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CHAPTER ONE
EQUITY AND DEBT SECURITIES
Introduction:
This first chapter will build the foundation upon which the rest of this text is built. A
thorough understanding of this material will be necessary in order to successfully
complete the series six exam. While a series six-registered representative may not directly
sell the securities detailed in this first section, most mutual funds and variable annuities
invest in these securities so it’s an important starting point.
What is a Security?
A security is any investment product that can be exchanged for value and involves risk. In
order for an investment to be considered a security it must be readily transferable between
two parties and the owner must be subject to the loss of some or all of their invested
principal. If the product is not transferable or does not contain risk it is not a security.
Types of securities Types of non securities
Common stock Whole life insurance
Preferred stock Term life insurance
Mutual funds Retirement plans
Variable annuities Fixed annuities
Variable life insurance Prospectus
Securities are broken up into two major categories for the series six equity and debt. Let’s
begin by comparing the two differed types of securities:
Equity = Stock
The term equity is synonymous with the term stock. Throughout your preparation for this
exam and on the exam itself, you will find many terms that are used interchangeably.
Equity or stock creates an ownership relationship with the issuing company. Once an
investor has purchased stock in a corporation they become an owner of that corporation.
The corporation sells off pieces of itself to investors in the form of shares in an effort to
raise working capital. Equity is perpetual, meaning there is no maturity date for the shares
and the investor may own the shares until they decide to sell them. Most corporations use
the sale of equity as their main source of business capital.
Debt = Bonds
A bond or any other debt instrument is actually a loan to the issuer. By purchasing a
bond, the investor has in fact made a loan to the corporation and has become a creditor of
the company that issued the instrument.
Debt instruments, unlike their equity counterparts, have a time frame or maturity date
associated with them. Whether it is one year, five years, or thirty years, at some point the
issue is going to mature and the investor will receive their principal back and will cease to
be a creditor of the corporation. We will examine how investors may purchase stocks and
bonds, but first we must look at how the corporation uses the sale of these securities to
meet their organizational goals.
Capitalization
The term capitalization refers to the sources and make up of the company’s financial
picture. To determine a company’s capital composition, an investor must look at the
corporation’s balance sheet. The balance sheet is like a snap shot of the corporation’s
finances at the time it was taken. It shows a list of all of the company’s assets and
liabilities as well as the company’s net worth or stockholders’ equity. Most publicly
traded companies have to disclose or report their performance at least quarterly.
The balance sheet equation
Assets – Liabilities = Net Worth
Assets
Assets are everything that a company owns including cash, securities, investments,
inventory, property, and accounts receivable.
Liabilities
Liabilities are everything that a company owes including accounts payable, both long and
short term debt along with any other obligations.
Net Worth
The company’s net worth is equal to the value of all assets after all liabilities have been
paid. This corporation’s net worth is the stockholders’ equity. Remember that the
stockholders own the company.
Common Stock
There are thousands of companies whose stock trades publicly and who have used the sale
of equity as a source of raising business capital. All publicly traded companies must issue
common stock before they may issue any other type of equity security. There are two
types of equity securities, common stock and preferred stock. While all publicly traded
companies must have sold or issued common stock, not all companies may want to issue
or sell preferred stock. Let’s take a look at the creation of a company and how common
stock is created.
Corporate Time Line
Authorized Stock
Authorized stock is the maximum number of shares that a company may sell to the
investing public in an effort to raise cash to meet the organization’s goals. The number of
authorized shares is arbitrarily determined and is set at the time of incorporation. A
corporation may sell all or part of its authorized stock. If the corporation wants to sell
more shares than it’s authorized to sell, the shareholders must approve an increase in the
number of authorized shares.
Issued Stock
Issued stock is stock that has been authorized for sale and that has actually been sold to
the investing public. The total number of authorized shares typically exceeds the total
number of issued shares so that the corporation may sell additional shares in the future to
meet its needs. Once shares have been sold to the investing public they will always be
counted as issued shares regardless of their ownership or subsequent repurchase by the
corporation. It’s important to note that the total number of issued shares may never
exceed the total number of authorized shares.
