read: IBM 120 1/8 Âź 3/8 (100 shares traded at 120 1/8, 120 Âź & 120 3/8) Tape B Tape B shows trades from regional exchanges as follows: P Pacific Stock Exchange B Boston Stock Exchange M Midwest Stock Exchange C Cincinnati Stock Exchange T Third Market Trades X Philadelphia Stock Exchange O Fourth Market Trades Short Sales Selling a stock short means selling a stock that is not owned. The reason for selling short is to benefit from downward movements in the price. Profits and losses from short sales are calculated the same as regular trades. (sale price-buy price=profit/loss). The only difference is that the buy and sell are done in reverse sequence. Ex: If you sold 100 shares short at 40 and later bought it back at 35, you would have a profit of $500 ($4,000-$3,500) In order to sell short, the following requirements must be met: 1.The stock must be borrowed 2.The stock must be marginable 3.When the trade is executed either on an exchange or on OTC, the last trade had to be an up-tick or zero-plus tick. The stock must be borrowed from someone else in order to make delivery to the buyer by settlement date. The stock must eventually be delivered back to the person from whom it was borrowed. (if you purchase through a brokerage house, the firm will handle this.) We will also get into margin in a later section. To avoid short sellers from continually driving a stock's price down, short sales must be after an up tick or zero up tick. An up tick is when a trade is higher than the previous trade. A down tick is when the last trade was at a lower price than the previous one and a


zero tick is when the last trade was at the same price as the previous one. Zero-plus tick is when the last movement was upward or a zero minus tick when the last movement was downwards. Price

Tick Unknown 25 25 1/8Up-tick 25Down-tick Zero-down-tick 25 Zero-down-tick 25 25 1/8Up-tick Zero-up-tick 25 1/8

Explanation We do not know the previous trade. 25 1/8 is higher than 25 25 is lower than 25 1/8 Same as last trade and the last movement was downward from 25 1/8 to 25. Same as last trade and the last movement was 25 1/8 (more). 25 1/8 is higher than 25. Same as last trade and the last movement was upward from 25 to 25 1/8.

Over the Counter Market/NASD Publicly traded securities not listed on an organized exchange trade in the over the counter marketplace. The over the counter market is not an auction like on the exchanges, it is a negotiated market. Prices investors buy or sell at are negotiated through a network of market makers who are trading the stock in their own accounts. The auction markets have a specialist and the OTC markets have a market maker, both are there to maintain an orderly market in the stock. The OTC market is also not centralized in one building or area. It is carried out across the country with market makers linked to computers and telephones. The market maker is responsible for maintaining a stable and liquid market in the securities he trades. Stock is bought and sold from the firm's inventory. So, unlike on an exchange, an investor's buy or sell order is not matched against another's buy or sell order. Instead, trading is directly with the market maker firm. The market maker does not act as agent and principal, but as principal only. Quotations/NASDAQ Firm Quote-Market makers publish competitive bids and offers. Any published quote from a market maker is firm for at least 100 shares of stock. Ex: “The market is at 10 at 1/2” This means that the stock could definitely be sold by the investor at 10 and bought by the investor at 10 ½. Subject Quote-In addition to firm quotes, a quote can be subject to change. Ex: “I saw it at 2121 3/8”


NASD The National Association of Securities Dealers is the organization which regulates the over the counter market and it's broker/dealers. Trade Settlements Regular way is how most buys and sells are settled. Regular settlement is 3 business days following the transaction. Ex: A purchase of 100 shares purchased on Monday, July 20th will settle on Thursday, July 23rd. Payment or delivery is due on this date. How to Read a Quote When you pull up a stock quote whether it's on a financial site such as or through your online brokerage account, you will see the following information: Last Trade-This is the price that the stock last traded Trade Time-The exact time of the last trade Change-The gain or loss for that trading day along with the percentage gain or loss from the previous day's close Previous Close-The price at the close of trading the previous day Open-The price at which the stock started trading for that day Bid-The price at which an investor can sell that stock Ask-The price at which an investor can buy that stock Day's Range-The range of prices that stock traded throughout that day 52wk Range-The range of prices that stock traded for the past 52 weeks VolumeThe amount of shares traded for that day Avg Volume-The average amount of shares traded for that day P/E- is shorthand for the ratio of a company's share price to its per-share earnings. For example, a P/E ratio of 10 means that the company has $1 of annual, per-share earnings for every $10 in share price. Div-The dollar amount of any dividend and the percentage yield (dividend/share price) PE (price to earnings ratio) A company's P/E ratio is computed by dividing the current market price of one share of a company's stock by that company's per-share earnings. A company's per-share earnings are simply the company's after-tax profit divided by number of outstanding shares. For example, a company that earned $5M last year, with a million shares outstanding, had earnings per share of $5. If that company's stock currently sells for $50/share, it has a P/E of 10. Stated differently, at this price, investors are willing to pay $10 for every $1 of last year's earnings. Like other indicators, P/E is best viewed over time, looking for a trend. A company with a steadily increasing P/E is being viewed by the investment community as becoming more and more speculative. And of course a company's P/E ratio changes every day as the stock


price fluctuates. The price/earnings ratio is commonly used as a tool for determining the value the market has placed on a common stock. A lot can be said about this little number, but in short, companies expected to grow and have higher earnings in the future should have a higher P/E than companies in decline. For example, if Amgen has a lot of products in the pipeline, I wouldn't mind paying a large multiple of its current earnings to buy the stock. It will have a large P/E. I am expecting it to grow quickly. PE is a much better comparison of the value of a stock than the price. A $10 stock with a PE of 40 is much more "expensive" than a $100 stock with a PE of 6. You are paying more for the $10 stock's future earnings stream. The $10 stock is probably a small company with an exciting product with few competitors. The $100 stock is probably pretty staid - maybe a buggy whip manufacturer.


Q&A 1. What investment goal would an investor who buys preferred stock most likely be trying to achieve? A. Growth B. Growth and Income C. Income D. Speculation 2. What is the current market value if an investor owns 1200 shares of ABC and it is currently trading at $30? A. $30 B. $36,000 C. $50,000 D. None of the Above 3. A stock split that decreases the number of shares outstanding is called: A. Positive Split B. Declining Split C. Reverse Split D. Bad Investment 4. In a regular way settlement, if an investor purchases stock on Monday, July 11th , when must the investor pay for the purchase by? A. Monday, July 11th B. Tuesday, July 12th C. Wednesday, July 13th D. Thursday, July 14th 5. An order that guarantees execution, but not price is called: A. Limit B. Market C. Stop Loss D. Stop 6. A specialist on the floor of the NYSE is comparable to what in the over the counter market? A. Floor Broker B. Brokerage Firm


C. Market Maker D. Two Dollar Broker 7. The price at which an investor can sell the stock is the: A. Bid B. Ask C. Quote D. Last Trade 8. The date that determines who is the owner of the stock for purposes of dividend disbursement: A. Declaration Date B. Record Date C. Ex-Dividend Date D. The date of the purchase 9. A firm quote is good for at least: A. 500 Shares B. 1000 Shares C. 100 Shares D. Any amount of shares 10. In order to sell short, the following requirements must be met: A. The stock must be borrowed B. The stock must be marginable C. When the trade is executed either on an exchange or on OTC, the last trade had to be an uptick or zero-plus tick. D. All of the above

Answers: 1) C 2) B 3) C 4) D 5) B 6) C 7) A 8) B 9)C 10) D



In tutorial 2, these are the topics we will discuss: I. New Account Forms II. Joint Accounts III.Margin and Loan Agreements IV.Options Agreements V. Limited Power of Attorney VI.Long Margin Accounts VII.SMA VIII.Buying Power IX.Using Securities to meet margin requirements X. Restricted Accounts XI.Frozen Accounts XII.NYSE & NASD Requirements XIII.Maintenance XIV.Short Accounts XV.Short sale requirements XVI.Excess equity in short accounts XVII.Short account maintenance requirements XVIII.Margin accounts with long and short positions


Accounts and Margins A customer may buy securities either in cash, by paying the entire amount of the purchase or on margin by depositing the required amount and borrowing the balance from the brokerage firm. A new account form is required for all types of accounts with the following information from the owner of the account: Name Address Age Marital Status Occupation Tax ID Number Citizenship Bank Reference Listing of other brokerage accounts Investment objectives Relationship, if any, to the broker Signature of the customer (s), broker and manager. Joint Account Forms Joint Tenants Agreement-This form establishes joint tenancy with rights of survivorship (JTWROS) between two parties to an account. Each party owns an undivided and equal interest in the account. In the event of death, his or her portion of the account belongs to the surviving party and bypasses the decedents estate. Joint Tenants in Common-This agreement states the account is shared by two or more persons and specifies the percentage ownership of each. Upon death of any party, that person's equity in the account belongs to his or her estate. Community Property Agreement-This establishes that funds and securities held in this account are the community property of a married couple. Margin and Loan agreements The margin agreements must be signed by the customer and returned to the firm prior to placing an order to buy on margin or sell short for the customer's account. When purchasing and maintaining securities on margin, the customer must agree to abide by exchange and Federal Reserve requirements. (again, margin will be handled in detail later). Options Agreement This agreement is required before options may be traded in a cash or margin account.


The options agreement includes a statement of the client's net worth, liquid assets and investment experience. Brokerage firms require varying amounts of income and net worth depending on the types of option strategies a client intends to use. (Since our entire trading system uses specific option strategies, we will get into more detail later regarding these limits and how to get accounts open without necessarily proving any such figures). All customers opening an option account must receive the “full disclosure� document approved by the options exchanges and the Options Clearing Corporation (OCC) at or prior to the account being approved. Limited Power of Attorney This agreement allows someone other than the customer to place buy and sell orders in the account. However, the third party may not withdraw funds or securities from the account. This is commonly set up when an investment advisor or money manager is trading on the customer's behalf. MARGIN When a customer buys securities on margin, the customer deposits a percentage of the purchase price. The brokerage firm lends the balance and charges interest on the loan. The initial margin requirement for stocks is 50%. If a customer wishes to buy $10,000 in stock, the required deposit would be $5,000. This allows leverage on your investment by only having to put up half of the purchase price, in effect, allowing you to control double the amount of stock. Options can not be margined, the premium must be paid in full prior to the trade, however, margin will play an important role in some of our option strategies discussed later. Long Margin Accounts The three components of the basic margin equation are the market value of the securities, the customer's equity (initially the amount of his margin deposit) and the debit balance, which is the amount owed to the brokerage firm. The basic margin formula is as follows: Market Value - Debit Balance = Equity Equity = Market Value - Debit Balance Example: A client purchases 100 shares of XYZ at $120 per share. The total purchase price is $12,000, so the customer must deposit $6,000 or 50%. The brokerage firm will lend the other $6,000. Initially, the account will look like this: Market Value Debit Balance

$12,000 $ 6,000


$ 6,000


If there are no further transactions, the debit balance will remain constant, except when the interest is charged to the account. Therefore, a change in the market value will cause the equity to change. If the market value increases, the equity increases by the same amount and if the market value decreases, so does the equity. At any time, the equity can be found by subtracting the debit balance from the current market value of securities in the account. For example, assume a client held the following securities with a debit balance of $5,000.

Ex: 100 XYZ @ 80 100 ABC @ 40 100 RDO @ 20

$8,000 $4,000 $2,000

Total Market Value: Debit Balance

$14,000 $ 5,000


$ 9,000

Special Memorandum Account (SMA) If the market value of securities in a long margin account increases, the equity in the account will increase. This could result in an equity figure higher than the initial 50% requirement. The account would therefore have excess equity. EX: Consider the following margin account: Market Value Debit Balance

$20,000 $ 2,000



The account has excess equity which is calculated as follows: Excess Equity= Account Equity - (mkt value x 50%) $18,000 - ($20,000 x 50%) $18,000 - $10,000 = $8,000 Excess equity is $8,000 This excess equity is noted in a separate section of the margin account called the Special


Memorandum Account or SMA. This excess equity may be withdrawn in cash by the customer. If the customer withdraws in cash, the debit balance increases by the amount withdrawn. This is because the client is taking an additional loan based on the market value of the securities. If the customer in the above example withdrew $8,000, the account would appear as follows: EX: Market Value Debit Balance

$20,000 $10,000



The $8,000 withdrawn has been added to the debit balance. Equity as a percentage of the market value is again at 50%. SMA can be created in three ways: 1.Excess equity in a margin account caused from market value increases, as described above. 2.Non-required cash deposits, such as dividends on stock in the account, if not withdrawn within 35 days 3.The sale of securities in the account. SMA is not decreased when the market value of securities in the account decline. It will only decrease when used for purchase of securities or withdrawal of cash. Buying Power In the previous section with the requirement at 50%, the client's account had excess equity or SMA of $8,000. The client could withdraw that amount, or use it to purchase $8,000 in securities in a cash account. If the client wished to purchase additional securities on margin, the SMA would enable him to purchase more than $8,000 in securities. The SMA in the account gives the client BUYING POWER. Buying power is the value of the securities that may be purchased on margin. Buying power would be the SMA figure divided by the requirement (50%). In the above example, buying power would be figured as follows: EX: Buying Power = SMA/Requirement (50%) = $8,000/50% Buying Power = $16,000 The client could therefore purchase an additional $16,000 in securities on margin. The debit balance would be increased by $16,000 since the brokerage firm is actually lending


the entire amount of the purchase based on the market value of securities in the account. If the client purchased the additional $16,000 in securities, the account would appear as follows: EX: Market Value Debit Balance Equity

$36,000 $18,000 $18,000

When the requirement is 50%, the buying power is easy to calculate, it is simply the SMA x 2. Using Securities to Meet Margin Requirements When securities are purchased on margin, a client must meet the margin requirement. If the client does not wish to deposit cash, the margin call (requirement) may be met with securities that the client owns fully paid having a loan value greater than or equal to the amount of the margin call. Ex: A customer purchases $20,000 in securities with the requirement at 50%. The required deposit is $10,000. The client could meet this by depositing $10,000 in cash. To use securities instead of cash, the securities must have a loan value equal to the required deposit of $10,000. As explained above, the loan value of securities is equal to their market value times the requirement (50%). In this example, the market value of fully paid securities times the 50% requirement must equal $10,000. Value of fully paid securities needed = Margin requirement/50% = $10,000/100-50% = $10,000/50% = $20,000 The value of fully paid securities needed to meet the margin call is $20,000. With the requirement at 50%, this calculation is also very easy. It is simply the margin call x 2. The account would appear as follows: Market Value: Debit Balance

$40,000 $20,000



The market value of $40,000 is the total of the new purchase plus fully paid securities


deposited. The debit balance of $20,000 results when the client purchases $20,000 in securities without a cash deposit. Now, the equity in the account is exactly at the 50% requirement. Restricted Accounts When the market value of securities in a margin account decreases, the equity in the account may fall below the initial requirement of 50%. In this case, the account becomes restricted. If a client's account is restricted, the client can make additional purchases only by meeting the initial 50% requirement.

EX: With the requirement at 50%, the account shown below would be restricted. Market Value Debit Balance

$20,000 $14,000


$ 6,000

The equity as a percentage of the market value is below the 50% requirement (6,000/20,000= 30%) If the client purchased $10,000 in additional securities and deposited the required $5,000, the account would still be restricted and would appear as follows: EX: Market Value Debit Balance Equity

$30,000 $19,000 $11,000

A purchase of securities in a restricted account is allowed only if the customer meets the entire initial margin requirement for the purchase. The client may also substitute securities in a restricted account by selling another security in the account with a value greater than or equal to the new purchase. However, the sale must be made before or on the same day as the purchase. If the sale follows the purchase, the client is in violation of Regulation T for liquidating to meet a margin call. If the client sells a long security before making a new purchase, and if the proceeds of the sale are greater than or equal to the new purchase, no deposit is required. If the amount of the purchase exceeds the proceeds of the sale, the client must meet the margin requirement on the difference. EX: A client sells a position worth $10,000 in a restricted account, and invests $15,000 in another security. With the requirement at 50%, the required deposit is as follows: Purchase Sale

$15,000 ($10,000)




Required Deposit= $5,000 x 50% The client must deposit $2,500. Frozen Accounts The client must deposit the required margin within 7 business days of the trade date. If the customer does not pay within this period and no extension is granted, the brokerage firm must sell securities in the account sufficient to meet the margin call. The account then becomes frozen for a period of 90 days. If a customer wishes to purchase securities in a frozen account, a deposit equal to the full amount of the purchase must be made before the order is entered. If a customer whose account is frozen wishes to sell securities, the securities must be on account with the firm prior to executing the sale. Be careful here, because the brokerage firm can sell out any security (it's their choice) to meet a margin call and they are technically not required to notify you. NYSE and NASD Requirements The NYSE and NASD require customers to establish minimum equity with their initial transaction in a margin account. Minimum equity in a long account is $2,000 or 100% of the purchase price, whichever is less. If a client's initial purchase is $3,000 in securities, the requirement would be 50% or $1,500. However, the NYSE/NASD would require a minimum deposit of $2,000. If the initial purchase cost $1,800, the requirement would be $900, however, the NYSE/NASD would require the full $1,800 (100%). Maintenance Requirements As previously discussed, there are initial margin requirements which customers must meet on each transaction. Once the client has made the initial deposit, there are certain maintenance requirements that are established by the NYSE/NASD. Should equity drop below this minimum maintenance requirement, the client is required to deposit additional funds. This is known as a maintenance call. The NYSE/NASD minimum maintenance requirement for a long securities account is 25% of the market value. For example, if the current market value of an account is $20,000, minimum equity would be $5,000. Please note that although the NYSE/NASD minimum maintenance requirement is 25% and no brokerage firm may set a limit lower, most brokerage firms do set a more stringent maintenance, often 30-35%. This is to protect the firm and it will fluctuate based on general market conditions. It may be necessary to determine the price to which a security could decline before a maintenance call is issued. This can be determined by multiplying the debit balance by 133%. Ex: Market Value Debit Balance

$20,000 $ 9,000




The point at which a maintenance call would be issued is computed as follows: Debit Balance x 133% $9,000 x 4/3 = $36,000/3 = $12,000 So, if the market declined from $20,000 to $12,000, equity would be $3,000 or 25%. Market Value Debit Balance

$12,000 $ 9,000


$ 3,000

Short Accounts When selling short, a customer is selling securities he does not own, anticipating that the market price will decline. The client intends to purchase the securities back at a lower price thereby making a profit. Short Sale Requirements The margin requirements for short sales are the same as for purchases, but calculations for a short account are different than those for a long margin account. When a customer sells short and meets the initial margin requirement, a “credit balance� is established in the account. The credit balance is the total of the proceeds of the short sales and the cash deposited to meet the margin requirement. The customer's equity is initially equal to the amount deposited. However, as the stock price fluctuates, equity is equal to the total credit balance less the short market value. Equity = Credit Balance - Short Market Value EX: A customer sells short 100 shares of XYZ at $60 with the margin requirement at 60% let's say instead of 50%. The short sales generates a $6,000 credit. The customer must deposit 60% of $6,000, or $3,600. The total credit balance will be $9,600. Initially, the account appears as follows: Credit Balance Short Market Value

$9,600 $6,000




The equity is equal to the margin requirement met by the client. If there are no further transactions, the credit balance remains constant. If the market value decreases, the equity will increase and if the market value increases, the equity will decrease. EX: If XYZ declined to $50 per share, the above account would appear as follows: Credit Balance Short Market Value Equity

$9,600 $5,000 $4,600

Since the short market value has decreased, the customer has made a profit, equity has increased. Excess Equity in Short Accounts As shown above, when short market value decreases, the equity in a short account increases and excess equity may be created. As with a long account, the excess may be withdrawn in cash or used to generate buying power, or selling power in a short account. The amount of excess that may be withdrawn from a short account is the difference between the increased equity and the amount required by the Federal Reserve Board (Currently at 50%). In the above example, the market price of XYZ declined from $60 to $50, causing the equity to rise to $4,600. The FRB margin requirement in the above example was 60%, so on market value of $5,000 it would be $3,000 ($5,000 x 60%). The difference between the $3,000 required and the actual equity of $4,600 is $1,600. The excess equity of $1,600 can be withdrawn in cash. A “short-cut� method of determining the excess equity in a short account when the market value declines is to add the amount of the decrease in market value to the FRB requirement on that amount. In the above example, the market value declined by $1,000. With the requirement at 60%, the requirement on $1,000 is $600. Thus, the excess equity in the account is $1,600. With the requirement at 50%, the excess equity would be $1,500 ($1,000 increase + $500). Selling power in a short account is calculated in the same manner as buying power in a long account. The excess in the account may be used to meet the requirement on a new transaction. To determine selling power, the amount of excess equity is divided by the margin requirement. In the account shown above, the calculation would be as follows: EX: Selling Power = Excess Equity/FRB Requirement =



Selling Power = $2,667 The customer could sell short an additional $2,667 in stock, or purchase $2,667 in securities in a long margin account. Short Account Maintenance Requirements According to the NYSE and NASD, the minimum maintenance requirement for a short account is 30% of the short market value. To determine the price to which securities sold short could increase before a maintenance call is issued, the credit balance is multiplies by 10/13. The following is an illustration: EX: A customer's account appears as follows. Credit Balance Short Market Value Equity

$18,000 $12,000 $ 6,000

The value to which the short market value could rise before generating a maintenance call would be as follows. Credit Balance x 10/13 $18,000 x 10/13 =$180,000/13 = $13,846 If the short market value rose to $13,846 the account would appear as follows: Credit Balance: Short Market Value

$18,000 $13,846


$ 4,154

The equity of $4,154 is 30% of the short market value. OR you can simply use: Credit Balance/1.3 = Short account maintenance NOTE: In a short account, the change in market value resulting in a maintenance call is less than for a long margin account. In other words, given adverse price movement, a maintenance call is generated more quickly in a short account. Consider the following example: With the requirement at 50%, a client sells short 1000 ABC at $20 and meets the requirement of $10,000.


Credit Balance Short Market Value

$30,000 $20,000



The point at which a maintenance call would be issued is: $30,000 x 10/13 = $300,000/13 = $23,077 If the short market value rose by $3,077 to $23,077, the account would appear as follows: Credit Balance Short Market Value Equity

$30,000 $23,077 $ 6,923

The equity of $6,923 is 30% of the short market value. Any further adverse price movement would generate a maintenance call in the account. In a long margin account with the same market value and requirement, the calculations would compare as follows: A client buys 1000 ABC at $20 in a margin account and meets the required deposit of 50%. Market Value Debit Balance

$20,000 $10,000



Following a decrease in market value of $3,077, the account would appear as follows: Market Value Debit Balance

$16,923 $10,000


$ 6,923

The equity of $6,923 is approximately 41% of the market value. No maintenance call would be issued in this case. A special maintenance requirement exists for a short account in which stock sold short has a market price of less than $5 per share. The minimum maintenance requirement is $2.50 per share or 100% of the market value, whichever is greater.


Margin Accounts with Long and Short Positions For a “combined� margin account, both long and short positions are considered when determining equity, percentage equity, excess equity (SMA) and minimum maintenance. The customer's total equity is the long equity plus the short equity. The following formulas are used: Long Market Value - Debit Balance = Long Equity Credit Balance - Short Market Value = Short Equity The minimum maintenance requirement is the minimum on the long side of the account plus the minimum on the short side, as follows: Long Market Value x 25% = Minimum equity (long) Short Market Value x 30% + Minimum Equity (short) Another important consideration for margin accounts: Some stocks, especially tech oriented NASDAQ securities or very volatile stocks may have a maintenance requirement of 50% as well instead of the 25-35% set by the FRB or the brokerage firm. You must know this prior to trading because if it goes down at all after the initial requirement of 50% is met, you will immediately be in a margin call and the brokerage firm will request more funds or securities to cover the position. Also, brokerage firms usually set a limit on the price a stock must be to become marginable, for example $5 per share. So, anything under $5 per share would have to be paid for 100%. This is true even if you bought the stock on margin initially at say $8 and then the market value decreased to $4. EX: You bought 100 shares of ABC @ $8 on margin depositing 50% initially or $4,000. If that stock goes down to $4, it is no longer marginable and now 100% equity is required. So, the account would have looked like this before: Market Value Debit Balance

$8000 $4000




Now: Market Value Debit Balance

$4000 $4000





Now, you must deposit $4000 in cash or $8,000 in fully paid securities to erase the debit balance and bring the account to 100% equity instead of simply depositing enough for the maintenance requirement because the stock is no longer marginable.

Q&A 1. In a joint tenants account, how is ownership of the assets split? A. 100/100 B. 50/50 C. Depends on the amount each party deposits D. Main account holder 100% until death, then the account goes to the joint account holder. 2. What is the initial margin requirement on a $14,500 stock purchase when regulation T is at 50%? A. $14,500 B. $29,000 C. $1,450 D. $7,250 3. If the market value of an account is $25,000 and there is a $6,000 debit balance, what is the equity in the account? A. $25,000 B. $6,000 C. $19,000 D. Can't calculate 4. In the same account as above, what is the NYSE maintenance requirement? A. $6,250 B. $2,000 C. $6,000 D. Can't Calculate 5. Consider the following account: $26,000 Market Value $8,300 Debit Balance $17,700 Equity What is the excess equity?


A. $26,000 B. $17,700 C. $15,000 D. $4,700 6. In the above account, the market value drops to $20,000, how is SMA affected? A. Stays the same B. Increase C. Decrease D. None of the above 7. In the same account as above, what is the buying power? A. $4,700 B. $9,400 C. $26,000 D. $17,700 8. Consider the following account: Market Value $42,000 Debit Balance $17,000 Equity $25,000 What would the market value of this account have to be in order to get a margin call? A. $20,000.12 B. $17,000.61 C. $22,666.67 D. $21,098.19 9. Client A purchases 1000 shares of a $7 stock on margin and deposits the $3,500 initial requirement. The stock is no longer marginable under $5. The stock moves to $4.50 and the account looks like this: Market Value Debit Balance Equity

$4,500 $3,500 $1,500

How much must be deposited to bring this account to maintenance requirement? A. $2,000 B. $1,125 C. $3,500 D. $4,500


10. Client B receives a margin call for $4,000. How much in marginable securities must he deposit to satisfy the call? A. $4,000 B. $8,000 C. He must deposit cash D. None of the Above

Answers: 1) A 2) D 3) C 4) A 5) D 6) A 7) B 8) C 9) C 10) B



tutorial 3, these are the topics we will discuss:

I. Corporate Bonds II. Types of Bonds III.Secured and Unsecured IV.Types of Secured Bonds V. Types of Unsecured Bonds VI.Maturity VII.Features of Bonds VIII.Priority of Claims IX.Bond Ratios and Calculations X. Accrued Interest XI.Suitability of Bonds


Corporate Bonds While corporations issue stock as equity securities, they also issue bonds as debt securities. The owners of such bonds are in reality loaning the corporation money and thus become creditors of the corporation. As with any loan, the corporation promises to pay back the principal on a specific date in the future and in addition, they will make regular interest payments on the principal. The date that the principal is due is called the maturity date and is normally due and payable semiannually at a stated rate of interest. This stated rate of interest is the coupon or nominal rate. The interest paid to the bondholders is taxable as ordinary income. The standard denomination or par value for a bond is $1,000. So, if you have $10,000 worth of face value in bonds, you have 10 bonds. Bonds are usually considered less risky than equity securities. The reason for this is that a corporation is obligated to pay the principal and interest according to schedule unlike stock where there is no legal obligation to pay dividends. Because bond interest is paid before stock dividends, bonds are called Senior securities and common stock is called Junior securities. Many investors buy bonds of a company which has declared bankruptcy (or suspended interest payment) in order to take advantage of market fluctuations. Bonds which pay no interest, but continue to trade (buying and selling of the security) are “trading flat� and trade without accrued interest. This type of trading is highly speculative. Types of Bonds There are many classifications of bonds including secured, unsecured, registered, bearer, etc. Issuance Fully Registered-The principal and interest are registered in the owner's name on the certificate and the transfer book. Only the registered owner can receive the scheduled payments and principal when due. When the bond's ownership changes through sales or transfer, the transfer agent will cancel the old certificate and issue a new one. This is the most common type of bond. Registered to Principal-The owner's name is registered only on the company's books. The bond is issue with interest coupons, which must be sent in to receive payment. When the owner is due to receive an interest payment, he must clip the appropriate interest coupon and send it to the paying agent. In the case of ownership transfer, new certificates do not need to be issued because the bond has no name on it. The transfer agent will record the name of the new owner. The new owner will need to send in the interest coupons when they are due;the principal will be paid to the name that appears on the books at the time of maturity.


Bearer-these are also known as Coupon Bonds. There is no indication or reference to the bondholder on the certificate or on the books of the corporation. The bonds come with interest payment coupons attached, which must be clipped in order to receive payment. Principal is paid to the bearer of the certificate upon maturity. Bearer bonds have not been issued for many years and as the name implies the principal is paid to the bearer of the bond. The investor must present proof of ownership. Secured and Unsecured A secured bond is backed by the real assets which are owned by the corporation. In the event that the company should default, the creditor can claim the assets securing the bond. In opposition is the unsecured bond which is not backed by any specific assets. Types of Secured Bonds First Mortgage Bonds (or senior lien) give the bondholder a claim against property under a first mortgage. These are generally considered to be the most secure corporate bond investment. Second Mortgage Bonds (or junior lien) give the holder a claim against property under a second mortgage. These two bonds have a subdivision. An open-end mortgage bond allows the corporation to issue additional bonds with the same class at some later, unspecified date. If the corporation issued new securities in the same class, the would be secured by the same assets collateralized in the initial issue. This obviously would dilute the protection the first mortgage holders previously had, since these bonds have an equal claim. A closed end mortgage bond would offer greater protection. This type of mortgage bond would indicate the maximum amount of debt which could be incurred under the indenture. Any issues subsequent to the initial one would be classified as second or third mortgage bonds. Types of Unsecured Bonds Debentures-These bonds are backed by the general good credit of the company issuing the bond and not by any hard assets. Investors tend to act on their faith in the company's ability to buy the bond back. Debentures are usually issued by large, well established companies. Subordinated Debentures-Subordinate debentures have claims to interest and principal which are subordinated to ordinary debentures or to other corporate debt obligations. These bonds are less safe than ordinary debentures, but they usually have a higher yield. Income Bonds-Income bonds promise to pay principal at maturity. However, interest is contingent on earnings. Therefore, since the issuer is not promising to pay any accrued interest, the bonds normally offer higher interest rates.


Maturity Term Bonds-An offering in which the entire issue matures at the same time on some future date. These bonds are often callable prior to the maturity date. As such, these bonds often have a sinking fund to provide for bond retirement. Serial Bonds-Will mature in a successive number of years. For instance, an offering of bonds issued in 1990 which will mature in parts in 2018, 2019, and 2020 is a serial maturity. Balloon Maturity Bonds-Are basically serial bonds in which the larger portion of the issue matures in the last year. As an example, an issue which matures 100 in 2017, 100 in 2018 and 1000 in 2019. Features of Bonds Multiple Currency Bonds-Are issued by both foreign and US corporations that have subsidiaries in foreign countries. This feature gives the investor the option of receiving principal payment in either US dollars or foreign currency. Zero Coupon Bonds-Are regular bonds which pay no coupon interest over the life of the bond issue. Instead, they are purchased by the investor at a deep discount (IE: $1000 face value purchased for $400). The bonds then mature at par. The compounded annualized yield is the difference between the original issue discount price and par. Guaranteed Bonds-Either the principal, interest, or both are guaranteed against default for a corporation by someone other than the issuing company. If the issuer should default, the guaranteeing company would then assume the obligation. Callable Bond-This feature gives the corporation the option of calling (retiring) a bond prior to the maturity date. The corporation might wish to call an issue if the board wants to reduce outstanding debt, or if the bond was issued with terms that the corporation feels were unfavorable. This process compares with refinancing, a high interest mortgage and is known as “refunding�. Refunding is used by issuers when interest rates are falling. Bonds are usually called at a premium. This means that the investor will receive more than par value when they turn their bond in. The specific amount above par is referred to as the call price. The premium paid for called issues will usually be reduced as the issue approaches maturity. When bonds have been called, interest is no longer payable. Investors that buy callable bonds have call risk. They may lose the interest payment if the bond is called. Convertible Bonds-These bonds can be converted into common stock of the issuer. The choice to do this is with the holder. This gives the holder the potential of large profits if the underlying stock makes a large upward move.


