When To Use And How To Place A Market Order (MKT)

A market orders (MKT) simply tells your broker to buy or sell at the current market price. This is the most common order and it is used when you want to get the order executed immediately at the "market price". So this is preferable in fast market conditions or when you want to ensure that a position is taken and to protect against missing an opportunity. The broker will attempt to buy or sell the security at the current market price, whatever that price whatever that price may be. In an active market, market orders will always get filled, but not necessarily at the exact price that the trader intended. For example, a trader might place a market order when the best price is 30.00, but other orders might get filled first, and the trader's order might get filled at 30.01 instead. Market orders are used when you definitely want your order to be processed, and are willing to risk getting a slightly different price.

THERE IS NO SPECIFIED PRICE FOR THE MARKET ORDER

Example: Price of a stock ABC is: bid 30.00 ask 30.01

You place a market order, and it should be executed at the best ask, in this case it is 30.01. But, using a market order we instruct our broker that to us, it is more important that trade is executed, that at what price! As a result, our order can be executed at different price, for example at 30.02, because of a time lag between the moment we sent the orders and when it got to the exchange. But as a result, our order will definitely be executed.

Good thing about this type of order is that if you are in a loosing position  and want to close it immediately at whatever price is offered, then this is a type of order for you, because you will always get executed.

Bad part is the fact that if you use this type of order in illiquid stocks (or ETFs, futures etc), then your trade might be executed at worst price than the one you have expected.

Different Types Of Orders Used To Buy Or Sell A Stock

There's a lot more to trading stocks than just "buy" and "sell," and it's easy to be confused by all the types of orders you may have heard about. Placing orders correctly is probably one of the most important aspects of trading. It is vital that you understand and use the correct order when you trade. When placing an order with a broker, it's important to make sure you are placing your order properly. All orders are considered day orders and will expire the day you place it unless you specify that you want it to be a GTC order. (Good till canceled).

All trades are made up of separate orders, that are used together to make a complete trade. Every order can be a buy or a sell order, usually one order to enter the trade and one or more orders to exit the trade.

A single order is either a buy order or a sell order, and an order can be used either to enter a trade or to exit a trade. If a trade is entered with a buy order, then it will be exited with a sell order, and vice versa. For example, if you expect that stock price will go up, the simplest trade would be to place a buy order to enter the trade, and sell order to exit the trade. Contrary if you expect a drop in price, you will place a short sell order, and when you want to cover your shorts you will place a buy order.

It is important to remember that every order can be a buy order or a sell order. Here is a list of most used orders:

• Market Orders (MKT)
• Market On Open (MOO)
• Market On Close (MOC)
• Market If Touched (MIT)
• Limit Orders (LMT)
• Limit if Touched Orders (LIT)
• Stop Orders (STP)
• Stop Loss Order
• Stop Limit Order
• Trailing Stop Order
• Day Order
• Good Till Canceled (GTC)
• All or None (AON):
• Fill Or Kill (FOK)
• Spread Order

As you can see, this is huge amount of orders and if you want to trade properly, you will have to understand them all. In the next posts I will explain the main characteristics of each order with some examples of when they are used.

More About Full Service Brokers

Full service brokers are usually large and provide many types of services. They will allow you to select an individual account advisor, who can act as financial advisors providing guidance on which investment might be right for you. These firms have their own research departments and they recommend stocks to you, to buy or sell. Commissions vary according to the number of shares and dollar amount, but average is from 1% - 2%. This type of brokers offer two types of an accounts:

• Asset-based fees: An asset-based fee is one where the broker charges a fee based on the size of your portfolio (assets under management - AUM), which could be from 1.5% to 0.75%, instead of per transaction commission fee. This is good option if you want to hold a diversified portfolio of stocks and bonds.

• Wrap account fees: An account in which a brokerage manages an investor's portfolio for a flat quarterly or annual fee. This fee covers all administrative, commission, and management expenses. The advantage of a wrap is that it protects you from overtrading. This is when your broker trades your account excessively to make more commission. So, because the broker gets a flat annual fee, they only trades when it is advantageous to you. A traditional wrap typically requires an initial investment of at least $50,000 to $100,000. The initial intent, and probably the major continuing aspect of such accounts, is to allay the fears of stock and bond purchasers that a single broker would merely be trying to sell products solely for the commission. Wrap accounts charge the overall account an annual fee irrespective of how often the stocks within the account are bought or sold. Commissions are not charged to the investor. As one adviser stated, by removing the firm's vested interest in commission based products, its advisers would retain more objectivity and flexibility in structuring and moving client investments. Fees generally range from 1% to 3% (100 to 300 basis points) of the account value- perhaps 2% to 3% for equity accounts and from 1.25% to 1.75% for income accounts.

RISKS OF USING A FULL SERVICE BROKER AND ADVISOR?

• Unauthorized Trading: Trades that are made without your permission. If a broker asks you to sign a discretionary authority over your account (meaning that they can do whatever they want), do not sign it!. If you see a trade you did not authorize, bring it to their attention immediately. Keep a list of all trades you authorized, and if/when you see a unauthorized trade, if it occurred, this will help you to explain them where error has occurred an to correct an error.

• Churning: This is when brokers trade excessively in order to run up their commission, but bring no benefit to their clients. Churning is illegal under the SEC rules, but it is difficult to prove.

