Stock Investing For Dummies, 5th Edition - Paul Mladjenovic (2016)
Part IV. Investment Strategies and Tactics
Chapter 17. Understanding Brokerage Orders and Trading Techniques
IN THIS CHAPTER
Looking at different types of brokerage orders
Trading on margin to maximize profits
Making sense of going short
Investment success isn’t just about which stocks to choose; it’s also about how you choose those stocks. Frequently, investors think that good stock-picking means doing your homework and then making that buy (or sell). However, you can take it a step further to maximize profits (or minimize losses).
In 2008, millions of investors were slammed mercilessly by a tumultuous market; many could have used some simple techniques and orders that could have saved them some grief. Investors who used stop-loss orders avoided some of the trillion-dollar carnage that hit the stock market during that scary time. As a stock investor, you can take advantage of this technique and others available through your standard brokerage account (see Chapter 7 for details). This chapter presents some of the best ways you can use these powerful techniques, which are useful whether you’re buying or selling stock.
Checking Out Brokerage Orders
Orders you place with your stockbroker fit neatly into three categories:
· Time-related orders
· Condition-related orders
· Advanced orders (such as trade triggers; find out more about these in Chapter 18)
At the very least, get familiar with the first two types of orders because they’re easy to implement, and they’re invaluable tools for wealth-building and (more importantly) wealth-saving! Advanced orders usually are combinations of the first two types.
Using a combination of orders helps you fine-tune your strategy so that you can maintain greater control over your investments. Speak with your broker about the different types of orders you can use to maximize the gains (or minimize the losses) from your stock-investing activities. You also can read the broker’s policies on stock orders at the brokerage website.
On the clock: Time-related orders
A time-related order is just that — the order has a time limit. Typically, investors use these orders in conjunction with condition-related orders, which I describe later in this chapter. The two most common time-related orders are day orders and good-til-canceled (GTC) orders.
A day order is an order to buy or sell a stock that expires at the end of that particular trading day. If you tell your broker, “Buy BYOB, Inc., at $37.50 and make it a day order,” you mean that you want to purchase the stock at $37.50. But if the stock doesn’t hit that price, your order expires, unfilled, at the end of the trading day. Why would you place such an order? Maybe BYOB is trading at $39, but you don’t want to buy it at that price because you don’t believe the stock is worth it. Consequently, you have no problem not getting the stock that day.
When would you use day orders? It depends on your preferences and personal circumstances. I rarely use day orders because few events cause me to say, “Gee, I’ll just try to buy or sell between now and the end of today’s trading action.” However, you may feel that you don’t want a specified order to linger beyond today’s market action. Perhaps you want to test a price. (“I want to get rid of stock A at $39 to make a quick profit, but it’s currently trading at $37.50. However, I may change my mind tomorrow.”) A day order is the perfect strategy to use in this case.
If you make a trade and don’t specify a time limit with the order, most (if not all) brokers will automatically treat it as a day order.
A good-til-canceled (GTC) order is the most commonly requested order by investors, and it’s one that I use and recommend often. The GTC order means just what it says: The order stays in effect until it’s transacted or until the investor cancels it. Although GTC orders are time-related, they’re always tied to a condition, such as the stock achieving a certain price.
Although the order implies that it can run indefinitely, most brokers have a limit of 30 or 60 days (or more). I’ve seen the limit as high as 120 days. By that time, either the broker cancels the order or contacts you (usually by email) to see whether you want to extend it. Ask the broker about his particular policy.
GTC orders are always coupled with condition-related orders (see the next section for the lowdown on conditional orders). For example, say that you think ASAP Corp. stock would make a good addition to your portfolio, but you don’t want to buy it at the current price of $48 per share. You’ve done your homework on the stock, including looking at the stock’s price-to-earnings ratio, price-to-book ratio, and so on (see Appendix B for more on ratios), and you say, “Hey, this stock isn’t worth $48 a share. I’d only buy it at $36 per share.” (It’s overpriced or overvalued according to your analysis.) How should you proceed? Your best bet is to ask your broker to do a GTC order at $36. This request means that your broker will buy the shares if and when they hit the $36 mark (unless you cancel the order). Just make sure that your account has the funds available to complete the transaction.