Priority of Claims Bondholders are creditors of the corporation, and therefore have priority over equity owners in the event of corporate liquidation. 1.Wages 2.Taxes 3.Secured Bondholders 4.General Creditors 5.Unsecured Bondholders (debentures having priority over subordinated debentures) 6.Subordinate Debentures 7.Preferred Stockholders 8.Common Stockholders Bond Ratios and Calculation Pricing- Quotes on bonds are expressed as a percentage of par value. Corporate bonds, like stocks price fractions are quoted in 1/8s. So, a bond quote of 97 means that the bond is trading at $970, or 97% of price under par is noted as Discount;any price above is Premium. Calculating the price with a fraction is just a little bit different. In order to determine the price of a bond quoted at 97 3/8, you must do the following: a. To convert the fraction to it's decimal point equivalent. In this case, it is .3750, and the bond price can be expressed as 97.3750. b. The next step is to move the decimal over one space to the right. This now gives you the correct market (or dollar value) of $973.75 per bond. Stated Yield (nominal yield)-This is the interest rate stated on the bond. So, an ABC Corp. 7 他% due 3-1-98 has a stated yield of 7 他%. This is the same as the Coupon Rate. Nominal Yield= Dollar amount of annual interest/Par value Current Yield-This is the actual, current yield based on the market value of the bond. The current yield is calculated by dividing the stated interest amount (the actual dollar figure, not the percentage) by the current market price. Using the same market value as shown above, our bond has a current yield of 7.96% Stated interest amount $77.50 (7 他 in decimal form is 7.75) divided by market price $973.75 = 7.958% Current Yield= Stated Interest Amount/Bond Market Price


Yield to Maturity-A bond held to term will mature at $1,000. Figuring YTM takes into account not only the current market price, but the fact that a bond purchased at a discount (less than par) will realize a gain, and one purchased at a premium (over par) will show a loss at maturity. YTM is calculated by dividing the average value of the bond into it's net return. YTM= Stated interest $ + Accretion of discounts, or - Amortization of premium/average bond value To find the average value of the bond, add the redemption price to the purchase price and divide by 2. Let's presume that the investor paid a premium for this bond, and bought it at $1,100. The bond will mature in 10 years. The average value is $1050 ($1100 + 1000 divided by 2 = $1050). Average Bond Price= Present Price + Par Value/2 Next, take the net return by taking the coupon amount $77.50 and adding or subtracting the annual accretion. In this case, the investor is losing $100 over a 10 year period. This comes to an annual loss of $10. This makes the net return $67.50 ($77.50 interest minus $10 annual loss) So, the calculation is: $67.50 (net return) divided by $1050 (avg value) = 6.43% (YTM) Yield to Call is calculated the same way as YTM. Substitute the maturity price of $1,000 with the call price. Accrued Interest As noted earlier, bonds pay interest on a semiannual basis. The owner of a bond is entitled to receive interest for the entire period that the bond is held. If the bond is traded in between those two annual payments, the seller is paid his accrued interest by the buyer of the bond. The buyer would then receive the interest payment for the entire six month period. As you can see, each investor gets the full amount they are entitled to: The buyer gets the full semiannual interest payment, and for his/her records, subtracts the amount paid to the seller. To determine the amount of interest owed to the seller, the semiannual payment must be pro rated over the time that the seller held the investment. A bond that pays $80 per year will make a $40 disbursement twice yearly. A standard 30 day month/360 day year is used to calculate interest on corporate bonds. The seller is entitled to receive payment up to, but not including trade settlement date. As an example, a bond pays interest on January 15th and July 15th. The bond is sold on March 15th, and the trade settles on March 18th. The seller is entitled to interest from the interest payment date up to, but not including the settlement date. Interest begins


accruing the morning of January 15th, the last payment date. So, the seller is owed interest for 63 days (remember to give each month 30 days, 16 days January, 30 days February, and 17 days in March= 63 days). Our seller is owed $14.00, which is the annual payment divided by 180 days times the number of days interest is owned. Suitability of Bonds Bonds are normally used by investors who need stable income at higher yields than are provided by bank interest and similar instruments. Corporate bonds of large, stable companies are an example of this type of investment. The market value does not move much and the interest is paid on time. Bonds can also be used for growth and even speculation in the case of junk bonds. Junk bonds are debt issues of corporations with bad credit ratings and often are companies in bankruptcy. The investor is speculating on the company's turnaround and thus a higher market value for the bonds.

Q&A 1.What is the Yield to Maturity of a corporate bond selling at 90, has a stated yield of 8% and matures in 10 years? A. 9.47% B. 7.5% C. 8.10% D. 92% 2.A sinking fund is a capital reserve used to: A. Retire Bonds B. Pay dividends on preferred stock C. Pay for executive stock options D. None of the above 3. The type of corporate bond which does not pay interest unless the company has earnings is: A. Subordinated Debentures B. Convertible C. Indentured Trusts D. Income Bonds 4.To calculate current yield on a corporate bond, divide the nominal yield dollar amount by: A. Bond market price


B. Bond coupon rate C. Average yearly value of bond D. None of the above 5.ABC Corporation is in liquidation. It will pay claims against assets in which order? A. Common stockholders, taxes, bondholders B. Wages, taxes, secured bondholders C. General creditors, wages, preferred stock D. A and B 6.Bonds purchased at a price over $1,000 are: A. Purchased at a premium B. A bad investment C. Over priced D. Lower Yielding 7.A bond quoted at 96 has a market value of: A. $960 B. $96 C. $1090 D. None of the above 8.All of the following are secured bonds except: I. Collateral Trust Bond II. Debenture III.Income Bond IV.Junior Lien Bond A. III only B. I and IV C. II and III D. All are secured bonds 9.XXX Corporation has issued $100 million 8% bonds at a premium having a current yield of 7% and a yield to maturity of 6%. An investor purchasing $2,000,000 face value worth of bonds at the offering will receive an annual income of:

A. $80,000 B. $160,000 C. $40,000 D. None of the above


10.A 10% bond maturing in 5 years is currently selling in the market at 90 ($900). The current yield is: A. 7% B. 4% C. 11% D. 6.25%

Answers 1) A 2) A 3) D 4) A 5) B 6) A 7) A 8) C 9) B10) C



tutorial 4, these are the topics we will discuss:

I. Municipal Securities II. Tax Exemption III.Maturities and Interest IV.Calculations V. Types of Municipal Securities VI.Features of Municipal Bonds VII.Forms of Issuance VIII.Sources of Information on Municipal Securities IX.Evaluating Municipal Securities


Municipal Securities Municipal securities are debt obligations, both bonds and notes, issued by states, territories (such as Puerto Rico), political subdivisions (such as counties and cities), special districts (schools, water works, sewer systems, etc) and public agencies such as authorities and commissions. United States government securities are NOT municipal securities. They are issued to obtain funds to build or repair facilites such as streets, bridges, water works, power generating facilities and schools, or to meet other needs of the municipality. As with other debt securities, the issuer agrees to pay interest semiannually and to repay the principal at maturity. Municipal securities are exempt from the filing provisions of the Securities Act of 1933 and are therefore not registered with the SEC. Tax Exemption The interest received on municipal bonds is exempt from Federal income tax, however, the interest may be subject to state and local taxes. (the opposite is true with respect to US government securities, where the interest is exempt from state and local income taxes, but is subject to Federal income tax). This means the Federal Government cannot tax local government, and the local government cannot tax the Federal government. This principal of reciprocal immunity from taxation stems from the dual levels of government in the United States and, while not in the constitution, has been upheld by the Supreme Court several times. Most states will exempt the interest on bonds issued by political entities within their state, thus making these bonds “triple tax exempt” for residents of that state. For example, if a California resident purchases municipal bonds issued in California, the interest is exempt from Federal, state and local income taxes. If the same investor purchases the bonds issued in another state, such as NY, he or she is liable for California state and local income taxes on the interest. Bonds issued by a commonwealth, territory or possession of the United States, such as the Commonwealth of Puerto Rico, US Virgin Islands or Guam are not subject to federal, state or local income taxes. They are therefore “triple tax exempt”. Please note that although interest on municipal securities is exempt from federal tax, and may be exempt from state and local taxes, any capital gain resulting from sale or redemption is subject to applicable taxes at the federal, state and local levels.


Maturities and Interest Like other bonds previously discussed, municipal bonds have either short term or serial maturities. Term Bonds-The entire issue matures at the same time. These are often used on projects with uncertain revenues, because none of the bonds are short term. Serial Bonds-The issue matures over a period of several years. Serial maturities are often used for projects with a steady income stream. Serial bonds are quoted based on their yield to maturity. This is also called a basis quote. Serial Bonds with balloon maturities-are those where the largest number of bonds mature in a single year, known as the balloon year. The coupon rate, nominal rate, or stated interest rate, is shown on the face of a bond certificate as a percentage of par value. Par value for municipal bonds is $1,000.00. Interest on municipal bonds is paid semiannually, and payable dates are shown on the certificate. The maturity date (the date on which the principal must be repaid) is also stated on the face of the bond. Bonds in default trade without accrued interest, and are said to be “trading flat”. Other bonds include: zeroes, and income or adjustment bonds, which pay interest only if earned. Calculations The following terms are used in quoting prices and yields on municipal securities. Point: 1.0% (.01) of par value, or $10.00 Basis Point: 1/100th of 1%, or .01% (ie: the difference between a 4.25% yield and a 4.35% yield is 10 basis points). 100 basis points equal 1% Municipal bond prices-Most municipal bonds are serial bonds and are quoted on a “yield to maturity” (YTM) basis. (Remember, corporate bonds, which are usually term bonds, are quoted as a percentage of par value). Because of the difficulty in converting a YTM quote to a dollar amount, a basis book is often used. The basis book contains tables showing the dollar price of bonds given the specific coupon rate, years to maturity and yield to maturity. Original Issue Discounts (OID's)-If a bond is sold at a discount from face value on it's initial offering, the tax code requires that the discount be treated as interest income over the life of the bond. According to the 1983 Tax Equity and Fiscal Responsibility Act (TEFRA), original issue discount municipal bonds must be accrued on an economic accrual basis, as are zero coupon corporate bonds.


When original issue discount municipal bonds are traded in the secondary market, the cost basis increases incrementally each year. EX: A 10 year bond, issued at $600, is purchased in year 2. Amount of discount = $400 Life of Bond = 10 years $400/10 = $40 per year Interest income is $40 per year. Cost basis in year 2 is $680 If a municipal bond is originally issued at a premium, the premium must be amortized over the life of the bond. Municipal Bond Yields-Current yield, yield to maturity and yield to call for municipal bonds are calculated using the same methods that are used for corporate securities. Accrued interest for municipal bonds is calculated using a 360 day year and 30 days per month (the same method as corporate bonds). The settlement date for municipal transactions is regular way, which is trade date plus 3 business days (T+3). Taxable Equivalent Yields-Because the interest on municipal bonds is free from Federal income tax, corporate bond yields must be considered on an after-tax basis to make a valid comparison. Municipal Yield = Taxable Yield x (100% - Tax Bracket) To find the equivalent yield for a municipal bond given a taxable yield: Municipal Yield = Taxable Yield x (100% - tax bracket) EX: A corporate bond yields 10%. What is the equivalent municipal yield for a single investor in the 28% tax bracket.? Answer: Municipal Yield = 10% x (100% - 28%) = 10% x .72 = 7.2% Municipal Yield


To find the equivalent yield for a corporate bond given a municipal bond yield: Corporate Yield = Municipal Yield / (100% - tax bracket) Example: A municipal bond yields 7.2%. What is the equivalent corporate yield for an investor in a 28% tax bracket? Answer: Corporate Yield = 7.2% / (100% - 28) = 7.2% / .7 = 10% corporate yield This yield comparison is the most important aspect in determining whether Municipal bonds are appropriate investments. They are more beneficial to investors in higher tax brackets, because the tax exempt status increases their yield. Let's give an example of an investor in a 39.6% tax bracket: A municipal bond is paying 5%. An investor is trying to compare the yield of the municipal to a corporate bond paying 7.5% to see which gives him a better net return. To find the equivalent corporate bond yield: Corporate Yield = 5% / (100-39.6) = 5%/.604 = 8.28% So, you can see that the investor in this tax bracket would actually have a higher yield with the 5% municipal bond than the 7.5% corporate bond. Let's do the same comparison to someone in the 28% tax bracket: Corporate Yield = 5% / (100-28) = 5%/.72 = 6.94% So, this investor would have a higher yield with the 7.5% corporate bond. You can clearly see the impact of the tax bracket on municipal bonds. This is why they are most suitable for investors with high income. Types of Municipal Securities General Obligations (GO's) General obligation bonds are backed by the full faith and credit of the issuing municipality (ie: state, county, etc.) GO's are not issued for a single, specific purpose or project, but for the general needs of the municipality. They are backed by the issuer's general taxing powers. At the state level, income taxes and sales taxes collected back municipal issues. At the local level, “ad valorem� or property taxes back the municipal issues.


Unlimited tax bonds are backed by an issuer with no limitations on it's taxing powers. Taxes can always be raised to make payments on these bonds. Limited tax bonds are those where the issuer's taxing power is limited to a specific maximum tax rate. Limits may be placed on any type of tax, such as property, sales, income or gasoline, and could potentially inhibit the issuer's ability to pay off the bonds. States or municipalities may place limitations on the issuance of General Obligation bonds. A maximum dollar amount may be placed on debt issues, or voter approval may be required for each new issue. Revenue Bonds Revenue bonds are issued to fund a specific municipal project, such as an airport, power facility or toll bridge. Interest and principal are paid with the fees, rent or tolls generated by the project. Revenue bonds are intended to be “self-supporting”, no limitations are placed on the amount of bonds sold. General obligations are considered safer than revenue bonds because of their backing. The following are types of revenue bonds: Special tax bonds-are payable only from the proceeds of a special tax, such as highway revenue bonds payable from gasoline tax. Other special taxes include: tobacco, liquor, hotel/motel and business license taxes. Special assessment bonds-are payable only from an assessment on those who directly benefit from the facility. For example, if a new sewer system is built, residents of the community where it is located are taxed. Features of Municipal Bonds A “Call Feature” allows the issuer to redeem the bonds prior to maturity. The issuer may benefit from a call feature in a number of ways. The issuer can reduce it's debt when it chooses by calling part or all of the issue. The issuer can eliminate bonds with unfavorable provisions, or restructure it's debt by replacing short term with long term maturities. (or vice-versa). The issuer can take advantage of declining interest rates by replacing a high coupon issue with a new issue at a lower rate. For investor protection, bonds usually can not be called for five to ten years from the date of the issue, (called the “call protection period”) and are often callable at a premium. Call features can be optional or mandatory. The specifics and procedures for calling the bonds are clearly defined at the time of the issue. When bonds are called, a notice must appear in both local and national publications. The announcement must be made 30 days prior to the call date and must give details of redemption procedures for bondholders to follow.


Calling part of an issue is usually done with surplus funds. Calling an entire issue is usually done by means of a refunding issue. Refunding is the replacement of a maturing bond issue with a new bond issue. When an issuer retires outstanding bonds, either to reduce interest expense or eliminate unfavorable provisions, it may sell a new issue of refunding bonds. The proceeds of the refunding issue are used to purchase securities which will eventually be used to retire the outstanding issue. The outstanding issues is then referred to as “being refunded”. If the issue being refunded is callable, it will be retired at the call date. If it is noncallable, the proceeds of the refunding issue are placed in an escrow account and invested in government backed securities to retire the bonds at the stated maturity date. This is known as “prerefunding”, also called “defeased” and are rated AAA. If a municipality issues bonds without a call provisions, it may make a tender offer for these bonds. The tender offer is published in the appropraite media and interested bondholders may tender their bonds for payment at t he price offered by he municipality. Bond Trust Indenture A trust indenture is not required for municipal bonds as it is for corporate bonds. However, the bonds are more marketable if a trust indenture is included. Revenue bonds almost always have a trust indenture to protect the bondholder. The following are specific covenants of a trust indenture. The Rate Covenant is a promise to maintain rates charged for use of the facility at a level sufficient to meet expenses and debt service and to provide reserve funds. The Insurance Covenant is a promise to carry adequate insurance on any facilities constructed with the proceeds of the bond issue. The Maintenance Covenant is a promise to maintain the facilities in good working order. Feasibility Studies are conducted to indicate that the facilities built will be financially self sustaining. Financial Reports and Audit Reports insure that an accounting firm will be retained to conduct independent audits and that proper accounting records will be kept. Issuance of Additional Bonds. This clause states whether there is an open end indenture, meaning that additional bonds may be issued for the same purposes in the future, or a closedend indenture, which states that additional bonds may not be issued. In the Nondiscrimination Covenant, the issuer promises not to grant special usage rates to any person or group.


In addition, the trust indenture spells out how revenues produced by the facility are to be used. The manner in which revenues are spent is known as the “flow of funds�. The flow of funds can be based on a gross revenue pledge or a net revenue pledge. The net revenue pledge is more common, and the typical order of priority is as follows. Operation and Maintenance Fund. This is used to meet the costs of operating and maintaining the project. Debt Service Account. This is equal to one year's worth of principal and interest. Debt Service Reserve Fund. These are funds in excess of the current year interest and principal obligations. Reserve Maintenance Fund. This fund is used to meet extraordinary maintenance costs. Replacement Fund. This is used to replace equipment as it wears out. Sinking Fund. This fund is used to retire bonds. Surplus Fund. This is used for emergencies not provided for by the reserve maintenance fund. The gross revenue pledge pays debt service expense from gross revenues. Operations and maintenance are paid from net revenues. Physical Securities-Until 1983, most municipals were issued as bearer, or coupon securities. However, as a result of the TEFRA legislation, new municipals issued after July 1, 1983 with maturities of more than one year may only be held in registered or book entry form. Forms of Issuance Fully Registered municipal bonds are registered as to both principal and interest. The name, address and tax id number of the bondholder is on record with the municipality, which forwards semiannual interest payments directly. Municipal bonds registered as to principal only have interest coupons attached to the bond. The bondholder's identity is on record with the municipality, however, semiannual interest payments are made when the holder sends in the coupon or redeems it at a bank. Bearer Bonds are also referred to as coupon or unregistered bonds. The bondholder's identity is not recorded by the municipality;whoever holds the bond (bearer) is considered to be the owner. These bonds have coupons to be redeemed for semiannual interest payments. Good Delivery-A bond in good delivery form is readily negotiable and transferable. For a coupon bond to be good delivery, all remaining coupons must be attached to the bond. If a municipal bond has defaulted (missed interest payments), the coupons for interest in


arrears must still be attached. For good delivery, a municipal bond certificate must show the name of the issuer, par value, coupon rate and maturity date. It must also bear the signature of an official, seal of the issuer, legal opinion and certificate number. Sources of Information on Municipal Securities The following are the most widely used publications covering the municipal securities markets. The Daily Bond Buyer-This municipal industry newspaper contains articles pertaining to both the municipals market and the financial community in general. It also publishes notices of sale, call notices, a new issue calendar and the other pertinent announcements. The Daily Bond Buyer compiles a variety of statistics relating to the municipals market. The Bond Buyer Index (BBI) is a leading indicator of the movement of yields. The BBI, calculated each Thursday, is the average yield on twenty selected general obligation issues with 20 year maturities. The issues are rated from Baa to Aaa, with an average rating of A. The Eleven Bond Index is the average yield on the 11 highest rated bonds in the BBI. The average rating of these bonds is Aa. The Bond Buyer also computes a Revenue Bond Index, which is the average yield on 25 specific revenue bonds with 30 year maturities. The Bond Buyer Placement Ratio is compiled at the close of business each Friday. The ratio represents the dollar amount of bonds sold weekly compared to the dollar amount of new issues available. The 30-Day Visible Supply is compiled daily based on the Bond Buyer's sealed bids invited and proposed negotiated offerings sections. It reflects the total dollar volume of bond issues expected within the next thirty days. Notes with maturities of 13 months or longer are included in the 30 day visible supply. The Blue List is a daily publication of Standard and Poors Corporations. Published since 1935 on blue paper, it contains secondary market, inter-dealer offerings of municipals that dealers are holding in inventory and offering for sale. The Blue List contains approximately 60 to 70 percent of the total dollar volume of secondary issues beig offered. The Blue List volume (stated in par value) is often used as an indicator if the current supply of municipal bonds. The Blue List also includes delivery dates of primary issues. Munifacts is a wire service used by many municipal dealers. Current news items pertaining to the municipals market and the financial community in general appear on munifacts throughout the day. Current municipal offerings are listed, as well as information from the Daily Bond Buyer.


Evaluating Municipal Securities Bond Rating Services The two largest rating services for municipal bonds are Moody's and Standard and Poor's (S&P); both companies also rate corporate debt. An issuer must request and pay for an analysis and rating of it's issue. Once Moody's and/or S&P assigns a rating, they will periodically review it and may raise or lower it based on changes in the issuer's financial situation or other new developments. Both services assess the risk of default in their ratings. The ratings scales used are: S&P AAA -The highest debt rating assigned. Borrower's capacity to repay is extremely strong. AACapacity to repay is strong and differs from the highest rating only in a small degree. A-Has strong capacity to repay; however, borrower is somewhat susceptable to adverse effects of changes in circumstances and economic conditions. BBB-Has adequate capacity to repay, but adverse economic conditions or circumstances are more likely to lead to risk. BB, B, CCC, CC-These are regarded, on balance, as predominantly speculative. B indicates the lowest degree of speculation and CC the highest. C-Reserved for income bonds on which no interest is paid D-In default or payments are in arrears. Moody's Aaa-Judged to be of the best quality with small degree of risk. Aa-High quality, but rated lower than Aaa because margin of protection may not be as large or because there may be other elements of long term risk. A-Bonds possess favorable investment attributes, but may be susceptible to risk in the future. Baa-Neither highly protected nor poorly secured. Payment capability is adequate. Ba-Judged to have speculative elements, and future cannot be considered well assured. B-Bonds generally lack characteristics of a desirable investment. Assurance of payment may be small.


Caa-Poor standing and may be in default or have elements of danger. CaSpeculative to a high degree. Issues often in default. C-Highly speculative. Often in default. The rating's are used to determine credit worthiness and just like when an individual has a good or bad credit rating and must pay more or less in interest on a loan due to it, so must a corporation pay a higher interest rate to investors when their rating is lower and less when it's higher. Insured Bonds There are a number of insurance companies or groups that currently insure new municipal issues. They guarantee interest and principal payments should the issuer fail to pay for any reason. The two oldest are the American Municipal Bond Assurance Corporation (AMBAC) and the Municipal Bond Insurance Association (MBIA). The objective of insurance is to lower the interest cost to the issuer by giving bonds a higher rating. S&P assigns an automatic AAA rating to all insured issues. Moody's assigns an Aaa rating to all issues insured by MBIA.

Q&A 1.Interest is “triple exempt� for which of the following bonds? (assume the investor is an Arizona resident). A. State of California G.O. B. Arizona Public Services Corp. C. US Treasury Notes D. Commonwealth of Puerto Rico 2. An issue of City of San Francisco Toll Bridge Revenue Bonds would be backed by: A. The full faith and credit of the city of San Francisco B. Revenue earned from tolls C. The Toll Bridge Authority D. Special taxes assessed on California residents 3. Municipal bonds would be least attractive to: A. a corporation in a 40% tax bracket B. a pension fund C. an individual who has just won a $5,000,000 state lottery


D. an unmarried attorney earning $150,000 per year 4.On a bond, one point is equal to: A. $.10 B. $1.00 C. $10.00 D. $100.00 5. Accrued interest on a municipal bond is computed using: A. 360-day year, 30-day month B. 365-day year, 30-day month C. 360-day year, actual days per month D. 365-day year, actual days per month 6. An investor in the 28% tax bracket can buy a municipal bond yielding 5.76%. What would be the equivalent yield for a corporate bond? A. 9% B. 8% C. 5.76% D. 11.52% 7. A client in a 35% tax bracket owns a 13% corporate bond. What would be the equivalent yield for a municipal? A. 4.55% B. 6.50% C. 8.45% D. 9.36% 8. What is the yield to maturity for a municipal bond purchased at 85, with a 5% coupon maturing in 10 years? A. 5.40% B. 5.88% C. 7.03% D. 7.65% 9. Which of the following corporate securities is similar to a general obligation bond? A. Debenture B. Convertible C. Zero Coupon D. Project Note


10. A double barreled municipal bond is: A. Backed by the revenue from a project B. An obligation of the federal government C. An obligation of the local or state government D. Both A and C

Answers: 1) D 2) B 3) B 4) C 5) A 6) B 7) C 8)C 9) A 10) D


U.S. Government & Money Market Securities-TUTORIAL 5 In

tutorial 5, these are the topics we will discuss:

V. US Government Securities VI.Marketable Government Securities VII.Treasury Bills VIII.Treasury Notes IX.Treasury Bonds X. Trade Settlement and Accrued Interest XI.GNMA XII.Government Sponsored Agency Securities XIII.FNMA XIV.Freddie Mac XV.Federal Farm Credit Association XVI.FICB XVII.FLB XVIII.Sallie Mac XIX.Nonmarketable Government Securities XX.Series EE Bonds XXI.Series HH Bonds XXII.Money Market Instruments XXIII.Suitability of Government Securities


US Government Securities Government securities and money market instruments are major components of the US financial system. They are the most widely owned types of securities among individual and institutional investors, and carry the lowest levels of investment risk. US Government securities, which consist of bills, notes and bonds are a significant source of financing for the US treasury. Various government agencies also issue debt securities, making credit available to such important segments of the economy as agriculture and housing. The US money market includes short term government and agency obligations as well as various other debt instruments with maturities of less than one year. Billions of dollars in transactions take place in the money market each business day. It is a wholesale market for low risk, highly liquid short-term securities. While these securities are traded in large denominations, generally $100,000 or more, small investors participate indirectly in money market funds. The US government raises money through debt offerings in order to meet expenses and finance the budget deficit. It issues both marketable and nonmarketable securities with maturities ranging from three months to 35 years. Once issued, after market trading of US government securities is handled by brokers and dealers in the over the counter market. Government securities are backed by the full faith and credit of the federal governement. Because the government has unlimited taxing power, it can always raise taxes to finance it's debts. The US government has never defaulted on it's securities. Government securities (also known as treasury securities), are considered virtually risk-free, with the highest possible credit ratings. They are also highly liquid investments with an active secondary market for all types of issues. While their interest is lower than corporate fixed income securities, the interest on government securities is exempt from state and local taxes. It is, however, fully taxable at the federal level. Capital gains on government securities are subject to all applicable taxes. Marketable US government securities are traded in the primary market between the Federal Reserve System and several firms designated as primary dealers. These are large commercial banks and securities dealers which maintain a high level of activity in the government securities market. These dealers trade securities with each other, as well as with the public. Their transaction are generally made with very large accounts, such as banks, corporations and insurance companies. Many other commercial banks and securities firms not designated as primary dealers handle government securities transactions in the secondary market.






Treasury Bills US treasury bills, referred to as T-bills, are the government's shortest term maturity. T bills are sold in minimum denominations of $10,000. Most mature in three months. (91 days). The treasury also issues six month bills (182 days), and those with maturities of one year. Because of the short time to maturity, the government does not send interest payments to investors who own treasury bills. Instead, the bills are sold at a discount from face value (par). The difference between the discount price and face value is the interest. Example: Face value upon maturity: Price paid for 91-day bill: Interest earned:

$10,000 $ 9,800 $200

Holders of treasury bills do not receive certificates, bills are issued in book entry form only. When treasury bills mature and an investor instructs his broker or bank to reinvest the proceeds in new bills, the investor is said to be “rolling over” his t-bills. When the government issues treasury bills, they are sold at auction by competitive bid. Three and six month bills are auctioned each Monday; nine and twelve month bills are auctioned monthly. Primary dealers submit their competitive bids to the Federal Reserve. The winning bid represents the highest dollar price, or lowest interest cost for the issue. To service small investors, the Fed also accepts “noncompetitive” bids for amounts up to $1,000,000 per investor, per auction. A person submitting a noncompetitive bid may purchase bills at a price equal to the average of the competitive bids accepted by the treasury. Since competitive bids are generally made within a very narrow range, non competitive bids are very fair in price. Unlike other government securities, treasury bills are quoted on a discounted yield to maturity basis. The yields quoted are annualized. T-bill quotes are shown as follows: Example: Bid 7.33

Asked 7.29

Yield 7.54

The bid is numerically higher than the ask price, because the higher the yield, the lower the dollar price. Discount yield differs from current yield, and is calculated using a 360day year as follows: Discount Yield = Par - Purchase Price/100 X 360/Days to maturity


When quoting the yield on a treasury bill, a basis point is equal to .01%, or $.10. To calculate the discount yield of a six month bill purchased for $9,400, the purchase price and days to maturity are used as shown below: Example: Discount Yield: $10,000 - $9,400/100 X


= 11.87% To calculate the current yield, the amount of interest (par value less purchase price) is divided by the purchase price. In the above example, the difference between par value ad the price paid for the bill is $600 for six months. The current yield must be expressed as an annualized figure so $1,200 is used as the amount of interest that would be earned on the bill in one year. Current Yield = Annual Interest/Purchase Price Example: $1,200/$9,400 = 12.77% Treasury Notes US Treasury notes are interest bearing, medium-term debt obligations. Like t-bills, treasury notes are sold on an auction basis. Their maturities range from one to ten years. They are issued with par value of $1,000 and carry a fixed rate of interest paid semiannually. Because of their longer maturities, treasury notes carry a greater amount of interest rate risk than t-bills. Interest rate risk is the risk of a decline in the market value of a fixed income security, due to a rise in interest rates. For example, if you are holding a 7% note and interest rates rise to 7.5%, then your note will be worth less in the market, because an investor can buy a new note at 7.5%. Treasury notes are issued, quoted and traded based on a percentage of par value, as are corporate notes, debentures and bonds. However, US government securities (with the exception of t-bills) are quoted in 1/32's, not 1/8's like corporate debt securities. Example: Bid 99.8

Ask 99.16


99.8 = 99-8/32, or 99 ¼ = $992.50 99.16 = 99-16/32, or 99 ½ = $995.00 Coupon (nominal) yield, current yield, and yield to maturity for treasury securities are calculated using the same methods as for corporate bonds, t-bills are an exception. Treasury Bonds US Treasury Bonds are long term debt obligations. Their maturities usually range from ten to 35 years, and they may be callable. Treasury bonds are sold at auction in a manner similar to t-bills and notes. Like notes, treasury bonds pay a fixed rate of interest semiannually and have a par value of $1,000. A round lot is five bonds ($5,000 par). Treasury bonds are traded in the same manner as notes. Like notes, they are quoted in 1/32s as a percentage of par value. The coupon rate of interest for treasury bonds has a ceiling established by congress of 41/4% with occasional exceptions. Congress allows a certain amount of bonds to be sold without this interest rate limit. Treasury bonds with coupon rates of 4-1/4% and below are sold at a discount from face value given the current level of interest rates. Zeroes-Since 1984, the US Treasury has allowed certain treasury issues to be separated into distinct principal and interest components. These securities are known as “Strips”, which separate trading of registered interest and principal of securities. “Strips” are zero coupon bonds that are backed by the full faith and credit of the US government. Brokerage firms have been allowed to create zero coupon bonds from Treasury bonds and notes. Receipts of ownership in the principal or interest payments are sold at a discount separately to investors as “Treasury Receipts”. They are not backed in full by the US government. Both Strips and Receipts may be attractive to investors since they have no reinvestment risk. Investors do not face the problem of investing income received at a comparable rate, since there is no current interest paid on zero coupons. Trade Settlement and Accrued Interest Transactions in government securities settle the day after the transaction is made. A cash settlement, the same day as the trade, can also be arranged between dealers and investors. Interest on government securities accrues up to but not including the settlement date. Accrued interest is calculated using actual days per month and a 365-day year. (this does not apply to tbills, which are sold at a discount).