• Failure to execute: Brokers are supposed to execute your orders and in a timely manner. If the brokers fails to execute your order (and it was executable!) or caused a lengthy delay you should complain.

• Misrepresentation of risk: If they are making a recommendation, they should provide you accurate information about potential risks.

• Inappropriate investment recommendations: One reason you are paying the big bucks for a financial advisor or a full service broker is that they are supposed to know your investment goals and help you try to reach them. If, I know it is a long way off, if you are about to retire, and your broker suggests you put most of your money in a speculative stock, then take your money out.

How To Buy Or Sell Stocks Using Execution Only And Discount Brokers?

An execution only stockbroker such as discount broker offers to only execute your orders at the market but without giving you an advice to buy or sell a specific stock. He buys and sells shares on the instructions of clients but who offers no advice about what to buy and sell. Self-directed investors who want to make their own decisions are most suited to this service, and will probably be attracted by the lower dealing costs. So you as an investor take all responsibility for investment decisions. You give the instructions to buy or sell a stock by telephone or online, on a stock brokerage website or by using their software. So discount brokers:

• Do business over the phone or on the Internet by using their web site or software

• Because of low overheads, such as support a research department or spending time with their clients, they can charge lower commissions.

• You will pay less than if you trade with a full service broker.

• Discount brokers also offer no-load mutual funds with no transaction fee.

• Deep discount brokers charge a minimum commission of at least $5 up to $15

It is important to make sure that you know all the charges upfront. Execution only brokers may also require a minimum level of activity for an account or they charge a minimum fee (inactivity fee). So it is important to now how many trades you will make a month or a year, and choose a broker based on that.

WHAT DO I NEED TO DO BEFORE I CAN BUY SOME STOCKS:

To be able to buy/sell stocks, you have to choose a brokerage and sign up with them. You have to decide what is the best brokerage to use for trading. Sometimes it is one with lowest commission, but sometimes there are other important factors such as: interest paid on unused balance of your money in your brokerage account, interest charged for used margin in trading, maintenance inactivity fees, friendly using trading platform, trading platform monthly fee, wire transfer in/out if you live outside of US etc.

Before you can start trading, you have to fund it first! To fund the trading account, most executing only (discount) brokerages allow funding via cheque, account transfer and bill payment from any online banking account or by wire transfer. After the account is open and funded, you will get a username and password to log in in to the trading platform or on a web site, and you will be able to buy or sell stocks in the supported markets.

HOW TO OPEN A BROKERAGE ACCOUNT

Opening a brokerage account is very similar to opening a bank account with some additional information required. There is also likely to be a minimum investment required which could be as low as $500 or $1,000 for cash account and $2,000 for a margin account. So you have several types of accounts to choose when opening an account:

• Single Account: Only one individual person is allowed to trade.

• Joint Account: Two individual persons can trade

• Cash Account: When you buy a stock (or ETFs) you have to pay 100% within a three days. This is the most common type of all accounts. If you don’t have the cash, you can buy the stocks.

• Margin Account: Using this type of account you can borrow money from your brokerage account to purchase a security, for which they charge interest. You have to put up a minimum of 50% or more, with a $2,000 minimum to open an account. Rules for margin accounts are set by FINRA (http://www.finra.org/index.htm). If the price of a security declines by a certain amount, generally by 30%, then the broker will ask you to come up with the cash immediately by selling other securities to make up the amount or cash. 

Margin accounts can be very dangerous, especially in a declining or volatile market. For example, SP500 index is the most secure instrument of all stocks, and has the lowest volatility compared to individual stocks which is also known as the "beta". If you bought it in October 2007, before crisis began, your highest loss at any moment would be at 02 Mart 2009 when SP500 fall from 1562 in October 2007 to 756. Percentage loss in index was around 53%! So, if you have used all margin available in your account, you would got a margin call, and all your positions would be sold. On the other hand, if you bought right stocks, and they had an advance in price of 50%, your profits would be 100% on your original investment because of your leverage. It all depends how leveraged is used.

What Does A Full Service Brokers Do?

A stock broker or a broker is an intermediary between buyer and seller who helps them to make a transaction. Brokers are the people who handle customer orders to buy and sell securities. They are the ones who enable the trade to be completed.
If there were no brokers, then we would have to find a counter party for a trade, and that would mean to wait for months sometimes, like in a pink sheet stocks. Also, if the price that the other party offered was lower then we wanted to sell at, than we would have to wait for another buyer.

So, we have a middlemen. That is a stock brokerage company. To make a living and provide their service, they charge a fee. That fee is usually charged on a "per trade" basis. So if you buy a stock today and sell it tomorrow, you pay commission two times. 

These three main types of stock brokers are:

• Full service brokers or advisory stockbrokers
• Execution only brokers
• Discount brokers

In recent years, there a variations of discount brokers, such as: deep discount brokers and direct access brokers.

WHAT IS A FULL SERVICE BROKER AND WHAT AN ADVISORY STOCK BROKER?

Full service broker or an advisory stockbroker offer a service where broker who act as a financial advisor, discusses or reviews the investments of a client on a regular basis or when client requires, and he build a portfolio for him. The client makes the final decision to buy or sell. The adviser will supply research materials relating to markets, sectors and individual firms, and knowing individual needs of a client, such as his age, risk tolerance etc. The stockbroker will also make a specific recommendation for what stock are good to buy at the moment.