Additional authorized shares may be issued in the future for any of the following reasons:
- To pay a stock dividend
- To expand current operations
- To exchange common shares for convertible preferred or convertible bonds
- To satisfy obligations under employee stock options or purchase plans
Outstanding Stock
Outstanding stock is stock that has been sold or issued to the investing public and that
actually remains in the hands of the investing public.
Treasury Stock
Treasury stock is stock that has been sold to the investing public, which has subsequently
been repurchased by the corporation. The corporation may elect to reissue the shares or it
may retire the shares that it holds in treasury stock. Treasury stock does not receive
dividends nor does it vote.
A corporation may elect to repurchase it’s own shares for any of the following reasons:
- To maintain control of the company
- To increase earnings per share
- To fund employee stock purchase plans
- To use shares to pay for a merger or acquisition
To determine the amount of treasury stock, use the following formula:
Issued stock – outstanding stock = treasury stock
Values of Common Stock
A common stock’s market value is determined by supply and demand and may or may not
have any real relationship to what the shares are actually worth. The market value of
common stock is affected by the current and future expectations for the company.
Book Value
A corporation’s book value is the theoretical liquidation value of the company. It is found
by taking all of the company’s tangible assets and subtracting all of its liabilities. This
will give you the total book value. To determine the book values per share divide the total
book value by the total number of outstanding common shares.
Par Value
Par value in a discussion regarding common stock is only important if you are an
accountant looking at the balance sheet. For investors, it has no relationship to any
measure of value which may otherwise be employed.
Rights of Common Stockholders
As an owner of common stock, investors are owners of the corporation. As such,
investors have certain rights which are granted to all common stock holders.
Preemptive Rights
As a stockholder, an investor has the right to maintain their percentage interest in the
company. This is known as a preemptive right. Should the company wish to sell
additional shares to raise new capital, they must first offer the new shares to existing
shareholders. Should the existing shareholders decide not to purchase the new shares they
may be offered to the general public.
Test Focus!
Number of Existing Shares Number of New Shares Total Shares After Offering
100,000 100,000 200,000
10,000 10,000 20,000
10% ownership 10% of offering 10% ownership
In the example above, the company has 100,000 shares of stock outstanding and an
investor has purchased 10,000 of those original shares. As a result, they own 10% of the
corporation. The company wishing to sell 100,000 new shares to raise new capital must
first offer 10% of the new shares to the current investor (10,000 shares) before the shares
may be offered to the general public. So if the investor decides to purchase the additional
shares as is the case in the example, the investor will have maintained their 10% interest in
the company.
A shareholder’s preemptive right is ensured through a rights offering. The existing
shareholders will have the right to purchase the new shares at a discount to the current
market value for 45 days. This is known as the subscription price. Once the subscription
price is set, it remains constant for the 45 days, while the price of the stock is moving up
and down in the market place. There are three possible outcomes for a right. They are:
- Exercised:
The investor decides to purchase the additional shares and sends in the money along with
the rights to receive the additional shares.
- Sold:
The rights have value and if the investor does not want to purchase the additional shares
they may be sold to another investor who would like to purchase the shares.
- Expire:
The rights will expire when no one wants to purchase the stock. This will only occur
when the market price of the share has fallen below the subscription price of the right and
the 45 days has elapsed.
Voting
As a common stockholder, you have the right to vote on the major issues facing the
corporation. You are a part owner of the company, and as a result, you have a right to say
how the company is run. The biggest emphasis is placed on the election of the board of
directors.
Common stockholders may also vote on:
- The issuance of bonds or additional common shares
- Stock splits
- Mergers and acquisitions
- Major changes in corporate policy
Methods of voting
There are two methods by which the voting process may be conducted, they are known as
the statutory and cumulative methods of voting. A stockholder may cast one vote for each
share of stock owned and the statutory or cumulative methods will determine how those
votes are cast. The test focuses on the election of the board of directors, so we will use
that in our example.