Example: $10,000 in 8% US government bonds, paying interest on February 1st and August 1st, is sold on November 18th. Accrued interest due the seller would be calculated as follows: Interest per year is $800. Interest per day is computed as: $800/365 = $2.19/day (rounded) Settlement date would be November 19th. The period for which interest is owed to the seller is as follows: August September October November

31 days 30 days 31 days 18 days 110 days

(the interest payment received by the seller on August 1st covered the period from February 1st to July 31st) Accrued interest is: 110 x $2.19 = $240.90 Government National Mortgage Association (GNMA) The Government National Mortgage Association (“Ginnie Mae”) is part of the Department of Housing and Urban Development. It's purpose is to provide financing for residential housing. Securities issued by the Government National Mortgage Association are backed as to principal and interest by the full faith and credit of the US Government. Like other government backed securities, they are sold at auction. GNMA's differ from treasury obligations in that, while their yields are higher, the interest they pay is taxable at the federal, state and local levels. GNMA's are sold in minimum denominations of $25,000 and $5,000 increments thereafter. They are issues in registered form only. While GNMA issues mortgage backed securities and participation certificates, it's most popular security is the Modified Pass-Through Certificate. Modified pass-through certificates are backed by pools of Federal Housing Authority (FHA) or Veterans Administration (VA) mortgages having the same interest rate and maturity. Interest and principal payments received from homeowners each month are “passed through” to investors. GNMA guarantees monthly payments to investors whether or not mortgage payments have been collected.


While the mortgages in a GNMA pool have 25-30 year maturities, the average life of the pool is generally between 12 and 14 years due to prepayments, refinancing and foreclosures. This means that in addition to regular monthly payments of principal and interest, additional amounts of principal are returned to investors periodically. This shortens the period for which the investor is guaranteed a certain percentage return. Government Sponsored Agency Securities Several federally sponsored and regulated agencies sell securities to obtain money to lend to cooperatives and institutions, and to purchase mortgages and other loans. The agencies are privately owned, but are supervised by the federal government. Some are subject to government restrictions on the value of securities they may issue. While these agencies are sponsored by the federal government, their securities are not direct obligations of the US Government. However, they are considered to have little more risk than US Treasury securities, as the government would most likely cover them in the event of default. Government agency securities are quoted in 1/32s as a percentage of par, as are treasury securities. Most are issued in registered form. Federal National Mortgage Association (FNMA/Fannie Mae) The Federal National Mortgage Association, referred to as Fannie Mae, sells securities in order to raise money to buy insured FHA and VA residential mortgages, from lenders such as mortgage banks and savings and loans. FNMA ssues are backed by the agency's authority to borrow from the US Treasury. FNMA issues long term, noncallable debentures and short term notes. The notes are issued at a discount to face value. Interest paid is fully taxable. FNMA is a publicly held company and it's common stock is traded on the NYSE. Federal Home Loan Banks (FHLB/Freddie Mac) The 12 Federal Home Loan Banks are owned by savings and loan institutions, and are supervised by the Federal Home Loan Bank Board. The banks buy mortgages from savings and loans, which in turn lend the funds on new mortgages. The Federal Home Loan Banks issue short term notes maturing in 30 to 270 days, which are sold at a discount. FHLB also issues interest bearing notes and bonds. The bonds mature in one to 20 years. The notes pay interest at maturity and the bonds pay interest semiannually. Interest paid on FHLB securities is fully taxable. The securities are issued in $100,000 minimum denominations, and are only available in book entry form. While FHLB securities are not backed by the US Government, the Treasury is allowed to buy up to $4 billion in FHLB issues. FHLB obligations are also secured by the assets of the 12 Federal Home Loan Banks.


Federal Farm Credit Association Banks for Cooperatives Under the supervision of the Farm Credit Association, the 13 Banks for Cooperatives (Co-Ops) make and service loans for farmers cooperatives associations, to fund handling and marketing of commodities and to finance buildings and equipment. To provide this financing, the Banks for Cooperatives issue short term debt obligations, usually maturing in six months. As an investment, Co-op notes are most popular amongst banks and state and local governments. They are sold in $5,000 minimum denominations. Co-op obligations are not guaranteed by the federal government but by the 13 banks, which are organized under federal charter and operate under government supervision. The interest paid on Co-op securities is fully taxable to the recipient under federal regulations, but exempt from state and local income taxes. Federal Intermediate Credit Banks (FICB) The 12 Federal Intermediate Credit Banks are supervised by the Farm Credit Administration. The banks provide funds to lending institutions which make short-term loans to farmers. The securities issued by Federal Intermediate Credit Banks are backed by the 12 banks, and not by the US Government. FICB securities are issued with maturities ranging from nine months (most common) to five years, in $5,000 minimum denominations. Interest paid on FICB securities is federally taxable, but is exempt from state and local income taxes. Federal Land Banks (FLB) The 12 Federal Land Banks make first mortgages on farm properties. They are also supervised by the Farm Credit Administration. As with other Farm Credit System Issues (Coops and FICB's), their securities are not backed by the US Government. They are backed by the 12 Federal Land Banks and other collateral. FLB bonds are sold in minimum denominations of $1,000 and mature in one to ten years. As with FHLB, Coops and FICB's, interest paid on FLB's is subject to federal income taxes, but exempt from state and local taxes. Student Loan Marketing Association (Sallie Mac) The Student Loan Marketing Association (non-negotiable) was established in 1992 to increase availability of money for educational loans. It is a publicly owned corporation that buys student loans from the financial institutions that originated them and repackages them for sale in the secondary market. Nonmarketable Government Securities US savings bonds were designed for individual, rather than institutional investors. US savings bonds differ from treasury bills, notes and bonds in that they are not transferable.


For this reason, there is no secondary market for savings bonds, and they cannot be used as collateral for loans. Purchase and redemption of US savings bonds is handled for the Treasury Department by various by various agents including savings and loans and commercial banks. Series EE Bonds Series EE savings bonds are appreciating securities. This means they are purchased at a discount. Investors do not receive periodic interest payments. Instead, the redemption value of Series EE bonds increases over time. The difference between the purchase price and redemption is the accumulated interest. The bonds mature to their face value. The purchase price for Series EE bonds is 50% of the face amount. For example, a $50 bond costs $25. Series EE bonds can be purchased with face amounts of $50, $75, $100, $200, $500, $1,000, $5,000 and $10,000. An individual may purchase a maximum of $30,000 face value in Series EE bonds per year. The interest on Series EE bonds purchased on or after November 1, 1983, works out to 85% of the average market yield on five year treasury securities, compounded semiannually, when the savings bonds are held for five years and ten months or longer. Bonds held at least five years are guaranteed to earn a minimum of 7.5%. Bonds redeemed less than five years from issue earn lower rates of interest. Newer Series EE bonds earn 5.5% if redeemed after one year;the rates rise gradually after that. Six months after issue, Series EE bonds may be exchanged (alone or in combination with eligible Series E bonds) for series HH bonds. The series EE bonds must have a redemption value of at least $500 to be eligible for this exchange. Series HH Bonds Series HH bonds are also nontransferable, nonmarketable and cannot be used as collateral. While they can no longer be purchased at face value, they continue to be available in exchange for Series E and/or Series EE bonds with a redemption value of $500 or more. Series HH bonds are current income bonds that sell at face value. Holders receive interest payments semiannually at the stated rate on the certificate. Series HH bonds have 10 year maturities and are issued in several denominations between $500 and $5,000. Money Market Instruments Federal Funds Due to the timing of deposits, withdrawals, and loan demands, banks periodically have either an excess or a deficit in their reserve positions. If a bank has excess reserves, it can


lend these funds to borrowers or other banks in deficit reserve positions. Loans of excess reserves among banks are called federal funds or “fed funds�. The loans are extremely short term, usually payable overnight. The rate of interest charged for use of the funds is the Federal Funds Rate. The federal funds rate is determined by supply and demand. It is a key interest rate in the money market, as the basis for other short term rates. It is the most volatile in the economy. Negotiable Certificates of Deposits (CD's) A CD is a receipt from a bank for a deposit at a stated rate of interest for a specified period of time. Principal and interest (calculated on an actual day basis using a 360 day year) are repaid at maturity. While most CD's mature within one to 12 months, there is no time limit; CS's are also issued with three and five year maturities. Denominations for CD's range from $100,000 to $1,000,000. An active secondary market exists as owners of CD's in need of cash sell them to dealers and investors. Negotiable CD's trade with accrued interest. Government Securities Treasury Bills that have began trading in the secondary market and notes or bonds within one year of maturity are considered money market instruments. Other agency issues of short term discount notes are also included. Suitability of Government Securities Generally, government securities and money market instruments are used by investors to preserve capital. They are the safest investments, however, in return, they are the lowest yielding. They are also used to keep funds liquid. Money market instruments are specifically good for keeping funds available to use as cash while earning more interest than a traditional bank savings account.


Q&A 1. A US Treasury note sells for 101.60. The dollar value of the note is: A. $101.60 B. $1,016.00 C. $1,011.25 D. $1,011.88 2. Which of the following does not pay interest every six months? A. Treasury Bills B. Treasury Notes C. Treasury Bonds D. Series HH Bonds 3. When interest rates move up or down, which would most likely have the greatest fluctuations? A. Treasury Bonds B. Treasury Bills C. Treasury Notes D. Commercial Paper 4. 50 basis points on a T-bill is equal to: A. .5% B. .05% C. .005% D. .0005% 5. What will happen to the price of outstanding bonds if interest rates declined from 10% to 8%? A. Rise B. Decline C. Remained unchanged D. It depends 6. The Federal Intermediate Credit Bank (FICB): A. Makes loans to commercial banks B. Is a publicly held company C. Makes agricultural loans to farmers D. lends money to finance residential mortgages 7. What is the purpose of Fannie Mae?


A. to buy mortgages from savings banks B. to provide a secondary market for mortgages on farm properties C. to provide a secondary market for FHA and VA insured mortgages D. to guarantee timely payment of mortgages 8. A treasury note with a bid price of $968.75 would be quoted in the Wall Street Journal as: A. 96.25 B. 96.28 C. 96.75 D. 96.87 9. What is the spread on the following government bond? Bid 98.14

Ask 98.18

A. $.40 B. $1.25 C. $4.00 D. $12.50 10. The minimum face value of US Treasury notes and bonds is: A. $100,000 B. $ 10,000 C. $5,000 D. $1,000

Answers: 1) D 2) A 3) A 4) A 5) A 6) C 7) C 8) B 9) B 10) D



In tutorial 6, these are the topics we will discuss:

I. Investment Companies II. Structure of Investment Companies III.Investment Objectives IV.Types of Mutual Funds V. Open-End Mutual Funds VI.Redemption of Open-End Fund Shares VII.Features of Open-End Funds VIII.Evaluating Mutual Funds IX.Real Estate Investment Trusts


Investment Companies

Investment companies, also called portfolio intermediaries, are regulated by the Investment Company Act of 1940. The Act defines an investment company as a corporation or trust in which investors pool their funds, in order to obtain diversification and professional management. Investment companies invest this pooled money;their shareholders' investments are represented by stocks and bonds of other companies. Investors, instead of making decisions individually or seeking the advice of a broker, give the responsibility of managing their money to an investment company. Most investment companies are organized as corporations;some have been established as trusts. A corporation is run by a board of directors, while a trust is generally supervised by a bank as trustee. There are 3 different types of Investment Companies: 1.Face Amount Certificate Companies-are relatively rare. They issue a face amount certificate which in effect is a corporate version of a zero, purchased over an installment period not less than 2 years. 2.Unit Investment Trusts-are portfolios that once established are not actively traded. They are called fixed trusts and have no investment manager or board of directors. Investors buy units which are redeemed by the trust upon request. UIT's are usually based on some investment strategy or theory. A good example is the “Dogs of the Dow�. 3.Management Companies-are actively traded and are classified as open-end or closed end as described below. Most popular mutual funds are open end management companies. Mutual fund shareholders receive two types of cash distributions: dividends and capital gains. Dividends consist of income generated by the investments in the fund. Capital gains are earned when positions in the fund are sold at a profit. Three Major Advantages: 1.Diversification-the average individual investor, with limited assets, is often unable to diversify his holdings. By pooling funds with other investors, the individual is able to purchase an interest in a diversified portfolio of securities. 2.Professional Management-Many investors lack sufficient knowledge or time to manage their own investments. By combining their assets with others in a mutual fund, they are able to secure the services of professional portfolio managers at a cost substantially lower than what each would pay individually. 3.Liquidity-Liquidity is the ability to sell an asset at a reasonably predictable price and convert the asset to cash within a short period of time. Most mutual funds are liquid investments. Shareholders can usually sell or redeem their holdings on any business day at the market price and receive the proceeds within a week.


Structure of Investment Companies Investment companies are structures as either closed-end or open-end funds. Closed-End Funds Closed-end funds were the first type of fund to be publicly traded. Closed-end funds issue a limited number of shares. Following the initial offering, the shares are traded in the secondary market in the same manner as stocks. Some closed-end investment companies are traded on the New York Stock Exchange; others are traded over the counter. Open-End Funds Open-end investment companies continually issue new shares. As new investors enter the fund, the investment company adds securities to the portfolio. Open-end fund shares do not trade in the secondary market. They may only be purchased from the investment company and if redeemed, must be sold back to the investment company. Open-end funds issue only common stock;they are not permitted to issue bonds or preferred shares. They are, however, allowed to borrow from banks. Note: Open-end fund shares are priced and traded differently than closed end funds and other equity securities. Open-end funds offer certain unique features not available from other types of investments. For these reasons, a separate section of this tutorial is devoted to the characteristics of open-end mutual funds. Investment Objectives All investment companies have stated objectives. Investors must understand a fund's goals in order to select a fund which suits their individual needs. Most investment companies' objectives can be categorized as follows. Growth Investment Programs Growth funds attempt to provide long term growth of capital by investing in companies or industries doing continuing research and product development. Growth funds may be invested in companies expanding into new sales areas, or those seeking to diversify their businesses. As many growth companies do not pay dividends, growth funds provide a low level of income to shareholders, in hopes of achieving above average capital gains. Income Investment Programs Income funds seek to provide a steady stream of income and above average yield by investing in bonds, money market instruments, preferred stocks or high yielding common stocks such as utility issues. Often these funds trade safety for potential income. Income funds are popular among individuals who invest primarily for income, such as retired


investors. Balanced Investment Programs Balanced funds have multiple objectives. Their primary goal is to preserve capital by investing conservatively and taking limited risk. The secondary objectives of a balanced fund are income and moderate growth. Balanced funds contain both stocks and bonds. While most have at least 20% of their assets in debt securities, the ratio of debt to equity investments may change according to the investment company's outlook for markets and interest rates. Speculative Investment Programs Speculative funds, also called specialty or sector funds may invest heavily in a particular industry, or in securities from a certain area of the country or the world. Other specialty funds may use investment techniques generally considered risky. The minimum investment in one sector for a fund to be included in this classification is 25%. Examples included funds which invest exclusively in South African gold mining or the computer software industry. Types of Mutual Funds Common Stock Funds These portfolios consist mainly of common stocks, and have a variety of investment objectives. Income Funds have a high current income as their primary investment objective. Typically, these funds buy stock in companies with high dividend yields, such as utilities. These stocks generally have below average growth potential. Income funds are designed for individuals who depend on their investments for income, and must forego the opportunity for above average growth of capital. Other conservative common stock funds might invest primarily in blue chip stocks, those in companies considered industry leaders with excellent earnings and dividend records. Specialty Funds are those investing a large portion of their assets in a particular industry (such as biotechnology or telecommunications) or in companies in a certain geographic area (such as the sunbelt or the Pacific Basin). Other specialty funds might invest primarily in small, aggressive companies with above average earnings growth, which spend heavily on research and product development and reinvest their earnings in the business. Bond and Preferred Stock Funds Most funds with income as their primary objective consist exclusively of bonds, or a


combination of bonds and preferred stock. These funds seek to provide investors with stable income and safety of principal. Regular interest payments on bonds and dividends on preferred shares give these funds a predictable stream of income, enabling them to provide shareholders with a steady return. Some bond funds invest only in tax exempt municipal debt, or in US government securities. Bond funds may also be speculative in nature. Some specialty funds invest exclusively in high yield or deep discount debt securities. Balanced Funds Balanced funds have assets invested in a mixture of bonds and common and preferred stocks. The percentage of the fund invested in each of these types of securities varies as market conditions warrant. Because of their diversification, balanced funds tend to be less sensitive to movements in the stock market than common stock funds, and less vulnerable to interest rate movements than bond funds. Money Market Funds Money market funds are invested in short term money market instruments such as commercial paper, certificates of deposit and treasury bills. Some are invested solely in US government securities, others may invest exclusively in tax exempt municipal notes. The net asset value of money market funds is fixed at $1.00 per share, and they are sold to investors without a load (commission/fee). They offer a high liquidity with little risk. Dual Purpose Funds These closed-end investment companies issue two types of shares. Income shares receive all income generated by the fund. Capital shares receive all of it's capital gains. Capital losses are absorbed by the capital shareholders up to a stated amount and are then shared by the income investors. The advantage of a dual purpose fund to income shareholders is that they earn income not only on their own investments, but also on the capital shareholders money. Capital shareholders achieve leverage, as they benefit from gains on the income shareholders' investments, as well as on their own investments. Open-End Mutual Funds Quotations Prices of open-end funds are determined by net asset value, rather than supply and demand. Net asset value (“NAV�) is the book value of open-end investment company shares. Net asset value per share is calculated as follows: NAV = Assets-liabilities/number of shares outstanding The total value of investment company holdings, including distributions not yet paid to


shareholders, is the investment company's total asset value. To find this, the fund totals the current market value of all securities in it's portfolio and adds any dividends, interest income or profit earned but not yet paid to shareholders. Liabilities are deducted from the fund's total asset value to arrive at total net assets. To find the net asset value per share, the investment company divides total net assets by it's number of outstanding shares. Net asset value per share must be computed at least once each business day, at the close of the New York Stock Exchange. Sales Charge The public offering or “POP� price of an open-end mutual fund is equal to it's net asset value plus a sales charge, also called the sales load. In fund sales literature, the sales charge must be stated as a percentage of the public offering price. The sales charge for fund shares can be determined as follows using the NAV and offering price quoted in the newspaper. Example: Offering Price $10.00 Less NAV -9.20 Sales Charge per share .80 The sales charge as a percentage of the offering price is calculated as follows: Example: (Sales Charge/per share)

/ (offering price/per share)

$.80 /$10.00= 8% The offering price can be computed given the NAV, and percentage sales charge. Because the sales charge is stated as a percentage of the offering price, it is necessary to find the complement of the sales charge. Example: If the sales charge is 8%, to determine the complement of the sales charge: Sales Charge complement 100%-8%= 92% or .92 The offering price is computed by dividing the NAV by the complement of the sales charge, as follows:


NAV Complement of sales charge

$9.20 .92

= Offering Price $10.00 Under the Investment Company Act of 1940, the maximum sales charge permitted for an openend mutual fund is 9%. However, the NASD limits the charge to 8 ½%, and this rate prevails. No-Load Fund-a No Load Fund is one without a sales charge. Many no-load funds are money market funds. These are designed to accommodate investors seeking to earn the market rate of interest on money pending investment. Front/Back-End Load-A fund with a front end load is one which deducts the sales charge when the initial investment is made. A back end load is a sales charge deducted when fund shares are liquidated. Some funds with back end loads become no load funds (ie; eliminate the sales charge) if the investor holds the shares five years or longer. Purchase of open-end fund shares Open end fund shares may be purchased only from the investment company. Individuals may invest in the fund directly, or indirectly through a broker. When open end fund shares are purchased, the investor pays the offering price (NAV + Sales Charge). Mutual fund purchases may be made based on a specified number of shares or a stated dollar amount, with a minimum of $100. If an investor buys based on dollar amount, the investor may receive fractional shares. Example: A customer invests $5,000 in an open end fund with an offering price of $15.27 per share. Amount Invested

$5,000 / $15.27 = 326.7845

The number of shares purchased is 326.7845 Open end fund shares are sold based on the net asset value at the close of business on the day the order is entered. The Wall Street Journal lists the closing prices for the market day preceding the day of publication. The concept is known as “forward pricing”. Example: In the Tuesday, October 11th Wall Street journal, the mutual fund prices shown would be the closing prices on Monday, October 10th. The amount an investor would pay for shares purchased on October 11th would be the closing price for October 11th, which would be published on Wednesday, October 12th.


Most underwriters reduce sales charges for investors buying large dollar amounts of the fund. These investors pay a lower percentage of the total investment as a sales charge than investors buying small amounts. The dollar amounts at which sales charges are reduced are called breakpoints. Breakpoints must be clearly stated in fund literature. A breakpoint sale is the sale of dollar volume just below the breakpoint without informing the customer of the breakpoint, for the purposes of generating a higher percentage sales charge. Breakpoint sales are not permitted. Individuals investing large amounts of money in a fund over time may pay a lower percentage sales charge by signing an agreement known as a letter of intent. The lower overall sales charge is based on the total dollar amount of the intended investment, which may exceed the breakpoints and entitle the investor to a lower percentage. The lower sales charge may only be valid if the investor completes the terms of the agreement, by making the intended investment within a 13 month period. The following are other alternatives often available when purchasing open-end funds: Periodic Payment-An investor may start a periodic payment plan with a minimum initial investment of $25, and subsequent monthly payments of $10 or more. The fund's regular sales charge is applied to each payment, and distributions are automatically reinvested. Dollar Cost Averaging-Dollar cost averaging is a method whereby a fixed sum of money, such as $30 per month, $500 per quarter or $1,000 per year is invested in a fund at regular intervals regardless of the market price. The net effect of dollar cost averaging is that the shareholder invests at a cost per share lower than the average price. This occurs because the fixed amount invested buys a greater number of shares when the price is low;and fewer shares when the price is higher. Dollar cost averaging can be a very effective tool in lowering the average cost per share. Dividend Reinvestment Plans (Often called DRIP plans or DRIPS)-Investors may receive fund distributions in cash, or use them to purchase additional shares in the fund by participating in a dividend reinvestment plan. The investor completes a form authorizing the fund to reinvest dividends by purchasing full and fractional shares. Some funds apply a sales charge to these additional investments and others do not. Capital gains distributions are reinvested at no charge. Certain Corporations also have a DRIP program for their common stock. These are some of the largest blue chip companies that regular pay dividends. You can usually buy the shares directly from the company and have dividends reinvested into additional shares. Redemption of Open End Fund Shares When open end shares are redeemed, they must be sold back to the investment company at net asset value. The net asset value is also referred to as the bid price and redemption price. To redeem open end mutual fund shares, an investor must submit written instructions to the transfer agent. The investor will receive the next computed NAV or redemption price


following the agent's receipt of the instructions. Some funds charge a redemption fee, usually ½% of the amount redeemed. The fund is required to remit the proceeds of a redemption to the investor within 7 days. Features of Open-End Funds The following are features an open-end fund may offer it's shareholders. While not all funds offer these services, many provide some or all of them to investors. Rights of Accumulation-This feature allows existing shareholders to make additional purchases at a reduced sales charge. Shareholders accrue rights of accumulation by holding their fund shares for a specified period of time. Exchange (switch) Privilege-Some investment companies manage a variety of open-end funds, which make up what is known as a family funds. Some allow investors to move money from one fund to another fund under the same management without paying a sales charge. Systematic Withdrawal Plans-In a systematic withdrawal plan, a lump sum of money, usually a minimum of $10,000 is invested. The investor may then elect monthly or quarterly distribution. If earnings on the initial investment do not cover the desired distribution, a part of the investor's principal may be returned. Systematic withdrawal plans are popular with retired investors and others living on fixed incomes. However, in a falling market, investors in a systematic withdrawal plan may see their capital gains erode as a result of withdrawing principal. Evaluating Mutual Funds The following considerations are important when evaluating mutual funds: Past Performance-Mutual funds are regulated by the SEC as to how they present their past performance to prospective investors. Inherent in any published performance record is the fact that past performance is no indication of the future of the investment. Past performance of mutual funds may be useful when comparing a fund to other funds with the same objectives. Past performance may be shown for either the preceding 10 years or the life of the fund.

Charts showing performance must show capital gains as being reinvested. Dividends paid must be shown quarterly. Yield-The formulas for computing mutual fund yields are set forth by the SEC. A fund may use either of the following methods: Current Yield Formula = annual dividends / current offering price + Cap. Gains Distributions


Historic Yield Formula = annual dividends / average offering price for the year Yield calculation must be accompanied by a statemtent to the effect that the yield is based on past performance and does not indicate future results. Leverage-Investors should note whether the fund has borrowed money, and to what extent. Borrowing by open end funds is legally limited to 1/3 of their total asset value. Borrowing, or leverage, magnifies the effect of gains and losses on the fund's portfolio. Qualitative Factors-These include the quality and experience of management, and their investment objectives and policies.k kkkc,kocxkocxiiccciciciiiiiiiiiiiiiiiciicx Sales Load-With a lower sales charge, a higher percentage of the investment goes directly into the fund. Redemption Features-Some funds charge for redemption, others do not. Redemption fee, if any, should not exceed ½% of the redemption value or NAV. Expense Ratio-If the fund's expenses are too high, it's return will be lower. The expense ratio is calculated as follows:a Expense Ratio = Expenses / Total Investment Income Unrealized Appreciation-Another term for unrealized appreciation is 'paper profits�. These are profits on positions in the fund's portfolio which have not yet been sold (ie: profits have not yet been taken). Unrealized appreciation in mutual fund shares over a one year period is determined as follows. Example: Take the net asset value of the fund at the beginning of the year and subtract any capital gains paid. NAV, 1/1/86 $10.00 -capital gains paid 6/1/86 $ 1.00 = NAV 6/1/86 $ 9.00 Next, subtract the result from the net asset value at the end of the year, or other period for which unrealized appreciation is being measured. NAV 12/31/86 -NAV 6/1/86 =unrealized appreciation

$12.00 $ 9.00 $ 3.00

Unrealized appreciation is $3.00 per share. Unrealized appreciation is not currently


taxable to the shareholders. Real Estate Investment Trusts (REITs) REITs are pools consisting of real estate instead of financial instruments. REITs are regulated by the Real Estate Investment Trust Act of 1960. They are not considered investment companies. REITs invest in income and rental property, real estate development and construction loans and long term mortgages. The sponsoring investment company must invest at least $250,000 of it's own capital in the REIT. Income for REITs consist of rental revenue, gains on the sale of property and interest differentials between the rates paid for bank borrowings and the rates charged on loans and mortgages. A REIT which has 75% of its assets invested in real estate and mortgages, and derives at least 75% of its income from mortgage interest and rentals, can use the “conduit� treatment explained above. If a REIT distributes 95% of its income to fund investors, it is not taxed on that income. REITs are traded on exchanges and OTC. REITs do not distribute losses to investors.

Q&A 1. In a family of funds, investors may be allowed to move money from one fund to another: A. by signing a letter of intent B. without paying a sales charge C. within 45 days of the initial purchase D. under no circumstances 2. An investor who redeems shares of an open-end mutual fund will receive: A. the next-computed bid price B. the bid price on the day prior to the sale C. the next-computed offering price on the day of the sale D. the current offering price 3.Which of the following funds would not be appropriate for an individual seeking maximum income from his investment? I. an income fund II. a growth fund III.a balanced fund IV.a specialty fund A. I and II


B. II and III C. II and IV D. III and IV 4. The privilege of buying additional shares in a fund at a reduced sales charge is known as: A. a right of accumulation B. a breakpoint sale C. a systematic investment plan D. dollar cost averaging 5. A customer wishes to invest $5,000 in a mutual fund with NAV of $13, a sales charge of $1.00 and an underwriting discount of 20 cents. How many shares will the customer buy? A. 384 B. 357 C. 500 D. 352 6. The maximum sales charge allowed by the NASD for an open-end mutual fund is: A. 9% B. 8 ½ % C. 8% D. none of these 7. An open-end fund has a net asset value of $24.05 and an offering price of $26.00. The sales load on the fund is: A. 10% B. 8 ½ % C. 7 ½% D. 6% 8. On Wednesday, October 12th, an open-end fund is quoted in the Wall Street Journal at NAV of $15.25 and an offering price of $16.50, up 2 points from the previous day. A customer purchased 100 shares and paid $1,650. The customer's order was entered: A. Monday the 10th, prior to 4:00PM NY time B. Wednesday the 12th, prior to 4:00PM, NY time C. Friday the 7th prior to 4:00PM, NY time D. Tuesday the 11th prior to 4:00PM, NY time 9. An open-end fund has an offering price of $32.50. The fund has an 8% load and a 1% redemption fee. A customer redeeming 500 shares would receive:


A. $16,223.75 B. $14,979.00 C. $14,950.00 D. $14,800.50 10.Of the following, which is not an example of a specialty fund? A. municipal bonds issued in the Pacific Northwest B. stocks of paper and forest products companies C. a growth and income fund D. Dow Jones Industrial issues.