The relationship between a broker and a client will grow close over time. It is vital that both sides have clear guidelines as to how to work, and laying these principles down should be the role of the advisory management stockbroker. The client will almost certainly need a reasonable understanding of asset allocation and portfolio management techniques, or at least, importance of these in maintaining a client’s portfolio.

The costs associated with this type of brokers are highest of all. If you do not use an advisory management brokers, who charge up to $500 per trade, but use full service brokers, they will charge you from $30-50 per trade they execute for you, and they will give you advices about companies worth investing in, but they will not plan and maintain your portfolio, like an advisory management brokers will. Other costs include:

• Fees for transferring assets both into and out of an account
• Account maintenance fees
• Inactivity fees
• Interest on margin loans
• Sales charges on certain securities (such as loads on mutual funds)
• Fees for not maintaining a minimum balance

The biggest benefit for someone without experience is the opportunity to have a reputable firm guide you through the process of buying and selling stocks. Although it is highly probable that the fees will cut into your returns, you may be better off in the long run because a good broker can hold help you to overcome recession, and help you to avoid mistakes such as selling at market bottoms or buying during speculative bubbles.

CONCLUSION

If you have no idea about stock market and need someone to hold your hand while investing, and on the other hand are prepared to pay for it, I say go for full service brokers. On the other hand, if you understand importance of keeping your overheads as low as possible, see you in the next post about the executuion only brokers.

WHAT IS NAKED SHORT SELLING AND IS IT REALLY BAD AS THAY SAY?

As we have learned, selling a stock short is taking a negative position on a stock, it’s essentially a bet that the stock price will go down. You have to first borrow shares from a brokerage house, sell those, and then buy shares of the stock back at a later date to repay the borrowed ones, hopefully when the price has gone down.

Naked short selling is a practice of sale that is conducted before the seller has proper ownership or has been authorized to sell the security by the current owner. Naked short selling is conducted with the anticipation of being able to buy back the security at a lower price in short order, thus covering the original sale and managing to make a profit from the venture.

While the strategy of selling a stock short is considered ethical and legal in many parts of the world, naked short selling is considered to be highly unethical in most markets.

The SEC declared general naked shorting illegal in 1934. but they included a provision allowing market makers to employ the use of naked short selling when the anticipated result was to increase the liquidity of the investment market and help to restore some balance to an unstable situation.

Naked shorting to drive down share prices violates US law. Many companies have been accused of using naked shorts in order to make profits at the expense of share prices. To do this, the trader simply enters a naked short with no intention of ever delivering the shares. A large enough short sale could cause the price to fall, as is the case with any stock being sold, so as long as the trade is large enough to move the share price, the short is likely to be profitable. Normally this would be risky; if the price did move back up for other reasons, the trader would be driving the price up with every purchase, a condition known as a "short squeeze". But as long as the buyer turns around and shorts it back into the market, the price continues dropping, making the trades profitable even though no one actually holds any of the shares.

IS IT REALLY AS BAD AS THAY SAY?

You will hear from some people that naked short selling is not bad for a stock market. But it is. If you allow someone to sell stocks he doesn't own, if he does it in 1000 shares it’s not a problem. But what happens if he short a 100,000,000 shares of a company? The result is that naked short selling creates an increased supply of shares of a company and price of the stock eventually falls. So the fear is that, even if there is no reason for stock to fall, and the company is in great business like Coca-Cola Inc. someone could drive prices down and profit from it or by buying put options.

To help you understand this, I’ll give you an example: let’s say you bought a house for you your family for $100,000. You agreed to put a deposit of 30% ie $30,000. You pay your mortgage, and everything seams fine, until one day you realize that someone naked sold short your mortgages and several other in that area, increasing supply of houses like yours, and driving the prices down fast! As a result, the price of your house fall below $30.000 and you get a call from your bank (ie. a margin call) requesting to pay the difference or they will sell the house at the market. Next day, your house is sold a you had to move out. A week later, price of the house goes back up to $100.000.

That’s how feels every investor or Bear Stearns, or any other company which was under heavy naked short selling in the period of crash in 2008. Yes, prices fell anyway, but the question is did someone manipulated and fueled that fall?

CONCLUSION

Don't get me wrong, short selling has an important role in price discovery process, because short sellers are reality check and they try to exploit inefficiencies and  short sell companies that shouldn't have high valuations. That is OK. But allowing someone to sell something he doesn't own, in a way that each of his sale further depress and manipulate the price should be and is illegal.

HOW SHORT SELLING WORKS?

The process of stocks short selling consists of the following: The investor borrows shares of the stock they are going to short from his broker. This step is accomplished using "cash on deposit" at brokerage firm that can be used as collateral. So when an investor borrows stock, they're promising to give back the stock at a future point in time. The stock you borrowed is then sold at the market, and the cash from that transaction is paid in your brokerage account. You (investor) then wait for a decline in price, if there is any, and after the price goes form 15$ to 10$, you close a position by buying back the shares. This is what is called covering a short position. The investor returns the borrowed shares back to their broker or lender.

EXAMPLE OF HOW IT WORKS:

Let's say that you believe that ABC Company Inc. stock is due to fall, you then calls your broker to sell short 1000 shares of the company. Also, let's assume that your trade is immediately executed, to sell short 1000 shares of Company Inc. at $30.00 per share. You will receive a cash inflow of $30,000 from this transaction.
 

