Mutual Funds

Open End Mutual Funds

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Definition:
An open end mutual fund don’t have limits on the quantity of shares the fund will issue. Provided that demand is requested often, the fund will continue to issue shares no matter the number of investors. Open-end funds likewise will purchase back shares when investors would like to sell.

More Detail:
The large amount of mutual funds are open-end. By constantly buying and selling back fund shares, the funds will provide investors with a useful and convenient investing tool.

Please note that when a fund’s investment manager decides that a fund’s total assets are becoming too large to adequately accomplish its stated objective, the fund will be cut off to new investors and in extreme cases, be shut off to new investment by existing fund investors.

Glossary, N-T

Screeners

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Screeners (or Stock, ETF, Mutual Fund, Bond, etc Screeners) are a software that were once primarily used for stocks to help find a stock that corresponded to certain criteria. Nowaydays Screeners have been extended to all sorts of asset classes (even real estate if you think about it). There are large numbers of stock screeners and are available on most financial websites. More powerful screeners can allow to search with more criteria as well as more advanced and complex criteria.

As an example, if we wanted a very large company with high dividends. We could search in a stock screener for a high dividend yield and a large market cap.
Similarly if you wanted to start day trading you could look for stocks with a very high volatility and liquidity.
Most likely one of the most common searches are done to find favorable ratios (such as P/E, current and turnover ratios).

Given the huge number of stocks and ETF’s out there a stock screener is a must when trying out specific investment strategies.

Glossary, H-M, Mutual Funds

Loaded Mutual Fund

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Definition:
A load mutual fund comes with a sales charge or commission. To compensate a sales intermediary (ex: a broker, financial planner, investment advisor) for their knowledge and time in choosing a suitable fund for the investor, the fund investor will pay the load. The load is either paid prior to the time of purchase (front-end load), or when the shares are sold (back-end load), or as long as the fund is in possession by the investor (level-load).

More Detail:
To be considered a “no-load” fund, the fund will limit its level load to no more than 0.25% (the maximum is 1%), it will be located in its marketing literature.

Front-end and back-end loads are neither part of a mutual fund’s operating expenses, however level-loads, called 12b-1 fees will be included. The annals show that the performance of load and no-load funds are very much alike.

Mutual Funds

No-Load Mutual Fund

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Definition:
A no-load mutual fund in which shares are sold without a commission or sales fee. The notion for this is that the shares are allocated directly by the investment company, rather than going through a alternate party. This is different from a load fund, which charges a commission at the time you purchase the fund, at the time of the sale, or as a “level-load” for whatever time frame the investor holds the fund.

More Detail:
On account of there is no transaction fee to buy a no-load fund, all of the funds invested is being applied for the investor. For instance, if you buy $10,000 worth of a no-load mutual fund, the entire $10,000 will be invested into the fund. So if you purchase a load fund that charges a front-end load (sales commission) of 5%, the actual amount invested in the fund is only $9,500. Rather if the load is back-ended, when you sell the funds, the $500 sales commission will come directly from the proceeds. If the level-load (12b-1 fee) is 1%, the fund balance will be charged $100 yearly for as long as you have that fund.

The reason for a load fund is that investors will be compensating a sales intermediary (broker, financial planner, investment advisor, etc.) for their time and expertise in choosing an appropriate fund.

As a note, research shows that load funds do not outperform no-load funds.

ETFs

Spider ETF

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Spider ETFs

Spider ETFs are one of the most popular provider’s of ETFs in the US and are administered by State Street Global Advisors. Their most famous ETFs track either the whole or an industry part of the S&P 500, most notably the SPY (SPDR S&P500).

The SPY ETF in particular is very useful to beginners because it tracks what is generally regarded as “the market” (The S&P 500 and the Dow-Jones Industrial Average are usually the indices quoted in finance news). It is usually regarded as the goal of most investors to “beat the market”, which is always hard to do when picking individual stocks, but by buying a Spider ETF, investors can let the market do the work for them, with the ETF holdings representing a fairly balanced portfolio.

However, they offer over a hundred ETFs covering everything from the Russell 2000 (TWOK) to the DOW (DIA), to small cap to emerging market ETFs. One of their other well known ETFs is GLD, which tracks the price of gold.

You can learn more much more about SPDR ETFs and the various products they offer by visiting their site:

www.spdrs.com

ETFs

Commodity ETF

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Definition:
Exchange-traded funds that invest in physical commodities such as natural resources, agricultural goods as well as precious metals. A commodity ETF can be fixed on a single commodity and grasp it in physical storage or may invest in futures contracts. Alternative commodity ETFs look to track the performance of a commodity index which includes dozens of individual commodities through a combination of physical storage and derivatives positions.

Because a lot of commodity ETFs utilize bargaining through the buying of derivative contracts, ETFs may have big portions of uninvested funds, which is used to buy Treasury securities or other nearly risk-free assets.

More Detail:
Commodity funds frequently design their individual benchmark indexes which may contain only agricultural products, metals or natural resources. To the extent, there is frequent tracking errors around broader commodity indexes such as the Dow Jones AIG Commodity Index. Notwithstanding, any commodity ETF ought to be passively invested once the underlying index methodology is stationary. Commodity ETFs have risen in popularity due to the fact that they give investors exposure to different commodities without them having to learn how to purchase futures other derivative products.

ETFs

Country ETFs

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Definition

A “Country ETF” is an ETF that is invested across companies specific to a single country or region. Since Country ETFs are often listed on US exchanges, they are an easy and accessable way to invest in another country while using a standard brokerage account that only lists US stocks and ETFs.

However, since country ETFs invest in such a wide range of companies, they often have a hard time beating the market, and are usually recommended only for more advanced investors. There are also tax considerations; some special retirement accounts may exclude country ETFs from tax-exempt status, since it may require investments be made in US companies.

Examples

An example of these ETFs are some common Canadian-specialized ETFs, such as FCAN, EWC, and QCAN. These ETFs invest in a wide range of Canadian companies.

The ENY ETF is another Canadian ETF, specializing specifically on the Canadian energy sector.

You can find a more complete list of country ETFs at InvestSnips (Click Here to view)

ETFs

Indexed ETFs

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Definition:
A mutual fund designed to match or track the stocks in that market index, such as the Standard & Poor’s 500 Index (S&P 500). These type of mutual funds provide a great deal of diversity, market exposure, and low operating expenses in the selected category of stocks.
More Detail:
Indexed mutual funds have been used to successfully outperform most actively managed mutual funds. The most popular index funds track the S&P 500, a number of other indexes, including the Russell 2000 (small companies), the DJ Wilshire 5000 (total stock market), the MSCI EAFE (foreign stocks in Europe, Australasia, Far East) and the Lehman Aggregate Bond Index (total bond market). Using an index fund is a passive form of investing that rarely outperforms the broad indexes.

Beginners, ETFs, Stocks

ETFs vs Stocks

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What are the differences between investing in Exchange Traded Funds verses stocks? Let’s discuss…

Ease of Transaction – Most stocks are easy to buy or sell. You can buy them using a broker or an online account. ETFs are just as easy to buy.  ETFs are unlike indexes as trading ETFs require a single transaction. So as far as entering the stock market or ETF market, this one is the same.

Transaction Costs – Transaction costs of ETFs are smaller than indexes or mutual funds, but when it comes to stocks, it’s the same. Commissions are based on the number of stocks/ETFs or the value of the stocks/ETFs. Once again the same.

Liquidity – Liquidity is again pretty much the same and is based on how many of the stocks/ETFs exchange hands each trading day. But since there are more stocks to choose from than ETFs, we will say that in general stocks have greater liquidity.Risk / Reward – This can get tricky as any investment can have a different risk beta. However, you can make an argument that an ETF has slightly less risk since it’s a mini-portfolio and therefore slightly diversified, but it really depends on what is in the actual ETF. Then again, with less risk comes less chance of reward, so it all comes down to your risk tolerance. We have to call this one a tie since it’s case-by-case for each investment.

Taxes – Since ETFs and stocks use a single transactions, the capital gain taxes are realized when the fund/equity is sold. A tax advantages of ETFs is that it’s treated like a stock trade on your tax return as opposed to how mutual funds and indexes are handled.

Access to a Sector or Market – To get your foot into an industry, it is best to buy several stocks.  Multiple stocks spread the risk. Then you have to figure out which stocks to buy and how many. By buying an industry specific ETF, you get that broad exposure buying an industry sector ETF.

ETFs, Mutual Funds

ETFs vs Mutual Funds

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The goal of a smart investor should be to build a diversified portfolio of stocks and bonds with low fees and the Exchange Traded Funds (ETFs) offer seven advantages over mutual funds:

  • Lower cost
    ETFs have lower expenses than low-cost indexed mutual funds. The Barclays i-shares S&P 500 ETF charges 0.09% a year in fees, compared to about double that for the Vanguard 500 Index Mutual Fund.  A portfolio of index mutual funds costs about 18% less in annual expenses using ETFs than if we use a Vanguard index funds.   With indexed mutual funds, you are pretty much locked into a family of products. If you want to avoid transaction fees, you have to have a Vanguard account. But having your portfolio with a single fund locks you to that one provider’s funds.  It prevents you from shopping for the least cost funds.
  • Greater tax efficiency
    ETFs are better in terms of tax treatement than mutual funds.  Mutual Funds make regular capital gains distributions. Therefore investors who hold them in taxable accounts (as opposed to retirement accounts) will have to pay  tax bills on the distributions. In contrast, index ETFs generally make minimal or no capital gains distributions to help their investors avoid this tax. The larger the mutual fund and the more it trades hands, the smaller the capital gains.
  • Better tax management
    Better and easier tax management is possible with ETFs than index mutual funds. Tax treatment are the key advantage that results in financial differences, particularly for large accounts. If you buy ETFs in an account that tracks tax lots, you can sell ETFs with the highest cost-basis, thereby minimizing taxable gains. (You can make charitable gifts of appreciated stock funds with the lowest cost basis.) Your holdings in a mutual funds are often reported and sold using average purchase price.  This reduces your ability to realize tax losses.
  • Easier asset allocation
    You can manage your asset allocation more easily with ETFs. You can buy a basket of ETFs – stock, bond and REIT indexes – in a single online brokerage account, see all your assets in one place, and track your asset allocation.  Mutual funds from Vanguard, for example, don’t appear in the Schwab supermarket. That means that if you want to use mutual funds to allocate your funds among different asset classes, you’ll likely need multiple accounts. You will not be able to track your asset allocation in one place, and rebalancing assets.
  • Easier portfolio rebalancing
    You can rebalance your portfolio easier with ETFs.  You can use limit orders to buy and sell funds at preset prices. The ability to manage taxes better with ETFs means that rebalancing becomes an option in taxable accounts. With mutual funds held in a taxable account, you’re often forced to “buy and hold” without rebalancing because of the tax implications of rebalancing.
  • No fraud!
    ETF transactions are easier to track and far harder to manipulate.  ETFs and closed-end funds are baskets of stocks traded on exchanges, where the bid-offer spread is publicly available.  In contrast, mutual funds are purchased at set prices after the US stock market closes, creating the risk of legal or illegal arbitrage. This issue is particularly problematic for International mutual funds. The transparency and trading advantages effect both exchange traded mutual funds and closed-end fund versus regular or open-end mutual funds.
  • You can short ETFs
    Shorting ETFs is available and has sound uses in some cases for experienced investors.
A -G, Glossary, Options

Covered Calls

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Definition:
An options strategy where an investor purchase a long position in a stock and sells a call options on the same stock in an effort to create income from the asset. This is often utilized when an investor has a short-term unbiased outlook on the asset and then keeps the asset long and concurrently has a short position through the option to produce income from the option premium.

Example:
As an illustration, you may have shares of the TSJ Sports Conglomerate. You’re considering the long-term prospects of TSJ’s share price but you assume in the short term the stock may trade a bit flat, perhaps within a few dollars of its current price of $25. Whether you choose to sell a call option on TSJ for $26, you may make the premium from the option sale but might cap your upside. Consider one of three different scenarios that will play out: a) TSJ shares trade flat, below the $26 strike price. The option will decrease and you keep the premium from the option. In this example, by using the buy-write option you have exceeded the stock. b) TSJ shares fall then the option closes worthless, you maintain the premium, and once again surpass the stock. c) TSJ shares rise above $26, the option is utilized and your upside is capped at $26, as well as the option premium. In this case, if the stock price goes higher than $26, as well as the premium, your buy-write strategy has underperformed the TSJ shares.

Beginners

Common Investment Mistakes

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Avoid common investment mistakes and follow the following advise.

1. Create an investment plan.

Without a plan, your investments will be haphazardly selected with a shoot from the hip style.  Investors should decide the type of company they want to own — growth companies, cyclical firms or speculative ones.  You need to decide if you want current income or capital gains. Don’t abandon your plan when there is a bull or bear market.

2. Take the Time to be Informed.

The most common form of investment mistake is to forget to get information about a company’s finance. It it too common that investors buy stock without even checking what the company makes or what the future might be for that kind of product.

3. Check the Quality of Your Advice.

Many investors don’t check on their broker or adviser’s investment success before investing with them. They rarely check out their educational or professional background.

4. Do Not Invest Money that Should be Set Aside for Other Use.

People invest money that should be set aside for emergencies or for other urgent expense. If you invest with money that should have been set aside for emergencies, you may be forced to sell at a loss.

5. Be careful not to be Optimistic at the Top and Pessimistic at the Bottom.

Optimism and bullishness are infectious, as are pessimism and bearishness. Thus, even when the market is high, people go right on buying. They do it because everyone seems to be buying. They assume that nothing will change and that the bull market will continue.

Conversely, people grow increasingly pessimistic as the market drops. Often they reach the  bottom when stocks are cheapest. This may be when you should be buying.

6. Avoid Buying on the Basis of Tips and Rumors.

It is rare that people get inside information that has any value for a publicly held company. Even if you do, it is typically old and out of date.  No matter how hot a tip you hear, plenty of people knew it before you did.

7. Do Not Become Sentimental About a Stock.

Some investors grow attached to their stocks. They hold their stocks long after the potential for profit is gone. The other type of mistake is to ignore the fact that you were wrong about buying a stock.

8. Avoid Buying Low-Priced Stocks Assuming that they will Have Best Returns.

A low-priced stock may seem like a bargain but not because it is a low priced stock. The price of a stock is what the marketplace believes the company is worth divided by the number of outstanding shares. Stocks that have a low price are seen by the market to having little value. Period.

A -G, Accounting, Advanced, Business, Fundamental Analysis, Glossary, Personal Finance

Cash Flow Statement

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What is a Cash Flow Statement?

Businesses keep financial records so they will know how their company is performing financially.  For publicly traded companies (ones you can purchase stock in), these records are also shared with investors. The three main financial statements companies use are the Income Statement, the Balance Sheet, and the Cash Flow Statement.

Every time you get a paycheck, you think about the bills you have recently paid and the upcoming ones that require payment soon. You know which bills need to be paid regularly, how much money that will take, and you are aware that extra money is needed at different times, for things such as car repairs and medical expenses.  The cash flow statement does something similar – it allows company management to see where the company’s money is coming from and how it is being spent.  Most companies will complete a cash flow statement at least quarterly because it the best financial report to show how well the company generates cash to pay its debts and fund its operating expenses. 

Why is the Cash Flow Statement Important?

The Cash Flow statement is one of four financial statements required by the Securities and Exchange Commission based on the U.S. Generally Accepted Accounting Principles.  A cash flow statement shows changes over time rather than absolute dollar amounts at a point in time. When generating a Cash Flow Statement, a company may show the cash flow over a period of three months, six months, or a year. It uses and reorders the information from a company’s balance sheet and income statement.  The Cash Flow statement is important because it tracks all the monetary activities of a company, measuring where the actual cash comes from and where it is going. It provides insight into how a firm manages and allocates its cash to debts, investments and expenditures.

Thus, for management, investors and creditors, it will be essential to review the CF statement to ensure that the business is financially fruitful.

What are the components of a Cash Flow Statement?

ABC Inc.

Cash Flow Statement

For the year ended December 31 2999

Cash Flow from Operating Activities
     Net Income$x,xxx,xxx
     Depreciationxx,xxx
     Increase in A/R (accounts receivable)(xx,xxx)
     Decrease in A/P (accounts payable)xx,xxx
     Increase in Inventory(xx,xxx)
          Net cash provided by Operating Activitiesxxx,xxx
 
Cash Flow from Investing Activities
     Sale of Equipment, Machineryxxx,xxx
     Purchase of land(xx,xxx)
          Net cash provided by Investing Activitiesxxx,xxx
 
Cash Flow from Financing Activities
     Notes Payablexx,xxx
     New Equity Issuedxxx,xxx 
          Net cash provided by Financing Activitiesxxx,xxx
 
Net change in cash flowxxx,xxx
Beginning Cash Balancexx,xxx
Ending Cash Balancexxx,xxx
 

Cash flow statements are divided into three main parts. Each part reviews the cash flow from one of three types of activities: (1) operating activities; (2) investing activities; and (3) financing activities.

  1. The cash flow from operating activities represents the amount of money a company brought in from its regular business activities.  This includes cash generated through manufacturing and selling goods or providing services to customers.  It also includes cash paid to suppliers and taxes paid.
  2. The cash flow from investing activities are any transactions that are related to the firm’s investment in resources for growth and production which involve long-term uses of cash.  This includes cash paid to purchase fixed assets like property, a plant, or equipment.  It also includes cash earned through the sale of property or equipment and a cash out as a result of a merger. 
  3. The cash flow from financing activities focuses on how a company raised capital and how it pays it back to investors and creditors.  This includes paying cash dividends, issuing or buying back more stock, and adding or changing loans. 

Who is interested in a Cash Flow Statement?

There are three main players who are interested in the Cash Flow Statement:

  • Investors:  Current and future investors will review the Cash Flow Statement to understand how well a company’s operations are running and to view the company’s ability to generate cash and meet their obligations.
  • Lenders/Creditors:  Lenders and creditors will review the Cash Flow Statement to determine how much cash is available for the company to fund its operation and pay its debts. 
    • Management:  To the accountants and the CEO of the firm, the numbers on the Cash Flow Statement will show if the company is prepared to cover their payroll and other expenses.

Where can I find the Cash Flow Statement for a specific company?

You can find the Cash Flow Statements for any company in the United States in our Quotes Tool:

cash flow
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A -G, Glossary

Dollar Cost Averaging

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Definition:Dollar cost averaging is a simple method of investing a specific amount of money at specific periods of time without consideration for the cost. For example; you decide to take $100 a week out of your paycheck and have it automatically set aside to fund the purchase of a stock or bond each week. For the sake of simplicity, the stock originally sold for $20 per share so each week you were initially able to purchase 5 shares. Later the stock price increased to $25 per share so now you can only purchase 4 shares. Notice, the number of shares has declined but the original value of the first shares increased.

Month 1Month 2
5 shares at $20 = $1005 shares worth $25 = $125 

The rationale is that buy purchasing at a steady rate, you will benefit from the increases while negating the decreases. But does it actually work? According to a landmark bit of research conducted by the Journal of Financial & Quantitative Analysis in 1979…No, it doesn’t measure up to lump sum investing when comparing total return. Statistically speaking the overall rate of return was less for dollar cost averaging. On the other hand, dollar cost averaging does provide a return – just not quite as high as that of lump sum investing. It is also a valuable way to begin investing especially for new investors.

More Detail:Hereafter, the typical cost per share of the security will come to be smaller and smaller. Dollar cost averaging decreases the chance of investing a big amount in an individual investment at the incorrect time. For example, you decide to buy $100 worth of XYZ every month for three months. In January, XYZ is worth $33, so you purchase three shares. In February, XYZ is worth $25, so you purchase four extra shares this time. Finally in March, XYZ is worth $20, so you purchase five shares. Totally, you bought 12 shares for an medium price of approximately $25 each.
A -G, Advanced, Fundamental Analysis, Glossary

Fundamental Analysis

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Definition:
Fundamental analysis is the process of looking at the basic or fundamental financial level of a business, especially sales, earnings, growth potential, assets, debt, management, products, and competition. This type of analysis examines key ratios of a business to determine its financial health and gives you an idea of the value its stock.

Many investors use fundamental analysis alone or in combination with other tools to evaluate stocks for investment purposes. The goal is to determine the current worth and, more importantly, how the market values the stock. Usually fundamental analysis takes into consideration only those variables that are directly related to the company itself, rather than the overall state of the market or technical analysis data but here I’m going to describe a top down approach to the typical fundamental evaluation.

It starts with the overall economy and then works down from industry groups to specific companies. As part of the analysis process, it is important to remember that all information is relative. Industry groups are compared against other industry groups and companies against other companies. It is important that companies are compared with others in the same group. First and foremost in a top-down approach would be an overall evaluation of the general economy. When the economy expands, most industry groups and companies benefit and grow. When the economy declines, most sectors and companies usually suffer. Once a scenario for the overall economy has been developed, an investor can break down the economy into its various industry groups. If the prognosis is for an expanding economy, then certain groups are likely to benefit more than others. An investor can narrow the field to those groups that are best suited to benefit from the current or future economic environment. If most companies are expected to benefit from an expansion, then risk in equities would be relatively low and an aggressive growth-oriented strategy might be advisable. A growth strategy might involve the purchase of technology, biotech, semiconductor and cyclical stocks.

If the economy is forecast to contract, an investor may opt for a more conservative strategy and seek out stable income-oriented companies. A defensive strategy might involve the purchase of consumer staples, utilities and energy-related stocks. To assess a industry group’s potential, an investor would want to consider the overall growth rate, market size, and importance to the economy. While the individual company is still important, its industry group is likely to exert just as much, or more, influence on the stock price. When stocks move, they usually move as groups. Once the industry group is chosen, an investor would need to narrow the list of companies before proceeding to a more detailed analysis. Investors are usually interested in finding the leaders and the innovators within a group.

The first task is to identify the current business and competitive environment within a group as well as the future trends. How do the companies rank according to market share, product position and competitive advantage? Who is the current leader and how will changes within the sector affect the current balance of power? What are the barriers to entry? Success depends on an edge, be it marketing, technology, market share or innovation. A comparative analysis of the competition within a sector will help identify those companies with an edge, and those most likely to keep it. At point you will have a shortlist of companies and the final step to this analysis process would be to take apart the financial statements and come up with a means of valuation. Some of the more popular ratios are found by dividing the stock price by a key value driver.

Fundamental Analysis Tools

These are the most popular tools of fundamental analysis. They focus on earnings, growth, and value in the market. For convenience, I have broken them into separate articles. Each article discusses related ratios.

None of these mean much on their own but when you combine some of them together and adapt your combinations based on the sector the company you’re analyzing is in you will find that they are very good identifying the true value of a stock, thus find you identify the “ticket price” of your potential investment and to determine if your current investments are at or near their full potential. This methodology assumes that a company will sell at a specific multiple of its earnings, revenues or growth. An investor may rank companies based on these valuation ratios. Those at the high end may be considered overvalued, while those at the low end may constitute relatively good value. But it could also mean that the ones on the low end are “bad companies” and are not worth investing in while the ones on the high end could be very good companies which still have room to grow. Remember that the market is usually right in the long run. After all this work you will be left with a handful of candidates and this is where I recommend using technical analysis to develop a trading plan for each one of them.

I know investors tend to shy away from technical analysis but this a grave mistake, in my opinion. Knowing how to read charts and understanding that technical analysis is in fact understanding basic human psychology will help you maximize your gains and minimize your losses; how does that sound to you? So here, in a nutshell, are the advantages and disadvantages of fundamental analysis:

Advantages:

Fundamental analysis is good for long-term investments based on long-term trends, very long-term. The ability to identify and predict long-term economic, demographic, technological or consumer trends can benefit patient investors who pick the right industry groups or companies.

Sound fundamental analysis will help identify companies that represent a good value. Some of the most legendary investors think long-term and value. Graham and Dodd, Warren Buffett and John Neff are seen as the champions of value investing. Fundamental analysis can help uncover companies with valuable assets, a strong balance sheet, stable earnings, and staying power.

One of the most obvious, but less tangible, rewards of fundamental analysis is the development of a thorough understanding of the business. After such painstaking research and analysis, an investor will be familiar with the key revenue and profit drivers behind a company. Earnings and earnings expectations can be potent drivers of equity prices. Even some technicians will agree to that. A good understanding can help investors avoid companies that are prone to shortfalls and identify those that continue to deliver. In addition to understanding the business, fundamental analysis allows investors to develop an understanding of the key value drivers and companies within an industry. A stock’s price is heavily influenced by its industry group. By studying these groups, investors can better position themselves to identify opportunities that are high-risk (tech), low- risk (utilities), growth oriented (computer), value driven (oil), non-cyclical (consumer staples), cyclical (transportation) or income-oriented (high yield).

Stocks move as a group. By understanding a company’s business, investors can better position themselves to categorize stocks within their relevant industry group. Business can change rapidly and with it the revenue mix of a company. This happened to many of the pure Internet retailers, which were not really Internet companies, but plain retailers. Knowing a company’s business and being able to place it in a group can make a huge difference in relative valuations.

Disadvantages:

The main disadvantage for me is that if used on its own, fundamental analysis (FA) doesn’t take into consideration the “herd mentality” phenomenon. In the long run, the price per share (PPS) of companies is driven by their earnings, i.e., the profit they’re yielding. In the short term, the momentum can be quite influential on the PPS; I’m sure you’ve noticed that some stock are considered market darlings and, to a certain degree, it doesn’t matter what their quarterly results are; people keep on buying. The same applies for companies that, all of a sudden, fall out of favor for whatever reason, genuine or not. They keep getting hammered regardless of the results the company pumps out, until one day it reverses. FA doesn’t consider this irrational behavior.

Fundamental analysis may offer excellent insights, but it can be extraordinarily time-consuming. Time-consuming models often produce valuations that are contradictory to the current price prevailing on Wall Street. When this happens, the analyst basically claims that the whole street has got it wrong. This is not to say that there are not misunderstood companies out there, but it is quite brash to imply that the market price, and hence Wall Street, is wrong.

Valuation techniques vary depending on the industry group and specifics of each company. For this reason, a different technique and model is required for different industries and different companies. This can get quite time-consuming, which can limit the amount of research that can be performed.

Fair value is based on assumptions. Any changes to growth or multiplier assumptions can greatly alter the ultimate valuation. Fundamental analysts are generally aware of this and use sensitivity analysis to present a base-case valuation, a best-case valuation and a worst-case valuation. However, even on a worst-case valuation, most models are almost always bullish, the only question is how much so.

The majority of the information that goes into the analysis comes from the company itself. Companies employ investor relations managers specifically to handle the analyst community and release information. As Mark Twain said, “there are lies, damn lies, and statistics.” When it comes to massaging the data or spinning the announcement, CFOs and investor relations managers are professionals. Only buy-side analysts tend to venture past the company statistics. Buy-side analysts work for mutual funds and money managers. They read the reports written by the sell-side analysts who work for the big brokers (CIBC, Merrill Lynch, Robertson Stephens, CS First Boston, Paine Weber, DLJ to name a few). These brokers are also involved in underwriting and investment banking for the companies. Even though there are restrictions in place to prevent a conflict of interest, brokers have an ongoing relationship with the company under analysis. When reading these reports, it is important to take into consideration any biases a sell-side analyst may have. The buy-side analyst, on the other hand, is analyzing the company purely from an investment standpoint for a portfolio manager. If there is a relationship with the company, it is usually on different terms. In some cases this may be as a large shareholder.

When market valuations extend beyond historical norms, there is pressure to adjust growth and multiplier assumptions to compensate. If Wall Street values a stock at 50 times earnings and the current assumption is 30 times, the analyst would be pressured to revise this assumption higher. There is an old Wall Street adage: the value of any asset (stock) is only what someone is willing to pay for it (current price). Just as stock prices fluctuate, so too do growth and multiplier assumptions. Are we to believe Wall Street and the stock price or the analyst and market assumptions? It used to be that free cash flow or earnings were used with a multiplier to arrive at a fair value. In 1999, the S&P 500 typically sold for 28 times free cash flow. However, because so many companies were and are losing money, it has become popular to value a business as a multiple of its revenues. This would seem to be OK, except that the multiple was higher than the PE of many stocks! Some companies were considered bargains at 30 times revenues.

To conclude, fundamental analysis can be valuable, but it should be approached with caution. If you are reading research written by a sell-side analyst, it is important to be familiar with the analyst behind the report. We all have personal biases, and every analyst has some sort of bias. There is nothing wrong with this, and the research can still be of great value. Learn what the ratings mean and the track record of an analyst before jumping off the deep end. Corporate statements and press releases offer good information, but they should be read with a healthy degree of skepticism to separate the facts from the spin. Press releases don’t happen by accident; they are an important PR tool for companies. Investors should become skilled readers to weed out the important information and ignore the hype.

More Detail:
Quantitative and Qualitative

You can define fundamental analysis as “researching fundamentals.”  This is not much help to an investor who does not know what “fundamentals” are and how to use them. Basically, fundamentals include things like revenue and profit.  Fundamentals also include everything from the company’s market share to the quality of its management.

Fundamental factors are grouped into two categories: quantitative and qualitative.  Quantitative factors are capable of being measured in numerical terms.  Qualitative factors relate to the quality or character of something, as opposed to size or quantity.

Quantitative fundamentals are numeric characteristics about a business. The easiest way to identify quantitative data is the financial statements. Revenue, profit and assets can be measured with great precision.

Qualitative fundamentals are less tangible factors – things like quality of a company’s board members and key executives, its brand-name recognition, patents or proprietary technology.

Strategies for Beginners

Dogs of Dow Strategy

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Definition:
A stock investing tactic where you purchase the ten DJIA stocks with the highest dividend yield at the start of each year.  At the start of each consecutive year the stock portfolio must be adjusted so that it always holds the 10 highest yielding stocks.

More Detail:
The Dogs of Dow investing tactic was drafted in 1972 and has proven to be quite rewarding. Actually, upon the adjustment of the Dog of the Dow, investors portfolios at the onset of each year, placed a price burden upon the stocks involved.

Glossary, H-M

IPO

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Definition:
The initial sale of stock by a private company to the public which turns it into a public company. IPOs are typically offered by smaller, younger companies who are seeking to expand through the infusion of capital from the IPO. It can also be done by large privately owned companies looking to become publicly traded.

Most IPOs use the services of an underwriting firm, which helps it determine the type of security to issue (common or preferred). The underwriting firm also helps select the price and timing for the IPO

More Detail:
The initial day of trading as well as the near term can see huge swings in price.  For small private investors, this makes IPOs tough to predict and highly risky for small investors. Most companies with an IPOs are going through a transitory growth period, which adds to the  uncertainty regarding their future values.

Strategies for Beginners

Finding Stocks Using a Stock Screener

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There are many research tools available and many of them are free. Of course, there are some very sophisticated tools that come with hefty price tags; however, for most investors all the research they’ll need is free or available for a modest subscription.

Stock Screener

The most basic research tool is the stock screener.  Some of the better ones come as part of subscription package.  Basically, screeners identify stocks that meet the user criteria.   Criteria can include industry type, market cap, sales, dividends, and so forth. The more sophisticated screeners provide more qualifiers. After you specify your qualifiers, the screener identifies the companies that meet your qualifications. If the list of companies is too large, you can run the screener again with more criteria. Sophisticated screeners will run follow up analysis on the set you just generated.

Beginners, Strategies for Beginners

Buy Stock: Making Your First Trade and Which Stocks to Buy

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I want to make my first stock trade. How do I find stocks to buy?
That is a very good question. Finding stocks to buy is easy, but finding GOOD stocks to buy is challenging. Everyone has their own opinion on which stocks to buy and how long to hold them.

The first thing you need to know about trading stocks is that each stock is assigned a Ticker Symbol by the stock exchanges. The Ticker Symbol is a unique combination of 1 to 5 letters the exchanges use to identify stocks. In order to trade stocks, you must know the ticker symbol of the stock you are thinking of buying. All of the tools here will list the ticker symbols.

Next, when you are thinking of spending real money on stocks, there are several factors to consider when thinking of which stocks to buy:

  • How long can you wait before you might need the money?
  • How much risk can you take?
  • How many stocks do you want to buy initially in your portfolio?

In terms of your portfolio, here are suggestions to help build a good portfolio:

  • Trade What You Know! Identify 5 to 10 stocks that you are interested in that you actually know something about. Think of where you, your friends, and your family spend money–food, clothes, travel, toys, banks, technology, etc. Where are you spending more money than you used to?
  • Diversify! This means don’t put all of your eggs in the same basket. Find a food company (think Coca-Cola, Pepsi, Kroger, Whole Foods, Proctor and Gamble, McDonalds, Starbucks), a travel company ( think Delta Airlines, Marriott Hotels, Ford, General Motors, BP Gas, Exxon), a bank, a technology company, etc. and make sure you are buying stocks in different industries.
  • Don’t spend all of your money at one time! Stock prices and the overall market move up and down all the time. You don’t want to spend all of your money today only to have the stock market decline 5% this week! You want to buy stocks when they are cheap and you want to to sell them when they are higher in price. If you think you want to buy 200 shares of General Electric (GE), then try buying 100 shares today and 100 shares next week or whenever you see the price decline slightly. In a bull market, this is called buying on the dips!

To help you get other trading ideas, the site is full of links to various resources.

Price to Earnings Ratio, Risk & Timeline

If you want to be conservative and keep your risk low, you should choose a few stable, blue-chip stocks like GE and hold them for a few years. The downside is that conservative stocks usually don’t gain value very quickly.

On the other hand, if you want to take some risks and try some more volatile stocks you have a chance at making a larger and faster gain. A good example is to buy Google stock.

Some of the riskiest stocks you can buy are Penny Stocks. They can give you the highest return (or loss!) in the shortest amount of time. They are usually not stocks one wants to buy.

Ensure and Increase Your Safety with Diversification

The more stocks you purchase, the more safe you will be in case one stock drops significantly. Experts often recommend 30 to 100 different stocks but that is often not practical to do. Of course, you will probably also make less money because some stocks will go up and some will go down. You will probably also want to buy from a few different industries so that you will be diversified in case one industry goes sour.

Price to Earnings Ratio

Many people like to use a company’s P/E Ratio to determine whether it’s a good buy or not.

The Price to Earnings (profit) Ratio can give you an indication of how high a stock’s price is relative to how profitable it is.

The best thing to do is to compare one company’s PE ratio to other companies in the same industry to see how high or low the price is. What can happen is many, many people can trade stock in a good company, which will cause the price to go much higher than it’s really worth.

See an example of Microsoft’s industry P/E ratios using Yahoo! Finance (scroll to the bottom).

Good Stocks for Long-Term Growth

Basically, you want to buy stocks that will go up in value over time. That may mean that you need to find some that are currently undervalued, using the PE Ratio or something similar. Or, you might look for companies that show potential to grow significantly over the next few years. But you should try to avoid buying stocks that are overpriced just because they are popular at the moment. That can lead to a quick loss! So it’s important to do your homework when looking for the best stocks to buy today.

Buy Stocks for Your Goals

The stocks to buy are the ones that fit your time frame and risk level. The “experts” in the stock market don’t always have your best interests in mind so you may want to consider asking trusted friends and relatives if they know any good stocks to buy instead.

Stocks to Buy

Buy direct. Some companies offer direct stock purchase plans (DSPPs). Search online or call or write the company whose stock you wish to buy, to inquire whether they offer such a plan, and forward you a copy of their plan’s prospectus, application forms, and other relevant information. Most plans allow you to invest as low as $50 per month, automatically withdrawn from your bank account. Pay close attention especially to the fees involved. A few companies, such as Procter & Gamble (see here), offer no fee investment plans. DSPPs also allow you to reinvest all your dividends automatically. Some companies even give you a discount, such as 5 percent, for dividend reinvestment.

Use an online discount broker. Search for “online discount brokers” on a search engine to find a list of brokers that you can use to buy and sell stocks online. Be sure to compare their fees and see if they have any hidden fees before signing up. Minimizing fees and expenses is key to successful investing. Most discount brokers charge less than $10 commission per trade, regardless the size of the trade. Some brokers may even offer a certain number of free trades, provided you meet certain criteria, so make sure you read carefully before committing to a broker. The best brokers also offer no fee dividend reinvestment, good customer service, and various research tools for customers.

  • Some brokerages have varying levels of services; pick one that is best for you.
  • Send the broker an initial deposit of funds. (Your broker needs this money to purchase your stocks.) The usual minimum is $2000 but can be as little as $500.00. Some online brokers don’t require a deposit at all.
  • Your broker must report your stock trades to the IRS. You will need to fill out the required forms and mail them back to the broker, possibly even before they will allow you to make your first trade. (Your broker will send you the forms.)
  • Select your stock, notifying your broker of the company’s “symbol” (a 1-5-letter code), the price you’re willing to pay per share, the number of shares to buy, and the length of time for which your offer will be valid (e.g. Single day vs. Good till Cancelled). Instead of specifying a price you are willing to pay (call a ‘limit order’), you may also put in order to buy at the market, which means you order is immediately filled at the current ask price for the stock.
  • Alternatively, use a full service broker. A full service broker is similar to a discount broker as discussed above, except that they charge considerably higher fees, and offer investment advice and more research tools. Because full service brokers are paid mostly by commissions, it is in their best interest to encourage you to trade as frequently as possible, even though it may not be in your best interest.
Stocks

What Are Stocks?

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The Definition of a Stock
Stocks are shares in ownership of a company. Stocks represents a claim on the company’s assets and earnings. As you increase your holdings of a stock, your ownership stake in the company increases. Whether you say shares, equity, or stock, it all means the same thing.
Being an Owner
Holding a company’s stock means that you are one of the many owners (shareholders) of a company and, as such, you have a claim (albeit usually very small) to everything the company owns. Yes, this means that technically you own a tiny sliver of every piece of furniture, every trademark, and every contract of the company. As an owner, you are entitled to your share of the company’s earnings as well as any voting rights attached to the stock.

A stock is represented by a stock certificate. This is a fancy piece of paper that is proof of your ownership. In today’s computer age, you won’t actually get to see this document because your brokerage keeps these records electronically, which is also known as holding shares “in street name”. This is done to make the shares easier to trade. In the past, when a person wanted to sell his or her shares, that person physically took the certificates down to the brokerage. Now, trading with a click of the mouse or a phone call makes life easier for everybody.

Being a shareholder of a public company does not mean you have a say in the day-to-day running of the business. Instead, one vote per share to elect the board of directors at annual meetings is the extent to which you have a say in the company. For instance, being a Microsoft shareholder doesn’t mean you can call up Bill Gates and tell him how you think the company should be run. In the same line of thinking, being a shareholder of Anheuser Busch doesn’t mean you can walk into the factory and grab a free case of Bud Light!The management of the company is supposed to increase the value of the firm for shareholders. If this doesn’t happen, the shareholders can vote to have the management removed, at least in theory. In reality, individual investors like you and I don’t own enough shares to have a material influence on the company. It’s really the big boys like large institutional investors and billionaire entrepreneurs who make the decisions.For ordinary shareholders, not being able to manage the company isn’t such a big deal. After all, the idea is that you don’t want to have to work to make money, right? The importance of being a shareholder is that you are entitled to a portion of the company’s profits and have a claim on assets. Profits are sometimes paid out in the form of dividends. The more shares you own, the larger the portion of the profits you get. Your claim on assets is only relevant if a company goes bankrupt. In case of liquidation, you’ll receive what’s left after all the creditors have been paid. This last point is worth repeating: the importance of stock ownership is your claim on assets and earnings. Without this, the stock wouldn’t be worth the paper it’s printed on.

Another extremely important feature of stock is its limited liability, which means that, as an owner of a stock, you are not personally liable if the company is not able to pay its debts. Other companies such as partnerships are set up so that if the partnership goes bankrupt the creditors can come after the partners (shareholders) personally and sell off their house, car, furniture, etc. Owning stock means that, no matter what, the maximum value you can lose is the value of your investment. Even if a company of which you are a shareholder goes bankrupt, you can never lose your personal assets.

Debt vs. Equity
Why does a company issue stock? Why would the founders share the profits with thousands of people when they could keep profits to themselves? The reason is that at some point every company needs to raise money. To do this, companies can either borrow it from somebody or raise it by selling part of the company, which is known as issuing stock. A company can borrow by taking a loan from a bank or by issuing bonds. Both methods fit under the umbrella of debt financing. On the other hand, issuing stock is called equity financing. Issuing stock is advantageous for the company because it does not require the company to pay back the money or make interest payments along the way. All that the shareholders get in return for their money is the hope that the shares will someday be worth more than what they paid for them. The first sale of a stock, which is issued by the private company itself, is called the initial public offering (IPO).It is important that you understand the distinction between a company financing through debt and financing through equity. When you buy a debt investment such as a bond, you are guaranteed the return of your money (the principal) along with promised interest payments. This isn’t the case with an equity investment. By becoming an owner, you assume the risk of the company not being successful – just as a small business owner isn’t guaranteed a return, neither is a shareholder. As an owner, your claim on assets is less than that of creditors. This means that if a company goes bankrupt and liquidates, you, as a shareholder, don’t get any money until the banks and bondholders have been paid out; we call this absolute priority. Shareholders earn a lot if a company is successful, but they also stand to lose their entire investment if the company isn’t successful.

Risk
It must be emphasized that there are no guarantees when it comes to individual stocks. Some companies pay out dividends, but many others do not. And there is no obligation to pay out dividends even for those firms that have traditionally given them. Without dividends, an investor can make money on a stock only through its appreciation in the open market. On the downside, any stock may go bankrupt, in which case your investment is worth nothing.Although risk might sound all negative, there is also a bright side. Taking on greater risk demands a greater return on your investment. This is the reason why stocks have historically outperformed other investments such as bonds or savings accounts. Over the long term, an investment in stocks has historically had an average return of around 10-12%.

Glossary, N-T

Trading Halts

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Definition:

Why does it happen?
Trading Halts are generally made by the exchanges.
A stock are halted from trading if
• The respective company is in the process of announcing important news or information that will significantly impact the stock price.
o It prohibits any trader with inside information from benefiting by trading that security before that news is publicly available.
• There is a significant order imbalance between the buyers and sellers of the securities.
o The halt gives the market specialist (market-maker) enough time to clear out the problems caused by this imbalance.

The NASDAQ and other exchanges currently use 11 codes to specify in more detail why trading has been halted for a security.
The “Over The Counter Bulletin Board” (OTCBB) currently uses 5 codes.

Example:
In June 2010, 6 executives of Sundance Resources Ltd, a mining company in Australia, went missing on a flight in West Africa.  Included in the missing were the CEO and the Chairman. This news was sure to cause a sharp decline in stock price as well as create an unfair arbitrage opportunity for people within the organization with access to the news. Hence, the company immediately requested the Australian Stock Exchange for a trading halt on the company’s stock prior to the open of trade on that morning, until they were sure that the news had been properly distributed to the public.

Advantages of Trading Halts:
• Each market participant gets the equal time to be informed about any news announcement
• Any illegal function caused by any traders are removed and brought to the attention of other investors
• Trading Halts do not cause a change in the stock price of firms
• Regulatory trading halts allow other markets (example: BP trades on the LSE and the NYSE) the opportunity to get the necessary information to halt trading of that stock on their own exchanges

Conclusion:
Trading Halts are necessary tools that exchanges utilize in order to restrict individuals with access to insider information from unfairly gaining profits, as well as fixing any abnormal and technical trading issues.

Glossary, N-T

Time Decay

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Definition: Time Decay is the inclination for options to decrease in worth as the expiration date draws near. The extent of the time decay is inversely connected to the changeability of that option.  Time Decay, also referenced to as theta, may be measured by watching the rate of decrease in the amount of an option over time.

Why does it happen?
Options have an intrinsic and an extrinsic worth. As time expires and the finish date of the option approaches, the value of the option loses its extrinsic value and gets near to its intrinsic value.

For instance, the worth associated with trading diminishes with time, meanwhile the value associated with the actual difference between the strike price and the underlying stock price becomes more noticeable.

The more often the option is traded, the less is the result of time decay as market forces maintain the extrinsic value. Also a thinly traded option is subject to considerable time decay as the extrinsic value rapidly dissipates due to a lack of demand.

Example:
Take for instance, AAPL stock price stays constant at $335 for 10 days before the options expiration date.

Price of $340 Call Option 10 days before expiration: $1.05
Price of $340 Call Option 5 days before expiration: $0.50
Price of $340 Call Option on day of expiration: $0.00

The intrinsic value of the call option was $0.00 as it was out of the money throughout the 10 days. Because of supply and demand of the option, the extrinsic value gave a price to the option. As the expiration got closer, the price of the option fell short of its extrinsic value and moved towards its intrinsic value.

Long and Short of Time Decay:

Time Decay can be a useful tool for Options Writers (shorts).

If you can estimate with the help of Theta what the rate of decay of an option is, it is possible to make good profits from the difference in the premium received and premium paid at or before expiration.

Generally, time decay begins gathering momentum around 30-60 days before the expiration date of an option.

Contrary to holding options for a long period of time, especially out of the money, one needs to be good at predicting where the price of the underlying stock will close at the date of expiration.

The investor must realize that because of time decay, the price of their option will not move as much as it does the prior day.

Options lose value every day the stock price does not go in the favor of their option.

Conclusion:
Time Decay increases the chance of a loss in option price daily for a long option holder, while decreasing the risk of a price increase for a writer of an option. Time decay is best measured via the Greek, Theta.

Advanced, Financial Ratios, Fundamental Analysis, Glossary, N-T

Sharpe Ratio (Advanced)

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Definition:
The Sharpe Ratio, named after Nobel laureate William F. Sharpe, measures the rate of return in association with the level of risk used to obtain that rate. It’s a particularly useful tool for novice investors to use as a method tracking “luck” versus “smarts.”

Here’s an easy example to help conceptualize how the Sharpe Ratio works in real life. You and your two friends are out for a drink when the topic turns to investing. Friend number one is the play it safe guy who puts his money in Treasury Bonds and hopes for the best. Essentially his investment is as close to risk free as possible (excluding the threat of inflation of course). It’s safe and requires nothing more than automatic payroll deductions to generate a steady – albeit decidedly insignificant – rate of return. This is considered a “risk free” rate. Since anyone can obtain that rate of return by doing almost nothing, it is removed from the equation. Stocks, by their very nature, have some element of risk and as a rule of thumb, any investment with an element of risk should generate a premium above the risk free level…otherwise, why put your money at stake?

Friend number two is telling you about his hot new investment tip that just generated an amazing 25 percent rate or return. Is this guy a genius or what? Maybe not. By using the Sharpe Ratio, you can measure whether your friend is taking on too much risk. Briefly, it works like this… Subtract the risk free rate (like that available from your friends Treasury bills) from the rate of return generated then divide by the standard deviation of the portfolio returns. The result provides a way to measure the excess return derived from the level of risk assumed…not necessarily insight and intuition. Chances are your friend isn’t a genius but rather a lucky hot-shot who needs to take the money and run before his luck runs out. To give you some insight, a ratio of 1 or better is considered good, 2 and better is very good, and 3 and better is considered excellent. One final note: if your investment portfolio isn’t performing above the risk free rate then it’s time to put up or shut up. Either figure out what you are doing wrong and begin educating yourself on the basics of investing or sign up for those bonds via payroll deduction and hope inflation leaves you a little to live on by retirement.

More Detail: The Sharpe Ratio calculates the difference between risk-free and a risky asset. Then you divide the difference by the Standard Deviation ( the value of risk) of the stock / portfolio.  The Sharpe Ratio is a strategy to maximize the reward to risk relationship.

What does the Sharpe Ratio Mean?

The Sharpe Ratio shows the excess return from the excess risk taken by an investor.

It is a measure which can be used to compare two or more investments to show which one earned the most excess return given the least amount of extra risk.

Two Stocks or Portfolios that generate the same return over a certain period might not be the same in terms of the risk taken to invest in each of them.

One of them might have been more volatile during that period, meaning that our risk for that stock / portfolio was greater.

Example:
Risk –Free Rate (Savings Account at ING Direct) = 3% Stock A = Apple (AAPL)
3-Month Return = 22%
Standard Deviation = 1%
Sharpe Ratio for AAPL = (0.22 – 0.03)/(0.01) = 19 Stock B = Google (GOOG)
3-Month Return = 24%
Standard Deviation = 2%
Sharpe Ratio for GOOG = (0.24 – 0.03)/(0.02) = 10.5

Results:
(i) Since both stocks had Sharpe Ratios greater than Zero, It was better to invest in one of them than to save the money at ING at 2%.
(ii) Even though GOOG had a slightly higher return that AAPL (24% > 22%), it would have been wiser to invest in AAPL as AAPL had a higher excess return per unit of risk than GOOG (19 > 10.5).

Practice this on your trading site

You can calculate your own Sharpe Ratio on stocks after trading it on:

Limitations of Sharpe Ratio
The limitation of the Sharpe Ratio is that it just tells you that one investment was better than the other comparing risk, but does not tell you HOW MUCH better that investment was. In other words, there are no units to measure the added benefit from choosing one investment over another.

Conclusion

Sharpe-Ratio

The Sharpe Ratio is a useful tool to evaluate the actual risk-adjusted performance of a stock or portfolio compared to another. It shows us which investment is better if we want to maximize our returns while minimizing our risk.

Click Here for instructions on calculating the Sharpe Ratio for your portfolio yourself in Excel

Beginners

Stock Market Myths

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There are  many stock market myths.  Here are a few of our favorites that you might like to add to the collection:

Fallen Angels RiseMany people  like the idea of buying at the 52 week low as it  leaves nowhere to go but up. Unfortunately, this myth of buying on price is a recipe for disaster.  Many professional investors call this catching a falling knife.  It is always possible for a stock’s price to continue to fall.  Always look for value.  Most professionals would prefer to buy at a new high than a new low.

What Goes Up Must Come Down
Lets look at a well known example.  Was Berkshire Hathaway (BRKb) expensive at $6,000 per share? How about at $10,000 per share? Who could have ever imagined that this stock would exceed $70,000 per share?  Inflationary alone would help stocks continued upward momentum.

Stock Market Investing is the same as Gambling
Many people go to Los Vegas and say that they are investing and get a higher return with craps than the stock market.  In fact, this really depends on the strategy you use.  If you listen to rumors and TV investment shows, the chance are that Vegas would be a better bet. On the other hand, vast fortunes have been made by those who use thoughtful investment strategies..

It requires advance training and college degrees.
Nothing could be further from the truth. It is equally easy for people using online resources and research as with college education.  The best approach is using virtual trading to test strategies till you find a method that works.

You get what you pay for
There are 100s of investment strategists and salesmen that will try to tell you that you “get what you pay for” in the stock market.  That if you pay higher fees for their advise, you will get better returns.  Statistics show that eliminating the middle man significantly increases the rate of return for many investors. Understand what you are paying for and then decide if it is really worth it.

Pay-for-Performance.
Mutual fund companies charge high fees before you know what kind of return they are going to provide. Don’t pay to play if the mutual fund doesn’t perform.  It is better to use no fee mutual funds or ETFs to achieve the same financial goals.

Strategies for Beginners

How To Select Your Trading Strategy

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Portfolio Management teaches that investors need to include input of the following personal issues:

  • personality,
  • goals,
  • amount of investment capital,
  • comfort zone.

Investors that enjoy a lot of in an out higher risk action should look into day trading for their style of investing.

Others, with long-term goals and objectives, will look into a trade and hold approach to trading.

Regardless of your method of trading, these factors contribute to the creation of most porttfolios:

  • Diversify your portfolio: To create a successful portfolio or win your stock market game, diversify your portfolio with different investments from a variety of industries.
  • Keep your eyes on profit: Whether looking for short-term gains or long-term growth, profits is king.
  • Evaluate key ratios: Learn the most important numbers (book value, return on equity (ROE), earnings per share (EPS), and net income) of all your portfolio assets.
  • Stay true to your investment strategy: Use your strategy as your roadmap or game plan.
  • Minimize mistakes and risks: You should avoid errors and undue risk at all costs to maximize profit..
A -G, Advanced, Fundamental Analysis, Glossary

Capital Asset Pricing Model : CAPM

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Definition: Capital Asset Pricing Model (CAPM) is a method used to rate  stocks given their limited cash.

More Detail: The CAPM estimates potential rate of return on a stock given the stock’s level of risk.

 It is easy to know the rate of return for savings account or a bond (Example: 3% Savings Account or 6% Coupon Bond).  But how to you figure the rate of return on a stock before you buy it?

For example, if you wanted to buy Apple stock (AAPL), there is no label that says, “AAPL Return = 15% per year”.

One of the methods to estimate a stock’s rate of return is using the Capital Asset Pricing Model (CAPM)
Formula
   R(a) = R(f) + β [R(m) – R(f)]

Where:

                                        R(a) = Expected rate of return on the stock, portfolio

                                        R(f) = Risk free rate

                                        β = beta of security/systematic risk

                                        R(m) = expected market return

What does it mean?

 It is a model that estimates the relationship between risk and expected return. The first part of the formula R(f) is the rate investors get if they were going to invest money risk-free.

The second part β [R(m) – R(f)] is a Beta factor (risk) for investors for accepting risk and investing in that particular security.

According to the model, you can use the CAPM to calculate rate of return.  This expected return is compared with the required rate of return for the investor. If the model shows the potential rate of return is greater than the investor’s required rate of return then the investor should invest in the stock.  But if CAPM shows a lower rate of return than expected by the investor, then the investor should not buy that security

Example

Expected return on Apple (AAPL) stock for 1 year can be calculated using the CAPM model

To get the market return we consider the S&P500 = R(m)

1 year average return on S&P 500 = R(m) = 14%

Risk Free Rate (Savings Account at ING Direct) = R(f) = 2%

Beta of Apple stock = β = 1.35

Using CAPM;

R(a) = R(f) + β[R(m) – R(f)]

R(a) = 0.02 + 1.35[0.14 – 0.02]

R(a) = 18.20%

Results:  The expected return on the Apple stock is 18.20%

Practice this on HTMW

You can practice trading for real on HTMW based on CAPM by:

(a)  Finding the desired holding period risk free rate

(b)  Finding the Stock’s Beta (Google Finance has an estimate of Beta on most stocks)

(c)  Taking an average of the S&P 500 historical prices for the desired time –period you want to hold the stock

(d)  Calculating the CAPM from the formula

(e)  And finally, seeing if CAPM holds by trading and holding the stock using the HTMW Virtual Trading Platform.
Conclusion

CAPM is a useful tool to find the expected return of a stock or portfolio. The model depends upon how much risk there is. Hence if we know the value of the Beta, which is a measure of risk, the approximate expected return of the stock can be easily calculated using the CAPM formula.

Glossary, N-T

Naked Short Selling

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Definition: The most basic form of short selling is where you sell stock that you borrow from an owner and do not own. You have delivered the borrowed shares. Another form of short selling is when you do not own the stock and do not borrow them from someone else. In this type of transaction,  you owe the shorted shares but “fail to deliver them to the owner.”

Explanation: These naked short sales are typically done by market makers because they tentatively need to in order to maintain liquidity in the options markets. These options market makers are often brokers of large hedge funds, who abuse the options market maker exemption.

Beginners, Glossary, N-T

Short Proceeds

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Definition: The cash received from the short sale of a security. The interest return from investment of the short proceeds is usually divided between the short seller, who gets partial “use of proceeds,” and the securities lender.

Glossary, N-T

Sell Short

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Definition:

Short selling is the act of borrowing a security from someone else, usually a broker, selling it and later repurchasing the stock in the hopes that it will be cheaper.

Explanation:

In simple terms opening a short position (or going short, shorting) is used when you think an asset will decrease in price. Short sales require a margin account and have strict margin requirements, so they may not be available to investors with less than $25,000 or so to invest. Part of this is because you are borrowing something that isn’t yours but also because, in theory, the loss can be infinite. When you buy a stock normally, the most you can lose is your purchasing price.

When you are shorting a stock, however, things are a bit more different. If you short a penny stock trading at $0.05, thinking it will go down to $0.01, but instead the company has a breakthrough and the price takes off, your loss can be far more than you were prepared to invest. To close a short, a cover order is used to buy the share you borrowed and essentially give back the share you had borrowed.

Example:

Let’s assume you think stock ABC is going to go from $35 to $30. So you call your broker and decide to short it. You then put money in your margin account which will be added with $35 for the borrowed sale of ABC (or less, sometimes some of the margin is frozen and kept by the broker for trading fees, etc.). You then notice that the price has gone from $35 to $45. The broker than calls you to put more money in your margin account, you decide not to and buy the shares for $45 to give back your borrowed shares. You have then incurred a loss of $10 per share plus the commission fees.

On the other hand, if the price did fall to $30, you could then “cover” your short by buying the shares for cheaper than you sold them, returning the shares to the broker, and keeping the $5 per share difference (minus commissions).

A -G, Glossary

Buy on Margin

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Definition: Buying on margin is borrowing money from a broker to purchase stock.

Example: Margin trading allows you to buy more stock than you’d be able to normally. To trade on margin, you need a margin account. This is different from a regular cash account, in which you trade using the money in the account. By law, your broker is required to obtain your signature to open a margin account. The margin account may be part of your standard account opening agreement or may be a completely separate agreement. An initial investment of at least $2,000 is required for a margin account, though some brokerages require more. This deposit is known as the minimum margin. Once the account is opened and operational, you can borrow up to 50% of the purchase price of a stock. This portion of the purchase price that you deposit is known as the initial margin. It’s essential to know that you don’t have to margin all the way up to 50%. You can borrow less, say 10% or 25%. Be aware that some brokerages require you to deposit more than 50% of the purchase price.

A -G, Glossary

Cash Flow Per Share

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Definition: A ratio of the cash generated divided by the number of outstanding shares.

In Depth Description:
A measure of a firm’s financial strength, calculated as:

Cash Flow Per Share = (Operating Cash Flow – Preferred Dividends) / Common Shares Outstanding.

Cash flow per share shows the after-tax earnings plus depreciation, on a per share basis. Many financial analysts place more emphasis on the cash flow per share value than on earnings per share values. While an earnings per share value can be easily manipulated to appear more positive than it really is, therefore putting its reliability in question, cash is more difficult to alter, resulting in what some analysts believe is a more accurate value of the strength and sustainability of a particular business model.

A -G, Advanced, Fundamental Analysis, Glossary

Form 10-Q

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Definition: Form 10-Q, is also known as a 10-Q or 10Q, is a quarterly report mandated by the United States federal Securities and Exchange Commission, to be filed by publicly traded corporations.

Explanation: Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934, it’s an SEC filing that must be filed quarterly with the US Securities and Exchange Commission. It contains similar information to the annual form 10-K, however the information is generally less detailed, and the financial statements are generally unaudited. Information for the final quarter of a firm’s fiscal year is included in the 10-K, so only three 10-Q filings are made each year.

These reports generally compare last quarter to the current quarter and last years quarter to this years quarter. The SEC put this form in place to facilitate better informed investors. The form 10-Q must be filed within 40 days for large accelerated filers and accelerated filers or 45 days after the end of the fiscal quarter for all other registrants (formerly 45 days).

A company’s earnings per share is the portion of a company’s profit that is allocated to each outstanding share of common stock, and, like cash flow per share, serves as an indicator of a company’s profitability. Because the cash flow per share takes into consideration a company’s ability to generate cash, it is regarded by some analysts as a more accurate measure of a company’s financial situation than the earnings per share metric. Cash flow per share represents the net cash a firm produces, on a per share basis.

Glossary, N-T

Stop Loss Order

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Definition:Just like the Limit Order, this is another form of trade with a different set of limitations. A Stop Loss Sell order is a conditional sell order that will only execute if the price of the stock reaches a target price (set by the seller) or lower.  For example, say you bought Apple at $100 and they are currently trading at $104. I could set a Stop Loss order at $101. This means that once the price of Apple starts to dip and hits $101, my order becomes an order to sell. This should limit any losses I could take on my profits.  If it sells at $101, then I still made a profit of $1 per share.

Explanation:Setting a stop-loss order for 10% below the price you paid for the stock will limit your loss to 10%. This strategy allows investors to determine their loss limit in advance, preventing emotional decision-making. It’s also a great idea to use a stop order before you leave for holidays or enter a situation in which you will be unable to watch your stocks for an extended period of time.

Glossary, N-T

Stop Order

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Definition: A stop order is an order to buy or sell a stock when the stock price reaches a specified price, which is known as a stop price. When the specified price is reached, the stop order becomes a market order.

More Detail: Stop orders are different from limit orders in that a buy stop order is placed above the current market price, and a buy limit order is placed below the current market price. A sell stop order is placed below the current market price, and a sell limit order is placed above the current market price.

(a) A Sell Stop Order is used by investors and traders long a stock to protect an existing profit or avoid further losses if the stock price drops. A stop order to sell must be placed below the current market price.

(b) A Buy Stop Order is used by investors and traders short a stock to protect a profit or limit a loss if the stock price increases. Remember, a stop order to buy must be entered at a price above the current market price and a sell stop order must be entered at a price below the current market price..

Stop orders may be placed as “Day” orders which are good for the day only, or as “GTC” orders, which are good until cancelled.

Example:

Scenario 1: You have bought 100 shares of stock ABC.

Stock: ABC
Quantity: 100
Purchase Price: $10
Position type: LONG
Market value: 100 X 10 = $1,000

Say you did not want to lose more than $500 on your long position in ABC. You would put in a “STOP SELL” order with a target price of $5 for all your 100 shares.

This way, if the market price in the market dropped from $10 to $5, and continued falling even more, you can rest assured that your shares would be sold at your target price, and the maximum loss you would incur would be:
($5 – $10) X 100 shares = -$500.

Scenario 2: You have shorted 100 shares of stock XYZ.

Stock: XYZ
Quantity: -100
Short Price: $10
Position type: SHORT
Market value: -100 X 10 = -$1,000

Say you did not want to lose more than $500 on your short position in XYZ. You would put in a “STOP BUY” order with a target price of $15 for all your 100 shares.

This way, if the market price in the market rose from $10 to $15, and continued rising even more, you can rest assured that your shares would be bought at your target price, and the maximum loss you would incur would be:
($10 – $15) X 100 shares = -$500.

online purchase
Glossary, H-M

Limit Order

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Definition: A limit order is an order to buy or sell a stock at a specific price or better. A buy limit order can only be executed at the limit price or lower, and a sell limit order can only be executed at the limit price or higher. A limit order is not guaranteed to execute. A limit order can only be filled if the stock’s market price reaches the limit price. While limit orders do not guarantee execution, they help ensure that an investor does not pay more than a per-determined price for a stock.

Explanation: Limit orders typically cost more than market orders. Despite this, limit orders are beneficial because when the trade goes through, investors get the specified purchase or sell price. Limit orders are especially useful on a low-volume or highly volatile stock.

Beginners, Glossary, H-M

Market Order

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Definition: Market Orders are an order to buy or sell a stock at the best available price. Generally, this type of order will be executed immediately. However, the price at which a market order will be executed is not guaranteed. It is important for investors to remember that the last-traded price is not necessarily the price at which a market order will be executed. In fast-moving markets, the price at which a market order will execute often deviates from the last-traded price or “real time” quote.

Explanation: A market order guarantees execution, and it often has low commissions due to the minimal work brokers need to do. Be wary of using market orders on stocks with a low average daily volume: in such market conditions the ask price can be a lot higher than the current market price (resulting in a large spread). In other words, you may end up paying a whole lot more than you originally anticipated! It is much safer to use a market order on high-volume stocks.

A -G, Beginners, Glossary

Ask Price

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Definition: The ask or offer price is the lowest price that a seller is willing to accept for a stock or other security. The ask size will specify the number of shares the seller is willing to sell at that ask price.  This is also sometimes called “the ask” or “ask price” or “offer price.”

Example: When you get a quote on a stock  or security you will often see the Last Trade Price and the current Bid/Ask prices.  For example, Google might have a Last of $700.75 and be Bid $700.50 and Ask $701.00.  A quote screen might also show the bid/ask size and show $700.50 x 1,000 and $701.00 x 500.  This would mean that you could immediately buy 500 shares at $701 or sell 1,000 shares at $700.50. The ask price is the complement of the bid price. The bid is the highest price a buyer is willing to pay for a stock or security.  The ask will always be higher than the bid.

A -G, Beginners, Glossary

Bid Price

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Definition:When you are selling your shares of a security, the bid price is what the buyer is willing to pay for your shares. This Bid Price offers you an exact price of how much you can sell your shares for. The Last Price offers you a look at what price the last trades were made; which is not sufficient to give you a price a buyer is willing to pay. Bid Price and Last Price are often different.  On the other side of the market, even though you are willing to offer a seller a bid price, he/she will only sell at the Ask Price. The Ask Price is the price at which a seller is willing to let go of her shares. More specifically, this is the price you will buy your stocks at.  Finally, the Bid Size comes hand-in-hand with the Bid Price. This is the amount of shares a buyer is willing to pay for a specific amount of shares. This gives the seller a better view on where they stand.

Example:$23.53 x 1,000 is an example of a bid.  This means that an investor is asking to purchase 1,000 shares at the price of $23.53.  The transaction will be completed if a seller is willing to sell that security at that price. Another example would be a Market bid for 1,000 shares. That means that the investor is willing to take 1,000 shares at the current market price.

Uncategorized

P/E Ratios

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Definition
P/E Ratio. It sounds good and makes novice investors feel like they have a grasp of the situation but how valuable is the Earnings Price Ratio? Surprisingly, the price to earnings ratio is a useful tool but certainly not the holy grail of investing as it is sometimes made out to be. For those novice investors, the P/E Ratio provides a numeric representation of the value between the stock price and earnings. To derive the P/E Ratio you divide the share price by the company’s EPS or Earnings Per Share. The formula looks like this: P/E = Stock Price/ EPS

    • Market sentiment. An overly optimistic P/E Ratio can indicate the market expects big things from this company. Temper optimism with reality.
    • Cover priced or over-bought. A high P/E Ratio can indicate a given stock is priced to high and ready for a correction. Be sure to compare against industry norms.
    • Lack of confidence. A low P/E Ratio may indicate a lack of confidence in the future of the company.
    • Sleeper. A low P/E Ratio might be a sleeper just waited to be discovered.Formula

Example
For example, if a company is currently trading at $43 a share and earnings over the last 12 months were $1.95 per share, the P/E ratio for the stock would be 22.05 ($43/$1.95).

Coca-Cola and Pepsi operate in the same industry and produce goods that are very similar in nature.
Coca Cola’s (KO:NYSE) stock price (Price per Share): $66
Coca-Cola’s Earnings-per share (EPS): $5.26
Coca-Cola’s P/E Ratio: $66 / $5.26 = 12.55

Pepsi’s (PEP:NYSE) stock price (Price per Share): $69
Pepsi’s Earnings-per share (EPS): $3.73
Pepsi’s P/E Ratio: $69 / $3.73 = 18.50
From our calculations, we can see that Pepsi has a higher P/E Ratio than Coca-Cola.

This could be perceived a couple of different ways:

      • Coca-Cola is under-valued and should be bought.
      • Pepsi is over-valued and should be sold or shorted.
      • Investors do not perceive Coca-Cola as doing as well as Pepsi presently.
      • Pepsi is launching a new product that Coca-Cola is not.

The truth is normally some combination of these perceptions.

How to use the P/E Ratio

The P/E Ratio by itself is just a number. Just because it is high or low does not lend much intuition by itself.

But, when we compare P/E ratios between companies and industries, we really start getting the picture for the particular company we are analyzing.

It does not make much sense to compare P/E Ratios of companies across different industries, as each industry has its own unique way of conducting business.

It’s like comparing a doctor with an engineer to see which one is more valuable.

Hence, if comparing P/E ratios, you should compare between companies in the same or similar industries.

You may also compare the P/E ratio of a company to the P/E Ratio of the entire industry that it operates in to analyze whether the stock is over or under-valued.

How to interpret the P/E Ratio

High P/E Ratio may mean:
Market sentiment: An overly optimistic P/E Ratio can indicate the market expects big things from this company. The company has high growth possibilities.
Lifecycle: The company could be entering into the Growth or Shake-Out stage of its lifecycle.
Industry: Specific Industries have a certain level for the P/E Ratios. For example most technology companies have high P/E Ratios.
Cover priced or over-bought: A high P/E Ratio can indicate a given stock is priced to high and ready for a correction. This means that it might be over-valued. Be sure to compare against industry norms.

Low P/E Ratio may mean:
Lack of confidence: A low P/E Ratio may indicate a lack of confidence in the future of the company.
Lifecycle: The company could be in the Mature or Decline stage of its lifecycle.
Industry: Specific Industries have a certain level for the P/E Ratios. For example most utility companies have low P/E Ratios.
Sleeper: A low P/E Ratio might be a sleeper just waiting to be discovered. This means that it might be undervalued, and a perfect time to start buying the shares.

Important Note

      • The Earnings-Per-Share in the P/E Ratio formula is a number that comes from the accounting books of the company.
      • Hence, it is possible to manipulate the EPS and hence the P/E Ratio in order to trick investors into perceiving the stock differently.
      • It is important to independently verify that the company’s’ financial statements are sound and true.

Conclusion
A PE Ratio is an important valuation tool that can give key insights into whether a stock may be over or under-valued.

Also sometimes known as “price multiple” or “earnings multiple.”

BEGINNERS: Learn To Trade Stocks

Intro to Stocks IPO
Trading Rules Bid
Volume Precedes Price and Confirm Price Patterns Ask
Trade with the HTMW Game Market Order
Making Your First Stock Trade Ticker Symbol
P/E Ratio Stock Quotes
Dividend Stock Charts
Dividend Yield
A -G, Advanced, Fundamental Analysis, Glossary

Dividend Yield

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Definition: A ratio showing how much a company pays in dividends each year relative to its share price. Assuming that the stock price does not change, the dividend yield is the only return on the stock holder’s investment.

Dividend Yield = Annual dividends per share / Price per share

Example: Dividend yield is a way to measure how much “bang for your buck” you are getting from your investment through  dividends.

To better explain dividend yield, lets explore an example. If two companies pay the same annual dividends of $1 per share per year, but XYZ company’s stock sells at $20 while ABC company’s stock sells at $40, then XYZ has a dividend yield of 5% while ABC is only yielding 2.5%. Assuming that all other factors are the same, an investor that is looking to add to his or her income would likely prefer XYZ’s stock over that of ABC’s stock.

A -G, Glossary, Stocks

Dividend

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Definition: Payments made to shareholders by corporations. When a company earns profit, the company can use the money to either re-invest in the business (called retained earnings) or to give shareholders as dividends or share repurchase. Many corporations keep a portion of their profit and pay the remainder as a dividend.

Explanation: Corporations can pay dividends in the form of cash, stock or property. Most large profitable companies offer dividends to their stockholders. Their share prices might not move much, but the dividend they pay make up for this.

Higher-growth companies typically don’t offer dividends because their profits are reinvested to help continue their higher than average growth.

Beginners, Glossary, N-T

Preferred Stock

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Definition: Preferred stock is a special class of stock issued by a company that pays dividends. Preferred stock is more like a bond than true stock because the main appeal is dividend income. Most preferred stocks are limited in the total profit they can earn.

Explanation:There are certainly pros and cons when looking at preferred shares. Preferred shareholders have priority over common stockholders on earnings and assets in the event of liquidation and they have a fixed dividend (paid before common stockholders), but investors must weigh these positives against the negatives, including giving up their voting rights and less potential for appreciation.

A -G, Beginners, Glossary

Common Stock

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Definition: Common stock is a form of corporate equity ownership, a type of security. The terms “voting share” or “ordinary share” are also used in other parts of the world; common stock being primarily used in the United States. It is called “common” to distinguish it from preferred stock. Common stock usually carries with it the right to vote on certain matters, such as electing the board of directors. However, a company can have both a “voting” and “non-voting” class of common stock.

Further Explanation: If the company goes bankrupt, the common stockholders will not receive their money until the creditors and preferred shareholders have received their respective share of the leftover assets. This makes common stock riskier than debt or preferred shares. The upside to common shares is that they usually outperform bonds and preferred shares in the long run.

A -G, Glossary

Capital Gains Distribution

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Definition: By law, every year, mutual funds must distribute that year’s net investment income (the total of dividends and interest received, less fund expenses) and net realized gain (gains less losses on securities sales) to its shareholders. These distributions are taxable income reported to the IRS on Form 1099. Investors must report the income on their tax returns. This poses a problem for some mutual fund investors who make initial purchases of mutual funds near the end of a calendar year. Because they receive a capital gains distribution, they immediately receive taxable income and face a mutual fund NAV that is reduced from the distribution.

A -G, Glossary

Capital Gain or Loss

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Definition: Profit or loss resulting from the sale of certain assets classified under the federal income tax legislation as capital assets. This includes stocks and other investments such as investment property.

Example: Long-term capital gains are usually taxed at a lower rate than regular income. This is done to encourage entrepreneurship and investment in the economy. For example, if you own your home for more than one year, if you had bought your home for $200,000 and sell the home for $$225,000, then you have a capital gain of $25,000. There is a move by many in government to increase capital gains taxes as they see this lower rate as unfair???

A -G, Glossary, Options, Options

Call Option

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Definition: A Call Option gives the holder the right, but not the obligation to purchase one hundred (100) shares of a particular stock at a specific price by a specified date. Call Options are bought by investors who anticipate a price increase.

Example: Options are derivative instruments, which means that their prices are derived from the price an underlyiny security or stock. Normally, options values are determined from the price of an underlying stock, the difference between the current stock price and the option’s strike price, and the amount of time left until the option expires. Let’s assume you bought a call option on shares of Intel (INTC) with a strike price of $40 and an expiration date of April 16th. With this option you would have the right to purchase 100 shares of Intel at a price of $40 on or before April 16th. The right time to do this will only be beneficial if Intel is trades above $40 per share at that particular point in time. Take notice that the expiration date consistently lands on the third Friday of each month when the option is scheduled to expire. (Note-recently the exchanges started issues weekly expiration options on the high volume stocks.)

Each call option corresponds to a contract between the buyer and the seller. The call option buyer has the right to buy the stock at the strike price, and the seller has the obligation to sell the stock at the strike price if the buyer chooses to exercise his option. When an option expires and it is not in the buyer’s best interest to exercise the option, then they are not obligated to take action.

As a quick example of how call options make money, let’s say IBM stock is currently trading at $100 per share. Now consider that an investor purchased one call option contract on IBM with a $100 strike and at $2.00 per contract. Because each options contract is for 100 shares of stock, the real cost of this option will be $200 (100 shares x $2.00 = $200). Take a look at will happen to the value of this call option under an assortment of several scenarios.

Suppose when the option expires, IBM will trade at $105. Keep in mind that the call option will give the buyer the ability to purchase shares of IBM at $100 per share. In this example the buyer can use the option to buy these shares at $100, then instantly sell those exact shares in the open market for $105. This option is therefore called in the money. As a result, the option will sell for $5.00 on the closing date, because each option represents an interest in 100 underlying shares, this will amount to a total sale price of $500. Because the investor bought this option for $200, the net profit to the buyer from this transaction will be $300.

When this option expires, IBM is trading at $101. Utilizing the identical analysis indicated above, the call option now has a value of $1 (or $100 total). Because the investor used up $200 to buy the option, the investor will display a net loss on this trade of $1.00 (or $100 total). This option will be called at the money since the transaction is basically a wash.

When the option expires, IBM is trading at or below $100. So if IBM ends up at or below $100 on the option’s close date, then the contract will expire out of the money. It’s now, so the option buyer will lose 100% of their money (in this case, the full $200 that the investor spent for the option).

A -G, Beginners, Glossary

Blue Chip Stocks

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Definition: Stocks of leading and nationally known companies that offer a record of continuous dividend payments and other strong investment qualities.

Example: The name “blue chip” came about because in the game of poker the blue chips have the highest value. Blue chip stocks are seen as a less volatile investment than owning shares in companies without blue chip status because blue chips have an institutional status in the economy. Investors may buy blue chip companies to provide steady growth in their portfolios. The stock price of a blue chip usually closely follows the S&P 500. Here is a partial list of Blue Chip Stocks:
Wal-Mart Stores
Exxon Mobil
Chevron
ConocoPhillips
Fannie Mae
General Electric
Berkshire Hathaway
General Motors
Bank of America
Ford Motor

A -G, Glossary

Block Trades

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Definition: Trades greater than or equal to 10,000 shares in size and greater than or equal to $100,000 in value.  The exact definition varies, but usually is 20,000 shares, 50,000 shares or 100,000 shares.

Example: 10,000 shares of stock (not including penny stocks) or $200,000 worth of bonds would be considered a block trade. However, in practice block trades are typically much larger as large hedge funds and institutional investors buy and sell huge sums of dollars and shares in block trades via investment banks and other intermediaries virtually on a daily basis.

A -G, Advanced, Glossary

Beta

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Definition: Beta  measures a stock’s volatility verses the market’s volatility.  A stock’s volatility is calculated by comparing its return verses that of the overall market return.  If a stock’s price does not move in the same direction as the market, it has a beta of zero. A BETA above zero means that the stock follows the market.  A Beta of 1 means that the stock follows the market very closely  If a stock has a negative Beta, then its price moves the opposite direction of the market.  The closer a stock is to a negative 1, the more the stock moves the opposite direction of the market.

Example: If a stock has a Beta of 2.0, it is twice as volatile as the market.  If the S&P 500 fell by -10% in a given month, then the stock would be expected to fall around -20%. The stock would also be expected to gain more than the general market during an up market.

A -G, Beginners, Glossary

Bull Market

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Definition: The tendency of the stock market to trend higher over time. It can be used to describe either the market as a whole or specific sectors and securities. The opposite of a Bull Market is a Bear Market when the market is moving lower over time.

Example: Market trends are classified as secular for long time frames, primary for medium time frames, and secondary for short time frames.  Traders identify market trends using technical analysis, a framework which characterizes market trends as predictable price tendencies within the market when price reaches support and resistance levels, varying over time.