Answers 1) B 2) A 3) C 4) A 5) B 6) B 7) C 8) D 9) D 10) C



In tutorial 7, these are the topics we will discuss: I. Basic Options Education II. Option Quotes III.Types of Options IV.Index Options V. Foreign Currency Options VI.Trading Exchanges VII.Chicago Board of Options Exchange VIII.Trading Hours IX.Rotations Adjustments X. Even Stock Splits XI.Odd Stock Splits XII.Option Exercises XIII.Taxes XIV.Buying Long Calls XV.Buying Long Puts XVI.Writing Calls XVII.Writing Puts XVIII.Spreads XIX.Types of Spreads XX.Combinations XXI.Hedging XXII.Break Even Points XXIII.Margin Requirements XXIV.Margin for Covered Call Writing XXV.Margin for Naked Writing XXVI.Spread Requirements XXVII.Straddles/Combos XXVIII.Risks of Option Trading XXIX.Buying Risks XXX.Writing Risks


Basic Options Education By definition, an option is a contract between two parties which gives the owner (holder) the right to buy or sell a specific amount of an underlying interest at a specified price and by a specified time. Options Terminology Call Options-Calls give the buyer the right to purchase (for a limited time) the specific quantity of the underlying interest. A call would be purchased if the investor expected a rise in the market value of the underlying interest in the future. EX: Jan MSFT 25 CALL would give the buyer or holder of that option the right to buy 100 shares of Microsoft stock at $25 per share up until the January expiration of the option contract, which is the Saturday following the third Friday of the month. The buyer or holder is bullish and hopes the market value of the stock is above $25 at expiration to make a profit. So, if the stock is trading at $28 at expiration, the buyer of the call option can exercise his right to buy the 100 shares at $25 and then immediately sell them in the open market for $28 and gain a $3 per share profit or $300 on that option contract. Put Options-Puts give the buyer of the option the right to sell (for a limited time) the underlying interest according to the terms of the contract. A put would be purchased if the investor expected a future decline in the value of the underlying interest. EX: Jan MSFT 25 PUT would give the buyer or holder the right to sell 100 shares of Microsoft at $25 per share up until the January expiration. The buyer or holder is bearish and hopes the market value of the stock declines at expiration to make a profit. So, if the stock is trading at $22 at expiration, the buyer of the put can exercise his right to sell 100 shares of the stock and then buy it back in the open market for $22 and gain $3 per share or $300 for that option contract. Option Buyer-The person purchasing the option contract, also referred to as “long”. The premium the buyer pays allows him/her the right to purchase the underlying interest at a specified price, for a limited time. The buyer (or holder) is the only one who can exercise the option. Option Writer-The person selling the contract to the buyer, also referred to as “short”. The seller is obligated to fulfill the terms of the contract if the holder exercised his/her option. The writer would be the investor on the other side of the trade in the above examples. They collect a premium for selling or writing the option and hope that the market value of the underlying stock stays the same or goes in the opposite direction by expiration. This way, they keep the premium without having to fulfill any obligation. EX: A option writer sells a Jan 25 MSFT CALL to a buyer for $4 premium. This means they are collecting $4 times the 100 shares that 1 contract represents or $400. At expiration, the stock is selling for $22 and did not go in favor of the buyer who wanted the underlying stock to go up. Now, it makes no sense to exercise and buy a stock for


$25 when the same stock in the open market only costs $22. Thus, the option expires worthless, the option buyer loses 100% of his premium ($400) and the option writer keeps the $400 without any obligation. The same is true of a put writer if the stock has increased above the strike price at expiration. Just to clarify which side of the market everyone is on: Call Buyer (holder) Bullish (market value of the stock must increase above strike) Call Writer (seller) Bearish (market value of the stock must decrease below strike) Put Buyer (holder) Bearish (market value of the stock must decrease below strike) Put Writer (seller) Bullish (market value of the stock must increase above strike) Exercise Price-Also known as the strike price. This is the dollar amount or value at which the seller agrees to deliver the underlying interest to the buyer. Strike prices (for stock options) are generally set at 2 ½ point intervals between $5 and $25, then 5 point intervals above that. EX: The strike price of a Jan 25 MSFT CALL is $25 per share. Expiration Date-This is the date that the rights of the holder (and the obligation of the writer) will expire. If an option contract is not exercised by expiration date, the contract ceases to exist. For most options, expiration date is the Saturday following the third Friday of the month at 5:30PM. Options stop trading on the exchanges on the third Friday of the month at 4PM Eastern. Currency options expire on the Saturday which precedes the third Wednesday of the expiration month. Expiration Cycle-The standardized cycle on which options contracts are issued and expire. Regularly, options trade on a quarterly cycle, with only the three closest trading at one time. (IE: an option trading on the January cycle would have contracts expiring in January, April, and July trading concurrently. October options would not begin trading until January contracts have expired). There is also currently a pilot program in effect where the options of selected corporations trade on a cycle which includes the three most current months, and one month on the quarterly cycle. (IE, in January a stock on a March cycle would trade the January, February, March and June contracts.) Premium-This is the amount that the buyer pays the seller for the rights which are covered by the contract. The premium is the market price of the option, and therefore will change periodically. The fluctuations in the premium are affected by a number of variables such as the time remaining until expiration, supply and demand, and the market value of the underlying interest. The premium is quoted in points (like stock) with 1 point equaling $1. To find the value of a stock option being traded, the premium must be multiplied by the number of shares (usually 100) covered by the contract. So, if an option is quoted at $2, the purchaser must pay the writer $200 ($2 times the 100 shares of stock covered by the contract). The two components of premium are time value and intrinsic value which are discussed below. Opening Transaction-This is the transaction (buy or sell) which establishes a new position


in the option. Someone purchasing an option to create (or add to) a long position in his/her portfolio would be “buying to open”. A writer selling to create a new short position would be “selling to open” Closing Transaction-A closing transaction is the opposite of an opening one. This is an offsetting transaction. In other words, the investor who previously purchased the option in an opening transaction may wish to “sell to close”, thereby liquidating the position through a trading transaction. Conversely, prior to expiration, the investor who had previously sold to open and created a short position may wish to offset that trade and “buy to close” the same option contract, thereby showing a zero position in this option. In this case, there is no exercise, the investor is choosing to trade back their option and close the position prior to expiration. An option buyer or seller can choose to do this at any time. EX: An investor buys 1 Jan 25 MSFT CALL @ 4, meaning they paid $400 in premium for that option. The stock starts moving in favor of the option buyer and in two weeks it is up to $30. Now, the option is worth a premium of 8 ½. Instead of waiting until exercising or coming up with the money to buy the stock at expiration, the investor can choose to simply “sell to close” and trade his option for the premium amount, which in this case is $8 ½ or $850. The profit is the sales price $850 minus the purchase price $400 for a profit of $450 in this example.

An investor can also do this if the market moves against him/her. Let's say that an investor buys 1 Jan 25 MSFT CALL @ 4 and in the next two weeks, the stock drops to $23. Now, the option premium is 1 7/8. Maybe the investor doesn't think the stock will come back and they want to cut their losses rather than lose the entire premium. So, again, they can “sell to close” for 1 7/8 or $187.50 and the loss would be $400 minus $187.50 or $212.50. Covered Call Writer-This investor owns, at minimum, enough of the underlying interest represented by the option which he has sold to enable him to deliver this interest upon assignment by the holder. For Example: an investor has written 1 IBM Jan 120 call, and has 100 shares of this stock on deposit at the brokerage firm. If this investor is assigned and must deliver 100 shares of IBM to the option holder, this can be done without having to go into the open market to purchase the shares necessary to fulfill the contract. Basically, being covered minimized the investor's market price risk in the event of assignment. In the Money Option-The situation that occurs when the market price of the underlying interest is favorable to the option holder. In the case of a call, this is when the market price is above the strike price. A put is in the money when the market price is below the strike price. EX: A Jan 25 MSFT CALL is in the money when the stock is trading over $25. A JAN 25 MSFT PUT is in the money when the stock is trading under $25.


Out of the Money Option-Obviously, the opposite of In the Money. When the market value of the underlying interest is not favorable to the option holder. At the Money Option-Occurs when the market price of the underlying interest is equal to the strike price. This is not favorable to the option holder. Types of Options-There are only two, Puts and Calls. Class of Options-These are all the option contracts of the same type. (puts or calls) which cover the same underlying interest. As an example, all IBM call options are considered the same class. Series of Options-All options of the same class which have the same strike price and expiration. For example, the ABC Feb. 30 puts are of the same series, and the ABC Feb. 35 puts would be yet another series. Intrinsic Value-The amount by which an option is in the money, IE: a $50 call option has an intrinsic value of $3 if the underlying stock is trading at 53. Time Value-This indicates whatever value the option may have in addition to it's intrinsic value. It is equal to the premium less the intrinsic value. Ex: if the stock is trading at $53 and the premium is $2 more than the intrinsic value, then the time value is $2. Option Quotes An option quote consists of the underlying stock symbol, the expiration month, the strike price, the type of option and then the premium. EX: Yhoo Jan 25 Call @ $4 is an option on the underlying stock of Yahoo with a January expiration and a strike price of $25. It is a call and the premium is $4. So, this option could be bought for $4 or $400 (100 x $4). Types of Options Stock Options-These are options in which the underlying interest is stock of a corporation. An option contract covers 100 shares of stock. (this can change in the event of a stock split). Assuming no adjustments, the buyer of an XYZ Jan 120 option can exercise his rights and purchase 100 shares of this stock at $120 per share prior to the January expiration date. Hopefully, when he/she exercises, the market value of the stock is above this strike price. You can see that the investor can exercise and purchase the stock for $120 per share ($12,000 investment) even though the actual market value may be higher. The investor can then immediately turn around and sell the stock or hold onto the newly purchased shares if the market price is still climbing. Many investors, however, trade options much the same way as they do stocks, for price


and appreciation. They hope to time the purchase and sale of their option contracts to create a profit by trading. One reason for this is the smaller initial investment necessary. For instance in the previous example, if the investor exercised his option prior to expiration, he would have to come up with the $12,000 investment to cover the purchase of the stock. (and you MUST come up with the initial investment even though you could sell the underlying stock right away for a profit). As an alternative to exercising, the investor can trade the option just like a stock, for example, let's say he bought the original Jan 120 option at a premium of $2, so a $200 investment. Once the market value of the underlying interest starts going up, so does the option premium. So, if the market value goes to 125 let's say, that would be $5 intrinsic value and let's say for arguments sake, another $2 in time value, so the option itself that was purchased for $2 is now worth $7. You could close out the option position for $7 ($700) and your profit would be $500 ($700-$200) without having to invest more than $200. This is the power of leverage that you can only get from option trading. The investor controlled 100 shares of a $120 dollar stock (market value of $12,000) for a mere $200. Index Options The underlying interest of an index option is the value of a specified market indicator index. These indexes range from broad based indexes (like the Standard & Poors 500) to indexes covering a more specialized market segment of trading (like the Philadelphia Gold & Silver Index) also known as narrow based indexes. Investors trading these options are betting on the movement, up or down of the specific index value covered by the option. For instance, if they feel the market in general is heading for an upturn, they may purchase calls on the S&P 500. Unlike stock options, exercises in index options are on a cash basis, so no securities change hands. It's simply the intrinsic value that is paid to the option holder. You can also trade the options like stock options without exercising. Foreign Currency Options Foreign Currency Option prices reflect the values of monetary exchange rates. The exchange rate reflects the values of the US dollar and the foreign currency in question. The contract size of these options will vary depending on the specific currency covered by the option, and depending on the rules of the market (exchange) trading the option. The premiums are generally quoted in cents with exceptions to the rule for Japanese Yen, which are quoted in 100th's of a cent and French Francs quoted in 10th's of a cent. If the value of the foreign currency rises in relation to the US Dollar, the premium of the call option will increase. The put premium would decrease in this case. If the value of the foreign currency decreases in relation to the US Dollar, the premium of the call option would decrease and the put would increase.


Example: Assume a call option gives the holder the right to purchase British pounds at $1.35 each. At expiration, that option will have intrinsic value if the price of British pounds is above $1.35. At the same time, it will have no intrinsic value if the price of the pound is at $1.35 or less. The change in price of British pounds could result from a change in the value of the US dollar relative to all other currencies or peculiar to the British pound. Foreign currency options trade on the Philadelphia Stock Exchange (PhX). Trading/Exchanges Standardized options trade on auction markets (exchanges). As such, there are specialists who maintain an orderly market in this security, much the same way as stock. Currently, option contracts trade on the following exchanges: Chicago Board Options Exchange (CBOE), American Stock Exchange (AMEX), Pacific Coast Stock Exchange (PSE), the Philadelphia Stock Exchange (PhX), and the New York Stock Exchange (NYSE). Listed options are issued by the OCC, which guarantees the contracts. Options that are sold by an investor are sold to the OCC. Contracts that are purchased by investors are bought from the OCC. This “third party� arrangement allows both the option buyer and writer to close their positions independent of each other. Most brokerage firms require cash to be in the account to pay for any option premiums prior to the trade being executed. This is unlike stock trades where you have three business days from the trade date to pay for the purchase. Chicago Board of Options Exchange The CBOE is the largest exchange if you consider number of issues traded and volume of trading. All of the exchanges will accept option orders on either a day or GTC basis. The CBOE, however, will not accept a GTC order with a qualifier attached such as all or none, etc. Trading Hours Regular securities trading hours are 9:30AM through 4:00PM Eastern time. Options trade for 10 minutes beyond that time. So, 9:30AM through 4:10PM Eastern time. Rotations Options do not start trading simultaneously at the beginning of each trading day. Options are opened for trading in a sequence called the opening rotation, and in the case of stock options this does not begin until the underlying security has started trading.


Adjustments Adjustments are made to either the strike price or number and or type of shares covered by the contract. These adjustments would be made in the event of a reorganization (IE: stock split, etc.) Generally, no adjustment is made for regular or ordinary cash dividends or distributions. Ordinarily, adjustments occur only in equity (stock) options. Even Stock Splits If a stock split results in the issuance of one or more whole shares for each whole share. (ex: 2 for 1 stock split), an adjustment is made in the number of contracts held by the investor and the strike price is reduced accordingly. For example, the holder of 1 XYZ Jan 50 call would, after a 2 for 1 split, own 2 Jan 25 calls. Each contract still covers 100 shares of the stock and the exercise value of the investment remains the same. (pre-split-100 shares x $50=$5,000 and post-split-200 shares x $25=$5,000). Odd Stock Splits If an odd stock split occurs, the number of contracts held remains constant, but the amount of shares covered by the option increases. The strike price is also reduced accordingly. For example, an investor owns 1 XYZ Jan 90 call. The exercise value is $9000 (100 shares x $90). A 3 for 2 split is declared. The contract is adjusted to cover 150 shares of stock. The strike price is adjusted to $60, the value remains the same (150 shares x $60) To calculate the above adjustment, divide the old exercise price by the split ratio to determine the new strike price. New strike price= Old exercise price/split ratio Ex: A 3 for 2 split: 3 divided by 2= 1.5; this is the split ratio. Strike price (90) divided by 1.5=60. $60 then, is the new strike price. The split ratio also indicates the new number of shares covered by each contract. Multiply the ratio by 100 shares (1.5 x 100) to determine the number of shares covered by each contract. # of shares in new contract=split ratio x 100


Option Exercises The rights of an option can be exercised in either European or American style. Since most options in the US are exercised American style, we will concentrate on it. American style means that the holder can exercise his/her option at any time after it's purchased, up until the time it expires. In order to effect an exercise, the customer must inform his/her broker of this desire prior to the firm's designated cut off time. The broker in turn gives exercise instructions to the OCC. The OCC assigns clearing member's accounts on a random basis, and notifies them prior to the start of trading on the business day following receipt of exercise instructions. The assigned brokerage firm then assigns their clients on either a random selection or first in/first out basis. The procedure used by the firm must be available to clients and must be fair. Settlement of the option contract must occur the next business day. Please note again that exercising your option rights and taking delivery of the stock or selling stock is different than simply trading the option for premium. (example: buying a call for a premium of $2 ($200) and selling it back for $7 ($700)). Taxes Questions regarding tax and taxation on securities transactions should always be deferred to a qualified tax consultant, however, here are some basics: Trading Closing an option through trading, the investor realizes a capital gain or loss. Subtracting the acquisition costs from the net sale proceeds will give you the capital gain or loss figure. Ex: Bought 2 XYZ Jan 40 calls at 2 Ÿ Sold 2 XYZ Jan 40 puts at 3 ½ Net Capital Gain

($225) ($350) $125

Exercise If the call is exercised, the holder purchases the stock at the strike price. For tax purposes, the cost basis of the stock would include exercise costs and the cost of the original option purchase price plus brokerage commissions. If an investor purchases a XYZ Jan 40 call at $4 and exercises it, the cost basis is $4,400;the exercise amount of $4,000 plus the $400 premium paid.


In the case of a put exercise, the holder is selling stock. A capital gain or loss would be realized on the sale. The cost to purchase the put is treated as a reduction in the sale proceeds. If an investor holds a stock long term and then purchases a put, this purchase has no effect on the stock holding period. If the put is acquired while the stock is still short term, the holding period is eliminated and will not begin again until the option position is flattened either through expiration, exercise or sale. OPTION STRATEGIES Buying Long Calls As discussed earlier, an investor would purchase a call if he/she expects the value of the underlying interest to increase prior to expiration. If the market price of the stock goes up, the investor can exercise the option and purchase the underlying stock at the strike price. The investor can then sell the stock at the higher price in the market and realize his/her profit. EX: A call with a $30 strike is purchased. The market value of the stock rises to $35. The investor exercises and purchases the stock for $3,000 ($30 times the 100 shares). The client can immediately sell the stock at $35 per share ($3,500) realizing a $500 profit less the premium paid for the option. In the event that the value decreases, the investor would let the option expire worthless. This limits his/her loss to 100% of the premium paid for that option. Buying a call gives the investor unlimited profit potential, as there is no limit to how high the value of the underlying stock can go. Furthermore, the investor does not have to outlay as much cash on an option as he/she would on purchasing 100 shares of stock. The market attitude of the call buyer is bullish. Buying Long Puts The purchase of a put indicates that the investor believes that the value of the underlying stock will decline prior to expiration. The maximum loss to a put holder is the amount of premium paid. If the value of the underlying stock increases, the put would decrease in value and expire worthless. If a put is purchased with a $30 strike, and the stock price falls to $25, the investor would exercise the contract and “put” the stock to the option writer. The writer would be obligated to purchase the stock at $30. The holder of the option has now received $30 per share for the stock, and has a “short” position in his/her brokerage account. The stock can now be purchased in the open market for $25, and the investor realizes a profit of $500. ($5 difference in market value x 100 shares).


Writing Calls When an investor writes a call, he/she has sold the right to purchase the underlying stock at the strike price. The investor is hoping the value of the underlying stock will fall. If this happens, the holder would not exercise and the option would expire worthless. In this case, the option writer would keep 100% of the premium. As an example, an investor writes a XYZ $30 call at $2. The stock price declines to $29 prior to expiration. Since the option is out of the money, there is no exercise and the writer keeps the $200 premium ($2 x 100 shares). The writer of a naked call option (naked means that the investor does not currently own the stock and would have to purchase it on the open market if assigned) exposes himself/herself to unlimited potential risk because the market value of the underlying stock could increase to infinity. Fast rising markets are the most dangerous to a naked call writer. Many investors use the strategy of writing covered calls (covered means the investor already owns the underlying stock and can simply deliver it upon assignment with no risk of market fluctuation). This limits the covered call writer's liability. The advantage is that it can increase the yield on a portfolio by providing premium income. Writing Puts Please pay particular attention to this section because it is a major part of our options trading system. The investor who sells a put to open a position has sold the right to sell the underlying stock at the strike price. He/She is hoping that the value of the underlying stock will increase. The holder of the put would let the option expire worthless if the underlying stock increases and the put writer would keep the premium. EX: A customer writes a XYZ $30 put at $2. On expiration, the underlying stock is worth $32. It is not advantageous for the holder to exercise, so the option expires worthless. The writer retains the $200 received. If the stock is trading below the strike price, the put writer would be assigned and must purchase the underlying stock. The risk to the naked put writer is limited to the value of the underlying stock decreasing to zero. Spreads This is a position where the investor is both long and short, the same type of option at the same time. There are several different kinds of spreads.


Spreads are generally the simultaneous purchase and sale of selected options. When entered together, the client can specify either a market or limit order. In the case of a limit order, the client indicates the net debit or credit that they wish. They cannot indicate a specific price on each leg. A Credit Spread would be one in which the investor receives more money (premium) than was spent. A Debit Spread is when the investor spends more on the long side than is received on the short side. If the spread position would be profitable in a rising market, it is further classified as a Bull Spread and if it is profitable in a declining market, it is a Bear Spread. Types of Spreads Time Spread-also known as Calendar Spread or Horizontal Spread. The purchase/sale of options with the same strike, but with different expiration, IE: Long Calls 5 XYZ Feb. 120 Short Calls 5 XYZ May 120 An investor who does not expect much volatility in the underlying stock would profit from a time spread. Price Spread-also known as a vertical spread. Contains options with the same expiration, but different strike prices, IE: Long Puts 5 XYZ Feb. 120 Short Puts 5 XYZ Feb. 100 Diagonal Spread-is a spread containing options with different strike prices and expirations, IE: Long Puts 2 XYZ Feb. 100 Short Puts 2 XYZ May 115 Below are examples of bull and bear spreads: Bull Call Spread

Long 1 XYZ Feb. 60 Short 1 XYZ Feb. 65

This is a bull spread because the investor is long the lower strike price. This position would become profitable in a rising market, as the investor can exercise the long side as the value of the stock rises above $60. The Feb. 65 (the short position) would not be exercised by the holder as long as the price of XYZ is below 65. If the price rises above 65 and the investor is assigned on the short side, he/she can exercise the long side (buying stock at $60) to satisfy his/her obligation. Bear Call Spread

Long 1 Short 1

XYZ Feb. 60 XYZ Feb. 55


This is a bear spread because the investor is short the lower strike price. This position would become profitable in a declining market. If the price of XYZ declines below 60, the long call would not be exercised. As the market on the stock continues to decline, the Feb. 55 call written by this investor would not be assigned and would also expire worthless. The investor keeps the premium received on the short call. Straddle positions are very similar to spreads, except that they contain both puts and calls. The strike price and expiration date would be the same. Also, both legs of straddles are either purchased or sold. The strategy of a long straddle is for the investor who anticipates a big move in the value of the underlying stock, but is unsure of the direction of that move. An example of a “long straddle� would be: Buy 1 call XYZ Jan 60 @ 4 Buy 1 put XYZ Jan 60 @ 3 This investor has paid a total of $700 in premiums. Let us assume that the stock is trading at 60. If the price of XYZ rises above 67, or falls below 53, this investor has a profit. The 7 point difference reflects the premium paid. At any price between 53 and 67 the loss on one leg of the straddle is partially offset by the profit on the other. An investor would choose this transaction if he felt the stock price was going to be very volatile short term, but doesn't know in which direction. The investor who sells a straddle to open (short straddle) expects the underlying interest to remain near the strike price. The straddle writer seeks income from the premium received on the sales. As long as the price of the underlying stock remains within the range of the strike price plus/minus the total premium, this investor profits. Combinations Combinations are similar to straddles, but the difference is that at least one of the contract variables (IE: strike price, month, number of contracts, etc.) are different. Hedging Short stock and long call. The investor with a short stock position exposes himself/herself to unlimited risk as the value of the stock rises. The purchase of a call limits this risk. An investor who shorts 100 shares of XYZ at $70 and then buys a call with a $70 strike guarantees that the short position can be covered at no more than $70 if the stock price rises. The maximum loss is the premium paid on the contract. Protection against large losses is achieved by buying an option with a strike price at or a bit above the price the stock was shorted for. Long stock and long put. The investor of a long stock can limit market risk if the stock


price slides. A purchase of XYZ at $70 and a subsequent purchase of a $70 put guarantees that the investor is not in a profit position until the premium paid on the put is covered. Protection against large losses is achieved by purchasing a put at or a bit below the price paid for the stock. If the stock price declines substantially and the investor exercises, the premium paid for the option is small compared to the loss which could have been incurred otherwise. With this hedge, paper profits are protected with the purchase of a put after a substantial rise in the stock price. Using this same investor, an $80 put is bought after the stock rises to 82. If the price falls, the client exercises and sells the stock at $80 per share. The profit is the 10 point difference between the stock purchase price and the strike price, minus the premium paid for the put. Long stock and short call. If the stock price is at or below the strike price, the option expires worthless. The investor keeps the premium received from writing the (covered) call. Loss is limited to the difference between the price paid for the stock and the strike price. In the case of the following example: Buy 100 XYZ @ 60 Sell 1 XYZ 60 call @ 5 Loss on the short call is limited to the difference between the strike price and the price paid for the stock (both $60), or zero (not counting transaction fees) if the stock price rises and the investor is assigned at $60, the stock long in the account is delivered. Short Stock and Short Put-A customer with a short put may partially hedge the short position by selling short the stock at the same price. For example, sell short 100 XYZ at 60, sell 1 XYZ 60 put at 5. If the price of the stock rises, the investor is partially protected by the amount of the premium received. Maximum Gain and Maximum Loss Chart Position Long Call Short Call Long Put Short Put SP=Strike Price

Maxi Gain Unlimited Premium SP-Premium=BE Premium

Maxi Loss Premium Unlimited Premium SP-Premium=BE

BE=Break Point Point

Remember that the long and short positions of options are opposites. Therefore, the max. gain of the long position equals the max. loss of the short position, and the max. loss of the long position equals the max. gain of the short position.


Break Even Points The following is a quick review of how to calculate when an investor breaks even on the most common option trading strategies. Call Buyer-The exercise price plus the premium paid. Put Buyer-The exercise price minus the premium paid Covered Call Writer-The cost to purchase the long stock position, minus the premium received. Naked Call Writer-The exercise price plus the premium. Put Writer-The exercise price minus the premium. Straddle Buyer-Exercise price plus/minus the combined premium paid. Straddle Seller-Exercise price plus/minus the combined premium received. Call SpreadThe lower strike price plus the net of the debit or credit. Put Spread-The higher strike price minus the net debit or credit. Margin Requirements Options have no loan value and cannot be purchased on credit (margin). Therefore, the regulation T requirement on the purchase of options is 100% of the premium due. In the case of option trading, “margin� refers to the amount of cash or securities an investor must deposit with his/her brokerage firm as collateral in order to cover certain strategies. (IE., writing, and multiple contract trades). Minimum margin requirements are set by the Federal Reserve and self regulatory organizations (IE., NASD and the exchanges). Individual brokerage firms are allowed to enforce more stringent margin requirements, however, they can never set limits lower. Margin for Covered Call Writing The writer of a call can either be covered or uncovered (naked). In order for a writer to be covered, one of the following must be on deposit in the brokerage account: 1.The underlying interest. 2.A security convertible into the underlying stock (e.g., convertible bond). 3.An unexpired long call with a strike price equal to or lower than the short call and an equal or longer expiration. 4.An escrow or depository receipt evidencing that the underlying interest is on deposit in a bank. 5.A warrant to purchase the underlying security. The warrant must be at least equal in value to the exercise price. Short puts offer the opportunity to keep the premium received if the market goes up. The put buyer will exercise only if the market falls. The contract will expire to the writer's advantage if the market price stays above the exercise price. Because of the premium received, a put writer can purchase the stock below it's current market price. The


premium is applied to reduce the cost of the stock. Margin for Naked Writing Naked writers must deposit margin (cash) into their brokerage account. In the case of equity options, the margin requirement is 100% of the premium plus 20% of the value of the underlying stock reduced by any out of the money amount. However, the minimum requirement is 100% of the premium plus 10% of the stock value. EX: Stock price $59; Call premium $4, Strike price $60 Premium ($400) plus 20% of the stock price ($1180) minus out of money amount ($100)= $1480 required. Uncovered OTC options have a different requirement. The calculation is: 100% of premium plus 45% of underlying stock value, minus the out of the money amount. Minimum requirement is the same as above. Naked index options require 100% of the premium plus 15% of the index value, reduced by the out of the money amount. The minimum requirement is the option premium plus 10% of the index value. The customer deposit is that the requirement reduced by the premium received for writing the option. Spread Requirements Requirements on spread positions are the lower of the following: 1.The difference between the strike prices of the long and short positions if there is a loss or 2.The short position figured as naked. EX: Buy 1 put XYZ Jul. 60 @ 6 Sell 1 put XYZ Jul. 50 @ 3 ½ Stock Price is 54 Using possibility #1, the requirement would be $1,250 (10 point difference between the strike prices, times 100 shares of the underlying stock plus $250 debit paid in net premiums). Using possibility #2, the requirement would be $1,030 (premium $350 plus 20% of stock price $1080 minus the out of the money figure $400 equals $1,030). Because the required margin is the lower of these two, the investor would need to deposit $1030 with the broker in order to be properly margined on this transaction.


Straddles/Combos Long straddles require 100% of the premium on both the put and the call. To figure the margin deposit due on short straddles, calculate the requirement on one leg, but do not subtract for any out of the money amount. Then add 100% of the premium from the other leg. EX: Sell 1 call XYZ Jan. 60 @ 4 Sell 1 put XYZ Jan. 60 @ 3 Stock price is 61 The call has a requirement of $1,620 ($400 premium plus 20% of $6,100). To $1,620, add the $300 premium from the put, for a total requirement of $1,920. RISKS OF OPTION TRADING All investments have some sort of risk involved, however, some of the risks of option trading are unique. The trading of options may allow the investor some control over the risk/return pattern of the investment portfolio. Options allow the investor a chance to limit losses, hedge a long position, or receive a premium. This section will briefly go over some of the general risks. We will go over the risks specific to our trading strategies in the next section. Buying Risks Because options are wasting assets, which will eventually expire, the buyer runs the risk that all of his/her investment could be lost in a very short amount of time. Individual option contracts have at most a life of only nine months from inception to expiration. Also keep in mind, however, that the purchaser of a call option experiences a greater profit potential (percentage wise) than the purchaser of 100 shares of stock, and this is on a smaller investment. The same would be true for the purchaser of a put versus selling short the underlying stock. The risk that the purchaser would lose all of his/her investment is increased the more the option is out of the money and the closer it is to expiration date. A holder does not have to exercise the option in order to realize a profit. The contract could be sold prior to expiration for more than it was bought for. However, the greater the move the underlying interest must make in order to exceed the strike price (or fall below it in the case of a put) the less likely it is to be profitable to the buyer. Writing Risks


The writer's greatest risk is that he/she can be assigned at any time over the life of the option. Also, the writer possibly would not know that he had been assigned for a day or two after the assignment had taken place. An investor cannot close out a short position after he/she has been assigned. If the option is significantly in the money upon expiration, the investor can pretty much assume they will be assigned. Covered Writing-The writer of a covered call continually bears the risk of a decline in the value of the underlying interest, but is limited on the upside by the strike price of the option written. For example, an investor writes a call on XYZ stock at $25, and owns 100 shares of stock. A premium of $2 is received. The stock price rises to $29 and an assignment is received. The investor would receive $25 per share for the stock he/she must deliver. Counting the $2 premium already received, our investor has gotten a total of $27. Thus, the investor would receive $2,500, plus a $200 premium. This is $2 per share less than they could have gotten had the stock been sold on the open market for $29 ($2,900). Uncovered Writing-An uncovered (or naked) call writer has to deal with the risk of potentially unlimited loss in the event that the value of the underlying interest rises above the exercise price. Because theoretically there is no cap on how much the value of a stock could rise, this investor is exposed to unlimited risk. EX: An investor sells/writes a Jan 25 ABC CALL @ $4. At expiration, the stock is trading at $52. They would be assigned and have to buy the stock in the open market for $52 ($5,200) to deliver to the option holder. Additionally, this investor would have had to put up some margin in order to establish the naked position. The margin requirements on the position will change if the value of the underlying stock moves against this investor. The Put Writer is in the same risk position as the covered call writer. If the price of the underlying stock falls below the strike price, there is a loss. The only limit on an uncovered put is that it cannot go below zero. If this investor is assigned, he/she must purchase the underlying stock at the strike price. Obviously, if he/she has been assigned, the market value of the stock is worse than the strike price. The loss would be the value of the underlying stock, minus the premium.

Q&A 1. An investor with a short options position enters an order to buy back the contract. This is a: A. closing transaction


B. opening transaction C. opposing buy D. a wash 2. An in the money put: A. is unprofitable B. has a strike price higher than the market price of the underlying interest C. has a strike price lower than the market price of the underlying interest D. cannot be resold 3. An investor writes 3 puts ABC Jun 60 at $3. The premium received would be: A. $900 B. $9 C. $180 D. $1800 4. Q-Tech Corporation announces a 5 for 4 stock split. After the split, the holder of a Jun 90 option would own an options with a strike price of: A. 54 B. 60 C. 72 ½ D. 72 5. In the example above, each contract would now represent: A. 150 shares B. 125 shares C. 100 shares D. 200 shares 6. A bull spread: A. is profitable in a rising market B. is long the leg with the higher strike price C. is short the leg with the lower strike price D. b & c 7. The Options Clearing Corporations A. issues options contracts B. assigns member firms when options are exercised C. determines margin requirements D. a & b only


8. Which of the following is considered to be the riskiest position for an option investor to hold? A. an uncovered writer B. a long call C. a long straddle D. a covered write 9. An investor purchases an XXX 95 Call and pays $10. She also writes an XXX 110 Call, the premium is $3. Assuming both expire worthless, this client's realized profit or loss is: A. $700 loss B. $300 loss C. $300 profit D. $700 profit 10.An option's intrinsic value is: A. the amount (if any) by which the option is in the money B. the amount (if any) by which the option is out of the money C. whatever value the option has left prior to expiration D. none of the above

answers 1) A 2) B 3) A 4) D 5) B 6) A 7) D 8) A 9) A 10) A



In tutorial 8, these are the topics we will discuss: I. Brokerage Firms II. TD Waterhouse III.Ameritrade IV.JB Oxford V. Scottrade VI.Etrade


Brokerage Firms This section will help you find out where the best place is to open an account. We will compare brokerage firms for the best deals and outline the benefits and features of each. We do not suggest using a full service brokerage firm because they simply charge too much in fees and commissions. We suggest learning as much about investing, so you can trade on your own with an online brokerage firm. Several of these firms such as Charles Schwab and TD Waterhouse actually have many resources to help you select investments without the high cost. If you are just starting out and simply need advice from a full service broker or advisor, select a firm and broker you are comfortable with. Check into their background, ask questions as if you were interviewing them for a job. Several large full service firms are: Morgan Stanley Edward Jones AG Edwards Merrill Lynch Below, we have outlined the features and benefits of some of the best online brokerage firms that have lower fees and commissions. The following information is often updated, but it is always subject to change. TD Waterhouse TD Waterhouse is an excellent online brokerage firm. Online trading is easy and trade executions are fast. Pricing is in the middle, however, and they have several programs that give active traders further discounts on commissions if they meet certain levels. Choice Program: If you have less then 18 trades per quarter and less than $250,000 in combined assets in your accounts, this is the program you would be eligible for. The option commission is $17.95 flat rate plus $1.75 per contract. So, if you traded 2 options, it would cost you $21.45. Market orders for stock trades is $17.95 and add $3 for limit or stop orders. Premier Program: If you have more than 18 trades per quarter OR a minimum of $250,000 in assets in your accounts, you would be eligible for Premier. The option commissions are $12.00 flat rate plus $1.75 per contract. Market orders for stock are $12 with $3 added for limit and stop orders. Premier Select: If you have 36-71 trades per quarter, you would be eligible for Premier Select. The option commissions are $9.95 flat rate plus $1.75 per contract. Market orders for stock are $9.95 with $3 added for limit and stop orders. Premier Select Plus: If you have 72 trades or more per quarter, you would be eligible for Premier Select Plus. The commissions are the same as premier select.