GTC orders are very useful, so you should become familiar with your broker’s policy on them. While you’re at it, ask whether any fees apply. Many brokers don’t charge for GTC orders because if they happen to result in a buy (or sell) order, they generate a normal commission just as any stock transaction does. Other brokers may charge a small fee (but that’s rare).
To be successful with GTC orders, you need to know the following:
· When you want to buy: In recent years, people have had a tendency to rush into buying a stock without giving some thought to what they could do to get more for their money. Some investors don’t realize that the stock market can be a place for bargain-hunting consumers. If you’re ready to buy a quality pair of socks for $16 in a department store but the sales clerk says that those same socks are going on sale tomorrow for only $8, what do you do — assuming that you’re a cost-conscious consumer? Unless you’re barefoot, you probably decide to wait. The same point holds true with stocks.
Say that you want to buy SOX, Inc., at $26, but it’s currently trading at $30. You think that $30 is too expensive, but you’d be happy to buy the stock at $26 or lower. However, you have no idea whether the stock will move to your desired price today, tomorrow, next week, or even next month (or maybe never). In this case, a GTC order is appropriate.
· When you want to sell: What if you buy some socks at a department store and you discover that they have holes (darn it!)? Wouldn’t you want to get rid of them? Of course you would. If a stock’s price starts to unravel, you want to be able to get rid of it as well.
Perhaps you already own SOX at $25 but are concerned that market conditions may drive the price lower. You’re not certain which way the stock will move in the coming days and weeks. In this case, a GTC order to sell the stock at a specified price is a suitable strategy. Because the stock price is $25, you may want to place a GTC order to sell it if it falls to $22.50 in order to prevent further losses. Again, in this example, GTC is the time frame, and it accompanies a condition (sell when the stock hits $22.50).
At your command: Condition-related orders
A condition-related order (also known as a conditional order) is an order that’s executed only when a certain condition is met. Conditional orders enhance your ability to buy stocks at a lower price, to sell at a better price, or to minimize potential losses. When stock markets become bearish or uncertain, conditional orders are highly recommended.
A good example of a conditional order is a limit order. A limit order may say, “Buy Mojeski Corp. at $45.” But if Mojeski Corp. isn’t at $45 (this price is the condition), then the order isn’t executed. I discuss limit orders, as well as market orders and stop-loss orders, in the following sections.
When you buy stock, the simplest type of order is a market order — an order to buy or sell a stock at the market’s current best available price. Orders don’t get any more basic than that. Here’s an example: Kowalski, Inc., is available at the market price of $10. When you call your broker and instruct her to buy 100 shares “at the market,” the broker implements the order for your account, and you pay $1,000 plus commission.
I say “current best available price” because the stock’s price is constantly moving, and catching the best price can be a function of the broker’s ability to process the stock purchase. For very active stocks, the price change can happen within seconds. It’s not unheard of to have three brokers simultaneously place orders for the same stock and get three different prices because of differences in the brokers’ capabilities. The difference may be pennies, but it’s a difference nonetheless. (Some computers are faster than others.)
The advantage of a market order is that the transaction is processed immediately, and you get your stock without worrying about whether it hits a particular price. For example, if you buy Kowalski, Inc., with a market order, you know that by the end of that phone call (or website visit), you’re assured of getting the stock. The disadvantage of a market order is that you can’t control the price at which you purchase the stock. Whether you’re buying or selling your shares, you may not realize the exact price you expect (especially if you’re dealing with a volatile stock).
Market orders get finalized in the chronological order in which they’re placed. Your price may change because the orders ahead of you in line cause the stock price to rise or fall based on the latest news.
A stop-loss order (also called a stop order) is a condition-related order that instructs the broker to sell a particular stock in your portfolio only when the stock reaches a particular price. It acts like a trigger, and the stop order converts to a market order to sell the stock immediately.
The stop-loss order isn’t designed to take advantage of small, short-term moves in the stock’s price. It’s meant to help you protect the bulk of your money when the market turns against your stock investment in a sudden manner.