In four weeks later, the price has indeed dropped, and you are able to buy back the shares (also known as covering a short position) for $20.00 per share. In this transaction, you will spend $20,000 to buy shares that you need to cover your position. Your profit on the trade will be $10,000 ($30,000 minus $20,000). If stocks had risen to $35.00 during the time position was opened, then he would have a loss of $5,000 (1000 shares x $5.00/share).

RISK OF SHORT SELLING STOCKS:

Short seller is still trying to do the same thing a regular investor is, and that is to buy low and sell high. But the short seller is trying to do this in reverse order. He is trying to first sell high and then buy low. The short sales strategy, which is the opposite of entering a long position, is a risky one for a several reasons. These include the potential for a margin call, and theoretically unlimited losses if stock price rise, since the price of a stock cannot fall below $0 per share, the upper limit for profit is the total value of the stock sold short.

OTHER IMPORTANT THINGS TO KNOW EVEN IF YOU DO NOT SHORT SELL STOCKS:

Short interest is a measure of the total share volume that is currently short the stock. When a person short sells, the order must be identified as a short sale and these statistics are kept for each stock by the exchange. Short interest can be a source of demand if buyers become enthusiastic for the stock and price rises prompting some short sellers to reduce risk by buying back stock to replace and closing the short position.

A high short interest ratio is considered bullish while a low ratio is considered bearish. A ratio of 2 is considered 2 days potential buying power. In some future posts, when I'll write more about investment strategies, and what does work and what don't, you will se that actually, low short interest ration is a bullish sign!!! But more about that later.

The short interest ratio is called a contrary opinion indicator because an increase in short selling is an indication of a strong potential demand element as short sellers are likely to close positions quickly if the market price proves them wrong.

Odd lot short sales has been considered a measure of uninformed investors and was used by investors to give evidence of market bottoms as late comers to the market were considered uninformed. Now it's not widely used.

Specialists short sales are also available as a data source for measuring short selling. This is considered the smart money. Often investors watch the ratio of specialists short sales to total number of short sales to give an indication if the smart money is bullish or bearish. A short sell can be used as part of a bullish strategy as so can skew the basis for interpreting the ratio.

That's all for today.

THE HISTORY OF SHORT SELLING

Short selling has been around since the 1600’s and it has always had good and bad opinions even from the beginning. In various examples throughout history, it has been labeled as a primary reason in large market declines.

WHO ARE THE BEST KNOWN SHORT SELLERS IN STOCK MARKET HISTORY?

There are theories that said that the practice of short selling was invented by Dutch trader Isaac Le Maire, a big shareholder of the Vereenigde Oostindische Compagnie in 1609. In 1602 he invested about 85,000 guilders in the Vereenigde Oostindische Compagni (VOC) and by 1609, the VOC still was not paying dividend, and Le Maire's ships on the Baltic routes were under constant threats of attack by English ships due to trading conflicts between the British and the VOC. Because he thought that eventually British ships will destroy some of the ships, there would be losses for Vereenigde Oostindische Compagnie, and as a result stock price will go down. So what he does? Le Maire decide to start another company with a few other people and front run the Vereenigde Oostindische Compagnie! He sold his shares and sold even more than he had. That moment, when he sold something (shares) he didn't owned, is a moment when short selling was invented. All this led to the first real stock exchange regulations, a ban on short selling.

In the 18th century, England banned short selling. The London banking house of Neal, James, Fordyce and Down collapsed in June 1772, leading the fall of other banks and finally leading to banking crisis which included the collapse of almost every private bank in Scotland. The bank had been speculating by shorting East India Company stock on a massive scale, and using customer deposits to cover losses.

The term "short" was in use from nineteenth century. It is commonly understood that "short" is used because the short seller was short ie. need shares to cover his position with his brokerage house. Jacob Little, known as "The Great Bear of Wall Street", was famous for shorting stocks in the United States in the early to mid 1800’s. (The picture above is the original certificate signed by himself). Another short seller, the great Jessie Livermore was the one who was blamed for the crash of 1929, because of his well known reputation.

SHORT SELLING REGULATIONS IN HISTORY OF THE US:

In Wall Street Crash of 1929, short sellers were blamed for it. After the crash,  SEC banned short sellers from selling shares during a downtick, and "uptick rule" was created. This means that a short sale order can only be filled after someone bought that same stock and their order caused an uptick when purchased at the Ask price. Some people believe that the uptick rule prevent stocks from dropping so fast and others believe the stocks would have gone down anyhow. This was in force until July 3, 2007 when it was removed. Legislation in 1940 banned mutual funds from short selling, until 1997, when this law was lifted. In 1949, Alfred W. Jones founded a fund that bought stocks while selling other stocks short, ie hedge market risk by using a combination of owning shares, using various stock option strategies and shorting the stock at the same time. This is how the hedge fund was born.

In September 2008 short selling, and naked short selling was seen as a contributing factor to undesirable market volatility, and it was prohibited by the SEC for around 800 financial companies for three weeks time.

WHO MADE THE HIGHEST AMOUNT OF MONEY IS A SINGLE SHORT SALE TRANSACTION?

In Black Wednesday of 1992, George Soros became became notorious for "breaking the Bank of England", when he sold short more than $10 billion worth of British pounds.

WHAT IS SHORT SELLING AND HOW CAN I BENEFIT FROM IT?