You can also trade by touch tone phone for a higher rate, which is $35 for stock market orders and $35 flat rate plus $1.75 per contract for options and with an account officer by phone for $45 stock market orders and $45 flat rate plus $1.75 per contract for options. TD Waterhouse's margin interest rates are as follows: $1-$9,999 - Broker call + 3.25% $10,000-$24,999 - Broker call + 2.75% $25,000-$49,999 - Broker call + 2.25% $50,000-$249,999 - Broker call + 1.75% $250,000-$999,999 - Broker call + 1.25% $1,000,000 Plus - Broker call + .75% Broker call rate is updated and published in the Wall Street Journal every Tuesday. A nice feature of TD Waterhouse is that they are one of the few online firms that also have branch offices. You can check and see if one of their 150 branches are near you by clicking this link and entering your zip code: TD Waterhouse offers a very convenient way to transfer money into your brokerage account called Transfer Direct. You can transfer as little as $100 and as much as $100,000 daily from any financial institution including your other brokerage accounts, bank accounts, etc. right online. They also have e-services, where you can obtain your account statements and 1099's right online and the have a free direct download service that allows you to import all your financial data from TD Waterhouse into Quicken or Microsoft Money. Securities in your TD Waterhouse account are protected up to 150 million per customer. There is also no minimum deposit required when opening a new account. Ameritrade Ameritrade is another reliable online brokerage firm. They offer quick executions and low commission rates. Stock trades are $10.99 (unlimited shares) with online trading, $14.99 by automated phone service and $24.99 broker assisted for market orders and $29.99 broker assisted for limit orders. Option rates are as follows: Internet- $10.99 flat rate plus $1.50 per contract


Automated Phone-$14.99 flat rate plus $1.50 per contract Broker Assisted$24.99 flat rate plus $1.50 per contract (market orders) $29.99 flat rate plus $1.50 per contract (limit orders) Option assignments/exercises incur a fee of $29.99 Accounts open for more than six months with a total liquidation value of under $2,000 are subject to a $15 quarterly fee. All accounts with at least four trades in the previous six months are not subject to this fee. Margin Rates Under $25,000- National Prime + 1.00% $25,000-$49,999- National Prime + .75% $50,000-$99,999-National Prime -.25% $100,000-$249,999-National Prime -.50% $250,000-$999,999-National Prime -.75% $999,999 and up-National Prime -1.50 Interest rates are subject to national prime, which is the rate most banks charge to their best customers. This rate is subject to a 6.25% minimum. Ameritrade offers a nice streaming quote system free with all accounts. Normally, this feature must be paid for or you only get it for being a very active trader. They offer electronic statements, direct download into Quicken and MS Money and electronic funding. SIPC protection of $500,000 and additional insurance of 100 million.

JB Oxford & Company JB Oxford is another quality online brokerage firm with low commissions. Their normal commission schedule is: Stock Orders Online- Market orders $14.50 Limit orders $19.50 Broker Assisted- Market orders $24.50 Limit orders $29.50 Options Online-$1.50 per contract ($14.50 minimum)


Broker Assisted-Add $10 to online rate Exercise or assignment is .25 per contract ($14.50 minimum) They also have a Premier Club for active traders that offer further discounts as follows: Stock Orders Market Limit

$9.95 $14.50

Options $1.50 per contract ($12.50 minimum) Premier Club requires at least 15 trades in your account during the quarter and only applies to online trading. Margin Rates Less than $10,000- Broker call + 2.25% $10,000-$49,999- Broker call + 2.0% $50,000-$99,999- Broker call + 1.5% $100,000-$249,999- Broker call + .75% $250,000-$999,999- Broker call + .25% $1,000,000 -Broker call Naked option writing is not allowed online, only through a broker at JB Oxford. The minimum deposit to open an account is $2,000 in cash or securities. Scottrade Scottrade also has branch offices, over 198 nationally. You can find the office nearest to you by clicking below: Scottrade has won the JD Power customer satisfaction award four times and is the only firm that has 5 stars in all categories including overall satisfaction, customer service, cost, integrity, trade execution, web site capability and information resources. Commission Schedule $7 for internet trades on Nasdaq and listed market orders


$12 limit orders on all limit, stop and stop limit orders and touch tone trades $17 for broker assisted trades For Nasdaq and listed limit, stop & stop limit orders add $5.00 OPTIONS $7 + $1.50 per contract (internet) $12 + $1.50 per contract (touch tone) $17 + $1.50 per contract (broker assisted) For Nasdaq and listed limit, stop and stop limit orders add $5.00 Option exercise and assignment $22 Scottrade does have some requirements to trade online. They are as follows: A $500 minimum equity balance is required to have your account activated for internet trading At least 75% of all trades must be made on the internet All money and stocks deposited for equity must be credited before trades can be accepted Margin interest rates are lower than any major brokerage firm, for example 5.45% is what they charge on a debit balance of $7,500. Other advantages of using Scottrade: stock alerts free real time quotes and charts free real time news and research Standard & Poor's research Dow Jones real time news for investors Thomson Financial research Free checking Real time accounting Electronic confirmations and statements $25,000,000 account protection No inactivity fees Low minimum deposit of only $500

Etrade Etrade has a standard commission schedule and a program for active traders called Power 103

Etrade that has discounted commission rates. Standard schedule: Nasdaq and listed market, limit and stop stock orders Listed securities (over 5,000 shares) the entire order

$19.99 $19.99 Plus .01 per share for

EX: 6,000 shares would carry a $60 commission Stock orders for trades 27+ per quarter


Option orders contract (no minimum charge)

$19.99 base plus $1.75 per

Option orders for trades 27+ per quarter contract (no minimum charge)

$9.99 base plus $1.75 per

Broker assisted trades above

$45.00 in addition to charges

Order handling fee (applies to first 26 trades per quarter)


Account maintenance fee (applies if your account is less than $5,000 or you have not executed at least two commissionable trades in the prior six months) $25.00 The Power Etrade commission schedule for active traders: Once you make 27 trades per quarter (9 per month), you qualify for Power Etrade. $9.99 stock trades from trade #1 $9.99 option base commission plus $1.75 per contract (no minimum charge) from trade #1 Margin interest from 3.99%-6.99% Option assignments/exercises are $19.99 Other features and benefits of Etrade are: Real time positions and balances Customizable portfolio manager Downloadable account history Electronic statements and confirms Easy online cash transfers 104

Online bill payments There is a minimum deposit of $1,000 required to open a new account. $2000 minimum for a margin account.


QUALIFIED PLANS/RETIREMENT-TUTORIAL 9 In tutorial 9, these are the topics we will discuss: I. Qualified Plans II. Types of Retirement Plans III.General Qualification Requirements IV.Participation and Coverage Requirements (Eligibility) V. Joint and Survivor Benefits VI.Minimum Vesting Standards VII.Top Heavy Vesting Requirements VIII.Minimum Funding Standards IX.Limitation on Contributions and Benefits X. Life Insurance XI.Permissible Investments XII.Unrelated Business Taxable Income XIII.Loans XIV.Integration with Social Security XV.Plan Termination XVI.Income Taxation of Benefits XVII.Taxation of Death Benefits XVIII.Cash or Deferred Arrangements (CODA)/401 (k) Plans XIX.Nondiscrimination Rules for CODA XX.Limits on Contributions XXI.Withdrawals XXII.Life Insurance and Other Investments XXIII.Employee Stock Ownership Plans (ESOPs) XXIV.Individual Retirement Savings Plans (IRAs) XXV.Roth Conversion XXVI.Investments XXVII.403 (b) Plans XXVIII.Annuities XXIX.Classification of Annuities XXX.Variable Annuities


Qualified Plans Qualified Plans are used specifically by the Internal Revenue Code to designate certain retirement plans that meet the requirements of the codes. They include the following types of plans commonly used by employers: profit sharing plans, money purchase plans, defined benefit plans, Keoghs, stock bonus plans, annuity plans, bond purchase plans, cash or deferred arrangement (CODA)/401K plan, ESOP's or employee stock ownership plans. These plans are highly promoted by the federal government as a supplement to the social security system. The tax benefits that they offer are much greater than other nonqualified retirement plans. These plans also cover the majority of employees in private businesses and corporations. The aggregate benefits of these plans at retirement sustain the livelihood of a large percentage of our retired workers. A recent study found that about 30% of corporate wealth in the United States is invested in retirement plan obligations, and the percentage is projected to increase to 40% and 50% in the next five and ten years respectively as our working population ages. A predominant percentage of the assets in these qualified plans are invested in securities; only a minor portion is invested in tangible properties such as real estate, gold coins, and precious metals. Types of Retirement Plans Defined Contribution Plans These plans distinguish themselves by their contribution formulas. Their benefits accrue solely from: a. amounts contributed to each participants account based on pre-set formula in relation to the participant's earnings, and b. income, expenses, capital gains and losses per participant's account, and c. shares of forfeitures from other participant's account due to nonvesting of benefit and other provisions in the trust document. A defined contribution plan may be a profit sharing plan, money purchase, or a stock bonus plan. A profit sharing plan's contribution formula may be declared annually, and this allows the employer the flexibility to contribute any amount that its earning o reserve permits. The contribution formula for money purchase plans is set by the original adoption agreement or subsequent amendment to the trust documents. Therefore, the employer may be forced to contribute to the plan even in periods of low or negative cash flows.

All defined contribution plan contributions are based on a percentage of the employee compensation, usually the employee's W-2 wages if the company is on a calendar year basis. Since the Tax Reform Act of 1986, profit sharing plans are no longer required to base their annual contributions on profit. Employers can contribute to employee accounts even if the company did not make any money for the year, so long as recurring contributions are intended to be made for future years. Defined Benefit Plans Any retirement plan other than a defined contribution plan is a defined benefit plan. These plans differ from defined contribution plans because the target retirement benefits of the plans are being used as factors to determine the current contribution levels for empoyees. Benefits are estimated by using the employee's years of service, compensation, and several other actuarial assumptions. They are never geared to the employer's profits as defined contribution plans are. Actuarial assumptions are projections set up by mathematicians that specialized in statistics (actuaries) employed by insurance companies. They project benefits based on factors relating to the calculations on premiums, reserves, dividends, insurance, pension, and the annuity rates, using risk factors obtained from experience tables. These experience tables are compiled from both the companies' insurance claims history and other industry and general statistical data. Defined benefit plans are usually more advantageous to older employees who are closer to retirement age, thus, having less time to accumulate the same benefits as other employees with similar earnings. General Qualification Requirements 1.A plan must be written, which is evidenced by the adoption of a plan and trust document. 2.A plan must be in effect. Obtaining a “Determination Letter” from the IRS, and having plan assets go a long way in proving that the plan is in effect. 3.A plan must be communicated to employees. This is easily accomplished by the delivery of “Notice to Employee” about the establishment of the plan, and a “Certificate of Participation” annually to the employees. 4.A plan must be established by the employer. By signing the plan adoption agreement and corporate or business resolution, the employer agrees to set up a plan for the benefit of the employees. 5.Contributions must be made by the employer, the employees or both. Contributions are usually made by the employer for the employees, but some plans also allow voluntary contribution by the employees up to the stature limitation. 6.A plan must be for the exclusive benefit of the employees. 7.A plan must be permanent. Any plan can be amended from time to time as circumstances change, but the plan must be for a permanent purpose.

107 108

8.Any life insurance benefits must be incidental. The tax code limits on how much life insurance (term or whole life) an employee may purchase through his/her plan. 9.Minimum participation standards must be met. This is especially emphasized in defined benefit and 401K plans. 10.A plan must not discriminate in coverage. 11.A plan must not discriminate in contributions or benefits on the basis of income or gender. 12.Annuity payments under a plan must be available in the form of a joint and survivor annuity. 13.Comprehensive vesting standards concerning the vesting of an employee's benefits must be followed. 14.Minimum funding standards must be met. Contributions must be actuarially adequate to meet the projected benefit payments at retirement for defined benefit plans. An insurance policy from Pension Benefit Guarantee Corporation would have to be purchased to cover any future funding inadequacies. 15.A plan must comply with the limitations on contributions and benefits. 16.There must be no assignment of benefits. 17.A plan must meet Social Security integration rules. Not all plans provide this integration. 18.A plan must meet rules for merger, and consolidations. 19.A plan must meet the rules for multi-employer plans. 20.A plan must meet the rules pertaining to the reduction of benefits because of Social Security. 21.A plan must fulfill plan termination requirements. 22.A plan must fulfill special requirements for particular plans. 23.A top heavy plan must contain contingency provisions. Top heavy and key employees in a plan creates special problems especially for small to medium sized plans. Participation and Coverage Requirements (Eligibility) Age and Employment Requirements An employee is eligible for plan coverage as specified in the adoption agreement, but employee must be eligible if he/she is: a. 21 years old and has worked full time for at least one year for the employer if the plan provides a graduate vesting schedule. Or, b. 21 years old and has worked full time for 3 years if the plan provides 100% immediate vesting. Full time is defined as having worked for at least 1,000 hours in a year. However, if the employee's pay period is other than hourly, he/she will be credited the full period if he/she worked at least one hour in that period. Example: An employee works one hour in January and is being paid monthly. The employee will be considered as having worked for the whole month of January when


computing his/her eligibility for plan coverage. The Tax Reform Act of 1986 mandates a minimum participation requirement for all qualified plans. Each plan must cover the lesser of 50 employees or 40 percent of all employees of the employer. All plans, whether new or existing, must comply with this provision for plan year 1989 and beyond. Also, there are the 70% and 80% tests for highly compensated employees. Top Heavy Plan Rules The tax code requires special provisions to be included in a plan to limit the contributions and benefits to certain employees if the plan is found to be top heavy. Beginning in 1984, a plan that primarily benefits key employees is considered “top heavy” and qualifies for favorable tax treatment only if in addition to the regular qualification requirements, it meets several special requirements. A “key employee” is: a. an officer of the company who earns 1 ½ times the defined contribution dollar limit. ($45,000) b. one of the ten largest owners of the company c. 5% owner, or d. 1% owner and earns more than $150,000 A plan will not meet the top heavy rule and favorable tax treatment if more than 60% of all accrued benefits are for key emloyees. There are exceptions to the top heavy rule, the exceptions are: a. Union employees are not included in the calculation b. If the company has no key employee (s) and c. Any government sponsored plan The top heavy rule allows only the first $200,000 of an employee's compensation to be used in the contribution and benefit calculations. This will be escalated annually under a cost of living adjustment. An “owner-employee” is: a. a sole proprietor b. a partner who owns more than 10% of the business Provisions in eligibility, vesting, loan to participants, and contribution limits are usually more generous to regular employees, and more restrictive to an owner-employee. Joint and Survivor benefits


Beginning January 1, 1985, a qualified plan must provide survivor benefits for the surviving spouse of a vested plan participant before retirement age. If a spouse decides not to be covered he/she must waive the survivor benefits in writing. Joint and survivor benefits are usually in the form of a qualified joint and survivor annuity provided by insurance companies. Minimum Vesting Standards “Vesting� means the transfer of the accrued benefit from the trustee to the participant in the event of a distribution. In other words, the employee's nonforfeitable rights to the portion of the plan's assets in specified time periods. The most common vesting schedules are: a. 100% in the 5th year b. 20% in the 3rd year, then 20% more per year, and 100% at the seventh year and later c. 20% in the 3rd year, then 20% more per year, and 100% at the sixth year or later d. 10 year vesting rule: 100% vesting at the tenth year, and no vesting is required before that date. This rule will apply to multi-employee plan only after 1988. Top Heavy Vesting Requirements One of the two more stringent schedules must be used for top heavy plans: a. 2 year full vesting b. 6 year graduated vesting: Years of Service

Vesting %

1 2 3 4 5 6 or more

0 20 40 60 80 100

Minimum Funding Standards Profit sharing and other defined contribution plans are not required to meet the minimum funding standards. 100% insurance funded, governmental and religious plans are also exempted from minimum funding standards. Defined benefit plans are subject to the minimum funding standards in areas such as the cost of the benefits for the participants and in amortizing the accrued unfunded liability and operational gains and losses of the plan. Limitation on Contributions and Benefits


The annual contribution limit for defined contribution plans per participant is the lesser of: a. maximum $30,000, or b. 25% of the participant's earnings These limitations apply to either money purchase plans or a combination of money purchase and profit sharing plans. Profit sharing plans have limits of $30,000 per participant per year and a maximum of 15% of his/her compensation. Example: Owner-employee's net business income is $100,000, contributions for regular employees are 15%. The amount the owner-employee can deduct is: $100,000 x .15 /1.15 = $13,043


The contribution limit for defined benefit plans is calculated annually by using sound actuarial assumptions on retirement benefits at age 65 or later, but not to exceed $90,000 benefit or 100% of the participant's average compensation for the highest three years of earnings with the same employer. Earlier retirement dates would have correspondingly lower limits, such as a $37,800 benefit for age 55 retirement. Employer's contributions to a corporate plan can be made no later than the time of filing the federal income tax return for that year, including extensions. An excess employer contribution to the plan for the current year would result in a 10% excise tax penalty, and additional tax penalty for the underpayment of tax due to the overstatements of deductions. Voluntary employee contributions to a qualified plan are no longer deductible for 1987 and later, except in accordance with the 401K provision of the plan document. All allowable employer contributions to a qualified plan are deductible by the employer, and the contributions are not a taxable event for the employees. Life Insurance Any life insurance benefit must be incidental. The tax code limits how much life insurance an employee can purchase through his/her plan. Rules of thumb for life insurance to be incidental: a. Any pure life insurance including term, universal, and variable life policies cannot exceed 25% of the cost of the participant's benefit. Whole life insurance can have up to 50% of the contribution since only 50% of the premium is considered insurance and the other half is attributed to investment purposes. b. total death benefit at normal retirement date is less than 100 times the anticipated


monthly retirement benefit. This rule is usually associated with defined benefit plans. The pure life insurance cost is taxable to the employee as current income. Permissible Investments Permitted Investments a. Publicly traded securities b. New issues c. Certain Option Strategies on Listed Stocks d. Real Estate Investment Trusts (REITs) e. Limited Partnership f. Mutual Funds g. Short Term Money Market Instruments h. Annuities i. Life Insurance j. Certificates of Deposit k. Deeds of Trust l. Secondary Market Transactions li. Passbook savings n. American Eagle Gold Coins Investments not permitted a. Index Options b. Commodities and Futures Contracts c. Short Sales d. Margin Accounts e. Leveraged Real Estate f. Precious Metal, Stones, Jewelry, Art Objects and other “collectibles” g. Foreign Currencies Unrelated Business Taxable Income All income and gains accumulated within a qualified plan are exempted from current income tax. However, income devised from any “publicly traded partnerships”, and income from any trade or business or yield from investments acquired with debt financing may be taxable to the pension trust as a separate taxable entity if it exceeds $1,000 in a year. Loans Loans from the participant's vested value cannot exceed the lower of: a. $50,000, or b. half of the vested amount unless it is less than $10,000


Loans must be repaid within 5 years. A higher limit is permitted for the first time purchase of a home. Integration with Social Security In order not to duplicate the benefit provided by the social security program and a qualified plan, the code permits the integration of the two benefits which results in savings to the employer. In practice, the employer would usually decide a higher contribution percentage for earnings exceeding a certain level within the social security wage base. Therefore, the lower compensated employees would receive a lower contribution percentage. It also proportionally increases the contribution percentage for the higher paid employees. The code retains a maximum of 5.7% difference between the higher and lower contribution percentages. Plan Termination Plan termination must be for a valid business reason. Plans terminated without a valid business reason within a few years of setting up may be retroactively disqualified by the IRS. Income Taxation of Benefits When to Distribute Benefits In order for distributions not to be subjected to the 10% tax penalty on early withdrawals, they must be for: a. an employee's death b. an employee's disability c. separation from service, such as termination of employment d. uninsured medical bills in excess of 7.5% of adjusted gross income e. the employee is over 59 ½ years old all excise taxes are to be paid in addition to income tax. Lump Sum Distribution The Tax Reform Act of 1986 replaced the ten-year forward income averaging with a five year averaging. This options is only allowed if elected after age 59 ½. A participant can elect this method of distribution only once. A lump sum distribution is the distribution of the entire balance of a plan participant's account due to the participant's death, disability, separation from service, or the participant is over 59 ½ years old. A 15% excise tax will be imposed on any excess of lump sum distribution over $750,000. This limit will be increased in future years.


Periodic Distributions Periodic distributions are payments over at least a two year period, the distributions are taxed by the annuity payments method. The income tax rules applied to annuities do nto require the recipient to include the portion of the annuity payments that represent a return of capital in his/her gross income for income tax purposes. Therefore, a ratio is established for tax withholding purpose which represents the nontaxable portion of the annuities bears to the original capital contribution in the plan. The taxable portion is to be included as gross income for the recipient and is taxed as ordinary income. There is an additional 15% excise tax on annual distribution over $150,000. Tax Free Rollovers A rollover is the tax-free transfer of assets from one plan to another, the assets made payable to the participant. Rollovers must be done within 60 days of asset distribution from a qualified plan, otherwise they are subject to tax as a non rollover distribution. Rollovers can be done: a. from one qualified plan to another b. from a qualified plan to an IRA When transferring money from a qualified plan to an IRA, the funds must be made payable to the IRA trustee to avoid a 20% withholding. This withholding only applies to qualified distributions made payable to the covered participant. Taxation of Death Benefits Pure life insurance proceeds are income tax free to the participant's beneficiary. Death benefits over $5,000 and were not funded by insurance (such as payment from employer's trust account) would be included in the beneficiary's gross income. The lump sum distribution of a cash benefit upon death of a participant would be subject to tax if over $5,000. Annuity payment would be subject to annuity rules. Cash or Deferred Arrangements (CODA)/401 (k) Plans 401 (k) plans have gained popularity in the past several years since employee contributions to the plan can substantially reduce the employer's plan cost. A majority of major US corporations have established or are contemplating to establish one for their employees. 401 (k) plans are very similar to defined contribution previously. It must meet the general qualification requirements of other qualified plans. In addition, CODA has its special requirements primarily involving the Actual Deferral Percentage (ADP), which makes certain that the lower paid employees' benefits will be adequately provided for.


CODA differs from other plans because the majority of its benefits can be provided for by voluntary employee contributions, either through salary reduction agreement or by forgoing a cash bonus, coupled with a matching employer contribution. It must meet the general qualification requirements of other qualified plans, which means: a. The plan must be formally adopted and communicated to all employees by establishing the necessary procedures and documents. b. The plan must meet standards in minimum participation, nondiscrimination, survivors benefit, vesting of benefit, minimum funding and other code requirements as discussed previously. Voluntary Employee Elections Salary Reduction Agreements A CODA can include a salary reduction agreement. Salary withheld as part of the contribution is usually: a. a forth coming raise b. an additional bonus c. a reduction in the present day salary of the employee Cash Payment or Contribution An employee can elect to receive the amount designated for contribution as a cash bonus payment or have all or part of the amount contributed on his/her behalf to the plan. Although contributions are elected and deducted from employees, the contributions are treated as though the employer has made the contribution and thus the employer is entitled to deduct the total employee salary reduction and the employer's matching contribution as costs of the plan. Employees that elect to receive cash instead, will have to include the amount in their gross income. Those who elect to have the amount withheld for contribution instead will have the tax deferred until retirement. Business Entities A self-employed individual, a sole proprietorship, a partnership, or a corporation can set up a CODA. Nondiscrimination Rules for CODAs CODAs have special rules that set them apart from other qualified plans. These rules cover both the number of employees participating in the plan and how the contributions are distributed to the participants' accounts. It is these rules, along with the ADP rules, that insure the lower paid group adequate funding of benefits.


There are two tests that all CODAs must meet to be qualified under the nondiscrimination provision. First Test This rule limits the participation of “highly compensated” and ensures the participation of the lower paid employees in the plan. A “highly compensated” employee is someone who has at least one of the following qualifications: a. 5% or more in ownership b. earns $75,000 or more per year c. earns the top 20% pay scale in the company, and makes $50,000 or more d. presently at $30,000 The first test determines if wnough lower paid employees participate in the plan. Second Test The second test determines whether or not sufficient amounts are being distributed to the lower paid employee accounts using the ADP tests. Actual Deferral Percentage (ADP) The ratio of the employee's annual compensation deferred, in relation to his compensation is called his “deferral percentage” a. The 1.25 Test The 1.25 test requires that the actual deferral percentage for the highly paid group be no more than 1.25 times higher than the lower-paid group, or b. The 2.0 Test 1.The actual deferral percentage for the highly paid group does not exceed those for the lower paid group by a factor of 2.0, and 2.The excess of the actual deferral percentage for the highest paid group over those for the lower paid group cannot exceed 2% Who can be excluded when testing for nondiscrimination? a. Employees who work for less than 6 months in a year b. Employees who work for less than 17 ½ hours per week c. Employees under age 21 d. Union Employees e. Nonresident Aliens


Top Heavy Company A minimum of 3% of compensation must be contributed to the lower paid employees' account in any top heavy plan. Limits on Contributions

1.401k limits can change every year The maximum amount you can contribute each year to all 401k plans in which you participate is the lower of: (1) the maximum percentage of your salary that's allowed under each of your employer's plans, or (2) the dollar limits shown below. For example, if your employer's 401k plan allows you to contribute 10% of your salary, and you earn $50,000, your maximum limit is $5,000, not the $13,000 limit in 2004 that applies only to higherpaid employees. Maximum Limits 2003 . . . $12,000 2004 . . . $13,000 2005 . . . $14,000 2006 . . . $15,000 After 2006, the $15,000 limit for 401k plans is subject to adjustment for cost-ofliving increases.

2.-- Catch-Up Contributions If you are age 50 or older, you may also be eligible to make additional "catch-up contributions" to your 401k plan IF your employer allows them. (Unfortunately, your employer is not required to do so.) 401k catch-up contributions are limited each year to an additional Maximum Limits 2003 . . . $2,000 2004 . . . $3,000 2005 . . . $4,000 2006 . . . $5,000 After 2006, the $5,000 limit can be adjusted for cost-of-living increases.

3.-- Employer Matching Contributions The matching contributions made your employer do NOT affect the above contribution limits. Even if you contribute the maximum amount each year, your employer's matching contributions are in addition to these limits. (FYI: Depending on the design of its 401k plan, a employer can match up to and including 6% of each employee's pre-tax compensation.)


Withdrawals Elective contribution from employee can be withdrawn for extreme emergencies without penalty. Employer matching and automatic contribution cannot be withdrawn without penalty, which is 10%. The tax effects of distributions upon death, disability, and separation from service, or retirement is the same as other qualified plans. Loans Loans are treated the same as other qualified plans. Life Insurance and Other Investments The incidental rule for life insurance is the same as for other plans, investments allowed are the same. Employee Stock Ownership Plans (ESOPs) An ESOP is a variation of a stock bonus plan that is similar to a profit sharing plan, with two exceptions: a. The employer can contribute whether the company is profitable or not b. The contribution is usually in the form of the employer's stock or in cash subject to the participant's right to demand stock in the employer's company. The ESOP trustee typically borrows money from a financial institution to purchase the employer's stocks. Thus, the employer can obtain new cash equity for the company's internal operation or for new ventures, and the employees obtain stock ownership of the company. Individual Retirement Savings Plans (IRAs) Individual Retirement Accounts/Annuity is a tax deferred savings plan for individuals that may also be tax deductible. The amount contributed and income accumulated will not be taxed until withdrawal. WITH THREE FLAVORS to choose from — Roth, deductible or nondeductible — figuring out which IRA is best for you can be confusing. So let us make this simple: If you qualify for a Roth (see table below), this is almost always the way to go. That said, let us reiterate that if your employer offers a 401(k) plan with a match, you should always max it out before considering any type of IRA. But after that, a Roth will typically give you the best bang for the buck. Why is a Roth better? Unlike traditional IRAs (both tax-deductible and nondeductible), withdrawals from Roth IRAs after age 59 1/2 aren't generally taxed. You pay your taxes on the front end by contributing after-tax dollars. So Roth IRAs enable savers who remain in the same income tax bracket at retirement to accumulate more money than even taxdeductible IRAs do. They're also more flexible. With a Roth, you can withdraw contributions (but not gains) for anything you want, penalty- and tax-free. College, home down payments, expenses related to a disability — you name it. The one big restriction is that you'll generally have to wait five years to withdraw conversion contributions from a traditional IRA.


The only problem with a Roth is that you might not qualify. Who does? Joint filers with modified adjusted gross income, or MAGI, below $160,000, and individuals with MAGI below $110,000. (Eligible contributions start to phase out at $150,000 for joint filers and $95,000 for individuals.) If you do qualify for a Roth, you can make annual contributions of $3,000 a person ($3,500 if you will be age 50 or older at year-end). And if your modified adjusted gross income is under $100,000, you can also convert money from traditional IRA accounts into a Roth. You'll have to pay taxes upfront, but over the long term, you'll probably end up earning a lot more. For more on how conversions work, see Roth IRAs: To Convert or Not The IRA Buffet TAX-DEDUCTIBLE IRA Who's Eligible In tax-year 2003, eligibility phases out for individuals with MAGI between $40,000 and $50,000 and for married couples with MAGI between $60,000 and $70,000* (for 2004, between $45,000 and $55,000 for singles, between $65,000 and $75,000 for couples). No income cap for individuals not covered by an employer sponsored retirement plan or for married couples when neither participates in such a plan. If only one spouse participates in an employer-sponsored plan, IRA eligibility phases out between MAGI of $150,000 and $160,000 for uncovered spouse, between $60,000 and $70,000 for covered spouse ($65,000 and $75,000 in 2004). If covered spouse files separately, phase out is between $0 and $10,000. Annual $3,000 tax-deductible ($3,500 if you are age 50 or older at year-end). Contribution Withdrawals taxed as income. Penalty-free withdrawals permitted before age 59 Withdrawals 1/2 for first-time home purchase up to $10,000, higher education expenses or in event of disability or death. Account Value $44,360 After 10 Years** ROTH IRA Who's Eligible Eligibility phases out between MAGI of $95,000 and $110,000 for singles, and $150,000 and $160,000 for married couples. Annual $3,000 not tax-deductible ($3,500 if you are age 50 or older at year-end). Contribution Withdrawals Tax-free and penalty-free withdrawals of earnings plus contributions after five years if you are 59 1/2 or in the following circumstances: death, disability or for first-time home purchase up to $10,000. Penalty-free, but not tax-free withdrawals permitted before age 59 1/2 for higher education expenses. Account Value $46,937 After 10 Years** NONDEDUCTIBLE IRA Who's Eligible Everyone who has earned income. $3,000 not tax-deductible ($3,500 if you are age 50 or older at year-end). Annual Contribution Withdrawals Withdrawals of earnings taxed as income. Penalty-free withdrawals permitted before age 59 1/2 for first-time home purchase up to $10,000, higher education expenses or in event of disability or death. Account Value $42,195 After 10 Years**


*These income caps will increase to $50,000 for singles by 2005 and $80,000 for couples by 2007. **$3,000 annual contributions at 8% growth rate. Assumes that contributions are made on the first day of each year and that withdrawals are taken at the end of the contribution period. Assumes a constant 28% tax rate throughout the projection period and assigns a constant 5% after-tax growth rate to the value of any tax deductions.