Say that your Kowalski, Inc., stock rises to $20 per share and you seek to protect your investment against a possible future market decline. A stop-loss order at $18 triggers your broker to sell the stock immediately if it falls to the $18 mark. In this example, if the stock suddenly drops to $17, it still triggers the stop-loss order, but the finalized sale price is $17. In a volatile market, you may not be able to sell at your precise stop-loss price. However, because the order automatically gets converted into a market order, the sale will be done, and you’ll be spared further declines in the stock.
The main benefit of a stop-loss order is that it prevents a major loss in a stock that you own. It’s a form of discipline that’s important in investing to minimize potential losses. Investors can find it agonizing to sell a stock that has fallen. If they don’t sell, however, the stock often continues to plummet as investors continue to hold on while hoping for a rebound in the price.
Most investors set a stop-loss amount at about 10 percent below the market value of the stock. This percentage gives the stock some room to fluctuate, which most stocks tend to do from day to day. If you’re extra nervous, consider a tighter stop-loss, such as 5 percent or less.
Keep in mind that this order is a trigger, and a particular price isn’t guaranteed to be captured because the actual buy or sell occurs immediately after the trigger is activated. If the market at the time of the actual transaction is particularly volatile, then the price realized may be significantly different.
In the following sections, I describe a certain type of stop-loss order (called a trailing stop), and I talk about the use of beta measurement with stop-loss orders.
Trailing stops are an important technique in wealth preservation for seasoned stock investors and can be one of your key strategies in using stop-loss orders. A trailing stop is a stop-loss order that an investor actively manages by moving it up along with the stock’s market price. The stop-loss order “trails” the stock price upward. As the stop-loss goes upward, it protects more and more of the stock’s value from declining.
Imagine that you bought stock in Peach Inc. (PI) for $30 a share. A trailing stop is in place at, say, 10 percent, and the order is GTC (presume that this broker places a time limit of 90 days for GTC orders). At $30 per share, the trailing stop is $27. If PI goes to $40, your trailing stop automatically rises to $36. If PI continues to rise to $50, your trailing continues along with it to $45. Now say that PI reverses course (for whatever reason) and starts to plummet. The trailing stop stays put at $45 and triggers a sell order if PI reaches the $45 level.
In the preceding example, I use a trailing stop percentage, but trailing stops are also available in dollar amounts. For example, say that PI is at $30, and I put in a trailing stop of $3. If PI rises to $50, my trailing stop will reach $47. If PI then drops from this peak of $50, the trailing stop stays put at $47 and triggers a sell order if PI actually hits $47. You get the picture. Trailing stops can help you sleep at night, especially in these turbulent times.
William O’Neill, founder and publisher of Investor’s Business Daily, advocates setting a trailing stop of 8 percent below your purchase price. That’s his preference. Some investors who invest in very volatile stocks may put in trailing stops of 20 or 25 percent. Is a stop-loss order desirable or advisable in every situation? No. It depends on your level of experience, your investment goals, and the market environment. Still, stop-loss orders (trailing or otherwise) are appropriate in many cases, especially if the market seems uncertain (or you are!).
A trailing stop is a stop-loss order that you actively manage. The stop-loss order is good-til-canceled (GTC), and it constantly trails the stock’s price as it moves up. To successfully implement stop-loss orders (including trailing stops), you should
· Realize that brokers usually don’t place trailing stops for you automatically. In fact, they won’t (or shouldn’t) place any type of order without your consent. Deciding on the type of order to place is your responsibility. You can raise, lower, or cancel a trailing stop order at will, but you need to monitor your investment when substantial moves do occur to respond to the movement appropriately.
· Change the stop-loss order when the stock price moves significantly. Hopefully, you won’t call your broker every time the stock moves 50 cents. Change the stop-loss order when the stock price moves around 10 percent. For example, if you initially purchase a stock at $90 per share, ask the broker to place the stop-loss order at $81. When the stock moves to $100, cancel the $81 stop-loss order and replace it at $90. When the stock’s price moves to $110, change the stop-loss order to $99, and so on.