Traditionally people understand investing in stocks in way that you buy an stock and hold it until it rises enough to make a sizable profit, and sell it after that. But what about the times you come across a stock that you wouldn't invest in, and you think that it is only a matter of time when it will collapse? Well you can profit from the decline of a stock and although it sounds easy, the mechanics of a short sale are little complicated and the investor's risks are high so it is important that you understand the transaction before getting into it.

PROCESS OF SHORT SELLING:

First, let's describe what short selling means when you purchase shares of stock. In purchasing stocks, you buy a piece of ownership in the company. Short selling is the selling of a stock that the seller doesn't own, so it’s the sale of a security that isn't owned by the seller, but that is promised to be delivered. When you short sell a stock, your broker will lend it to you. The stock will come from the brokerage's own inventory, from another one of the firm's customers, or from another brokerage firm. The shares are sold and the proceeds are credited to your account. Sooner or later, you must close the position by buying back the same number of shares and returning them to your broker. If the price drops, you can buy back the stock at the lower price and make a profit on the difference. If the price of the stock rises, you have to buy it back at the higher price, and you lose money. So the risk is that stock prices can theoretically rise indefinitely but fall down only to zero.

So short selling or "shorting" or "going short" is the practice of selling assets, such as stock, futures, options etc. that have been borrowed from a third party ie. a broker, and buying identical assets back at a later date to return it to whom lend it to you. In other words, you take a "negative" position in the market, because you bought a negative amount of assets. If you short a stock, you expect price to fall to profit form your position, and to be able to buy back the shares you nee to close a position, at a lover price that you paid for. So going short is a contrast of going long.

WHERE DOES BROKER GET THE STOCKS?

Short selling is a marginable transaction. You must open a margin account to sell short. This is the same account you would use if you want to use your stocks as collateral to by stock on margin (more about that in the future posts). The general rule is that the value of your portfolio must equal at least 50% of the size of the short sale transaction, so if you have $25,000 worth of stock/cash in your margin account, you can borrow $50,000 of stock to sell short.

HOW DO I SELL SHORT?

Short selling, unlike a normal stock transaction where we have buyer and a seller, here we have the original owner, the short seller, and the new buyer. Short seller borrows shares from the original owner, and then sells them on the open market to any willing buyer. To close his position, he (short seller) must buy the same amount of shares as he sold so that the broker can return them to the original owner.

While you have an open short sale position, your broker will charge you overnight interest on the value of the short position. If the stock you shorted goes up or down in price your collateral will be higher or lower, and if it is lower by certain amount you may be required to place more money in your brokerage account, or buy back the stock that you sold short. Also, you must pay any dividends issued by the company whose stock you sold short, because that person is still the real owner of the shares you hold.

WHY SELL SHORT? SPECULATION AND PORTFOLIO PROTECTION:

The two primary reasons for selling short are speculation and and portfolio protection. Occasionally investors see a stock that they believe has been hyped to a ridiculously high level, and they believe that the stock price will fall. A short sale provides the opportunity to profit from the overpriced stock.

Another reason is that short sales can protect your portfolio against a market downturn. An investor can diversify a long portfolio by adding some short positions. The portfolio will then have positions that make money both when prices rise and when they fall. This reduces the volatility in the portfolio's returns and helps protect the value of the portfolio when prices are falling. This is know as a hedging. More about that I'll caver in future posts.

STOCK BUYBACKS: GOOD, BAD AND THE UGLY

Just as stock options, warrants, and convertible preferred issues can dilute your ownership in a company, share repurchase plans can increase your ownership by reducing the number of shares outstanding. Here are three important truths about these programs - and most importantly, how they make your portfolio grow.

OVERALL GROWTH ISN'T IMPORTANT AS  GROWTH PER SHARE:

Here is an example of ABC Company Inc:

Stock price is  $50 per share. There are 100000 shares outstanding. Market Capitalization is $5.000.000.Profit made this year is 1 million dollars.

So in this example, each share equals .001% of ownership in the company, which is 100% divided by 100000 shares. If the management see that their company (business) will have the same amount of profit this year, like it was last year, that means that their growth rate is 0%. Because the management want to improve the picture and show to shareholders that they are good management, they come up with the idea of stock buybacks. The company use 1 million dollar profit to buy back it's shares on the open market.

After the buyback, as we learned in previous posts, those shares are owned by the ABC Company Inc. and removed form circulation. Now there are only 80000 shares outstanding instead of 100000 that were originally issued.

Average investor (aka shareholder) now no longer have  0.001% of the company, but 0.00125%. In percentage term it is rise of 25% in one year per share!. After the buy back, stock rise will rise in price to 62.50$ from 50.00$! So even though the company made the same amount of profit this year like it did last year, stock price rose 25%!!! Average investors are happy.


WHEN NUMBER OF SHARES OUTSTANDING ARE REDUCED, EACH OF SHARES IS MORE VALUABLE AND MEANS GREATER PERCENTAGE BUSINESS OWNERSHIP:

If a management, like in above example, is in charge, this can lead that amount of shares outstanding goes to 50 or 100. So it good to hold companies like one in the example, buy only if they are fundamentally strong, and hold it in your portfolio as long as they keep doing buybacks. This can increase your profits, but as I said, this destroys companies balance sheet and it's not good long term. One of the best examples is the Washington Post, which was at one time only $5 to $10 a share. It has traded as high as $650 over the past few years.


IF MANAGEMENT BUYBACK SHARES AT HIGH PRICES, BUYBACKS ARE NOT A GOOD THING TO DO!