Test Focus!
An investor own 200 shares of XYZ. There are two board members to be elected and
there are four people running in the election. Under both the statutory and cumulative
methods of voting, you take the number of shares owned and multiply them by the
number of people to be elected to determine how many votes the shareholder has. In this
case, 200 shares x 2 = 400 votes. The cumulative or statutory methods dictate how those
votes may be cast.
Candidate Statutory Cumulative
1 200 votes 400 votes
2
3
4 200 votes
The statutory method requires that the votes be distributed evenly among the candidates
that the investor wishes to vote for.
The cumulative method allows the shareholder to cast all of their votes in favor of one
candidate if they so choose. The cumulative method is said to favor smaller investors for
this reason.
Limited Liability
Stockholders’ liability is limited to the amount of money they invested in the stock. They
can not be held liable for any amount past their invested capital.
Inspection of Books and Records
All stockholders have the right to inspect the company’s books and records. For most
shareholders this right is ensured through the company’s filing of quarterly and annual
reports. Stockholders also have the right to obtain a list of shareholders, but they do not
have the right to review other corporate financial data, which the corporation may deem
confidential.
Residual Claim to Assets
In the event of a company’s bankruptcy or liquidation, common stockholders have the
right to receive their proportional interest in residual assets. After all other security
holders have been paid along with all creditors of the corporation; common stockholders
may claim the residual assets. For this reason common stock is the most junior security.
Why do people buy common stock?
Capital Appreciation / Growth
The main reason people invest in common stock is for capital appreciation. They want
their money to grow in value over time. An investor in common stock hopes to buy the
stock at a low price and sell it at a higher price at some point in the future.
Example:
An investor purchases 100 shares of XYZ at $ 20 per share on March 15, 1999. On April
30th of 2001, the investor sells 100 shares of XYZ for $ 30 per share realizing a profit of
$10 per share or $ 1,000 on the 100 shares.
Income
Many corporations distribute a portion of their earnings to their investors in the form of
dividends. This distribution of earnings creates income for the investor and investors in
common stock generally receive dividends quarterly.
Example:
ABC pays a $ .50 quarterly dividend to it’ shareholders. The stock is currently trading at
$ 20 per share. What is its current yield (also known as dividend yield)?
Current yield = annual income / current market price
$ .50 x 4 = $ 2.00 $ 2/$20 = 10%
The investor in the above example is receiving 10% of the purchase price of the stock
each year in the form of dividends, which would be a nice return for the investor by itself.
What are the risks of owning common stock?
The major risk in owning common stock is that the stock may fall in value. There are no
sure things in the stock market and even if you own stock in a great company, you may
end up losing money.
Dividends may be stopped or reduced
Common stockholders are not entitled to receive dividends just because they own part of
the company. It is up to the company to elect to pay a dividend. The corporation is in no
way obligated to pay common shareholders a dividend.
Junior claim on corporate assets
A common stockholder is the last person to get paid if the company is liquidated. It is
very possible that after all creditors and other investors are paid, that there will be little or
nothing left for the common stockholder.
How does someone become a stockholder?
We have reviewed some of the reasons why an investor would want to become a
stockholder, now we need to review how someone becomes a stockholder. While some
people purchase the shares directly from the corporation when the stock is offered to the
public directly, most investors purchase the shares from other investors. These
investor transactions take place in the secondary market on the exchange or in the over
the counter market. Although the transaction in many cases only takes seconds to
execute, trades actually take several days to fully complete. Let’s review the important
dates regarding transactions, which are done for a “regular way” settlement.
Trade Date
The trade date is the day when your order is actually executed. Although an order has
been placed with a broker, it may not be executed on the same day. There are certain
types of orders that may take several days or even longer to execute depending on the type
of order. A market order will be executed immediately as soon as it is presented to the
market, making the trade date the same day the order was entered.