· Understand your broker’s policy on GTC orders. If your broker usually considers a GTC order expired after 30 or 60 days, you should be aware of it. You don’t want to risk a sudden drop in your stock’s price without the stop-loss order protection. Make a note of your broker’s time limit so that you remember to renew the order for additional time.
· Monitor your stock. A trailing stop isn’t a “set it and forget it” technique. Monitoring your investment is critical. Of course, if the investment falls, the stop-loss order prevents further loss. Should the stock price rise substantially, remember to adjust your trailing stop accordingly. Keep raising the safety net as the stock continues to rise. Part of monitoring the stock is knowing the beta, which you can read more about in the next section.
To be a successful investor, you need to understand the volatility of the particular stock you invest in. In stock market parlance, this volatility is also called the beta of a stock. Beta is a quantitative measure of the volatility of a given stock (mutual funds and portfolios, too) relative to the overall market, usually the S&P 500 index. (For more information on the S&P 500, see Chapter 5.) Beta specifically measures the performance movement of the stock as the S&P moves 1 percent up or down. A beta measurement above 1 is more volatile than the overall market, whereas a beta below 1 is less volatile. Some stocks are relatively stable in terms of price movements; others jump around.
Because beta measures how volatile or unstable the stock’s price is, it tends to be uttered in the same breath as “risk” — more volatility indicates more risk. Similarly, less volatility tends to mean less risk. (Chapter 4 offers more details on the topics of risk and volatility.)
You can find a company’s beta at websites that provide a lot of financial information about companies, such as Nasdaq (www.nasdaq.com) or Yahoo! Finance (finance.yahoo.com).
The beta is useful to know when it comes to stop-loss orders because it gives you a general idea of the stock’s trading range. If a stock is currently priced at $50 and it typically trades in the $48 to $52 range, then a trailing stop at $49 doesn’t make sense. Your stock would probably be sold the same day you initiated the stop-loss order. If your stock is a volatile growth stock that may swing up and down by 10 percent, you should more logically set your stop-loss at 15 percent below that day’s price.
The stock of a large cap company in a mature industry tends to have a low beta — one close to the overall market. Small and mid cap stocks in new or emerging industries tend to have greater volatility in their day-to-day price fluctuations; hence, they tend to have a high beta. (You can find out more about large, small, and mid cap stocks in Chapter 1; Chapter 4 has more about beta.)
PRACTICING DISCIPLINE WITH STOP-LOSS ORDERS
I have a stack of several years’ worth of investment newsletters in which investment experts made all sorts of calls regarding the prospects of a company, industry, or the economy in general. Some made forecasts that were spectacularly on target, but you should see the ones that were spectacularly wrong — ouch! However, even some of the winners suffered because of a lack of discipline. Those spectacular gains disappeared like balloons at a porcupine convention.
At the height of the housing bubble (circa 2007), many real estate and mortgage companies saw record highs in their stock prices. A good example was the Federal National Mortgage Association (“Fannie Mae” with the stock symbol FNMA). FNMA was a public company, but it was technically a government-sponsored entity. Many thought that because it had the backing (real or imagined) of the federal government, it was a safe investment. In 2007, its stock price was around $75. I was very worried about the housing bubble and felt that any stock tied to this dangerous market was at risk. Yet there were still analysts toting the stock with “strong buy” and/or “buy” orders.
Whenever you own a stock (or an exchange-traded fund, known as an ETF) that you begin to worry about and aren’t sure about selling, consider a stop-loss order. A stop-loss order on FNMA, even at a much lower level, such as $50, would have saved investors a fortune. By the end of 2008, FNMA’s stock price fell below $1 per share (you read that right … under a buck a share!). In less than 12 months, FNMA fell almost 99 percent.
A limit order is a very precise condition-related order implying that a limit exists either on the buy or the sell side of the transaction. You want to buy (or sell) only at a specified price. Period. Limit orders work well if you’re buying the stock, but they may not be good for you if you’re selling the stock. Here’s how they work in both instances:
· When you’re buying: Just because you like a particular company and you want its stock doesn’t mean that you’re willing to pay the current market price. Maybe you want to buy Kowalski, Inc., but the current market price of $20 per share isn’t acceptable to you. You prefer to buy it at $16 because you think that price reflects its true market value. What do you do? You tell your broker, “Buy Kowalski with a limit order at $16” (or you can enter a limit order at the broker’s website). You have to specify whether it’s a day order or a GTC order, both of which I discuss earlier in this chapter.
What happens if the stock experiences great volatility? What if it drops to $16.01 and then suddenly drops to $15.95 on the next move? Nothing happens, actually, which you may be dismayed to hear. Because your order was limited to $16, it can be transacted only at $16 — no more and no less. The only way for this particular trade to occur is if the stock rises back to $16. However, if the price keeps dropping, then your limit order isn’t transacted and may expire or be canceled.
· When you’re selling: Limit orders are activated only when a stock hits a specific price. If you buy Kowalski, Inc., at $20 and you worry about a decline in the share price, you may decide to put in a limit order at $18. If you watch the news and hear that Kowalski’s price is dropping, you may sigh and say, “I sure am glad I put in that limit order at $18!” However, in a volatile market, the share price may leapfrog over your specified price. It could go from $18.01 to $17.99 and then continue its descent. Because the stock price never hit $18 on the mark, your stock isn’t sold. You may be sitting at home satisfied (mistakenly) that you played it smart, while your stock plummets to $15, $10, or worse! Having a stop-loss order in place is best.
Investors who aren’t in a hurry can use a limit order to try to get a better price when they decide to sell. For example, maybe you own a stock whose price is at $50 and you want to sell, but you think that a short-term rally in the stock is imminent. In that case, you can use a limit order such as, “Sell the stock at the sell limit order of $55 and keep the order on for 30 days.”
When you’re buying (or selling) a stock, most brokers interpret the limit order as “buy (or sell) at this specific price or better.” For example, presumably, if your limit order is to buy a stock at $10, you’ll be just as happy if your broker buys that stock at $9.95. That way, if you don’t get exactly $10 because the stock’s price was volatile, you’ll still get the stock at a lower price. Talk to your broker to be clear on the meaning of the limit order.
The joys of technology: Advanced orders
Brokers have added sophisticated capabilities to the existing repertoire of orders that are available for stock investors. One example is advanced orders, which provide investors with a way to use a combination of orders for more sophisticated trades. An example of an advanced order is something like, “Only sell stock B, and if it sells, use the proceeds to buy stock D.” You get the idea. My brokerage firm has the following on its website, and I’m sure that more firms will do the same. Inquire with yours and see the benefit of using advanced orders such as the following:
· “One order cancels another order”: In this scenario you enter two orders simultaneously with the condition that if one order is executed, the second order is automatically canceled.
· “One order triggers another order”: Here you submit an order, and if that order is filled, another order is automatically submitted. Many brokers have different names for these types of orders, so ask them if they can provide such an order.
Other types of advanced orders and order strategies are available (and covered in Chapter 18), but you get the picture. Talk to your brokerage firm and find out what’s available in your particular account. Investors need to know that today’s technology allows them to have more power and control over the implementation of buying and selling transactions. I love it!
Buying on Margin
Buying on margin means buying securities, such as stocks, with funds you borrow from your broker. Buying stock on margin is similar to buying a house with a mortgage. If you buy a house at a purchase price of $100,000 and put 10 percent down, your equity (the part you own) is $10,000, and you borrow the remaining $90,000 with a mortgage. If the value of the house rises to $120,000 and you sell (for the sake of simplicity, I don’t include closing costs in this example), you make a profit of 200 percent. How is that? The $20,000 gain on the property represents a gain of 20 percent on the purchase price of $100,000, but because your real investment is $10,000 (the down payment), your gain works out to 200 percent (a gain of $20,000 on your initial investment of $10,000).
Buying on margin is an example of using leverage to maximize your gain when prices rise. Leverage is simply using borrowed money when you make an asset purchase to increase your potential profit. This type of leverage is great in a favorable (bull) market, but it works against you in an unfavorable (bear) market. Say that a $100,000 house you purchase with a $90,000 mortgage falls in value to $80,000 (and property values can decrease during economic hard times). Your outstanding debt of $90,000 exceeds the value of the property. Because you owe more than you own, you’re left with a negative net worth.
Leverage is a double-edged sword. Don’t forget that you need approval from your brokerage firm before you can buy on margin. To buy on margin, you typically fill out the form provided by that brokerage firm to be approved. Check with the broker because each firm has different requirements.
In the following sections, I describe the potential outcomes of buying on margin, explain how to maintain a balance, and provide some pointers for successfully buying on margin.
Examining marginal outcomes
Suppose you think that the stock for the company Mergatroid, Inc., currently at $40 per share, will go up in value. You want to buy 100 shares, but you have only $2,000. What can you do? If you’re intent on buying 100 shares (versus simply buying the 50 shares that you have cash for), you can borrow the additional $2,000 from your broker on margin. If you do that, what are the potential outcomes?
If the stock price goes up
This outcome is the best for you. If Mergatroid goes to $50 per share, your investment is worth $5,000, and your outstanding margin loan is $2,000. If you sell, the total proceeds will pay off the loan and leave you with $3,000. Because your initial investment was $2,000, your profit is a solid 50 percent because your $2,000 principal amount generated a $1,000 profit. (For the sake of this example, I leave out any charges, such as commissions and interest paid on the margin loan.) However, if you pay the entire $4,000 upfront without the margin loan, your $4,000 investment generates a profit of $1,000, or 25 percent. Using margin, you double the return on your money.
Leverage, when used properly, is very profitable. However, it’s still debt, so understand that you must pay it off eventually, regardless of the stock’s performance.
If the stock price fails to rise
If the stock goes nowhere, you still have to pay interest on that margin loan. If the stock pays dividends, this money can defray some of the margin loan’s cost. In other words, dividends can help you pay off what you borrow from the broker. (Chapter 3 provides an introduction to dividends, and Chapter 9 covers dividend-investing strategies.)
Having the stock neither rise nor fall may seem like a neutral situation, but you pay interest on your margin loan with each passing day. For this reason, margin trading can be a good consideration for conservative investors if the stock pays a high dividend. Many times, a high dividend from 4,000 dollars’ worth of stock can equal or exceed the margin interest you have to pay from the $2,000 (50 percent) you borrow from the broker to buy that stock.
If the stock price goes down, buying on margin can work against you. What if Mergatroid goes to $38 per share? The market value of 100 shares is then $3,800, but your equity shrinks to only $1,800 because you have to pay your $2,000 margin loan. You’re not exactly looking at a disaster at this point, but you’d better be careful, because the margin loan exceeds 50 percent of your stock investment. If it goes any lower, you may get the dreaded margin call, when the broker actually contacts you to ask you to restore the ratio between the margin loan and the value of the securities. See the following section for information about appropriate debt to equity ratios.
Maintaining your balance
When you purchase stock on margin, you must maintain a balanced ratio of margin debt to equity of at least 50 percent. If the debt portion exceeds this limit, you’re required to restore that ratio by depositing either more stock or more cash into your brokerage account. The additional stock you deposit can be stock that’s transferred from another account.
To continue the example from the previous section: If Mergatroid goes to $28 per share, the margin loan portion exceeds 50 percent of the equity value in that stock — in this case, because the market value of your stock is $2,800 but the margin loan is still at $2,000, the margin loan is a worrisome 71 percent of the market value ($2,000 divided by $2,800 equals 71 percent). Expect to get a call from your broker to put more securities or cash into the account to restore the 50 percent balance.
If you can’t come up with more stock, other securities, or cash, the next step is to sell stock from the account and use the proceeds to pay off the margin loan. For you, that means realizing a capital loss — you lose money on your investment.
The Federal Reserve Board governs margin requirements for brokers with Regulation T. Discuss this rule with your broker to understand fully your (and the broker’s) risks and obligations. Regulation T dictates margin requirements set by brokers for their customers. For most listed stocks, it’s 50 percent.