Even though stock buybacks and share repurchases can be huge sources of long-term profit for investors, they are actually bad if a company pays more for its stock than it is worth or uses money it cannot afford to spend ie. Borrow the money. If the market is overpriced it is bad decision for management to buyback stocks. Instead, the company should put the money into assets that can be easily converted back into cash, to improve liquidity. This way, when the market moves the other way and is trading below its true value, shares of the company can be bought back up at a discount, giving shareholders maximum benefit.

There is a saying: "Even the best investment in the world isn't a good investment if you pay too much for it".

Stock Buybacks: Pros And Cons

What Methods Companies Use To Buyback It's Shares?

1. Open Market

This is the most common share repurchase method in the US and it represents around 95% of all buybacks. In this methods, company buy it's shares on the open market like an other investor would at the market price. When a company announces a buyback it is usually perceived by the market as a positive thing, and as a result, stock price goes up.

2. Fixed Price Tender

Up to 1981 all tender offer repurchases were done using a fixed price tender offer. This type of offer have specified purchase price, number of shares and offer duration with public disclosure required. Shareholders decide whether or not they wish to participate. Frequently, officers and directors are not allowed to participate in the tender offer. If the number of shares tendered exceeds the number that they wanted to buy, then company buy shares on pro-rata basis. which means that they buyback same % of stocks form the shareholders based on the number of stocks they own already.

3. Dutch Auction

It was introduced in 1981 and allows an alternative form of tender offer. The first firm to utilize the Dutch auction was Todd Shipyards.[3] A Dutch auction offer specifies a price range within which the shares will finally be purchased. Shareholders are invited to tender their stock, if they desire, at any price within the stated range. The firm compiles these responses, and create a demand curve for the stock. The purchase price is the lowest price that allows the firm to buy the number of shares originally wanted.


What Are Pros And Cons Of Stock/Share Buybacks:

Pros:

1. A company that is buying back its own stock usually believes the stock is undervalued and believes it is a good buy. This is a good sign for shareholders because the company is basically betting on their continued success.

2. Stock buybacks create a very nice price support level for investors. This is especially true in recessionary periods or bear market periods. A stock that has a massive stock buybacks will have that extra price support that can serve as a safety net for investors in the stock.

3. Buying back stock means less outstanding shares, which means higher earnings per share number if all other things stay equal. A higher EPS number is always important in the market.

Cons:

1. Serve as an easy cover up for poor financial ratios at the company, because company can buy their own shares and create an artificial lift in their financial ratios which makes market observers believe things are improving, even if they are not.

2. Allow the company insiders to take advantage of stock option programs while not diluting the overall EPS number that is reported to the market. Warren Buffett said several times that he believes employee stock option programs and buyback programs can be quite shady.

3. Typically creates a quick and often artificial jump in the price of a stock. Advantageous insiders then quickly sell at a higher price while individual investors tend to be late buying into the stock and buy in at high price levels.

More about pros and cons of buybacks I'll cover in some futures posts.

Stock Buybacks: What Is It And Why It's Done?

What Do We Mean By Stock Or Share Buybacks?

A stock buyback, also known as a "share repurchase", is a company's buying back its shares from the general public. We already know two most common ways in which company return value to the shareholders, and these are stock appreciation and dividends. The third one is stock buyback. When company buy its own shares, because it can not act as its own shareholder, these shares are owned by the company and the number of shares outstanding is reduced by that amount. As a result, every shareholder of the company now has larger % share in the company, and also has a larger EPS or earnings per share (we'll talk about meaning of that in later posts).

Why Would Company Buyback It's Own Shares?

When company make profit, it has two options: pay that money to its shareholders or reinvest it in the business. Usually, company do both, pay some dividend and keep rest of the profit as a retain earnings. But, there are times when management of a company do not see good opportunity to invest, or their main business is non worth investing in. Example is Berkshire Hathaway company. Their chairman, now investment legend Warren Buffett, used companies profits and cash flow from textile business to acquire shares in other companies, because he realized that textile industry was with low profit margins and that that had strong competition from China.

1st. Reason:

So when there are no other better options to put money to good use, last option is share repurchase or stock buyback. When a company repurchases its own shares, it reduces the number of shares held by the public. The reduction of shares held by the public (also known as a float) means that even if profits are the same, earnings per share will increase. Also, if company's share price is undervalued or depressed, share buybacks will improve return on investments.

2nd. Reason:

Other aspect of stock repurchases is this: if a company's management see that it's stock price is low, or that it is lower than actual book value (more about that in future posts) and currently trading below its intrinsic value, they will consider repurchases.

 3rd. Reason:

Another reason why management prefer share buybacks is that because their compensation is often tied to their ability to meet earnings per share targets. In companies where there are few opportunities for organic growth, share repurchases may represent one of the few ways of improving earnings per share in order to meet targets. It is important to understand that increasing earnings per share does not equate to increase in shareholders value. This investment ratio is influenced by accounting policy choices and fails to take into account the cost of capital and future cash flows, which are the determinants of shareholder value.

4th. Reason:

Share repurchases avoid the accumulation of excessive amounts of cash in the corporation, because companies with strong cash generation will accumulate cash on the balance sheet, which makes the company a more attractive target for takeover, since the cash can be used to pay down the debt incurred to carry out the acquisition (also known as Leveraged buybacks - LBO). Anti-takeover strategies therefore often include maintaining a low cash position and the share repurchases increase stock price which makes a takeover more expensive.