Settlement Date
The buyer of a security actually becomes the owner of record on the settlement date.
When an investor buys a security from another investor, the selling investor’s name is
removed from the security and the buyer’s name is “recorded” as the new owner.
Settlement date is three business days after the trade date. This is known as T + 3 for all
regular way transactions in common stock, preferred stock, corporate bonds, and
municipal bonds. Government bonds all settle the next business day following the trade
date and a trade done on a cash basis settles on the same day regardless of the security
involved in the transaction.
Payment Date
The payment date is the day when the buyer of the security has to have the money in to
the brokerage firm to pay for the purchase. Payment date for securities under the industry
rules is five business days after the trade date or T + 5. Payment dates are regulated by
the Federal Reserve Board under regulation T of the Securities Exchange Act of 1934.
While many brokerage firms require their customers to have their money in to pay for
their purchases sooner than the rules state, the customer has up to five business days to
pay for the trade.
Violation
If the customer fails to pay for the purchase within the five business days allowed the
customer is in violation of Regulation T. As a result, the brokerage firm will “sell out”
and freeze the customer’s account. The brokerage firm on the sixth business day
following the trade date will sell out the securities that the customer failed to pay for. The
customer is responsible for any loss that may occur as a result of the “sell out” and the
brokerage firm may sell out shares of another security in the investor’s account in order to
cover the loss. The brokerage firm will then freeze the customer’s account, which means
that the customer must deposit money up front for any purchases they want to make in the
next ninety days. After the ninety days have expired, the customer is considered to have
reestablished good credit and may then conduct business on the “regular way” and take up
to five business days to pay for their trades.
Preferred Stock
Preferred stock is an equity security with a fixed income component. Like a common
stockholder the preferred stockholder is an owner of the company. However, the
preferred stockholder is investing in the stock for the fixed income that the preferred
shares generate through their semi-annual dividends. Preferred stock has a stated dividend
rate or a fixed rate that the corporation must pay to its preferred shareholders. Growth is
generally not achieved through investing in preferred shares.
Features of all preferred stock
Par Value
Par value on preferred stock is very important because that’s what the dividend is based
on. Par value for all preferred shares is $100. Companies generally express the dividend
as a percentage of par value for preferred stock.
Example:
How much would the following investor receive in annual income from the investment in
the following preferred stock?
An investor buys 100 shares of TWT 9% preferred
$ 100 x 9% = $9 per share x 100 = $900
Payment of dividends
The dividend on preferred shares must be paid before any dividends are paid to common
shareholders. This gives the preferred shareholder a priority claim on the corporation’s
distribution of earnings.
Distribution of Assets
If a corporation liquidates or declares bankruptcy, the preferred shareholders are paid prior
to any common shareholder, giving the preferred shareholder a higher claim on the
corporation’s assets.
Perpetual
Preferred stock unlike bonds is perpetual with no maturity date. Investors may hold
shares for as long as they wish or until they are called in by the company under a call
feature.
Non-Voting
Most preferred stock is non-voting
Interest Rate Sensitive
Because of the fixed income generated by preferred shares their price will be more
sensitive to change in interest rates than the price of their common stock counterparts. As
interest rates decline the value of preferred shares tends to increase and when interest rates
rise the value of the preferred shares tends to fall. This is known as an inverse
relationship.
Types of Preferred stock
Preferred stock unlike common stock may have different features associated with it. Most
of the features are designed to make the issue more attractive to investors and therefore
benefit the owners of preferred stock.
Straight / Non-Cumulative
The straight preferred stock has no additional features. The holder is entitled to the stated
dividend rate and nothing else. If the corporation is unable to pay the dividend, it is not
owed to the investor.