To Convert or Not? JUST BECAUSE YOU qualify to open a Roth IRA doesn't mean you can convert your plainvanilla IRA into a Roth. Unfortunately, the income limits for conversion are lower than they are for opening new accounts -- $100,000 adjusted gross income for joint filers and singles. The other problem is that you have to pay taxes on the conversion. That can entail a big cash outlay - cash you may or may not have at the moment. But if you qualify -- and can afford the taxes -- you probably should convert for all the reasons we mentioned above. Do You Have the Cash? This is the biggest hurdle to conversion. The problem: When you move your regular IRA to a Roth, you will have to pay taxes on any earnings and pretax contributions. And you have to pay during this tax year. Technically, you could use some of the IRA money itself to pay the tax, but that's a bad idea. If you do, you will owe a 10% withdrawal penalty on that amount. Plus, you lose the opportunity for tax-free compounding of that principal. To minimize your tax hit, you could, of course, convert just part of your account. But you can't avoid the tax by only rolling over your after-tax contributions. Each dollar you roll over from your IRA is considered a "blended" dollar and taxed to the extent the entire account would be. Will the Rollover Disqualify You for Important Tax Benefits? The conversion income could push you into a higher tax bracket and disqualify you from other tax benefits such as tuition tax credits. How Much Time Do You Have Until Retirement? Generally, the older you are, the less sense it makes to convert a traditional IRA to a Roth. You'll have less time to make up for what you lost in taxes on the conversion. Do You Plan to Leave All of Your IRA to Your Heirs? One case in which it makes sense for an older, traditional-IRA holder to transfer funds to a Roth IRA is when he or she is planning to leave the money to heirs. Why? Two reasons: First, unlike traditional IRAs, Roths require no minimum distributions during the life of the IRA owner or, upon his or her death, the life of his or her spouse. With a tax deductible IRA, you must begin making withdrawals from that account at age 70 1/2, losing out on the chance for that money to continue compounding. That can mean a lot less money for your heirs. Secondly, conversion to a Roth will reduce your taxable estate by the amount of tax you pay. This reduces estate taxes for your heirs. Will Your Income-Tax Bracket Drop After Retirement? The clearest case in which converting from a tax-deductible IRA to a Roth IRA does not make sense is when you expect to drop into a lower income-tax bracket after you retire. Why? You will have to pay income tax on the conversion at your current high rate.


Instead, let the money compound in your regular IRA and pay taxes at your lower rate in retirement.

Who's Eligible?


TAX-DEDUCTIBLE IRA 1. A single person who has not actively participated in or qualified for an employersponsored retirement plan at any time during the year (including a selfemployed plan set up for that person). 2. A single person who actively participates in an employer-sponsored retirement plan and who has an AGI below $55,000 for 2004 ($50,000 for 2003), subject to phase-out rules. 3. A married person when neither spouse actively participates in an employersponsored retirement plan. 4. Both spouses when a joint return is filed, both are active participants in employersponsored retirement plans and joint AGI is below $75,000 for 2004 ($70,000 for 2003), subject to phase-out rules. 5. A married person who actively participates in an employer-sponsored retirement plan but whose spouse does not, provided the couple files jointly and has AGI below $64,000 for 2002 ($70,000 for 2003), subject to phase-out rules. 6. A married person who does not actively participate in an employer-sponsored retirement plan but whose spouse actively participates in such a plan, provided the couple files jointly and has joint AGI below $160,000 (subject to phase-out rules). 7. A married person filing separately with AGI below $10,000 (subject to phaseout rules) who actively participates in an employer-sponsored retirement plan or who has a spouse who actively participates. 8. A married person who: (a) files a separate return, (b) has been separated from the spouse for at least one year, (c) is an active participant in an employer sponsored retirement plan and (d) meets the AGI rule for singles in item 2 above. Note: In all cases, the taxpayer must have earned income (from compensation or self-employment activities) at least equal to the amount contributed to the IRA. For married couples filing jointly, either spouse can have the requisite earned income.

NONDEDUCTIBLE IRA 1. Anyone — regardless of AGI level — provided he or she has earned income at least equal to the amount contributed to the IRA. ROTH IRA 1. Any single person with an AGI below $110,000 (subject to phase-out starting at $95,000). 2. Married people filing jointly with AGIs below $160,000 (subject to phase-out starting at $150,000). 3. Married people filing separately with AGIs below $10,000 (subject to phase-out starting at zero). Note: In all cases, the taxpayer must have earned income (from compensation or self-employment activities) at least equal to the amount contributed to the Roth IRA. For married couples filing jointly, either spouse can have the requisite earned income.

How Much Can I Contribute?


TAX-DEDUCTIBLE IRA The maximum deductible contribution is the lesser of earned income or $3,000 ($6,000 for married couples filing jointly), but this deductible-contribution maximum is subject to the following phase-out rules: 1. If you are single and an active participant in an employer-sponsored retirement plan (including a self-employed plan set up for you), the AGI phase-out range $45,000 to $55,000 for 2004 ($40,000 to $50,000 for 2003). For example, if your 2004 AGI is $47,000, your maximum deductible contribution is $2,400. 2. If you are single and not an active participant, your maximum deductible contribution is $3,000, regardless of your AGI. 3. If you are married, and both you and your spouse are active participants, the joint AGI phase-out range for deductible contributions for both of you is $65,000 to $75,000 for 2004 ($60,000 to $70,000 for 2003). For example, if your 2004 AGI is $67,000, your maximum deductible contribution is $2,400 ($2,800 if you will be age 50 or older at year end). 4. If you are married, and your spouse is an active participant, but you are not, the joint AGI phase-out range for your deductible contribution is $150,000 to $160,000. 5. If you are married, and you are an active participant, but your spouse is not, the joint AGI phase-out range for your deductible contribution is $65,000 to $75,000 for 2004 ($60,000 to $70,000 for 2003). 6. If you are married, and neither you nor your spouse is an active participant, both of you can contribute and deduct up to $3,000 (total of $6,000) regardless of your AGI. 7. If you are married and filing separately, and either you or your spouse is an active participant, the AGI phase-out range for your deductible contribution is $0 to $10,000. 8. If you are married and filing separately, have been separated from your spouse for at least one year and are an active participant, the AGI phase-out range for your deductible contribution is $45,000 to $55,000 for 2004 ($40,000 to $50,000 for 2003). If you are not an active participant, you can contribute and deduct up to $3,000 regardless of your AGI ($3,500 if you will be 50 or older at year-end). Note: In all cases, the taxpayer must have earned income (from compensation or self-employment activities) at least equal to the amount contributed to the IRA. For married couples filing jointly, either spouse can have the requisite earned income.

NONDEDUCTIBLE IRA The maximum contribution is the lesser of earned income or $3,000 ($3,500 if you will be age 50 or older at year-end). This contribution is not tax-deductible. ROTH IRA The maximum contribution is the lesser of earned income or $3,000 ($3,500 if you will be age 50 or older at year-end). The maximum contribution is phased-out between the following AGI levels: 1. If you are single, $95,000 to $110,000. 2. If you are married filing jointly, $150,000 to $160,000. 3. If you are married filing separately, $0 to $10,000. Note: In all cases, the taxpayer must have earned income (from compensation or self-employment activities) at least equal to the amount contributed to the Roth IRA. For married couples filing jointly, either spouse can have the requisite earned income.

Taxes Due After Age 59 1/2 TAX-DEDUCTIBLE IRA Income tax due on earnings and original contributions.


NONDEDUCTIBLE IRA Income tax due on earnings (original contributions are withdrawn tax-free). ROTH IRA No tax due if funds are held in the account for at least five years and you are at least age 59 1/2. Total amount of annual contributions can be withdrawn tax-free and penalty-free at any time Early Withdrawal -- Higher Education IRA TYPE 10% PENALTY Tax-Deductible IRA No Nondeductible IRA


INCOME TAX DUE Yes On earnings, not original contributions. On earnings, not original contributions.

Roth -- Less than five years No old. On earnings, not original Roth -- Less than five years contributions. old. No Higher-education expenses must be for you or your family members. Expenses include tuition, fees, room and board (if the student is enrolled at least part time), books and supplies.

Early Withdrawal -- First-Time Home Purchase IRA TYPE 10% PENALTY



Tax-Deductible IRA


Nondeductible IRA


Yes On earnings, not original contributions. On earnings, not original contributions.

Roth -- Less than five years No old. Roth -- More than five years No No old. Limit is $10,000 over your lifetime. To qualify, you must not have owned a home for the past two years. This exemption can be used to buy, build or rebuild a first home for you, your parents, your children or your grandchildren. If you use only part of your exemption, you can use the remainder another time. Early Withdrawal -- Death or Disability 10% PENALTY IRA TYPE No Tax-Deductible IRA


Nondeductible IRA


On earnings, not original contributions.

Roth -- Less than five years old. Roth -- More than five years old.


On earnings, not original contributions.



Early Withdrawal -- Any Other Reason 10% PENALTY IRA TYPE Yes, with exceptions.* Tax-Deductible IRA On earnings, with Nondeductible IRA exceptions.*

INCOME TAX DUE Yes On earnings, not original contributions.

Roth -- Less than five yearsOn earnings, with On earnings, not original old. exceptions.* contributions. Roth -- More than five On earnings, with On earnings, not original years old. exceptions.* contributions. *Exceptions include: (a) if your medical expenses exceed 7.5% of your AGI; (b) if you annuitize your withdrawals; (c) if you collect federal unemployment benefits for 12 consecutive weeks and use IRA withdrawals to pay for health insurance.





1. Anyone who is self-employed. 2. Any employed person with freelance income. 3. Any business owner.

1. Employers with 100 employees or less who do not maintain any other retirement plan. 2. Any self-employed person who does not maintain another retirement plan.

Annual For self-employed: 20% of self Contributions for employment income up to $41,000. 2004 For employees: 15% of salary up to $41,000.

$9,000 in employee contributions ($10,500 if employee will be age 50 or older at year-end). Employer must match up to 3% of compensation. (In certain situations, the match can be 1% to 2%.) The alternative choice is an automatic 2% match for all employees. All employee and employer contributions are immediately vested.

Withdrawals after age 59 1/2. Withdrawals before age 59 1/2.

Taxes due on earnings and contributions. If funds are held for less than two years, there's a 25% early withdrawal penalty plus taxes. After two years, there's a 10% withdrawal penalty plus taxes.

Taxes due on earnings and contributions. 10% early withdrawal penalty plus taxes.

* Simplified Employee Pension Plan. **Savings Incentive Match Plan for Employees.

Tax-Free 60-Day Withdrawals IRA funds can be withdrawn tax-free and penalty-free for 60 days, provided the full amount is returned to the account within this time period. The money can be returned to the same account or to a new IRA. In effect, this is like being able to take a short-term, interest-free loan from your IRA. However, you can do this just once in any 12-month period. If you don't replace the money within 60 days, you will owe income tax on the withdrawal and generally a 10% penalty if you are under age 59 1/2.

What's AGI?


Your adjusted gross income is the number at the bottom on page 1 of your 1040. Specifically, it's your gross income minus so-called above-the-line deductions. These are deductible IRA contributions (as well as deductible SEP, SIMPLE and Keogh contributions), the student-loaninterest deduction, deductible contributions to medical savings accounts, moving-expense deduction, half of the self-employment tax paid by self-employed individuals, the deduction for health-insurance premiums paid by self-employed persons, the deduction for higher education expenses, penalties on the early withdrawal of savings and deductible alimony payments. AGI does not include the standard deduction or itemized deductions. However, the key figure for purposes of calculating eligibility for deductible and Roth IRA contributions is actually "modified" adjusted gross income, or MAGI. This is your AGI (as explained) with the following adjustments: (1) add back deductible IRA contributions, (2) add back the student-loan-interest deduction, (3) add back the deduction for higher education costs, (4) add back Series EE U.S. Savings Bond interest excluded from taxation because it's used to pay higher-education expenses, (5) add back certain employer adoptionassistance payments excluded from taxation and (6) add back certain foreign earned-income and foreign-housing-cost reimbursements excluded from taxation. For simplicity's sake, we have used AGI throughout this article when we really mean MAGI. However, for most people, the MAGI number will simply equal AGI before taking into account deductible IRA contributions. A fair number of people will then have to consider the add-backs for items 2, 3 and 4 above. Only a few will be affected by the add-backs for items 5 and 6 above.

What's Earned Income? This is income that you have actually worked for -- like salary or self-employment income. It does not include investment income such as interest, dividends or profits from sales. It also does not include earnings from pensions or annuities.

Investments The biggest misconception with IRA's is that an IRA is an investment. This is due largely in part to most banks, which package low yielding CD's inside of an IRA to make investors feel like they have no investment options. Many people say, “my IRA gets 6% per year in interest�. Really what that means is the investment inside the tax sheltered IRA account is earning 6%. An IRA is simply an account, where many different types of investments can be held including mutual funds, individual stocks, bonds, etc. Think of the IRA as a paper bag that holds these investments. These investments grow tax deferred and even tax free depending on the type of IRA. 403 (b) Plans A 403(b) plan, like a 401(k) plan, is a retirement savings plan that is funded by employee contributions and (often) matching contributions from the employer. 403 (b) plans are not "qualified plans" under the tax code, but are generally higher cost "TaxSheltered Annuity Arrangements" which can be offered only by public school systems and other tax-exempt organizations. They can only invest in annuities or mutual funds. They are very similar to qualified plans such as 401(k) but have some important differences, as follows. The rules for top-heavy plans do not apply. Employer contributions are excludable from income only to the extent of employees "exclusion allowance." Exclusion allowance is the total excludable employer contribution


for any prior year minus 20% of annual includible compensation multiplied by years of service (prorated for part-timers). Employer contributions must also be the lesser of 25% of compensation or $30,000 annually. Excess contributions are are includible in gross income only if employee's right to them is vested. I also don't know what this means. Contributions to a custodial account invested in mutual funds are subject to a special 6% excise tax on the amount by which they exceed the maximum amount excludable from income. The usual 10% penalty on early withdrawal and the 15% excise tax on excess distributions still apply as in 401(k) plans. Annuities Annuity is defined as a contract that provides an income for a specified period of time, such as a number of years, or for life. Annuity also often refer to the periodic payment itself. An annuitant is the person named in the contract and on whose life the first annuity payment is to be made. An annuitant's beneficiary is the person, persons or entity named in the insurance company's records to receive any death benefits upon the annuitant's death. Fixed Annuity Individuals who invest in an annuity enjoy certain guarantees and favorable income tax treatments: a. Interest accumulated and compounded tax deferred until withdrawal b. Minimum guaranteed return c. Principal guaranteed by the asset of the issuing insurance corporation d. Only the portion withdrawn is taxable The annuity option for annuity payments offer either a specific sum of money or stated periodic payments on regular intervals for the annuitant upon retirement. These future payments do not depend on the investment return of the insurance company's separate investment accounts, and will not fluctuate up or down due to the changing economic conditions. The annuitant will never outlive the annuity payments because they are guaranteed for life. However, the purchasing power of a fixed annuity may decrease during inflationary times. Contributions are not tax deductible by the owner. Classification of Annuities There are five ways to classify a commercial annuity. The name of a particular annuity may depend on the way the insurance company classifies it. a. Dollar value or shares i. Fixed-the value of the annuity contract is expressed in dollars, which is the surrender cash value


ii. Variable-the value of the annuity is the price per share times the number of shares owned by the annuitant b. When periodic payments begin i. Immediate-annuity payment will commence one month after contract effective date ii. Deferred-this accounts for the majority of annuities sold. The annuity payments will not begin until a much later date, usually after retirement c. Single or Multiple Premium Payments i. Single Premium-only one payment is needed. No additional premium is accepted other than reinvestment of dividends ii. Multiple Premium Payments: 1) Flexible-this is the most popular type of contracts sold. The amount of each premium payment can vary and can continue for one or more years at the purchaser's discretion 2) LevelPremiums are fixed at a certain amount d. Disposition of Proceeds i. Life Annuities-no refund if cancelled before death, benefit payments continue and are guaranteed for the life of the annuitant ii. Fixed Periods-10, 20 or more years iii. Guaranteed Payouts 1) Period Certain with no refund, means the benefit is guaranteed for the life of the annuitant but will pay to beneficiary the balance of the period if the annuitant dies prematurely 2) Refund is death occurs prematurely e. Individual or Joint Lives i. Individual-annuity would be paid to one life only ii. Joint Lives (joint and survivor)-annuity would continue after the first annuitant's death until the second annuitants death Variable Annuities A variable or equity annuity is one in which the value of the contract and the amount of the periodic payment depends on the investment results of the portfolio, or on the cost of living index. The cash value of an annuity policy is influenced by the investment performance of the separate accounts. It may increase or decrease daily, and the owner bears the entire investment risk. Both variable annuities and fixed annuities have mortality and expense guarantees. Variable annuities do not have interest guarantees. Both variable and fixed annuities offer loan provisions during the accumulation period. No loan is allowed after the annuity commencement date. The unit value of each share of the portfolio is expresses as the “Net Asset Value� (NAV), the per unit net worth of the portfolio. The NAV is calculated by dividing the 130

current market value of the total portfolio assets less all liabilities, by the total number of shares outstanding. The NAV must be computed at least once per business day. Variable annuities are products of insurance companies. Variable products are regulated by the following agencies: a. The State Insurance Bureau b. The State Securities Bureau c. The Securities and Exchange Commission (SEC) d. The National Association of Securities Dealers (NASD) They are regulated by the above agencies unless the variable product is offered to groups of 25 or more employees, the investment decisions are to made by the employer only, and the majority of the investment is going to the separate accounts and not towards the purchase of insurance. The Trust as a Separate Account The trust is administered and accounted for as part of the general business of the insurance company, but the income and gains or losses of each portfolio are credited to or charged against the assets held for the portfolio without regard to the company's other investment experience, because the trust is treated as a separate account. However, all obligations arising under a variable policy are general obligations of the insurance company, and all company assets are available to meet its expenses and obligations under the policies. The investment trust is usually organized as an open ended mutual fund;however, some are unit investment trusts. The trust has a series of portfolios managed by advisory divisions. Some possible portfolios are: a. Equity-common stocks b. aggressive Growth-small and emerging growth stocks c. World or international equity-stock of other countries d. Natural resources-such as gold and precious metals e. Cash management-money market fund f. U.S. Government-Treasury bonds, GNMAs and other U.S. Government securities g. Corporate bonds The accumulation value of a policy will vary in accordance with the investment performance of the portfolio to which the purchase payment is allocated. While the company is obligated to make the variable annuity payments under the policy, the amount of the payments is not guaranteed except when the fixed annuity option is chosen. Dividend or capital gain distributions received from a portfolio are to be reinvested in shares of that portfolio, when they are no needed to pay taxes. The trustee will redeem shares from the participant's account for annual fees and other expenses relating to the policy and to make annuity payment to the annuitant. These redemptions are usually free of charges. The owner of the policy may be entitled to vote at meetings of shareholders, policyowners 131

are allowed one vote per unit. However, the frequency of the meetings are not fixed. The Policy The variable policy can be either a deferred policy or immediate policy. The decision to exercise annuity payment options can be made when retirement age is reached, which is usually not earlier than age 60 or later than age 75. A variable annuity policy can be a qualified (purchased for a qualified pension plan) or nonqualified policy. The policy is usually nonparticipating and will not share in the profit of the insurance company. The insurance company may surrender any policy with a value below a certain level. Charges a. Policy issue fee-$30 to $100 b. Premium taxes-from 0.5% to 3% depending on the jurisdiction c. Partial withdrawal or total surrender charges-$10 to $20 plus a surrender charge usually starting at about 5%-10% and reducing 1% per year eventually ending without charges d. Annual policy maintenance charge-$30 to $50 e. Trust Charges-0.5% to 2% for administrative and mortality expenses f. Investment advisory fee-0.5% to 1% depending on the portfolio g. Exchange of accumulation units-usually $25 to transfer units between different portfolios Accumulation Period The accumulation period is the period during which purchase payments may be made and is prior to the annuity commencement date. An accumulation unit is a unit of measure used in the calculation of the accumulation value of each investment portfolio. The total in all portfolios account for the value of the policy. The term is used to express ownership of shares in a variable annuity'sseparate account fund. The premiums paid by the purchaser of a variable annuity are credited to the purchaser's account in the form of accumulation units. The valuation period is any business day that the New York Stock Exchange is open for trading or any day that the Securities and Exchange Commission requires the trust shares to be valued. Accumulation Value is the total value of each portfolio that makes up the aggregate value of the policy. The aggregate value is calculated each day by multiplying the value of an accumulation unit on the immediately preceding valuation date by the Net Investment Factor. Net Investment Factor is the value which indicates the percentage change in the net asset value of a portfolio since the preceding valuation date. Annuity Payout Period Annuity payments are payments made by the insurance company to the payee (annuitant) during the annuity period. There are two types of annuity payments, variable and fixed.


Annuity Commencement Date is the date on which the first annuity payment is to be made. Annuity Unit is a unit of measure used in the calculation of the amount of each variable annuity payment. Annuity Period is the period after the annuity commencement date during which anuity payments are made. An assumed investment rate is used to determine the initial monthly variable annuity payment. It bears no real relationship to the actual net investment of the portfolio or to the eventual monthly payouts, but is a benchmark used to compare to. If the separate account performance exceeds the AIR, the monthly payout will increase over the previous month. If the separate account performance is less than the AIR, the monthly income will decrease. During the lifetime of the annuitant and prior to the annuity commencement date, the owner must elect one of the annuity options provided under the policy. If no election is made 30 days prior to the annuity commencement date, an option is defaulted by the insurance company. Fixed Annuity Once established, fixed annuity payments will not change regardless of the investment, mortality, or expense experience. It is calculated based on an established annuity purchase rate by the company in the annuity commencement date, an option is defaulted by the insurance company. Variable Annuity The annuity unit value will not be constant and will vary according to the valuation of the portfolio. i) Annuity Options: Life annuity, life annuity with period certain, joint and survivor annuity, joint and contingent annuity, and fixed payments for a period certain. Death Benefit If the annuitant or owner of the policy dies while it is in effect, and before the annuity commencement date, the insurance company will pay a death benefit to the beneficiary, either in a lump sum or under one of the annuity options. The amount of the death benefit is the greater of: a. the aggregate value b. the net purchase payments less the sum of all amounts withdrawn Owner The policy belongs to the owner. Only the owner can change the beneficiary designations, assign or convey the policy to the annuitant, trustee or third party. Owner's beneficiary is the person, people or entity named to become the new owner if the owner dies prior to the annuity commencement date, and who will receive the death benefit upon death of an owner prior to the annuity commencement date.


Q&A 1. IRA distributions upon retirement are: a. taxed as an annuity payment, gains are realized when received only b. taxed as ordinary income, unless it is a capital gain or loss which must offset against other capital gains or losses before included in gross income c. taxed as ordinary income d. eligible for five year forward averaging 2. Upon separation from a previous employer, an employee must rollover his pension distribution to an IRA or to another qualified plan within: a. b. c. d.

1 year 30 days 60 days 2 months

3. What is the premature withdrawal penalty for an IRA? a. net asset value of the separate account b. accumulated units if a certain index or average is used to calculate the payout c. portfolio using the Dow Jones Industrial Average as one of the contributing factors d. portfolio using prime interest rate as published by the Wall Street Journal 4. Which of the following is/are a defined contribution plan? a. 401 (k) Plan b. Money Purchase Plan c. Defined Benefit Plan d. Both a and b 5. Which of the following individuals may not contribute to an IRA? a. an employee of a stock brokerage firm covered under a 401 (k) plan that i earning $15,000 per year b. a self-employed lawyer who contributes to his Keogh, is the senior partner of a firm and earns over $150,000 per year c. A partner, earning $100,000 per year, in an accounting firm which has established a qualified plan for it's employees d. None of the above 6. Agnes Smith, a single woman, is not covered under her employer's pension plan and has contributed to an IRA for 6 years. She leaves her job and starts a new job where she earns $20,000 annually, and is covered under the new employer's pension plan. Regarding her IRA: a. contributions to the IRA account may continue b. the IRA must be closed c. the money in the IRA account must be combined with any money she will receive


from the pension plan d. contributions into the IRA account must stop, the money in the account will be frozen and interest and dividends can accrue tax-free until she retires 7. In a defined benefit plan, the benefit is determined by: a. the employee's years of service, sex, and age b. the employee's years of service, compensation and several other actuarial assumptions c. the employee being qualified as a “key employee�, years of service and age d. compensation, age and actuarial asumptions 8. Employees of a dental office may be excluded from the dentists profit sharing plan based on which of the following? a. employee A is over 21 years old b. employee B worked 1,001 hours in a year c. employee C worked 7 months part time, total hours worked 980 d. employee D is 59 years old 9. by definition, a variable annuity: a. offers participation in a managed portfolio of securities b. offers tax-deferred income c. carries risk for the annuity holder d. all of the above 10. Mrs. Rugh has an IRA. She is 72 years old, but has not begun to withdraw money from the plan. The penalty that she will be subject to for not withdrawing from the plan is: a. 50% b. 10% c. 15% d. No penalty will be levied

Answers 1) C 2) C 3) B 4) D 5) D 6) A 7) D 8) C 9) D 10) A



In tutorial 10, these are the topics we will discuss: I. Economic Factors II. The Federal Reserve Board & Monetary Policy III.The Federal Reserve System& Securities Markets IV.Fundamental Analysis V. Financial Statement Analysis VI.Balance Sheet VII.Balance Sheet Ratios VIII.Income Statement IX.Income Statement Formulas & Ratios X. Technical Analysis XI.Chart Patterns XII.Trends XIII.Channels XIV.Retracements XV.Candlesticks XVI.MACD XVII.Risk Analysis & Investor Suitability XVIII.Investor Profiles


Economic Factors The following terms pertaining to the economy are often considered when analyzing markets and investments. Business Cycle-the business cycle has four phases: expansion, peak, recession and trough. These cycles create price changes, which lead to changes in total spending in relation to the amount of goods and services being produced. Inflation-Inflation is a gradual rise in prices and resulting decreasing in purchasing power. It is normally associated with economic expansion and a low unemployment figure. Deflation-Deflation is a decline in prices, where production exceeds demand. Deflation normally occurs during recessions and leads to a rise in unemployment. Gross National Product (GNP) or Gross Domestic Product (GDP)-This statistic measures all goods and services produced in the U.S. In a full year. GNP can be expressed in the following ways: Money GNP, using inflated dollars Real GNP, measured in 1972 dollars Real GNP is considered a more realistic measure, as it is adjusted for the effects of inflation. Recession-means 6 months of declining GNP. Depression-Means 6 quarters of declining GNP Consumer Price Index (CPI)-This indicator of the change in prices of goods and services is published by the U.S. Bureau of Labor Statistics. Included in the index are food, transportation, medical care, entertainment and other items purchased by households and individuals. Balance of Payments-This is a summary of money flowing in and out of the U.S. If the U.S. Is spending more for imported goods and services than it receives for goods it exports, a deficit results. If the US received more money by selling goods in foreign markets than it spent on imports, the deficit would decrease. A decrease in the balance of payments raises the federal deficit;an increase in the balance of payments would reduce the deficit. Money Supply-This is the total amount of available money and credit in the US. The Federal Reserve Board attempts to control money and credit to create a stable, growing economy. The following are the most significant components of the money supply for the


purposes of analyzing investment markets. M-1-includes all currency in circulation plus demand deposits. Demand deposits are those which depositors may withdraw at any time (on demand) without prior notice, such as business and personal checking accounts at commercial banks. M-2-includes M-1 plus overnight eurodollars (dollars trading overseas), overnight repurchase agreements, money market shares, savings deposits held by thrift institutions and time deposits in commercial banks. A time deposit is one that the depositor agrees to leave in the bank for a set period of time. (time deposits earn a specific amount of interest;if funds are withdrawn sooner than agreed, interest is forfeited). The Federal Reserve Board computes the M-1 measure weekly and publishes it each Thursday afternoon. The M-2 figure is published on the last Thursday of each month. Prime Rate-This is the rate of interest banks charge their best customers, usually well established companies, to borrow money. Call Rate-This is the rate of interest banks charge brokerage firms to borrow money, also referred to as the broker loan rate. Brokerage firms often borrow to extend credit for margin accounts. The loans are collateralized by securities and referred to as “call loans” Intermediation-This is the process whereby investors deposit funds in commercial banks and savings and loans. These “intermediaries” in turn to invest the funds in bonds or other securities with yields higher than the rates they are paying depositors. Disintermediation-This is the process whereby investors withdraw funds on deposit with banks and savings and loans, and invest directly in securities with higher rates of return. The Federal Reserve Board and Monetary Policy The Federal Reserve System, the nation's central bank, was established in 1908 as an independent agency of the federal government. The US is divided into 12 Federal Reserve Districts. The Federal Reserve's Board of Governors is responsible for coordinating the activities of the 12 district banks. The Board has seven members who are appointed by the President and confirmed by the Senate. In recent years, the goals of the Federal Reserve Board (“Fed”) have been to reduce the federal deficit, promote economic growth and control inflation. The following are its three primary tools for implementing monetary policy. Open Market Operations Open market operations are the Fed's most effective short term monetary control. Using open market operations, the Fed can effect changes in the economy by increasing or decreasing the money supply. Open market operations consist of buying or selling US government securities, primarily treasury bills. The Fed may also purchase or sell


treasury notes and bonds. When the Fed buys government securities, it pays for them with funds which are channeled into commercial banks. This increases the banks' deposits and adds to their funds available for loans. To tighten the money supply, the Fed sells government securities to banks and securities dealers, who pay for them using demand deposits held by commercial banks. The withdrawals reduce the amount of money banks are able to lend. The Federal Open Market Committee (FOMC) oversees the Fed's open market operations. Members of the FOMC include the seven governors of the Federal Reserve System, the president of the Federal Reserve Bank of New York and the presidents of four other district banks represented on a rotating basis. While each member of the FOMC has one vote, the Chairman of the Board of Governors traditionally plays a decisive role in formulating policy, and acts as chief spokesman for the system. The FOMC meets approximately once a month to review economic conditions, goals and guidelines for open market operations. At the end of its meeting, it issues directives to the manager of the Fed's open market account in New York to buy or sell government securities. Discount Rate This is the rate of interest the Fed charges commercial banks for borrowed funds. Borrowing from the Fed's “discount window� is intended to help banks in emergency situations;it is not to be used as an inexpensive means of borrowing to generate profits. If the Fed considers bank borrowing excessive, it may discourage it by raising the discount rate. An increase in the discount rate tightens the money supply;a decrease eases the money supply. Because the discount rate affects the cost of borrowed funds throughout the banking system, it has a significant impact on short term interest rates. Changes in the discount rate are made infrequently and are usually considered a strong indication of a shift or reversal in monetary policy. Reserve Requirements A reserve requirement is the percentage of its deposits a bank must keep on reserve with the Fed. Demand deposits are volatile, and therefore have a higher reserve requirement than time deposits, which remain in banks for longer periods of time. The higher the reserve requirement, the less banks can lend. An increase in reserve requirements makes money less available;a decrease in reserve requirements has the opposite effect. In summary, if the Fed wishes to decrease the availability of money and credit, it sells


government securities in the open market. When banks and dealers pay the Fed for securities they have purchased, substantial amounts of money are taken out of the banking system, resulting in tighter money and credit. If the Fed wishes to increase the availability of money and credit, the FOMC, through its trading desk, will buy government securities in the open market. When the Fed pays the banks and nonbank dealers for the securities, the result is an injection of funds into the banking system, making money and credit more available. Any method or tool that creates additional money for the banking system is inflationary; any method or tool that shrinks the amount available in the banking system is deflationary. It should be noted that the amount of money banks can lend depends not only on the Federal Reserve's policy of ease or restraint, but also on the banks' ability to attract money from depositors. The greater a bank's deposits, the greater it's lending ability and the more profit it will make on loans;the less deposits it attracts, the less money it will have to lend. The Federal Reserve System and Securities Markets In addition to open market operations and changes in the discount rate and reserve requirements, the Fed has several other methods of controlling the cost and availability of funds. These include raising and lowering margin requirements for loans to purchase securities. The Securities and Exchange Act of 1934 gave the Federal Reserve Board the power to determine the amount of credit extended by brokerage firms and banks for the purchase of securities. Regulation T of the Federal Reserve System governs margin lending by brokerage firms;Regulation U covers lending by banks. For several years, the “Reg T” margin requirements for initial stock purchases has been 50%. Margin requirements are not as effective a tool for the Fed as the three methods described above. Margin requirements affect only the securities markets;open market operations, the discount rate and reserve requirements affect the entire banking system. Multiplier Effect The multiplier effect is the magnifying effect of the Fed's monetary policy. As money is created by loans, and deposits are made with the borrowed funds, there is a multiplying effect as “money creates more money”. For example, if a $10,000 loan from a bank is deposited in another bank, the second bank may lend the deposited funds less the reserve requirement. For example, if the reserve requirement is 16%, the second bank must keep $1,600 and may lend $8,400. If this $8,400 is deposited into a third bank, the bank must keep 16% or $1,344 on reserve and may lend $7,056.


Theoretically, this process can continue through several banks, until many times the amount of the original $10,000 loan is added to available credit. If the above example were carried further, it would show that $10,000 of new money in the banking system creates approximately $62,500 in additional credit. A rough method of determining the amount of credit generated by a new deposit is to divide 100 by the reserve requirement as follows: Ex: 100/16% = 6.25, so the multiplier is 6.25 times $10,000 new money injected into the banking system x 6.25 = $62,500 in credit. The multiplier effect is accomplished through the commercial banking system, this is why banks are said to “manufacture money”. Fiscal Policy Fiscal policy involves taxation and government spending. While Congress must approve fiscal policy, it is the Office of Management and Budget (“OMB”) that conceives the strategy. If the economy is at full employment, where an increase in government spending would only increase prices and lead to inflation, the government may adopt a policy of restraint. It can implement this policy by raising taxes or decreasing expenditures. If unemployment rises to a level where the nation's resources are under utilized, the government may respond with a fiscal policy to stimulate the economy. The results could be a decrease in taxation, an increase in government spending or both. The system which requires interaction between the Federal Reserve's monetary policies and the government's fiscal policies is intended to curb inflation and deflation, thus minimizing the extremes of economic expansion and recession. Fundamental Analysis The focus of fundamental investment analysis is on a company's primary business and how it is managed. Industries are evaluated based on qualitative factors such as general outlook, foreign competition and the possible effects of the economy and fiscal policy. Individual companies are examined with respect to their products, profitability, financial structure, management and other internal considerations. Industry Analysis Industries develop through a cycle which consists of the following phases. Pioneering, characterized by rapid expansion;


Maturity, where many small companies consolidate into a few large companies;and Stabilization, where growth slows and a few companies remain. As an industry evolves through these three phases, and growth potential is diminished, investors demand higher dividend payouts from individual companies within the industry. Industries are classified as follows: Defensive-A defensive industry is one that is relatively insensitive to changes in the economic environment. Demand for its products will remain fairly level regardless of the economy, interest rates or fiscal policy. Defensive industries include food, pharmaceuticals and utilities. Cyclical-Cyclical industries are those most affected by changes in the general economy and business cycles. Many cyclical industries are highly sensitive to interest rates. The automobile, housing and steel industries are among those considered cyclical. Growth-A growth industry is one that is growing faster than the overall economy. Growth industries are characterized by accelerated research and development;dividend payouts, if any, are low. For most companies in growth industries, stock prices are influenced more by investor expectations of future performance than by economic factors. Current examples of growth industries include biotechnology, robotics, and telecommunications. Fundamental analysts seek industries with positive aspects, and then examine individual companies within those industries to determine which have the best potential. Financial Statement Analysis The basic purpose of analyzing financial statements and ratios is to determine the success with which a company is meeting its objectives. The overall objective of most businesses is to earn a profit on invested capital, while maintaining steady growth and a sound financial condition. A company's financial strength and profitability are inter-related. A company unable to meet it's debts on a timely basis is likely to experience difficulty in obtaining credit. This limits expansion and could lead to a decline in profitability. A company with profits substantially lower than its competitors may be at a disadvantage in obtaining debt financing or new equity capital. In fundamental analysis, the financial statements most often used to determine a company's soundness and profitability are the balance sheet and the income statement. Balance Sheet The balance sheet is a financial picture of a company as of a specific date, usually the last


day of a financial reporting period. (most companies follow a calendar year with quarters ending March 31, June 30, September 30 and the year ending dates). A balance sheet lists what a company owns and what it owes. It is divided into two sidesassets are shown on the left, and liabilities and equity are shown on the right. The totals for each side are the same. The following is a sample balance sheet, followed by a description of its various components and the most commonly used formulas and ratios for analyzing them. Balance Sheet (000's omitted) Assets


Current Assets

Current Liabilities

Cash $60,000 Marketable Secs $20,000 Accts. Receivable $30,000 Inventory $50,000

Accts. Payable Interest Pay. Notes Payable Taxes Payable

$30,000 $ 2,000 $18,000 $ 2,000

Total Current assets

Total Current liabilities



Fixed Assets

Long Term Liabilities

Plant & Equipment (orig. cost $30,000) $20,000 Furniture & Fixtures $10,000 (orig. cost $15,000)

8% First Mtg. Bonds due 1990


Total Liabilities


$30,000 Intangible Assets Goodwill

Shareholder's Equity $10,000

5% Pd. Stock ($100 par) Common Stock ($4 par) Capital Surplus Retained Earnings Total Shareholders Equity

Total Assets


Total Liabilities & 143

$10,000 $48,000 $ 3,000 $19,000 $80,000

Shareholder Eq.


Assets are what the company owns, along with property or equipment it is buying. Liabilities are what the company owes, including mortgages on property or loans payable on equipment. Shareholder's equity is the portion of the company belonging to the investors. In theory, if the company were to liquidate, by selling all its assets and paying all its debt, the shareholder's equity figure would remain, to be divided among the shareholders according to the number of shares held. This is illustrated by the basic balance sheet equation shown below. Assets-Liabilities = Shareholder's equity or Assets = Liabilities + Shareholder's Equity The mechanics of a balance sheet are such that an increase or decrease on one side will result either -an equivalent change (increase or decrease) on the opposite side in the same amount; -an offsetting change on the same side in the same amount. For example, when the company pays its debts the result is that liabilities and cash decrease by the same amount. If it purchases equipment on installment, an increase in fixed assets and a corresponding increase in liabilities results. If the company purchases inventory for cash, the amount of cash decreases and the value of inventory rises by the same amount. Assets Assets are usually categorized as either current or fixed. Current Assets In general, current assets include cash, financial assets (such as treasury bills and CD's) and other assets that would, in the normal course of business, become cash within one year. Current assets are listed in order of how readily they can be turned into cash, and include the following: Cash includes funds in checking and savings accounts, along with petty cash. Marketable Securities represent funds invested in securities which can be sold (ie: readily converted to cash). They are usually valued at no cost on the balance sheet;more conservative companies list their value at the lower of cost or market. If there are any restrictions on the sale of a security within the coming year, it would not be considered a


current asset but would be listed among “other assets” on the balance sheet. Accounts Receivable include amounts owed the company for goods sold or services rendered. Companies in business for several years can usually estimate a small percentage of receivables which will not be collected. In this case, the accounts receivable figure may be shown less an allowance for bad debts. Inventory is often the most valuable current asset. It consists of goods the company holds for sale. For a manufacturing company, inventory includes raw materials used to make products, partially completed goods or “work in process” and finished goods. While there are many acceptable ways of valuing inventory, it is usually shown either at cost, or the lower of cost or market. Prepaid Expenses consist of advance payments the company has made for goods or services it will use within the next twelve months. Examples are prepaid rent or prepaid insurance premiums. If an item is prepaid more than one year in advance, it would be shown as a “deferred charge” and listed among “other assets”. Fixed Assets Fixed assets are capital assets the company uses in its primary business and does not intend to sell. Fixed assets are sometimes referred to as “property, plant and equipment” and include the following: Land-land owned by the company is generally shown at original cost. While buildings are depreciable for tax purposes, raw land is not. Raw land is therefore listed separately on the balance sheet. Buildings, Machinery and Office Equipment are also shown on the balance sheet at original cost. These assets are subject to “wear and tear”, which decreases their value as they get older. To adjust for the decline in value, a portion of their cost is deducted each year as depreciation. The annual amount of depreciation is deducted from income, thus reducing the company's tax liability and enabling it to recover the cost of the item. The value of fixed assets is shown on the balance sheet “less accumulated depreciation”. Other Assets Assets which cannot be classified as either current or fixed are listed on the balance sheet as “other assets”. The following are examples. Intangible Assets-These are assets which do not have a physical presence, but are valuable to the company. Intangible assets include goodwill, patents, copyrights, trademarks, franchises, customer lists and the like. Deferred Charges-Deferred charges are prepayments for goods and services which will not be used in the coming year. Liabilities


Liabilities are shown on the right side of the balance sheet and are categorized as either current or long term. Current Liabilities These are debts payable within one year. The following are current liabilities. Accounts Payable are amounts the company owes its vendors and suppliers, usually payable within 90 days or less. Notes Payable are amounts owed to banks or other lenders, payable within 12 months of the balance sheet date. Taxes Payable include quarterly payroll taxes, sales tax or any other tax liability incurred by the company but unpaid as of the date of the balance sheet. Accrued Expenses are salaries, wages and commissions due employees;insurance premiums;fees for attorneys or accountants and any other expenses the company has incurred as of the balance sheet date but has not yet paid. Accrued Interest is interest the company owes but has not paid as of the balance sheet date. Long Term Debt, Current Position-This figure represents any portion of the principal of a long-term bond or note issue, or other loan payable within one year of the balance sheet date. Dividends Payable would be shown as a current liability if the company's board of directors had declared a dividend which had not actually been paid to shareholders as of the balance sheet date. Long Term Liabilities The following debts, if payable more than one year from the date of the financial statement, are listed as long term liabilities or long term debt. Bonds and Notes. These long term liabilities are normally issued in denominations of $1,000. They represent funds the company has borrowed from investors and agreed to pay back at some future date, referred to as the maturity date. Until this time, the company pays a fixed rate of interest in semiannual installments. Any portion of the principal payable within one year is considered a current liability, and listed on the balance sheet as “long term debt, current position�. Interest owed as of the balance sheet date and not yet paid is shown as accrued interest, a current liability.


Shareholder's Equity This section follows the liabilities on the right hand side of the balance sheet. It reflects the ownership interest of the company's investors and is also referred to as net worth. It is the amount remaining after subtracting total liabilities from total assets. Shareholder's equity is classified as follows. Preferred Stock is an equity security the company has issued, shown on the balance sheet at it's par value. This is usually the amount the company received for the stock when it was first sold. In the event of liquidation, preferred shareholders have a claim on the company's assets prior to the common stockholders. Preferred holders are also entitled to dividends, which are usually at a fixed rate and must be paid before any dividends may be paid on common shares. Common stock is an equity security ranked junior to preferred stock. Common stockholders have a subordinated claim on the company's assets and any dividends the company may pay. However, while preferred dividends are almost always a fixed amount, the amount of common stock dividends may fluctuate with the company's earnings. Capital Surplus, also called paid-in surplus or paid-in capital, is any amount received for stock when originally issued in excess of its par value. EX: If the company received $9.00 per share for its common stock, which has a par value of $4.00, the difference of $5.00 must be accounted for. This amount would be shown in the capital surplus account. Retained Earnings are also referred to as earned surplus. The entry reflects accumulated profits the company has earned over its years in business, less any dividends paid to shareholders. It is also a “balancing� factor for the balance sheet, and is adjusted up or down to compensate for an increase or decrease in the value of assets. Balance Sheet Ratios Working Capital Ratios-Working Capital is the difference between total current assets and total current liabilities. Working Capital = Current Assets - Current Liabilities Example: $160,000 - $70,000 = $90,000 Working capital enables a company to meet it's obligations, expand its value and take advantage of opportunities. The following formulas are used to determine whether a company has a sound working capital position.


Current Ratio-This is the ratio of current assets to current liabilities. Example: Current Assets/Current Liabilities = $160,000/$70,000 = 2.29:1 For most companies, a current ratio of at least 2:1 is considered sound. If the company has less than $1.00 in current assets for each $1.00 in current liabilities, it could have a near term cash shortage. Quick Ratio-This ratio is also referred to as the Acid Test or Liquidity Ratio. Quick assets are cash and other current assets which can be quickly converted to cash. Inventories are not included, as they must first be sold. (in other words, quick assets are current assets less inventory). The quick ratio is a more rigorous test of a company's ability to meet it's short term obligations. It is found by dividing quick assets by current liabilities. Acid Test = Current Assets - Inventory/Current Liabilities Ex: $160,000 - $30,000/ $70,000 = 1.86:1 For each $1.00 in current liabilities, $1.86 in liquid assets are available. A well established company should show a comfortable ratio of quick assets to current liabilities, normally at least 1 to 1. Capitalization Ratios-these ratios give the percentage of total capital represented by bonds and notes, preferred equity and common stock. The total amount of capital invested in the company is determined as follows. Total Capitalization = Bonds & Notes + Shareholder's Equity Ex: Bonds and Notes $50,000 Shareholders Equity $80,000 = Total Capitalization $130,000 Capitalization ratios divide the par value of the security by the company's total capital. Debt Ratio-This formula shows how much of the company's capital structure consists of debt. Debt Ratio = Bonds + Notes/Total Capitalization Ex: Bonds + Notes/Total Capitalization

$50,000/$130,000 = 38.5% Preferred

Stock Ratio-This is the ratio of preferred equity to total capitalization. Preferred stock ratio = preferred stock/total capitalization Ex: Preferred Stock/Total Capitalization

$10,000/$130,000 = 7.7%


Common Stock Ratio-Because capital surplus and retained earnings accrue to the common shareholders, they are added to the par value of common stock when comparing it to the company's total capitalization. Common Stock Ratio = Common Stock + Capital Surplus + Retained Earnings/Total Capitalization Ex: $48,000 + $3,000 + $19,000/$130,000 = 53.8% Debt to Equity Ratio-This measures the percentage of debt in a company's capital structure, or the degree to which the company is using leverage. Debt to Equity Ratio = Total Liabilities/Total Liabilities + Shareholder's Equity Ex: $120,000/$200,000 = 60% The percentage of debt to equity acceptable from an investment standpoint varies among industries. Utilities, for example, tend to have a high percentage of debt in their capital structures, while the percentage for service industries is relatively low. Book Value-This figure actually represents the value per share of common stock in the event of liquidation. Book value per share is equal to the net assets available for common stock, divided by the number of outstanding shares. Ex: To find net assets available for common stock: Total Assets -Intangible Assets = Total tangible assets

$200,000 $(10,000) $190,000

-total liabilities -preferred stock =net assets available for common stock

(120,000) (10,000) $60,000

To find the number of shares outstanding, Common Stock/Par value per share

48,000/$4 = 12,000 shares outstanding Book Value

= Net assets available for common stock/number of shares outstanding Ex: $60,000/12,000 = $5.00 per share Income Statement Unlike the balance sheet, which reflects the company's financial position as of a particular date, the income statement summarizes the company's activities over a given period of


time, usually either a quarter or full year. The income statement shows revenues and expenses from both the company's primary business and its other activities. It also reflects taxes and dividends paid, and any profit or loss remaining after all obligations have been met. The income statement is sometimes referred to as the operating statement, profit and loss statement (P&L) or earnings report. The following is an example, along with a brief definition of the items included in the statement, and formulas and ratios commonly used to analyze it. INCOME STATEMENT (000s omitted) Net Sales Cost of Goods Sold Selling & Admin. Expense Depreciation

$100,000 $40,000 $10,000 $10,000 $60,000

Operating Income Nonoperating Income Earnings before interest & taxes

$40,000 $10,000 $50,000

Interest Expense Taxable Income

$2,000 $48,000

Provision for Income Tax (40%) Net Income Preferred Dividends Earnings Available for Common Stock

$19,200 $28,800 $500

Common Stock Dividends Amount Added to Retained Earnings

$28,300 $12,000 $16,300

Note: The income statement shows revenues generated during the reporting period whether or not they have actually been collected, and expenses incurred whether or not they were actually paid. Depreciation, a noncash expense, also appears on the income statement. A separate financial statement, the cash flow or funds flow statement, reports only the company's actual cash receipts and disbursements. Net Sales, also referred to as Revenues, are monies earned by the company's primary business (ie, the price of goods sold or services rendered). Cost of Goods Sold includes raw material, labor, electricity, insurance, maintenance and other items directly used in manufacturing the company's product.


Selling and Administrative Expenses, also called general and administrative or selling, general and administrative expenses, are those required in the company's primary business which do not directly contribute to its product. These include salaries and commissions paid to salespersons, advertising and marketing expense, office equipment rental and supplies, salaries paid to administrative personnel, accounting and legal expenses, management compensation and the like. Depreciation, while shown as an expense item on the income statement, does not require an actual cash outlay. Depreciation enables the company to recapture the cost of a fixed asset over its useful life. Operating Income-this is the difference between revenues from the company's primary business, and the cost of generating those revenues. Other Income or Loss-this entry is also referred to as Nonoperating Income or Loss. It represents gains or losses not associated with the company's primary business. For example, if a manufacturing company earned dividends or interest from securities investments, this income would be considered nonoperating, as the company's main business is manufacturing, not investing in securities. Extraordinary Gains or Losses are another item occasionally found on an income statement. These gains or losses are material in amount, and generally unusual and infrequent. Extraordinary items may include gains or losses on bond retirements, benefits of tax loss carryforwards accumulated in earlier years, or losses from hurricanes or other natural disasters. Earnings Before Interest and Taxes (“EBIT”)-this is the sum of operating income, plus or minus any nonoperating or extraordinary gains or losses. Interest Expense-Interest expense includes interest the company pays on bonds, notes, bank loans or other debt. (interest is considered “tax deductible” because it is subtracted from income before taxes are computed). Taxable Income-This is the amount on which the company pays taxes at the prevailing corporate tax rate. Provision for Income Taxes-this is the amount of money set aside with which income taxes will be paid when due. (taxes already paid may be shown simply as taxes). Preferred Dividends-This is the fixed amount paid to preferred shareholders, usually on a quarterly basis. (Remember, the company must pay preferred dividends before any dividends may be paid to common stockholders). Earnings Available for Common Stock-This figure represents net income less preferred dividends. It is the amount that accrues to the common shareholders in the shareholder's equity section of the balance sheet.


Common Stock Dividends-This is the amount of dividends, if any, paid to the common shareholders. Amount Added to Retained Earnings-This is the amount of profit which accrues to the common shareholders. It should be noted that this amount is not necessarily represented by cash, but is more likely to be reinvested in the business to purchase inventory, new equipment and the like. If a company is profitable, the amount listed on the balance sheet as retained earnings will increase each quarter, with a corresponding increase in total assets. Income Statement Formulas and Ratios Several formulas are used to analyze the income statement. The following are most useful when comparing companies in like or similar industries. These examples are based on the income statement shown above and the following additional data. Market Price of common stock: Annual Dividend on common stock:

$25.00 $ 1.00

Operating Margin-the operating margin is operating income or profit as a percentage of sales. It indicates the company's gross profit on each $1.00 in revenue, and is computed by dividing operating income by net sales as follows. Operating Margin

= Operating Income/Net Sales Ex: Operating

Income/Net Sales = $40,000/$100,000 = 40% The company is therefore spending 60 cents to generate $1.00 in sales. Note: the operating margin does not include nonoperating or extraordinary gains or losses. Expense Ratio-this is also referred to as the operating ratio, and is a way of examining the company's operating efficiency. The higher the expense ratio, the higher the company's expense for each $1.00 of sales. This measure is especially useful when comparing two companies in the same industry. The formula for the expense ratio is as follows. Expense Ratio = Operating Expense + Interest Payable/Net Sales Ex: $60,000 + $2,000 / $100,000 = 62% Expense Ratio Profit Margin-The profit margin, also called net profit margin or simply net margin is among the most important ratios used to analyze the income statement. It shows the profitability of the company's activities after taxes have been paid. The profit margin is computed as follows. Profit Margin = Net Profit/Net Sales Ex: Net Profit/Net Sales = $28,800/$100,000 = 28.8%


In the above example, for every $1.00 in sales the company made a profit of $.288. The profit margin differs from the operating margin in that it includes nonoperating and extraordinary gains or losses. A company with a highly profitable primary business will have a high operating margin. However, if it loses money on activities not related to its main line of business, such as investing, the profit margin will reflect the drain on profits. Unlike operating margin, the profit margin also accounts for taxes the company has paid. Return on Assets (ROA)-This ratio computes the return the company is generating from its asset base. Return on assets is calculated as follows. ROA = Net Income/Total Assets Ex: ROA = Net Income/Total Assets $28,800/$200,000 = 14.4% Return on Equity (ROE)-this ratio is of particular importance to shareholders. It computes the return the company is earning on investors' capital. ROE is figured as follows. ROE = Net Income - Preferred Dividends/Common Shareholder's Equity Ex: ROE = $28,800 - 500/$48,000 + $19,000 + 3,000 = 40.4% Note that common shareholder's equity includes capital surplus and retained earnings. Cash Flow-Cash flow is the total of net income plus depreciation. While depreciation does not require an actual cash outlay, it is treated as a source of funds which the company can save for eventual replacement of fixed assets. Because it is subtracted before taxes are computed, depreciation provides the company with a tax savings and therefore usable funds. Cash flow is figured as follows. Cash Flow = Net Income + Depreciation Expense Ex: $28,800 + $10,000 = $38,800 Inventory Turnover-this is a measure of how efficiently the company is able to turn its inventory into revenue. Inventory turnover is another figure which is most useful when comparing companies in like industries. The following is the formula for inventory turnover. Inventory Turnover = Net Sales/Year-End Inventory Ex: Net Sales/Year-End Inventory $100,000/$50,000 Inventory turnover= 2 times per year The following are the most widely studied ratios with respect to a company's common stock.


Earnings Per Share (EPS)-EPS is the total income which accrues to common shareholders, expressed on a per share basis. It is the most widely used measure of the company's profitability and is computed as follows. EPS = Net Income - Preferred Dividends/Common Shares Outstanding Ex; EPS = $28,800 - $500 / 12,000 = 2.36 Preferred dividends are deducted when computing EPS because they must be paid before any earnings are available for common stock. If a company has issued convertible securities (preferred stock or debt), it must report another EPS figure known as fully diluted EPS. When convertible securities are tendered in exchange for common stock the number of common shares outstanding increases, which causes a decrease in earnings per share. Fully diluted EPS assumes that all convertible securities-preferred stock, debt, rights and warrants-have been converted to common stock. (for a company with convertible securities in its capitalization, the EPS figure before conversion is referred to as primary EPS. Analysts and investors often compare a company's quarterly EPS figure with those from previous quarters and with EPS for the same period the prior year. This gives an indication of the trend in the company's profitability. Ideally, EPS will rise consistently and steadily over time. Price/Earning Ratio (P/E Ratio)-This figure shows the relationship between the price per share of a company's common stock and the underlying earnings per share. It is also referred to as the P/E multiple and is calculated as follows. P/E = Market Price per Share/Earnings per Share Ex: P/E= Market Price per Share/Earnings per share = $25.00/$2.36 P/E = 10.59, rounded to 10.6. The stock is selling at 10.6 times earnings per share. The P/E ratio considered reasonable varies among industries. The price investors will pay for common stock is a function of their expectation of future profitability. Shares of a company in a growth industry, such as technology, will command a higher price per share in relation to earnings than a company in a declining industry such as steel. From an investor's standpoint, shares in a growth company are worth more than shares in a company experiencing little or no growth in profitability. Current Yield -The current yield for common stock expenses the dividend as a percentage of the stock price. It is also referred to as dividend yield, and is calculated as follows. Current Yield = Annual Dividend per Share/Market Price


Ex: Current Yield = Annual Dividend Per Share/Market Price = $1.00/25.00 = 4% The yield on a stock naturally depends on the price paid;once shares are purchased, an investor's yield remains constant until the amount of the dividend is increased or reduced. Dividend yield is particularly important to investors for whom income is of prmiary importance. Dividend Payout Ratio-This is the percentage of earnings available for common stock that the company pays to shareholders as a cash dividend. The formula is as follows. Dividend Payout Ratio = Dividend per share of common stock/Earnings per share Ex: Dividend per share of common stock/earnings per share = $1.00/$2.36 Dividend Payout Ratio = 42% Most companies attempt to keep their dividend payout ratio level over time. However, if a company experiences a particularly strong year with a sharp rise in earnings, it usually will not raise its dividend unless it expects the surge in profitability to continue. Conversely, most companies will not reduce the amount of the dividend in a disappointing year if there is a reason to believe that earnings will recover in the near future. Technical Analysis A technical analyst is also called a chartist. Technical analysis uses statistics to plot graphs;investment decisions are made based on stock price movements and trading volume. Other factors used in technical analysis include new highs and lows in securities prices and the number of issues advancing in price compared to the number declining. In addition to individual stocks, technical analysts often chart stock indices and averages. A stock index is composed of a large number of issues whose prices are tracked on a regular basis. The Standard and Poor's (S&P) 500 Index is composed of 500 companies' stocks, 400 of which are industrial companies. The NYSE Composite Index is composed of all common stocks traded on the New York Stock Exchange. The Wilshire Index is the broadest index and includes 5,000 different stocks. An average is composed of a smaller number of issues considered to represent the overall market. The most widely followed are the Dow Jones Averages. The Dow Jones Industrial Average is composed of 30 companies, all of which were industrial until the mid 1970's. (the average now includes retailing and service companies). The 30 companies in the Dow Jones Industrial Average are not equally weighted. Chart Patterns Technical analysts consider the following patterns of stock price movement and trading activity when planning and timing investments.


Resistance Level This is the point to which the price of a stock will rise, but have difficulty exceeding. This point is also called the demand level. A technical analyst would usually consider selling at this point. Support Level The support level is the point to which a stock declines, where buying materializes to keep the price from falling any further. The support level is also called the supply level; technical analysts usually recommend buying at this point. TRENDS Trend is simply the overall direction prices are moving -- UP, DOWN, OR FLAT.




________ ________ _ ______ _ _________________________ ____ _____________________ ________ _ _________ ___________ ________ _____ ___ __ __ ___ _ ___________ _____ ___ _ __________ _________ ________ _____ ___ __ __ ___ _______



__ ____ __ _

_________ ______


____________ _____ ____ ____ __ ___ _____ _


Candlesticks Another very useful way of charting is to apply Japanese Candlestick charting to technical analysis.


Introduction Japanese rice traders developed candlesticks centuries ago to visually display price activity over a defined trading period. Each candlestick represents the trading activity for one period. The lines of a candlestick represent the opening, high, low and closing values for the period. The main body (the wide part) of the candlestick represents the range between the opening and closing prices. If the closing price is higher than the opening price, the main body is white. If the closing price is lower than the opening price, the main body is black. The lines protruding from either end are called wicks or shadows.

Bearish 3 Pattern

A long black body followed by several small bodys and ending in another long black body. The small bodys are usually contained within the first black body's range.


A bearish continuation pattern.

Bearish Harami Pattern

A very large white body followed by a small black body that is contained within the previous bar.

Interpretation A bearish pattern when preceded by an uptrend.

Bearish Harami Cross Pattern

A Doji contained within a large white body.

Interpretation A top reversal signal.

Big Black Candle Pattern

An unusually long black body with a wide range. Prices open near the high and close near the low.

Interpretation A bearish pattern.

Big White Candle Pattern

A very long white body with a wide range between high and low. Prices open near the low and close near the high.

Interpretation A bullish pattern.

Black Body Pattern

This candlestick is formed when the closing price is lower than the opening price.

Interpretation A bearish signal. More important when part of a pattern.

164 165

Bullish 3 Pattern

A long white body followed by three small bodies, ending in another long white body. The three small bodies are contained within the first white body.

Interpretation A bullish continuation pattern

Bullish Harami Pattern

A very large black body is followed by a small white body and is contained within the black body.

Interpretation A bullish pattern when preceded by a downtrend.

Bullish Harami Cross Pattern

A Doji contained within a large black body.

Interpretation A bottom reversal pattern.

Dark Cloud Cover Pattern

A long white body followed by a black body. The following black candlestick opens higher than the white candlestick's high and closes at least 50% into the white candlestick's body.

Interpretation A bearish reversal signal during an uptrend.


Doji Pattern

The open and close are the same.

Interpretation Dojis are usually components of many candlestick patterns. This candlestick assumes more importance the longer the vertical line.

Doji Star Pattern

A Doji which gaps above or below a white or black candlestick.

Interpretation A reversal signal confirmed by the next candlestick (eg. a long white candlestick would confirm a reversal up).

Engulfing Bearish Line Pattern

A small white body followed by and contained within a large black body.

Interpretation A top reversal signal.

Engulfing Bullish Line Pattern

A small black body followed by and contained within a large white body.

Interpretation A bottom reversal signal.


Evening Doji Star Pattern

A large white body followed by a Doji that gaps above the white body. The third candlestick is a black body that closes 50% or more into the white body.

Interpretation A top reversal signal, more bearish than the regular evening star pattern.

Evening Star Pattern

A large white body followed by a small body that gaps above the white body. The third candlestick is a black body that closes 50% or more into the white body.

Interpretation A top reversal signal.

Falling Window Pattern

A gap or "window" between the low of the first candlestick and the high of the second candlestick.

Interpretation A rally to the gap is highly probable. The gap should provide resistance.

Gravestone Doji Pattern

The open and close are at the low of the bar.

Interpretation A top reversal signal. The longer the upper wick, the more bearish the signal.


Hammer Pattern

A small body near the high with a long lower wick with little or no upper wick.

Interpretation A bullish pattern during a downtrend.

Hanging Man Pattern

A small body near the high with a long lower wick with little or no upper wick. The lower wick should be several times the height of the body.

Interpretation A bearish pattern during an uptrend.

Inverted Black Hammer Pattern

An upside-down hammer with a black body.

Interpretation A bottom reversal signal with confirmation the next trading bar.

Inverted Hammer Pattern

An upside-down hammer with a white or black body.

Interpretation A bottom reversal signal with confirmation the next trading bar.


Long Legged Doji Pattern

A Doji pattern with long upper and lower wicks.

Interpretation A top reversal signal.

Long Lower Shadow Pattern

A candlestick with a long lower wick with a length equal to or longer than the range of the candlestick.

Interpretation A bullish signal.

Long Upper Shadow Pattern

A candlestick with an upper wick that has a length equal to or greater than the range of the candlestick.

Interpretation A bearish signal.

Morning Doji Star Pattern

A large black body followed by a Doji that gaps below the black body. The next candlestick is a white body that closes 50% or more into the black body.