5th. Reason:

Share repurchases also allow companies to covertly distribute their earnings to investors without inflicting them with double taxation.

In latter post I'll cover pros and cons of stock buybacks.

Is Stock Split Beneficial For The Investors?

Do Companies With Splitted Stocks Outperform Similar, Non-Splitted Ones?

On the surface, a stock split is nothing more than accounting transaction, it leaves investors no better or worse off. That is the reason why critics argue that a stock split is a non-event. They're convinced that a split is simply an accounting function with no relationship to stock performance. In fact, they think investors are foolish to believe there is any money to made from something as unimportant as a stock split.

On the other hand, companies argue that by reducing per share prices, stock splits make shares more attractive to individual investors. And splitters often claim that a higher share count allows for more trading liquidity and greater institutional ownership. Finally, some investors argue that stock splits are bullish because of the positive signal they send about a company’s prospects.

Most traders view stock splits as high potential trading opportunities. They consider splits a positive progression in value and goodwill for companies and their investors. Corporate executives use stock splits as marketing and investor relation tools. They know that stock splits make shareholders feel better and engender a sense of greater wealth.

What Academic Researches Tells Us?

One study supports the belief that stock splits help attract new investors and improve liquidity. More important, research suggests that stocks tend to outperform after split announcements.

For many years, academics argued that stock splits should be a poor predictor of stock-market returns. The position was easily defended, because stock splits do not increase a company’s intrinsic value. If you hold 1000 shares of a stock that trades for $100 a share, your position is worth $100,000. After that stock splits 2-for-1, you hold 2000 shares valued at $50 apiece, also worth $100,000.

Some studies using price data from the 1920s through the 1970s,  suggested that stock splits have little effect on future price movements. But a number of studies in the 1980s and 1990s show that stocks tend to outperform after they announce a split, despite the fact that prices had often risen sharply before the announcement.

One study of 2-for-1 stock splits between 1975 and 1990 found companies that split their stock outperformed companies of similar size by an average of 7.9% in the year after the split and 12.2% in the three years after the split.

Another study, between 1988 and 1997,  found that shares of companies that split their stock outperformed stocks of similar size, type such as value or growth and liquidity by an average of nearly 9.0% in the year after the split. Other studies showed that that stock splits increase trading costs because of higher bid-ask spreads, which translate into more profits for market makers on the stock exchange and less money to investor.

While stock prices tend to rise in the days after the split announcement, much of the excess return occurs later. One study found that stock prices outperformed by an average of 3.4% in the five days after the split announcement, then another 4.5% over the next 51 weeks of trading.

The relationship between stock-split announcement and price gains appears to continue today. The Forecasts looked at more than 700 stock-split announcements between August 2000 and July 2004 and determined that, on average, splitters outperformed the S&P 500 Index by 9.7% and 14.7%, respectively, in the six and 12 months after the announcement. More than 64% of the stocks beat the market during those periods. On average, only 3% of the out performance occurred during the five days after the announcement.

A 1996 study by David Ikenberry of Rice University measured the short and long-term performance of stock splits. His research included all the 1,275 companies whose stock split 2-for-1 between 1975 and 1990. Ikenberry compared the split stocks to a control group of stocks for similar-sized companies in similar sectors that had not split. His results were startling. The split stock group performed 8% better than the control group after one year, and 16% better after three years.

In August 2003, Ikenberry updated the stock split study. This time he looked at companies from 1990 to 1997. Using a similar methodology that included 2-for-1, 3-for-1 and 4-for-1 stock splits, he found the results were the same. Shares of split stocks on average outperformed the market by 8% the following year and 12% over the next three years.

 

Reasons Why Stock Splits Increase Profits For Investors:
 
1. The stock split announcement draws attention to a company's success. This results in increased buying and higher prices. 
2. Companies will often report high earnings and raise dividends at the same time they announce a stock split. The synergy of these events can drives the price of the stock up even more. 
3. The reduced price per share after companies split a stock attracts many smaller investors. 
4. With so many news and information services reporting stock splits, the announcements themselves have become a market-moving force. 

Whatever side you take, my advice is not to buy a stock solely based on a split!

What Is A Stock Split And Why Company Do This?

A stock split is simply increasing the number of shares outstanding and proportionally adjusting the share price to compensate that.

Here is an example: if a company announce that it will split its stock 2 for 1 in month from now, a month later, their stock were traded at 50$/share and after the split is done, the stock price will be 25$/share. If a company had 50 million shares outstanding, after the split was done, there will be 100 million shares outstanding. The most common splits are 2 for 1, 3 for 1, 5 for 4, 4 for 3, 3 for 2. Also there is a reverse splits, such as 1 for 2, or 1 for 3. In that case, the price goes up, but number of shares outstanding down.

There are several reasons why would company do a stock split. First reason is if stock price rise too much, some people wouldn't have enough money to buy even a one share (such as Berkshire Hathaway, which was at $8 a share in the 1960's, has traded as high as $190,000. This has created the welcome condition of a stable shareholder base). Also psychologically, if you have a stock that is traded at 25$/share and the other at 700$/share, the later one will "look" more expensive to average investors. So if company do a stock split, it brings it down to a more attractive level. Second important reason is that if you have lower priced stocks, their liquidity incises, and as a result bid-ask spread lowers. Third reason is if a stock is traded in a market where there is a high minimum number of shares, or a penalty for trading in odd lots (number of shares under 100), a reduced share price may attract more attention from small investors.