Striving for success on margin
Margin, as you can see from the previous sections, can escalate your profits on the up side but magnify your losses on the down side. If your stock plummets drastically, you can end up with a margin loan that exceeds the market value of the stock you used the loan to purchase. In the emerging bear market of 2000–2002, stock losses hurt many people, and a large number of those losses were made worse because people didn’t manage the responsibilities involved with margin trading. In 2008, margin debt again hit very high levels, and that subsequently resulted in tumbling stock prices. In 2015, total margin debt again hit record highs by midyear, and it contributed to the stock market’s down moves during late 2015 and early 2016 as selling pressures forced the sale of stocks tied to margin loans (with margin calls to boot!). Ugh!
If you buy stock on margin, use a disciplined approach. Be extra careful when using leverage, such as a margin loan, because it can backfire. Keep the following points in mind:
· Have ample reserves of cash or marginable securities in your account. Try to keep the margin ratio at 40 percent or less to minimize the chance of a margin call.
· If you’re a beginner, consider using margin to buy stocks in large companies that have relatively stable prices and pay good dividends. Some people buy income stocks that have dividend yields that exceed the margin interest rate, meaning that the stock ends up paying for its own margin loan. Just remember those stop-loss orders, which I discuss earlier in this chapter.
· Constantly monitor your stocks. If the market turns against you, the result will be especially painful if you use margin.
· Have a payback plan for your margin debt. Taking margin loans against your investments means that you’re paying interest. Your ultimate goal is to make money, and paying interest eats into your profits.
Going Short and Coming Out Ahead
The vast majority of stock investors are familiar with buying stock, holding on to it for a while, and hoping its value goes up. This kind of thinking is called going long, and investors who go long are considered to be long on stocks. Going long essentially means that you’re bullish and seeking your profits from rising prices. However, astute investors also profit in the market when stock prices fall. Going short (also called shorting a stock, selling short, or doing a short sale) on a stock is a common technique for profiting from a stock price decline. Investors have made big profits during bear markets by going short. A short sale is a bet that a particular stock is going down.
Most people easily understand making money by going long. It boils down to “buy low and sell high.” Piece of cake. Going short means making money by selling high and then buying low. Huh? Thinking in reverse isn’t a piece of cake. Although thinking of this stock adage in reverse may be challenging, the mechanics of going short are really simple. Consider an example that uses a fictitious company called DOA, Inc. As a stock, DOA ($50 per share) is looking pretty sickly. It has lots of debt and plummeting sales and earnings, and the news is out that DOA’s industry will face hard times for the foreseeable future. This situation describes a stock that’s an ideal candidate for shorting. The future may be bleak for DOA, but it’s promising for savvy investors. The following sections provide the full scoop on going short.
To go short, you have to be deemed (by your broker) creditworthy — your account needs to be approved for short selling. When you’re approved for margin trading, you’re probably set to sell short, too. Talk to your broker (or check the broker’s website for information) about limitations in your account regarding going short.
You must understand brokerage rules before you conduct short selling. The broker must approve you for it (see Chapter 7 for information on working with brokers), and you must meet the minimum collateral requirement, which is typically $2,000 or 50 percent (whichever is higher) of the shorted stock’s market value. If the stock generates dividends, those dividends are paid to the stock’s owner, not to the person who borrows to go short. Check with your broker for complete details, and review the resources in Appendix A.
Because going short on stocks has greater risks than going long, I strongly advise beginning investors to avoid shorting stocks until they become more seasoned.
Setting up a short sale
This section explains how to go short. Say that you believe DOA is the right stock to short — you’re pretty sure its price is going to fall. With DOA at $50, you instruct your broker to “go short 100 shares on DOA.” (It doesn’t have to be 100 shares; I’m just using that as an example.) Here’s what happens next:
1. Your broker borrows 100 shares of DOA stock, either from his own inventory or from another client or broker.
That’s right. The stock can be borrowed from a client, no permission necessary. The broker guarantees the transaction, and the client/stock owner never has to be informed about it because he never loses legal and beneficial right to the stock. You borrow 100 shares, and you’ll return 100 shares when it’s time to complete the transaction.