Interpretation A bottom reversal signal.


Morning Star Pattern

A large black body followed by a small body that gaps below the black body. The following candlestick is a white body that closes 50% or more into the black body.

Interpretation A bottom reversal signal.

On Neck-Line Pattern

In a downtrend, a black candlestick is followed by a small white candlestick with its close near the low of the black candlestick.

Interpretation A bearish pattern where the market should move lower when the white candlestick's low is penetrated by the next bar.

Piercing Line Pattern

A black candlestick followed by a white candlestick that opens lower than the black candlestick's low, but closes 50% or more into the black body.

Interpretation A bottom reversal signal.

Rising Window Pattern

A gap or "window" between the high of the first candlestick and the low of the second candlestick.

Interpretation A selloff to the gap is highly likely. The gap should provide support.


Separating Lines Pattern

In a downtrend, a white candlestick is followed by a black candlestick with the same opening price.



In an uptrend, a black candlestick is followed by a white candlestick with the same opening price.

Interpretation A continuation pattern. The prior trend should resume.

Shaven Bottom Pattern

A candlestick with no lower wick.


A bottom reversal signal with confirmation the next trading bar.

Shaven Head Pattern

A candlestick with no upper wick.


A bullish pattern during a downtrend and a bearish pattern during an uptrend.


Shooting Star Pattern

A candlestick with a small body, long upper wick, and little or no lower wick.

Interpretation A bearish pattern during an uptrend.

Spinning Top Pattern

A candlestick with a small body. The size of the wicks is not critical.

Interpretation A neutral pattern usually associated with other formations.

Three Black Crows Pattern

Three long black candlesticks with consecutively lower closes that close near their lows.


A top reversal signal.

Three White Soldiers Pattern

Three white candlesticks with consecutively higher closes that close near their highs.

Interpretation A bottom reversal signal.


Tweezer Bottoms Pattern

Two or more candlesticks with matching bottoms. The size or color of the candlestick does not matter.


Minor reversal signal.

Tweezer Tops Pattern

Two or more candlesticks with similar tops.


A reversal signal.

White Body Pattern

A candlestick formed when the closing price is higher than the opening price.


A bullish signal.

To see real examples of candlestick charts, go to YAHOO and look up a basic chart for any stock symbol. Once the basic chart loads, you will see a CDL option at the top under “type�. Click on this to view the candlestick chart for that symbol. MACD In addition to candlestick charting, we also look at another technical indicator called the MACD. The MACD is the most used and probably the most reliable technical indicator around. The reason we like it is because it gives early signals which is good for fast moving markets and short term trading. In our lesson regarding the MACD, we will use stock charts, however, the indicator is read the same way for any instrument. Developed by Gerald Appel, Moving Average Convergence Divergence (MACD) is one of the simplest and most reliable indicators available. MACD uses moving averages, which are lagging indicators, to include some trend-following characteristics. These lagging indicators are turned into a momentum oscillator by subtracting the longer moving average from the shorter moving average. The resulting plot forms a line that oscillates above and below zero, without any upper or lower limits.


The most popular formula for the "standard" MACD is the difference between a security's 26-day and 12-day exponential moving averages. This is the formula that is used in many popular technical analysis programs and quoted in most technical analysis books on the subject. Appel and others have since tinkered with these original settings to come up with a MACD that is better suited for faster or slower securities. Using shorter moving averages will produce a quicker, more responsive indicator, while using longer moving averages will produce a slower indicator, less prone to whipsaws. For our purposes in this article, the traditional 12/26 MACD will be used for explanations. Later in the indicator series, we will address the use of different moving averages in calculating MACD. Of the two moving averages that make up MACD, the 12-day EMA is the faster and the 26-day EMA is the slower. Closing prices are used to form the moving averages. Usually, a 9-day EMA of MACD is plotted along side to act as a trigger line. A bullish crossover occurs when MACD moves above its 9-day EMA and a bearish crossover occurs when MACD moves below its 9-day EMA. The Merrill Lynch chart below shows the 12-day EMA (thin green line) with the 26-day EMA (thin blue line) overlaid the price plot. MACD appears in the box below as the thick black line and its 9-day EMA is the thin blue line. The histogram represents the difference between MACD and its 9-day EMA. The histogram is positive when MACD is above its 9-day EMA and negative when MACD is below its 9-day EMA.



MACD measures the difference between two moving averages. A positive MACD indicates that the 12-day EMA is trading above the 26-day EMA. A negative MACD indicates that the 12-day EMA is trading below the 26-day EMA. If MACD is positive and rising, then the gap between the 12-day EMA and the 26-day EMA is widening. This indicates that the rate-of-change of the faster moving average is higher than the rate-of change for the slower moving average. Positive momentum is increasing and this would be considered bullish. If MACD is negative and declining further, then the negative gap between the faster moving average (green) and the slower moving average (blue) is expanding. Downward momentum is accelerating and this would be considered bearish. MACD centerline crossovers occur when the faster moving average crosses the slower moving average.


This Merrill Lynch chart shows MACD as a solid black line and its 9-day EMA as the thin blue line. Even though moving averages are lagging indicators, notice that MACD moves faster than the moving averages. In this example with Merrill Lynch, MACD also provided a few good trading signals as well. 1.In March and April, MACD turned down ahead of both moving averages and formed a negative divergence ahead of the price peak. 2.In May and June, MACD began to strengthen and make higher lows while both moving averages continued to make lower lows. And finally, MACD formed a positive divergence in October while both moving averages recorded new lows. MACD generates bullish signals from three main sources: 3.Positive divergence 4.Bullish moving average crossover 5.Bullish centerline crossover


A positive divergence occurs when MACD begins to advance and the security is still in a downtrend and makes a lower reaction low. MACD can either form as a series of higher lows or a second low that is higher than the previous low. Positive divergence's are probably the least common of the three signals, but are usually the most reliable and lead to the biggest moves.


A bullish moving average crossover occurs when MACD moves above its 9-day EMA or trigger line. Bullish moving average crossovers are probably the most common signals and as such are the least reliable. If not used in conjunction with other technical analysis tools, these crossovers can lead to many false signals. Moving average crossovers are sometimes used to confirm a positive divergence. The second low or higher low of a positive divergence can be considered valid when it is followed by a bullish moving average crossover. Sometimes it is prudent to apply a price filter to the moving average crossover in order to ensure that it will hold. An example of a price filter would be to buy if MACD breaks above the 9-day EMA and remains above for three days. The buy signal would then commence at the end of the third day.


A bullish centerline crossover occurs when MACD moves above the zero line and into positive territory. This is a clear indication that momentum has changed from negative to positive, or from bearish to bullish. After a positive divergence and bullish moving average crossover, the centerline crossover can act as a confirmation signal. Of the three signals, moving average crossover are probably the second most common signals.

Even though some traders may use only one of the above signals to form a buy or a sell signal, using a combination can generate more robust signals. In the Halliburton example, all three bullish signals were present and the stock still advanced another 20%. The stock formed a lower low at the end of February, but MACD formed a higher low, thus creating a potential positive divergence.


MACD then formed a bullish crossover by moving above its 9-day EMA. And finally, MACD traded above zero to form a bullish centerline crossover. At the time of the bullish centerline crossover, the stock was trading at 32 1/4 and went above 40 immediately after that. In August, the stock traded above 50. MACD generates bearish signals from three main sources. These signals are mirror reflections of the bullish signals. 1.Negative divergence 2.Bearish moving average crossover 3.Bearish centerline crossover Negative Divergence A negative divergence forms when the security advances or moves sideways and MACD declines. The negative divergence in MACD can take the form of either a lower high or a straight decline. Negative divergence's are probably the least common of the three signals, but are usually the most reliable and can warn of an impending peak.


The FDX chart shows a negative divergence when MACD formed a lower high in May and the stock formed a higher high at the same time. This was a rather blatant negative divergence and signaled that momentum was slowing. A few days later, the stock broke the uptrend line and MACD formed a lower low. There are two possible means of confirming a negative divergence. First, the indicator can form a lower low. This is traditional peak-and-trough analysis applied to an indicator. With the lower high and subsequent lower low, the up trend for MACD has changed from bullish to bearish. Second, a bearish moving average crossover, which is explained below, can act to confirm a negative divergence. As long as MACD is trading above its 9day EMA or trigger line, it has not turned down and the lower high is difficult to confirm. When MACD breaks below its 9-day EMA, it signals that the short-term trend for the indicator is weakening, and a possible interim peak has formed. Bearish moving average crossover The most common signal for MACD is the moving average crossover. A bearish moving average crossover occurs when MACD declines below its 9-day EMA. Not only are these signals the most common, but they also produce the most false signals. As such, moving average crossovers should be confirmed with other signals to avoid whipsaws and false readings.


Sometimes a security can be in a strong uptrend and MACD will remain above it's trigger line for a sustained period of time. In this case, it is unlikely that a negative divergence will develop. A different signal is needed to identify a potential change in momentum. This was the case with MRK in February and March. The stock advanced in a strong up trend and MACD remained above its 9-day EMA for 7 weeks. When a bearish moving average crossover occurred, it signaled that upside momentum was slowing. This slowing momentum should have served as an alert to monitor the technical situation for further clues of weakness. Weakness was soon confirmed when the stock broke its uptrend line and MACD continued its decline and moved below zero. Bearish centerline crossover A bearish centerline crossover occurs when MACD moves below zero and into negative territory. This is a clear indication that momentum has changed from positive to negative, or from bullish to bearish. The centerline crossover can act as an independent signal, or confirm a prior signal such as a moving average crossover or negative divergence. Once MACD crosses into negative territory, momentum, at least for the short term, has turned bearish.


The significance of the centerline crossover will depend on the previous movements of MACD as well. If MACD is positive for many weeks, begins to trend down and then crosses into negative territory, it would be considered bearish. However, if MACD has been negative for a few months, breaks above zero and then back below, it may be seen as more of a correction. In order to judge the significance of a centerline crossover, traditional technical analysis can be applied to see if there has been a change in trend, higher high or lower low. The UIS chart depicts a bearish centerline crossover that preceded a 25% drop in the stock that occurs just off the right edge of the chart. Although there was little time to act once this signal appeared, there were other warnings signs just prior to the dramatic drop. 1.After the drop to trendline support , a bearish moving average crossover formed. 2.When the stock rebounded from the drop, MACD did not even break above the trigger line, indicating weak upside momentum. 3.The peak of the reaction rally was marked by a shooting star candlestick (blue arrow) and a gap down on increased volume (red arrows). 4.After the gap down, the blue trendline extending up from Apr-99 was broken. In addition to the signal mentioned above, the bearish centerline crossover occurred after MACD had been above zero for almost two months. Since 20-Sept, MACD had been weakening and momentum was slowing. The break below zero acted as the final straw of a long weakening process. As with bullish MACD signals, bearish signals can be combined to create more robust signals. In most cases, securities fall faster than they rise. This was definitely the case with UIS and only two bearish MACD signals were present. Using momentum indicators like MACD, technical analysis can sometimes provide clues to impending weakness. While it may be impossible to predict the length and duration of the decline, being able to spot weakness can enable traders to take a more defensive position.

After issuing a profit warning in late Feb-00, CPQ dropped from above 40 to below 25 in a few months. Without inside information, predicting the profit warning would be pretty much impossible. However, it would seem that smart money began distributing the stock before the actual warnings. Looking at the technical picture, we can spot evidence of this distribution and a serious loss of momentum.


1. In January, a negative divergence formed in MACD. 2. Chaikin Money Flow turned negative on January 21. 3. Also in January, a bearish moving average crossover occurred in MACD (black arrow). 4. The trendline extending up from October was broken on 4-Feb. 5. A bearish centerline crossover occurred in MACD on 10-Feb (green arrow). 6. On 16, 17 and 18-Feb, support at 41 1/2 was violated (red arrow). A full 10 days passed in which MACD was below zero and continued to decline (thin red lines). The day before the gap down, MACD was at levels not seen since October. For those waiting for a recovery in the stock, the continued decline of momentum suggested that selling pressure was increasing, and not about to decrease. Hindsight is 20/20, but with careful study of past situations, we can learn how to better read the present and prepare for the future.


One of the primary benefits of MACD is that it incorporates aspects of both momentum and trend in one indicator. As a trend-following indicator, it will not be wrong for very long. The use of moving averages ensures that the indicator will eventually follow the movements of the underlying security. By using exponential moving averages, as opposed to simple moving averages, some of the lag has been taken out. As a momentum indicator, MACD has the ability to foreshadow moves in the underlying security. MACD divergence's can be key factors in predicting a trend change. A negative divergence signals that bullish momentum is waning and there could be a potential change in trend from bullish to bearish. This can serve as an alert for traders to take some profits in long positions, or for aggressive traders to consider initiating a short position. MACD can be applied to daily, weekly or monthly charts. MACD represents the convergence and divergence of two moving averages. The standard setting for MACD is the difference between the 12 and 26-period EMA. However, any combination of moving averages can be used. The set of moving averages used in MACD can be tailored for each individual security. For weekly charts, a faster set of moving averages may be appropriate. For volatile securities, slower moving averages may be needed to help smooth the data. No matter what the characteristics of the underlying security, each individual can set MACD to suit his or her own trading style, objectives and risk tolerance. One of the beneficial aspects of MACD may also be a drawback. Moving averages, be they simple, exponential or weighted, are lagging indicators. Even though MACD represents the difference between two moving averages, there can still be some lag in the indicator itself. This is more likely to be the case with weekly charts than daily charts. One solution to this problem is the use of the MACD-Histogram. MACD is not particularly good for identifying overbought and oversold levels. Even though it is possible to identify levels that historically represent overbought and oversold levels, MACD does not have any upper or lower limits to bind its movement. MACD can continue to overextend beyond historical extremes. MACD calculates the absolute difference between two moving averages and not the percentage difference. MACD is calculated by subtracting one moving average from the other. As a security increases in price, the difference (both positive and negative) between the two moving averages is destined to grow. This makes its difficult to compare MACD levels over a long period of time.


The AMZN chart demonstrates the difficulty in comparing MACD levels over a long period of time. Before 1999, AMZN's MACD is barely recognizable and appears to trade close to the zero line. MACD was indeed quite volatile at the time, but this volatility has been dwarfed since the stock rose from below 20 to almost 100. An alternative is to use the Price Oscillator, which find the percentage difference between two moving averages: (12 day EMA - 26 day EMA) / (12 day EMA) (20 18) / 20 = .10 or +10% The resulting percentage difference can be compared over a longer period of time. On the AMZN chart, we can see that the Price Oscillator provides a better means for a long-term comparison. For the short term, MACD and the Price Oscillator are basically the same. The shape of the lines, the divergence's, moving average crossovers and centerline crossovers for MACD and the Price Oscillator are virtually identical. 188

Since Gerald Appel developed MACD, there have been hundreds of new indicators introduced to technical analysis. While many indicators have come and gone, MACD is an oscillator that has stood the test of time. The concept behind its use is straightforward and its construction simple, yet it remains one of the most reliable indicators around. The effectiveness of MACD will vary for different securities and markets. The lengths of the moving averages can be adapted for a better fit to a particular security or market. As with all indicators , MACD is not infallible and should be used in conjunction with other technical analysis tools. In 1986, Thomas Aspray developed the MACD-Histogram. Some of his findings were presented in a series of articles for Technical Analysis of Stocks and Commodities. Aspray noted that MACD would sometimes lag important moves in a security, especially when applied to weekly charts. He first experimented by changing the moving averages and found that shorter moving averages did indeed speed up the signals. However, he was looking for a means to anticipate MACD crossovers. One of the answers he came up with was the MACD-Histogram.


The MACD-Histogram represents the difference between MACD and the 9-day EMA of MACD, which can also be referred to as the signal or trigger line. The plot of this difference is presented as a histogram, making centerline crossovers and divergence's are easily identifiable. A centerline crossover for the MACD-Histogram is the same as a moving average crossover for MACD. If you will recall, a moving average crossover occurs when MACD moves above or below the signal line. If the value of MACD is larger than the value of its 9-day EMA, then the value on the MACD-Histogram will be positive. Conversely, if the value of MACD is less than its 9-day EMA, then the value on the MACD-Histogram will be negative. Further increases or decreases in the gap between MACD and its 9-day EMA will be reflected in the MACD-Histogram. Sharp increases in the MACD-Histogram indicate that MACD is rising faster than its 9-day EMA and bullish momentum is strengthening. Sharp declines in the MACD-Histogram indicate that MACD is falling faster than its 9-day EMA and bearish momentum is increasing.

On the chart above, we can see that MACD-Histogram movements are relatively independent of the actual MACD. Sometimes MACD is rising while the MACDHistogram is falling. At other times, MACD is falling while MACD-Histogram is rising. MACD-Histogram does not reflect the absolute value of MACD, but rather the value of MACD relative to its 9-day EMA. Usually, but not always, a move in MACD is preceded by a corresponding divergence in MACD-Histogram. 1.The first point shows a sharp positive divergence in MACD-Histogram that preceded a bullish moving average crossover. 2.On the second point, MACD continued to new highs, but MACD-Histogram formed two equal highs. Although not a textbook positive divergence, the equal high failed to confirm the strength seen in MACD. 3.A positive divergence formed when MACD-Histogram formed a higher low and MACD continued lower. 4.A negative divergence formed when MACD-Histogram formed a lower high and


MACD continued higher Thomas Aspray designed the MACD-Histogram as a tool to anticipate a moving average crossover in MACD. Divergence's between MACD and the MACD-Histogram are the main tool used to anticipate moving average crossovers. A positive divergence in the MACD-Histogram indicates that MACD is strengthening and could be on the verge of a bullish moving average crossover. A negative divergence in the MACD-Histogram indicates that MACD is weakening and can act to foreshadow a bearish moving average crossover in MACD. The main signal generated by the MACD-Histogram is a divergence followed by a moving average crossover. A bullish signal is generated when a positive divergence forms and there is a bullish centerline crossover. A bearish signal is generated when there is a negative divergence and a bearish centerline crossover. Keep in mind that a centerline crossover for the MACD-Histogram represents a moving average crossover for MACD. Divergence's can take many forms and varying degrees. Generally speaking, two types of divergence's have been identified: the slant divergence and the peak-trough divergence


A peak-trough divergence occurs when at least two peaks or two troughs develop in one direction to form the divergence. A series of two or more rising troughs (higher lows) can form a positive divergence and a series of two or more declining peaks (lower highs) can form a negative divergence. Peak-trough divergence's usually cover a longer timeframe than slant divergence's. On a daily chart, a peak-trough divergence can cover a timeframe as short as two weeks or as long as several months. Usually, the longer and sharper the divergence is, the better any ensuing signal will be. Short and shallow divergence's can lead to false signals and whipsaws. In addition, it would appear that peaktrough divergence's are a bit more reliable than slant divergence's. Peak-trough divergence's tend to be sharper and cover a longer time frame than slant divergence's The main benefit of the MACD-Histogram is its ability to anticipate MACD signals. Divergence's usually appear in the MACD-Histogram before MACD moving average crossovers. Armed with this knowledge, traders and investors can better prepare for potential trend changes.

MACD-Histogram can be applied to daily, weekly or monthly charts. (Note: This may require some tinkering with the number of periods used to form the original MACD; shorter or faster moving averages may be required for weekly and monthly charts.) Using weekly charts, the broad underlying trend of a stock can be determined. Once the broad trend has been determined,


daily charts can be used to time entry and exit strategies.

On the IBM weekly chart, the MACD-Histogram generated four signals. Before each moving average crossover in MACD, a corresponding divergence formed in the MACD Histogram. To make adjustments for the weekly chart, the moving averages have been shortened to 6 and 12. This MACD is formed by subtracting the 6-week EMA from the 12-week EMA. A 6-week EMA has been used as the trigger. The MACD-Histogram is calculated by taking the difference between MACD (6/12) and the 6-day EMA of MACD (6/12). 1.The first signal was a bearish moving average crossover in Jan-99. From its peak in late Nov-98, the MACD-Histogram formed a negative divergence that preceded the bearish moving average crossover in MACD. 2.The second signal was a bullish moving average crossover in April. From its low in mid-February, the MACD-Histogram formed a positive divergence that preceded the bullish moving average crossover in MACD. 3.The third signal was a bearish moving average crossover in late July. From its May peak, the MACD-Histogram formed a negative divergence that preceded a bearish moving average crossover in MACD. 4.The final signal was a bullish moving average crossover, which was preceded by a slight positive divergence in MACD-Histogram. 5. The third signal was based on a peak-trough divergence. Two readily identifiable and consecutive lower peaks formed to create the divergence. The peaks and troughs on the previous divergence's, although identifiable, do not stand out as much. The MACD-Histogram is an indicator of an indicator or a derivative of a derivative. MACD is the first derivative of the price action of a security and the MACD-Histogram is the second derivative of the price action of a security. As the second derivative, the MACD-Histogram is further removed from the actual price action of the underlying security. The further removed an indicator is from the underlying price action, the greater the chances of false signals. Keep in mind that this is an indicator of an indicator. MACD-Histogram should not be compared directly with the price action of the underlying security. Because MACD-Histogram was designed to anticipate MACD signals, there may be a temptation to jump the gun. The MACD-Histogram should be used in conjunction with other aspects of technical analysis. This will help to alleviate the temptation for early entry. Another means to guard against early entry is to combine weekly signals with daily signals. There will of course be more daily signals than weekly signals. However, by using only the daily signals that agree with the weekly signals, there will be fewer daily signals to act on. By acting only on those daily signals that are in agreement with the weekly signals, you are also assured of trading with the longer trend and not against it. Be careful of small and shallow divergence's. While these may sometimes lead to good signals, they are also more apt to create false signals. One method to avoid small divergence's is to look for larger divergence's with two or more readily identifiable peaks


or troughs. Compare the peaks and troughs from past action to determine significance. Only peaks and troughs that appear to be significant should warrant attention. Risk Analysis and Investor Suitability Investment Risk All securities investors assume a certain level of risk. A basic concept of investing is the relationship between risk and reward. Individuals will make risky investments if they consider the potential rewards commensurate with the level of risk. As the level of risk for an investment increases, the potential reward must increase as well. The following are the various types of investment risk. Market Risk This is the risk that the price of a security will decline despite the strength of the underlying company. Market risk is considered nondiversifiable because regardless of how diversified an investor's portfolio is, a decline in the overall market could cause prices of all positions to fall. Business Risk Also called financial risk, this is the risk that a company may experience a decline in earnings, impairing its ability to pay dividends or interest causing the price of its securities to decline. Business risk is diversifiable;if an investor's portfolio is well diversified, consisting of stock in several different companies, the effect of one company's decline in earnings is minimized. Common stock is most vulnerable to business risk;bonds are least vulnerable. Interest Rate Risk Interest rate risk is the effect of rising interest rates on the value of investments. Bonds are most vulnerable to interest rate risk;common stocks are least vulnerable. When interest rates rise, bonds must fall to bring their yields in line with the interest rate market. Because of the effects of compounding, long term bonds are more sensitive to interest rate fluctuations than those with shorter maturities. If interest rates fall, bond prices rise. Again, bonds with the longest maturities are affected the most. Common stocks are less affected by interest rate risk. However, a substantial rise in interest rates tends to lower the earnings of highly leveraged companies with large amounts of variable rate debt in their capital structures. Purchasing Power Risk This is the risk that the rate of increase in the value of an investment may be lower than the prevailing inflation rate, leading to a decline in purchasing power. Bonds are very vulnerable to this type of risk;common stocks are seldom affected by it. Purchasing power risk has a more serious effect on bonds because bondholders receive a fixed return based on the coupon rate. If a company's earnings rise due to inflation, bondholders do not benefit from the increase. Bond investors therefore suffer a loss of earnings in terms of real dollars. Similarly, since bondholders receive only par value upon maturity, they forego appreciation potential and suffer loss of principal in terms of


real dollars. This is one of the most misunderstood investing topics. Many people feel “safe” from all risk when they invest in low yield bonds, CD's and money market instruments, however, if the earnings are not enough to outpace inflation, you are actually losing principal in terms of real dollars. Liquidity Risk This is the risk of not being able to sell a security, or being forced to sell at an unfavorable price due to lack of a liquid market. An illiquid, or “thin” market usually involves an over the counter security, and is characterized by a large difference between bid and asked prices. Tax Risk Interest on municipal securities is tax exempt, while returns on corporate debt, as well as dividends on preferred and common stocks are fully taxable. This puts the municipals investor at risk if tax rates are lowered. Lower taxes would increase the effective aftertax yield on corporate securities. Municipal bond prices would then fall, to bring their equivalent yields in line with those of corporate securities. Investors in corporate securities, particularly bonds, are at risk if taxes are raised. Higher tax rates would decrease their effective after-tax yields. Prices of corporate securities would then fall, to bring yields in line with those of municipals. Economic Risk Economic risk includes the effects of adverse international developments, changes in government policies or legislation and changes in consumer demand. Investor Profiles When identifying their investment objectives, individuals should consider their financia; obligations and resources. Appropriate investment strategies for one individual may be too risky for another. While this may seem obvious, many individuals fail to make investments suitable for their financial situation and needs. Factors to consider when investing include age, health, employment and family. For example, a young bachelor in good health who is securely employed can afford to take more risk than a young man with a family. A person with dependents needs safety and liquidity, so that short term obligations and emergencies can be met. The more obligations an individual has, the greater the need for a conservative portfolio. Investor objectives may include growth, income, speculation or tax advantages. Those seeking growth are usually young investors;they are able to earn their income, and do not need to depend on income from their portfolios. Older investors often invest for income, as they are at or near retirement and must rely on their investments for support. Individuals who speculate in the investment markets should have a high degree of financial stability and “risk capital”-assets they can afford to lose without affecting their lifestyles or commitments. Investors seeking tax advantages are generally those with high incomes who can therefore afford a certain degree of risk. Aggressive investment strategies are more suitable for younger investors and those able to bear risk. Aggressive strategies are riskier, have higher potential returns and may involve


the use of leverage. The following are examples of aggressive investment strategies: Purchasing securities on margin Options Trading Investing in smaller, more speculative companies Investing with minimal diversification Defensive investment strategies are suitable for older investors and those seeking to avoid risk. Defensive strategies seek to preserve capital and generate a steady stream of income. The following are examples: Purchasing investment grade bonds with staggered maturities Investing in government securities Investing in blue chip stocks Purchasing income funds and unit investment trusts Covered call writing Maintaining a well diversified portfolio Holding securities for long periods of time A mixed strategy combines aggressive and defensive investments to create a balanced portfolio. Q&A 1. Which of the following is the best indication of whether a company can meet its shortterm obligations? A. capitalization ratio B. quick ratio C. current ratio D. expense ratio 2. Which of the following are components of a company's capital structure? I. preferred stock II. current assets III. Common stock IV. Long-term debt A. I and II B. I and III C. I, III, and IV D. I, II, III, and IV 3. ABC Corporation has sales of $24,000,000, operating income of $7,200,000 and an extraordinary loss of $1,500,000. What is its operating margin? A. 30% B. 23.75% C. 16% D. Cannot be determined 4. The interest rate banks charge brokerage firms is: 196

A. the federal funds rate B. the discount rate C. the call rate D. the prime rate 5. Which of the following is responsible for directing the Fed's open market operations? A. the Governors of the Federal Reserve Board B. the Department of the Treasury C. the President of the Federal Reserve Bank of NY D. the Fed Open Market Committee 6. Which of the following can be determined from a company's income statement? I. expense ratios II. Inventory turnover III. Annual depreciation IV. Current portion of long term debt A. I and II B. I and IV C. II and III D. II and IV Use the following information for questions 7 and 8. Sales $800,000,000 Net Income 42,000,000 Number of shares outstanding 24,000,000 Annual Dividend $.80 Market price of stock $18 7. The dividend yield is: A. 2.25% B. 3.3% C. 4.4% D. 30% 8. The P/E ratio is approximately: A. 10.3 B. 13.3 C. 18 D. 22.5 9. RST Corporation common stock has a P/E multiple of 12.5 and is selling for 77 5/8. What are the company's earnings per share? A. $1.61 B. $6.21 C. $12.04 D. Cannot be determined


10. When the Fed buys government securities from banks and dealers, its objective is to: A. take advantage of favorable prices B. support the price of government securities C. decrease inflation D. curtail a recession

Answers 1) B 2) C 3)A 4) C 5) D 6) D 7) C 8) A 9) B 10) C



In tutorial 11, these are the topics we will discuss: I. Investor Education and Trading Resources II. #1 Options Trading Course III.#1 Options Advisor IV.Books V.Software


Investor Education & Trading Resources #1 Options Trading Course: -Step by step guide on how to research and trade equity options. With this options trading course, you'll get the following benefits: Learn strategies that can take $200 and turn it into thousands of dollars every month from your own home using nothing but your PC. It's the perfect online, home based business with nothing to sell. Learn how to make $96,000 + per year doing stock research online Learn the hidden secrets brokerage firms don't want you to know about getting approved for certain option trading levels. In the past, these levels have only been reserved for wealthy traders. Learn risk management techniques that will show you how and when to cut losses and let profits run, so you never get burned. You can make money in any market, up, down or sideways! How to get dirt cheap trading commissions. Learn the exact same investor education that brokers study when going for their securities license. With the easy to understand language, you will have more knowledge than most professional stock brokers. How to stop relying on a broker or anyone else for investment advice by learning how to do your own research, narrow down opportunities and pull the trigger on trades with consistent profitable returns of 150-1000% and more per trade! Create a six figure income with a few hours of work per month. Learn secrets and tips to profitable option trading that have in the past been reserved for a select group of professional traders, institutional investors and high net worth individuals


#1 Options Advisor: We offer option trading alert services based on our proprietary strategies and research. These trading alerts will be sent to subscribers in real time via email. Alerts will include the date and time we are entering the trade, the symbol of the underlying security, type of option, strike price and any price limits. We will also continue to send updates when we enter any stop loss orders or trailing stop loss orders and will finally update subscribers when we exit the position including a summary of the gain/loss of the trade. OPTION BUYER The Option Buyer service provides trade alerts based on our strategy of buying undervalued calls and puts. The key to this strategy is finding option premiums that are well undervalued compared to the normal market price of that particular option. We also look at volatility of the underlying security and the probability of it moving enough to hit our target returns at any time prior to expiration. This strategy is appropriate for any level of investment.


Books-All of the following books can be found at Options Options as a Strategic Investment by Lawrence G. McMillan Options Made Easy by Guy Cohen

Trading Trading for a Living: Psychology, Trading Tactics, Money Management by Alexander Elder Come into my Trading Room: A Complete Guide to Trading by Alexander Elder Forex An Introduction to Foreign Exchange & Money Markets by UK London Reuters Ltd.


Technical Analysis Technical Analysis from A to Z, 2nd Edition by Steven B. Achelis Japanese Candlestick Charting-2nd Edition by Steve Nison

Taxes The Motley Fool Tax Guide 2002: Money Saving Tax Tips you can Actually Understand by Roy A. Lewis, Selena Maranjian General Investing & Financial Planning The Guide to Smart Investing in the Internet Era: Everything you Need to Know to Outsmart Wall Street and Select Winning Stocks by David Kansas The Warren Buffet Way: Investment Strategies of the World's Greatest Investor by Robert Hagstrom The Road to Wealth-A Comprehensive Guide to your Money-Everything you Need to Know in Good and Bad Times by Suze Orman The Motley Fool Investment Guide : How The Fool Beats Wall Streets Wise Men And How You Can Too by David Gardner, Tom Gardner Motley Fool Money Guide by Selena Maranjian, David Gardner The Motley Fool Personal Finance Workbook : A Foolproof Guide to Organizing Your Cash and Building Wealth by David Gardner Software Microsoft Money 2004 Standard-Great software to organize daily accounts, investments, budget planning and more.


BONUS2-TheCompleteGuidetoInvesting The Complete Guide to Investing We want your feedback. Please email us at the address below wi...

Read more
Read more
Similar to
Popular now
Just for you