Cumulative Preferred
A cumulative feature protects the investor in cases when a corporation is having financial
difficulties and cannot pay the dividend. Dividends on cumulative preferred stock
accumulate in arrears until the corporation is able to pay them. If the dividend on a
cumulative preferred stock is missed it is sill owed to the holder. Dividends in arrears on
cumulative issues are always the first dividends to be paid. If the company wants to pay a
dividend to common shareholders, they must first pay the dividends in arrears as well as
the stated preferred dividend before common holders receive anything.
Test Focus!
GNR has an 8% cumulative preferred stock outstanding. It has not paid the dividend this
year or for the prior three years. How much must the holders of GNR cumulative
preferred be paid per share before the common stockholders are paid a dividend?
The dividend has not been paid this year nor for the previous three years, so the holders
are owed four years worth of dividends or
4 x $8 = $ 32 per share
Participating Preferred
Holders of participating preferred stock are entitled to receive the stated preferred rate as
well as additional common dividends. The holder of participating preferred receives the
dividend payable to the common stockholders over and above the stated preferred
dividend.
Convertible Preferred
A convertible feature allows the preferred stockholder to convert or exchange their
preferred shares for common shares at a fixed price known as the conversion price.
Example:
TRW has issued a 4% convertible preferred stock, which may be converted into TRW
common stock at $ 20 per share. How many shares may the preferred stock holder receive
upon conversion?
Number of shares = par / conversion price (CVP)
$ 100 / $ 20 = 5
The investor may receive 5 common shares for every preferred share.
There are some additional concepts regarding convertible securities, which will be
addressed in the convertible bond section that follows.
Callable Preferred
A call feature is the only feature that benefits the company and not the investor. A call
feature allows the corporation to call in or redeem the preferred shares at their discretion
or after some period of time has expired. Most preferred which is callable may not be
called in the first few years after its issuance. This feature that does not allow the stock to
be called in its early years is known as “call protection”. Many callable preferred shares
will be called at a premium price above par. For example a $ 100 par preferred stock may
be called at $ 103. The main reasons a company would call in their preferred shares would
be to eliminate the fixed dividend payment or to sell a new preferred stock with a lower
dividend rate when interest rates decline. Preferred stock is more likely to be called by the
corporation when interest rates decline.
Types of Dividends
Cash
A cash dividend is the most common form of dividend and it is one that the test focuses
on. A corporation will send out a cash payment in the form of a check directly to the
stockholders. For those stockholders who have their stock held in the name of the
brokerage firm, a check will be sent to the brokerage firm and the money will be credited
to the investors account. Securities held in the name of the brokerage firm are said to be
held in “street name”. To determine the amount that an investor will receive, simply
multiply the amount of the dividend to be paid by the number of shares.
Example:
JPF pays a $ .10 dividend to shareholders. An investor who owns 1,000 shares of JPF will
receive $ 100. 1,000 shares x $ .10 = $ 100.
Stock
A corporation that wants to reward its shareholders, but also wants to conserve cash for
other business purposes, may elect to pay a stock dividend to their shareholders. Each
investor will receive an additional number of shares based on the number of shares that
they own. The market price of the stock will decline after the stock dividend has been
distributed to reflect the fact that there are now more shares outstanding but the total
market value of the company will remain the same.
Example:
If HRT pays a 5% stock dividend to its shareholders, an investor with 500 shares will
receive an additional 25 shares. This is determined by multiplying the number of shares
owned by the amount of the dividend to be paid.
500 x 5% = 25
Property / Product
This is the least likely way in which a corporation would pay a dividend, but it is a
permissible dividend distribution. A corporation may send out to its shareholders samples
of its products or portions of its property.
Dividend Distribution
If a corporation decides to pay a dividend to its common stockholders, they may not
discriminate as to who receives the dividend. The dividend must be paid to all common
stockholders of record. An investor who already owns the stock does not need to notify
the company that they are entitled to receive the pending dividend it will be sent to them
automatically. However, new purchasers of the stock may or may not be entitled to
receive the dividend depending on when they purchased the stock relative to when the
dividend is going to be distributed. We will now examine the dividend distribution
process.
Declaration Date
The declaration date is the day that the Board of Directors decides to pay a dividend to
common stockholders of record. The declaration date is the starting point for the entire
dividend process. The company must notify the regulators at the Exchange or the NASD
depending where the stock trades at least ten business days prior to the record date.
Ex-Dividend Date
The ex-dividend date or “The Ex date” is the first day when purchasers of the security are
no longer entitled to receive the dividend that the company has declared for payment.
Stated another way the ex date is the first day when the stock trades without (ex) the
dividend attached. The exchange or the NASD set the ex date for the stock based on the
record date determined and announced by the corporation’s Board of Directors. Because
it takes three business days for a trade to settle, the ex date is always two business days
prior to the record date.
Record Date
This is the day when investors must have their name recorded on the stock certificate in
order to be entitled to receive the dividend that was declared by the Board of Directors.
All stockholders whose name is on the stock certificate (owners of record) will be entitled
to receive the dividend. The investor would have had to have purchases the stock before
the ex dividend date in order to be an owner of record on the record date. The record date
is determined by the corporation’s Board of Directors and is used to determine the
shareholders that will receive the dividend.
Payment Date
This is the day when the corporation actually distributes the dividend to shareholders and
it completes the dividend process. The payment date is controlled and set by the Board of
Directors of the corporation and is usually four weeks following the record date.
Stock Price and the Ex Dividend Date
It is important to note that the value of the stock prior to the ex dividend date reflects the
value of the stock with the dividend. On the ex dividend date, the stock is now trading
without the dividend attached and new purchasers will not receive the dividend that had
been declared for payment. As a result of this the stock price will be adjusted down on the
ex dividend date in an amount equal to the dividend.
Test Focus!
TRY declares a $ .20 dividend payable to shareholders of record as of Thursday August
22nd. The ex dividend date will be two business days prior to the record date. In this case
the ex date will be Tuesday August 20th. If TRY closed on Monday August 19th at $ 24
per share, the stock would open at $ 23.80 on Tuesday.
Sunday Monday Tuesday Wednesday Thursday Friday Saturday
1 2
3 4 5 6 7 8 9
10 11 12 13 15 16 17
18 19 20 21 22 23 24
25 26 27 28 29 30 31
Taxation of Dividends
All dividends received by investors are taxed as ordinary income for the year in which the
dividend is received.
Selling Dividends
Selling dividends is a violation! A registered representative may not use the pending
dividend payment as the sole basis of their recommendation to purchase the stock.
Additionally, using the pending dividend as a means to create urgency on the part of the
investor to purchase the stock is a prime example of this type of violation. If the investor
was to purchase the shares just prior to the ex dividend date simply to receive the
dividend, the investor in many cases will end up worse off. The dividend in this case will
actually be a return of the money that the investor used to purchase the stock and the
investor will have a tax liability when they receive the dividend.
Rights and Warrants
Rights
A right is issued to existing shareholders by a corporation that wants to sell additional
common shares to raise new capital. All common stockholders have a preemptive right to
maintain the proportional ownership in the company. If the corporation were allowed to
sell additional shares to the general public, the existing shareholders interest in the
company would be diluted. As a result, any new offering of additional common shares
must first be made to the existing shareholders. Common shareholders will receive a
notice of their right to purchase the new shares. They will be offered the opportunity to
purchase the new shares at a price that is below the current market value of the stock.
This is known as the subscription price. The shareholder will have the right to purchase
the new shares for 45 days.
Possible Outcomes for a Right
Exercised
The shareholder may elect to purchase the additional shares. This is known as exercising
the right. The investor sends in the rights along with a check for the total purchase price
to the rights agent and the additional shares are issued to the investor.
Sold
The investor may not want to purchase the additional shares and may elect to sell the
rights to another investor. The investor who purchases the right will then have the
opportunity to purchase the stock at the subscription price for the duration of the original
45-day period.
Expire
The right to purchase the additional shares will expire at the end of the 45-day period if no
one has elected to purchase the shares. A right will only expire if the stock’s market price
has fallen below the subscription price of the right. While market price of the stock is
fluctuating during the 45-day period, the subscription price of the right remains fixed.
Terms
The particular terms of the rights will be printed on the right certificate and each share of
outstanding stock will be issued one right. The terms will include: the subscription price,
the final date for exercising the rights, the number of rights required to purchase additional
shares, and the date that the new shares will be issued.
Standby Underwriting
A corporation may retain a brokerage firm to purchase any shares which existing
shareholders do not purchase. This is known as a standby underwriter. The brokerage
firm will purchase the shares that were not bought by the existing shareholders and resell
them to the investing public.
Warrants
A warrant is a security that gives the holder the opportunity to purchase common stock.
Like a right, the warrant has a subscription price; however, the subscription price is
always above the current market value of the common stock when the warrant is
originally issued. A warrant has a much longer life than a right and the holder of a
warrant may have up to ten years to purchase the stock at the subscription price. The long
life is what makes the warrant valuable even though the subscription price is higher than
the market price of the common stock when the warrant is issued.
How Do People Get Warrants?
Units
Many times companies will issue warrants to people who have purchased their common
stock when it was originally sold to the public during its initial public offering (IPO). A
common share, which comes with a warrant attached to purchase, an additional common
share is known as a unit.
Attached to Bonds
Many times companies will attach warrants to their bond offerings as a “sweetener” to
help market the bond offering. The warrant to purchase the common stock makes the
bond more attractive to the investor and may allow the company to issue the bonds with a
lower coupon rate.
Secondary Market
Warrants will often trade in the secondary market just like the common stock. An
investor who wishes to participate in the potential price appreciation of the common stock
may elect to purchase the corporation’s warrant instead of its common shares.
Possible Outcomes of a Warrant
A warrant like a right may be exercised or sold by the investor. A warrant may also expire
if the stock price is below the warrant’s subscription price at its expiration.
Rights vs. Warrants
Rights Warrants
Up to 45 days Term Up to 10 years
Below the Market Subscription price Above the market
May trade with or Trading May trade with or
Without common without common stock
Stock or bonds
Issued to existing Who Offered as a sweetener
Shareholders to to make securities more
ensure preemptive rights attractive
Options
An option is a contract between two parties that determines the time and price at which a
security may be bought or sold. The two parties to the contract are the buyer and the
seller. The buyer of the option pays money to the seller known as the option’s premium.
For this premium the buyer obtains a right to buy or sell the security depending on what
type of option is involved in the transaction. The seller because they received the
premium from the buyer, now has an obligation to perform under that contract.
Depending on the type of option involved, the seller may have an obligation to buy or sell
the security.
Types of Options
Calls
A call option gives the buyer the right to buy or to “call” the security from the option
seller at a specific price for a certain period of time. The sale of a call option obligates the
seller to deliver or sell that security to the buyer at that specific price for a certain period
of time.
Puts
A put option gives the buyer the right to sell or to “put” the security to the seller at a
specific price for a certain period of time. The sale of a put option obligates the seller to
buy the security from the buyer at that specific price for a certain period of time.
Bullish vs. Bearish
Bullish
Investors who believe that a security’s price will increase over time are said to be bullish.
Investors who buy calls are bullish on the underlying security. That is, they believe that
the security’s price will rise and have paid for the right to purchase the security at a
specific price known as the exercise price. An investor who has sold puts is also
considered to be bullish on the security. The seller of a put has an obligation to buy the
security, and therefore believes that the securities price will rise.
Bearish
Investors who believe that a security’s price will decline are said to be bearish. The seller
of a call has an obligation to sell the security to the purchaser at a specified price and
believes that the security’s price will fall and is therefore bearish. The buyer of a put
wants the price to drop so that they may sell the security at a higher price to the seller of
the put contract. They are also considered to be bearish on the security.
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