2. Your broker then sells the stock and puts the money in your account.
Your account is credited with $5,000 (100 shares multiplied by $50) in cash — the money gained from selling the borrowed stock. This cash acts like a loan on which you’re going to have to pay interest.
3. You buy the stock back and return it to its rightful owner.
When it’s time to close the transaction (because either you want to close it or the owner of the shares wants to sell them, so you have to give them back), you must return the number of shares you borrowed (in this case, 100 shares). If you buy back the 100 shares at $40 per share (remember that you shorted this particular stock because you were sure its price was going to fall) and those 100 shares are returned to their owner, you make a $1,000 profit. (To keep the example tidy, I don’t include brokerage commissions.)
Oops! Going short when prices grow taller
I bet you guessed that the wonderful profitability of selling short has a flip side. Say that you were wrong about DOA and that the stock price rises from the ashes as it goes from $50 to $87. Now what? You still have to return the 100 shares you borrowed. With the stock’s price at $87, that means you have to buy the stock for $8,700 (100 shares at the new, higher price of $87). Ouch! How do you pay for it? Well, you have that original $5,000 in your account from when you initially went short on the stock. But where do you get the other $3,700 ($8,700 less the original $5,000)? You guessed it — your pocket! You have to cough up the difference. If the stock continues to rise, that’s a lot of coughing.
How much money do you lose if the stock goes to $100 or more? A heck of a lot. As a matter of fact, there’s no limit to how much you can lose. That’s why going short can be riskier than going long. When going long, the most you can lose is 100 percent of your money. When you go short, however, you can lose more than 100 percent of the money you invest. Yikes!
Because the potential for loss is unlimited when you short a stock, I suggest that you use a stop order (also called a buy-stop order) to minimize the damage. Better yet, make it a good-til-canceled (GTC) order, which I discuss earlier in this chapter. You can set the stop order at a given price, and if the stock hits that price, you buy the stock back so that you can return it to its owner before the price rises even higher. You still lose money, but you limit your losses. Like a stop-loss order, a buy-stop order effectively works to limit your loss.
THE UPTICK RULE
For many years, the stock market had something called the uptick rule. This rule stated that you could enter into a short sale only when the stock had just completed an uptick. “Tick” in this case means the actual incremental price movement of the stock you’re shorting. For a $10 stock that was just $9.95 a moment ago, the 5-cent difference represents an uptick. If the $10 stock was just $10.10 a moment before, the 10-cent difference is a downtick. The amount of the tick doesn’t matter. So, if you short a stock at the price of $40, the immediate prior price must have been $39.99 or lower. The reason for this rule (a Federal Reserve regulation) is that short selling can aggravate declining stock prices in a rapidly falling market. In practice, going short on a stock whose price is already declining can make the stock price fall even farther. Excessive short selling can make the stock more volatile than it would be otherwise.
In 2007, however, the uptick rule was removed. This action contributed to the increased volatility that investors saw during 2007–2008. Investors had to adapt accordingly. It meant getting used to wider swings in stock price movements on days of heavy activity.
Feeling the squeeze
If you go short on a stock, you have to buy that stock back sooner or later so that you can return it to its owner. What happens when a lot of people are short on a particular stock and its price starts to rise? All those short sellers are scrambling to buy the stock back so that they can close their transactions before they lose too much money. This mass buying quickens the pace of the stock’s ascent and puts a squeeze (called a short squeeze) on the investors who’ve been shorting the stock.
In the earlier section “Setting up a short sale,” I explain that your broker can borrow stock from another client so that you can go short on it. What happens when that client wants to sell the stock in her account — the stock that you borrowed and which is therefore no longer in her account? When that happens, your broker asks you to return the borrowed stock. That’s when you feel the squeeze — you have to buy the stock back at the current price.
Going short can be a great maneuver in a declining (bear) market, but it can be brutal if the stock price goes up. If you’re a beginner, stay away from short selling until you have enough experience (and money) to risk it.