 

Effect On Historical Stock Price Charts:
 

When a stock splits, many charts show it similarly to a dividend payout and they do not show a dramatic dip in price. For example, company have 500 shares of stock priced at $50 per share. The company splits its stock 2-for-1. There are now 1000 shares of stock and each shareholder holds twice as many shares. The price of each share is adjusted to $25. Based on this example you might expect to see the stock dropping from $50 to $25. If this whas the case, and average investor didn't realize that it was a stock split, he would think that some news cause this, and there would be a panic in the market because a stock dropped 50% in one day!

So what is done is something called adjusted close price. Adjusted close price will take all the closing prices before the split and divide them by the split ratio. So when you look at the charts it will seem as if the price was always $25. Later, when we come to real trading stuff and come to backtesting, you'll see why is it important to understand these corporate actions, such as stock splits and their effect on price data.

SOUTH Trading System Performance (February 2011): +20.18%

SOUTH – Short Only

Direction: Short Only

Leverage Used: 2:1

Max Drawdown: -5.37%

Starting Capital: $10,000

Ending Capital: $15,892

Net Profit (Month February): $2,668

Net Profit % (Month February): 20.18% 

Net Profit (Since Inception): $5,892

Net Profit % (Since Inception): 59.92% 

February was another very good month posting an overall gain of 20.18%, after making 32.23% in January! Similar to last month’s result, system started to make profits from the first trading day, having only two negative days. Drawdown in February was -5.36%.

At the end of February, South trading system made 20.18% before commissions, and a compounded gains of 58.92% (since inception in January 2011). This month’s drawdown was -5.37%, which is a new historical drawdown, as it is bigger than last month’s drawdown of -3.47%.

Largest daily loss during the month was -5.36%, and a largerst gain of 7.87%.

At the end of this month, since inception South trading system made $5,892 and finished a month with a balance of $15,892.

To see South's last month report click here, and other trading systems offered click here. If You would like to subscribe to this system and start reciving daily Trade Alerts,  click on the link below and fill out the form:

More About Dividends

What Are Two Main Types Of Dividend Policies?

Cash dividends,  are those paid out in currency. This is the most common method of sharing corporate profits with the shareholders of the company.They are form of investment income and are usually taxable to the recipient in the year they are paid. For each share owned, a declared amount of money is distributed. So if an investor owns 100 shares and the cash dividend is $1.50 per share, the holder of the stock will be paid $150.

 
Stock or scrip dividends are paid out in the form of additional stock shares of the issuing corporation instead of paying in cash.They are usually issued in proportion to shares owned (pro-rata). If the payment involves the issue of new shares, it’s same as stock splits, which will cover later, in that it increases the total number of shares while lowering the price of each share without changing the market capitalization of a company.

Ratios Commonly Used To Gauge The Sustainability Of A Firm's Dividend Policy: Dividend Cover And Payout Ratio:

 
Dividend cover of a company is important factor to understand about an investment, and see if a company has a stable payment policy. Do they increase their payments in an orderly and regular way, are payments made at a constant rate and will the firm be able to maintain these payments? 

 
One measure used to help answer these questions is a ratio known as dividend cover:

 
Dividend Cover = Earnings Per Share divided by Dividend Per Share

 
The inverse of this ratio is the proportion of earnings that belong to ordinary shareholders which are distributed to them, better known as the dividend payout ratio. If a company has a dividend cover ratio of 1.0, it pays out all earnings in dividends. This means that should earnings fall, the company might be forced to cut annual dividend payments. 

 
Many firms use annual dividend payments as a signal to shareholders and the market of confidence, so in the short term, directors will be reluctant to reduce payments, unless the firm is in trouble.


How Is Dividend Yield Calculated?

Dividend yield is used for comparing the relative attractiveness of various income stocks, or stocks that pay dividend. It tells you, in a percentage terms, what you can expect to profit in a year if you buy that stock. It is useful because it allows us to compare it, not only with other stocks, but with other investments such as bonds or certificates of deposit.

 
Formula is: Dividend yield =  Annual dividend / Current stock price. 

 
So if company has a price 20$/share and it pays 2$/share dividend, dividend yield will be: 2$ / 20$ = 10%.

EAST Trading System Performance (February 2011): +14.87%

EAST – Short Only

Direction: Short Only

Leverage Used: 2:1

Max Drawdawn: -3.04%

Starting Capital: $10,000

Ending Capital: $14,185

Net Profit (Month February): $1,836

Net Profit % (Month February): 14.87% 

Net Profit (Since Inception): $4,185

Net Profit % (Since Inception): 41.86%

System made very good profits this month also – 14.87%! Maximum drawdown is based only on losing trades ie. If winning position had a one time loss of 5%, it would not be reported buy our platform. But if it was exited with a loss of 5%, that would increase final drawdown figure. As a result one should not pay to much attention to this figure, because it is not reliable. Real drawdown is usually higher by 3-5% at least.

In February 2011, system made a profit of 14.87% with a -3.04% drawdown. First chart below shows daily profit and loss made during this month. 

As it can be seen from the chart, largest daily loss was -2.12% and largest daily gain was 4.56%.

To see EAST's last month report click here, and other trading systems offered click here. If You would like to subscribe to this system and start reciving daily Trade Alerts,  click on the link below and fill out the form: