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Path: senator-bedfellow.mit.edu!dreaderd!not-for-mail Message-ID: <investment-faq/general/part17_1082200966@rtfm.mit.edu> Supersedes: <investment-faq/general/part17_1079601013@rtfm.mit.edu> Expires: 31 May 2004 11:22:46 GMT References: <investment-faq/general/part1_1082200966@rtfm.mit.edu> X-Last-Updated: 2003/03/17 From: noreply@invest-faq.com (Christopher Lott) Newsgroups: misc.invest.misc,misc.invest.stocks,misc.invest.technical,misc.invest.options,misc.answers,news.answers Subject: The Investment FAQ (part 17 of 20) Followup-To: misc.invest.misc Summary: Answers to frequently asked questions about investments. Should be read by anyone who wishes to post to misc.invest.* Organization: The Investment FAQ publicity department Keywords: invest, finance, stock, bond, fund, broker, exchange, money, FAQ URL: http://invest-faq.com/ Approved: news-answers-request@MIT.Edu Originator: faqserv@penguin-lust.MIT.EDU Date: 17 Apr 2004 11:28:39 GMT Lines: 1090 NNTP-Posting-Host: penguin-lust.mit.edu X-Trace: 1082201319 senator-bedfellow.mit.edu 569 18.181.0.29 Xref: senator-bedfellow.mit.edu misc.invest.misc:42162 misc.invest.stocks:840681 misc.invest.technical:101770 misc.invest.options:54805 misc.answers:17229 news.answers:270011 Archive-name: investment-faq/general/part17 Version: $Id: part17,v 1.61 2003/03/17 02:44:30 lott Exp lott $ Compiler: Christopher Lott The Investment FAQ is a collection of frequently asked questions and answers about investments and personal finance. This is a plain-text version of The Investment FAQ, part 17 of 20. The web site always has the latest version, including in-line links. Please browse http://invest-faq.com/ Terms of Use The following terms and conditions apply to the plain-text version of The Investment FAQ that is posted regularly to various newsgroups. Different terms and conditions apply to documents on The Investment FAQ web site. The Investment FAQ is copyright 2003 by Christopher Lott, and is protected by copyright as a collective work and/or compilation, pursuant to U.S. copyright laws, international conventions, and other copyright laws. The contents of The Investment FAQ are intended for personal use, not for sale or other commercial redistribution. The plain-text version of The Investment FAQ may be copied, stored, made available on web sites, or distributed on electronic media provided the following conditions are met: + The URL of The Investment FAQ home page is displayed prominently. + No fees or compensation are charged for this information, excluding charges for the media used to distribute it. + No advertisements appear on the same web page as this material. + Proper attribution is given to the authors of individual articles. + This copyright notice is included intact. Disclaimers Neither the compiler of nor contributors to The Investment FAQ make any express or implied warranties (including, without limitation, any warranty of merchantability or fitness for a particular purpose or use) regarding the information supplied. The Investment FAQ is provided to the user "as is". Neither the compiler nor contributors warrant that The Investment FAQ will be error free. Neither the compiler nor contributors will be liable to any user or anyone else for any inaccuracy, error or omission, regardless of cause, in The Investment FAQ or for any damages (whether direct or indirect, consequential, punitive or exemplary) resulting therefrom. Rules, regulations, laws, conditions, rates, and such information discussed in this FAQ all change quite rapidly. Information given here was current at the time of writing but is almost guaranteed to be out of date by the time you read it. Mention of a product does not constitute an endorsement. Answers to questions sometimes rely on information given in other answers. Readers outside the USA can reach US-800 telephone numbers, for a charge, using a service such as MCI's Call USA. All prices are listed in US dollars unless otherwise specified. Please send comments and new submissions to the compiler. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Technical Analysis - Information Sources Last-Revised: 12 Dec 1996 Contributed-By: (Original author unknown), Chris Lott ( contact me ) This article lists some sources of information for technical analysis, including books, magazines, and courses. Books on Technical Analysis: * Design, Testing, and Optimization of Trading Systems by Robert Pardo. Published by John Wiley & Sons, Inc. * The Disciplined Trader by Mark Douglas of NYIF - 1990. ISBN 0-13-215757-8 * Elliott Wave Principle by A. J. Frost and Robert Prechter, New Classics Library, ISBN: 0-932750-07-9. * Encyclopedia of Technical Market Indicators by Robert Colby and Thomas Meyers, Dow Jones Irwin. * Market Wizards by Jack Swager * The Mathematics of Technical Analysis by Clifford Sherry, 1992 Probus Publishing, ISBN 1-55738-462-2 * New Market Wizards by Jack Swager * Patterns for Profits by Sherman McClellan, Foundation for the Study of Cycles, 900 W. Valley Rd. Suite 502, Wayne, PA 19087, 215-995-2120. * Proceedings, Second Annual conference on Artificial Intelligence Applications on Wall Street, Roy S. Freedman, Ed. NYC, April 19-22, 1993, Pub: Software Engineering Press, 973C Russell Ave, Gaithersburg, MD 20879, (301) 948-5391. * Secrets for Profiting in Bull and Bear Markets, by Stan Weinstein, Dow Jones-Irwin. * Technical Analysis, by Clifford Sherry, 1992 Probus Publishing, ISBN 1-55738-462-2. * Technical Analysis Explained, by Martin J. Pring, McGraw-Hill, 3rd ed. 1991, ISBN 0-07-051042-3. * Technical Analysis of the Futures Markets, by John J. Murphy of NY Institute of Finance, Prentice Hall, 1986, ISBN 0-13-898008-X. * Study Guide for Technical Analysis of the Futures Markets: A self-training manual, by John Murphy (the most comprehensive book on the subject). * Technical Analysis of Stock Trends, by Edwards and Magee (a serious study of classical charting techniques). * The Major Works of R. N. Elliott, edited by Robert Prechter, New Classics Library. * Timing the Market: HOW TO PROFIT IN BULL AND BEAR MARKETS WITH TECHNICAL ANALYSIS, by Weiss Research (a good introductory text for those using METASTOCK PROFESSIONAL and want to make money with it). Sources for books on technical analysis: * TRADERS PRESS, INC., P.O. BOX 10344, Greenville, S.C. 29603, (800)927-8222, (803)-298-0222, FAX: (803)-298-0221. Offer a 40+ page catalog, nice folks, great service. VI/MC/AX accepted. * TRADER'S WORLD, 2508 Grayrock Street, Springfield, MO 65810, (800)288-4266, (417) 298-0221. Puts out a quarterly magazine (mostly junk) with discounted Technical Analysis books (usually 10% cheaper than elsewhere). VI/MC/AX accepted. * New Classics Library, Inc., P.O. Box 1618, Gainesville, GA 30503. Books on options pricing: * Continuous Time Finance, by Robert Merton * The Elements of Successful Trading, by Rotella, Robert P., 1992 * Options as a Strategic Investment, by McMillan, Lawrence G., New York Inst. of Finance, 2nd edition, 1986, ISBN 0-13-638347-5. * Options Markets, by Cox, J.C and Rubenstein, M., Prentice-Hall, 1985. * Options: Essential Trading Concepts and Trading Strategies, Edited by The Options Intsitute, 1990, Business One Irwin, ISBN 1-55623-102-4. * Options, Futures, and Other Derivative Securities, by Hull, J., Prentice-Hall, 1989. * Options: Theory, Strategy, and Apllications, by Ritchken, P, Scott, Foresman, 1987. * Option Pricing, by Jarrow, R. A., Irwin, 1983. * Option Volatility and Pricing Strategies, by Natenberg, Shelly * Theory of Financial Decision Making, by Ingersoll Magazines on technical analysis: * Technical Analysis of Stocks & Commodities 4757 California Ave. SW, Seattle, WA 98116-4499, 800-832-4642, (206) 938-0570. 1 yr. - $64.95 -- 12 issues Everything explained at the level of the beginner, however you should complete a course before getting this magazine. Best part is building a library by buying the bound back issues -- worth every penny. * Futures - commodities, options & derivatives 800-221-4352 Ext. 1000 1 yr. - $39.00 - 12 issues * NeuroVe$t Journal Pub. by Randall B. Caldwell, PO Box 764, Haymarket, VA 22069-0764, email: rbcaldwell@delphi.com $75(US)/yr, published bi-monthly * Traders Cataloge and Resource Guide 619-930-1050 $39.50 year. * Traders World Magazine 1-800-288-4266 Published every 3 months, $15 per year A self-paced course on technical analysis: The Technical Analysis Course by Thomas Meyers An introductory course covering: Stochastics, RSI, Trendline/chanels, Support/resistance, Point and Figure, Oscillators, Moving averages, Volume & Open Interest, Chart construction, Gaps, Reversal Patterns, and Consolidation formations. Easy read for someone new that doesn't want to be intimidated. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Technical Analysis - MACD Last-Revised: 25 Nov 1998 Contributed-By: (Original author unknown), Chris Lott ( contact me ), Jack Hershey (jhershey at primenet.com) The Moving Average Convergence/Divergence (MACD) was invented by Gerald Appel sometime in the sixties and comes in various flavors, but most are based on a technique developed by McClellan (which he based on a technique developed by Haurlan). The technique is to take the difference between two exponential moving averages (EMA's) with different periods. This produces what's generally referred to as an oscillator. An oscillator is so named because the resulting curve swings back and forth across the zero line. Appel's version used the difference between a 12-day EMA and a 25-day EMA to generate his primary series. This series was plotted as a solid line. Then he took a 9-day EMA of the difference and plotted that as a dotted line. The 9-day EMA trails the primary series by just a bit, and trades are signalled whenever the solid line crosses the dotted line. For more volatile markets, you may want to shorten the periods of the EMA's. I seem to remember one trader that used an MACD on futures data with 7-day and 13-day for the primary series and a 5-day EMA of that for the trailing curve. I also know a fellow who runs an MACD on the adline (advancing issues minus declining issues). Here are some web resources that may help: * Classic MACD Trend Analysis by MoneyFlow.com. http://www.moneyflow.com/macd.htm --------------------Check http://invest-faq.com/ for updates------------------ Subject: Technical Analysis - McClellan Oscillator and Summation Index Last-Revised: 23 Dec 1997 Contributed-By: Tom McClellan In 1969, Sherman and Marian McClellan developed the McClellan Oscillator and its companion tool the McClellan Summation Index to gain an advantage in selecting the better times to enter and exit the stock market. This article gives a brief overview of the McClellan Oscillator and Summation Index. Every day that stocks are traded, financial publications list the number of stocks that closed higher (advances) and that closed lower (declines). The difference between these numbers is called the daily breadth. The running cumulative total of daily breadth is known as the Daily Advance-Decline Line. It is important because it shows great correlation to the movements of the stock market, and because it gives us another way to quantify the movements of the market other than looking at the price levels of indices. Another indicator is called the daily breadth. Each tick mark on a daily breadth chart represents one day's reading of advances minus declines. In order to identify the trend that is taking place in the daily breadth, we smooth the data by using a special type of calculation known as an exponential moving average (EMA). It works by weighting the most recent data more heavily, and older data progressively less. The amount of weighting given to the more recent data is known as the smoothing constant. We use two different EMAs: one with a 10% smoothing constant, and one with a 5% smoothing constant. These are known as the 10% Trend and 5% Trend for brevity. The numerical difference between these two EMAs is the value of the McClellan Oscillator. The McClellan Oscillator offers many types of structures for interpretation, but there are two main ones. First, when the Oscillator is positive, it generally portrays money coming into the market; conversely, when it is negative, it reflects money leaving the market. Second, when the Oscillator reaches extreme readings, it can reflect an overbought or oversold condition. While these two characteristics are very important, they merely scratch the surface of what interpreting the Oscillator can reveal about the stock market. Many more important structures are outlined in the book Patterns For Profit by Sherman and Marian McClellan, available from McClellan Financial Publications. If you add up all of the daily values of the McClellan Oscillator, you will have an indicator known as the McClellan Summation Index. It is the basis for intermediate and long term interpretation of the stock market's direction and power. When properly calculated and calibrated, it is neutral at the +1000 level. It generally moves between 0 and +2000. When outside these levels, the Summation Index indicates that an unusual condition is taking place in the market. As with the Oscillator, the Summation Index offers many different pieces of information in order to interpret the market's action. Among the most significant indications given by the Summation Index are the identification of the end of a bear market and the confirmation of a new bull market. Bear markets typically end with the Summation Index below -1200. A strong rise from such a level can signal initiation of a new bull market. This is confirmed when the Summation Index rises above +2000. Past examples of such a confirmation have resulted in bull markets lasting at least 13 months, with the average ones lasting 22-24 months. The McClellans publish a stock market newsletter called The McClellan Market Report. Sherman McClellan and his wife Marian McClellan were the originators of the McClellan Oscillator; Tom McClellan is their son. For more information, please contact Tom McClellan at (800) 872-3737, or visit the web site at http://www.mcoscillator.com . --------------------Check http://invest-faq.com/ for updates------------------ Subject: Technical Analysis - On Balance Volume Last-Revised: 27 Feb 1997 Contributed-By: Y. D. Charlap, Scott A. Thompson (satulysses at aol.com) On Balance Volume is a momentum indicator that relates volume to price changes. It is calculated by adding the day's volume to the cumulative total when the security's price closes up, and subtracting the day's volume when the price closes down. The scale is not of any value; only the slope (i.e., the direction) of the line is of value. The theory is that the trend of this indicator precedes price changes. This indicator was pioneered by that famous (?) market maven Joseph Granville. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Technical Analysis - Relative Strength Indicator Last-Revised: 17 July 2000 Contributed-By: (Original author unknown), Chris Lott ( contact me ), C. K. Krishnadas (ckkrish at cyberspace.org) The Relative Strength Indicator (RSI) was developed by J. Welles Wilder in 1978. This indicator is one of a family of indicators called oscillators because it varies (oscillates) between fixed upper and lower bounds. This particular indicator is supposed to track price momentum. Wilkder's relative strength indicator is based on the observation that a stock which is advancing will tend to close nearer to the high of the day than the low. The reverse is true for declining stocks. It's easy to confuse Wilder's relative strength indicator with other relative strength figures that are published. Wilder's indicator compares the price performance of a stock to that of itself and might be more appropriately called an "internal strength index". Other similarly named indicators compare a stock's price to some stock market index or to another stock. This indicator has evolved into several forms, but Wilder's RSI is generally regarded as the most useful. The oscillator is indexed from 0 to 100, and like all oscillators it indicates overbought and oversold readings. The RSI oscillator is most useful in a trading channel, especially those with deeply pronounced crests and troughs. Trending prices tend to distort overbought and oversold signals because indicator readings will be skewed off-center from a neutral reading of "50". Very basically, "buy" signals are considered to be readings of 30 or less (the security is considered oversold) and "sell" signals are considered to be RSI values of 70 or greater (the security is considered overbought). Depending on the technician and price volatility, there are various other qualifiers and nuances that can be incorporated into a signal. For example, in very volatile markets, the bounds of 20 and 80 might be used to judge oversold and overbought conditions. Another aspect of this indicator that is commonly varied is the period over which the indicator is calculated. Wilder began with 14 periods, but other values are common (e.g., 9 and 25). The formula is as follows: Average price change on up days Relative Strength = --------------------------------- Average price change on down days The indicator (RSI) is calculated from the RS value as follows: 100 RSI = 100 - ------ 1 + RS Now that you have the general idea, you probably want to calculate some RSI values for stocks you're following. Perhaps the easiest way is to visit one of the web sites shown at the end of this article. But if you're really determined to compute it yourself, here's one way to do so. RS = P / N P = PS / n1 N = NS / n2 PS = Total of PCi values NS = Total of NCi values PCi = positive price change NC = negative price change for period i for period i Pp = previous value of P Np = previous value of N (initially 0) (initially 0) n1 = number of times the price changed in the positive direction in the last n periods. There will be n1 PCi values to add together to get PS. n2 = number of timee the price changed in the negative direction in the last n periods. There will be n2 NCi values to add together to get NS. n = n1 + n2 (the number of periods in the RSI calculation) Basically you can calculate both PCi and NCi for every day. One or both of PCi and NCi will be zero. This makes it fairly straightforward to enter the computation in a spreadsheet. To make it easy to count the values in a spread sheet, use an "if" statement for each that will yield blank if appropriate. Then use Excel's count() macro, which counts only cells with numbers and ignores blanks. Here are the formulas; of course you will have to replace "this_price" and "previous_price" by approprate cell references. * PCi: IF( this_price - previous_price > 0, this_price - previous, "" ) * NCi: IF( this_price - previous_price < 0, this_price - previous, "" ) The first non-zero period of PS and NS is computed by doing a simple moving average of the PC and NC of the previous n periods according to Wilder's formula. Remember to skip the first n points before starting the RSI calculations. Also remember that the first time PS and NS are calculated, they are simple moving averages of the last n PC's and NC's respectively. That's where most mistakes are made. Here are some resources on RSI. * The May 2000 issue of AAII Journal included a 5-page article about RSI with examples (they have a two-week free trial membership). http://www.aaii.com * BigCharts offers a free interactive charting feature that includes (among many others) RSI. http://www.bigcharts.com * The original book by J. Welles Wilder New Concepts in Technical Trading Systems --------------------Check http://invest-faq.com/ for updates------------------ Subject: Technical Analysis - Stochastics Last-Revised: 25 Nov 1998 Contributed-By: (Original author unknown), Chris Lott ( contact me ) This article gives the formula for stochastics. The raw stochastic is computed as the position of todays close as a percentage of the range established by the highest high and the lowest low of the time period you use. The raw stochastic (%K) is then smoothed exponentially to yield the %D value. These calculations produce the original or fast stochastics. %K = 100 [ ( C - L5 ) / ( H5 - L5 ) ] where: C is the latest close, L5 is the lowest low for the last five days, and H5 is the highest high for the same five days %D = 100 x ( H3 / L3 ) where: H3 is the three day sum of ( C - L5 ) and L3 is the 3-day sum of ( H5 - L5 ) --------------------Check http://invest-faq.com/ for updates------------------ Subject: Trading - Basics Last-Revised: 6 June 1999 Contributed-By: Chris Lott ( contact me ) This article offers a very basic introduction to stock trading. It goes through the steps of buying and selling shares, and explains the fundamental issues of how an investor can make or lose money by buying and selling shares of stock. This article will simplify and generalize quite a bit; the goal is to get across the basic idea without cluttering the issue with too many details. In some places I've included links to other articles in the FAQ that explain the details, but feel free to skip those links the first time you read over this. You may know already that a share of stock is essentially a portion of a company. The stock holders are the owners of a company. In theory, the owners (stock holders) make money when the company makes money, and lose money when the company loses money. But in this age of internet stocks where companies lose lots and lots of money but the shareholders still make lots and lots of money, let's just say that the main trick is to buy only stocks that go up. Next we will walk through a stock purchase and sale to illustrate how you, an investor in stocks, can make money--or lose money--by buying and selling stocks. 1. One fine day you decide to buy shares of some stock, let's pick on AT&T. Maybe you think that company will soon return to being the all-powerful, highly profitable "Ma Bell" that it once was. Or you just think their ads are cool. So now what? 2. Although there are many ways to buy shares of stock, you decide to take the old-fashioned route of using an old-fashioned stock broker who has an office in your town and (imagine!) takes your phone calls. You open an account with your friendly broker and deposit some good old-fashioned cash. Let's say you deposit $1,000. 3. You ask your broker about the current market price quoted for AT&T shares. Your broker is a good broker, and like any good broker he knows that AT&T's ticker symbol is the single letter 'T'. He punches T into his quote request system and asks for the current market price (supplied from the New York Stock Exchange, where T is primarily traded), and out pops a price of 50 1/2. That's right, stock prices are quoted in terms of grade-school fractions instead of numbers with decimal points. But no matter, you were a good student in grade school and know that the price in dollars and cents is US$50.50. Looks like your $1,000 will buy almost 20 shares, but because this is your very first stock trade, you decide to buy just 10. 4. You ask your broker to buy 10 shares for you at the current market price. In the lingo of your broker, you give a market order for 10 shares of T. Your broker is a nice guy and only charges a commission on a single stock trade of $30 (not too bad for someone who takes your phone calls). Your broker enters the order, and his computer then figures the price you will ultimately pay for those 10 shares, which is 10 (the number of shares) times 50.50 (the current price for the shares on the open market) for a total of 505, plus 30 (the broker's commission, don't forget he has to eat too), for a grand total of $535. 5. Then magic happens: your broker instantly finds someone willing to sell you 10 shares at the current market price of 50 1/2, and buys them for you from that someone. Your broker takes $505 of your money from your account and sends it off to that someone who sold you the shares. Your broker also takes his $30 commission from your account. In the end, $535 of your hard-earned money is gone, and your account has 10 shares of AT&T. A (very small) fraction of the company, as represented by those 10 shares, is now in your hands! Now it's time for a few details, which you can safely skip if you choose. The person who sold you the shares was a specialist ("spec") on the NYSE; for more information, look into the NYSE's auction trading system . Roughly, a specialist is a type of middleman and a member (like your broker) of the financial services industry. After you give the order, the shares do not appear instantly; they appear in your account three business days after you gave the order (called "T+3"). In other words, trades settle in three business days. Please pardon a fair amount of oversimplification here, but the trade and settlement procedures involved with making sure those 10 shares come to your account can happen in many, many different ways. You're paying that commission so things are easy for you, and indeed they are: for a relatively modest fee, your broker got you the shares. It may be important to point out here that AT&T, that big company from Basking Ridge, New Jersey, did not participate in this stock trade. Sure, their shares changed hands, but that's all. Shares of publicly traded companies that are bought on the open market never come from the company. Further, the money that you pay for shares bought on the open market does not go to the company. Sure, the company sold shares to the public at one point (an event called a public offering), but your trade was done on the open market. After the trade settles, then what? Your broker keeps some of the $30 commission personally, and some goes to the company he works for. The shares are in your brokerage account. This is called holding shares "in street name." If you really want to hold the stock certificates, your broker will be happy to arrange this, but he will probably charge you about another $30. Since you feel you've paid your broker enough already (and you're right), you decide to leave the shares in your account ("in street name"). 6. The next day, AT&T shares close at a price of 52, which is a rise of 1 1/2. Great, you think, I just made $15 (10 times 1 1/2)! And in some sense you're right. The value of your holdings has increased by $15. This is a paper gain or unrealized gain; i.e., on paper, you're $15 wealthier. That money is not in your pocket, though, and you do not need to tell the IRS. The IRS only cares about actual (realized) gains, and you don't have any, not yet. 7. The following day, AT&T shares close at a price of 54 1/8, which is another rise over the price you paid and a rise of 2 1/8 over the previous day. Fantastic, you think, boy can I pick them, today I made another $21.25! At this point, you have a paper gain of 10 times 3 5/8 which is 36.25. Not too bad for two days. 8. That evening you decide that maybe AT&T really isn't such a great cable TV company after all and it's time to sell. You make a call the next morning, and although your broker is a bit surprised to hear from you again so soon, he's obliging (after all, it's your money). Again your broker asks for a quote of the current market price for 'T.' The current market price for AT&T on the NYSE is 55 1/2 (wow, another rise). Your broker accepts your order to sell T at the market. Again his computer figures the money you will receive from the sale: 10 (the number of shares) times 55 1/2 (the current market price) for a total of 555, less his commission of 30, for a grand total of 525. 9. Magic happens again: instantly your broker finds someone willing to buy the 10 shares of AT&T from you at the current price, and sells your shares to that someone. That someone sends you $555. Your broker deducts his commission of $30 from the proceeds of the sale, so eventually the shares of AT&T disappear from your account and a credit of $525 appears. Note again that the company did not participate in this trade, although shares (and fractional ownership of the company represented by those 10 shares) changed hands. As explained above, that someone was a person at the NYSE called a specialist ("spec"), a member of the financial services industry. The trade will be settled in exactly 3 business days (upon settlement, the shares are gone and you have the cash). Again I apologize for the oversimplification here. 10. So you calculate the result. Gee, you think, the stock went up every day.. and I paid $535.. but I only received $525.. and pretty quickly you come to the inescapable conclusion that you lost $10, even though you had a paper gain every day. This is the problem with commissions: they reduce your returns. You paid over 10% of your capital in commissions, so although the share price rose 10% in just a couple of days, you lost money because the commissions exceeded the gains. 11. Eventually you do your taxes. You have a short-term capital loss of $10 from this pair of trades. Depending on your tax situation, you may be able to deduct your loss from your gross income. Now you should understand the basic mechanics of buying and selling shares of stock, and you see the importance of commissions. Just for comparison, let's run the numbers if you had bought 20 shares instead of just 10 (maybe you found another few dollars in your pockets). The purchase price of (20 * 50.50) + 30 is 1040. The sales price of (20 * 55.50) - 30 is 1080. The difference is $40 in your favor. (Calculated differently, the difference was 20 * (55.50 - 50.50) - 60, or (20 * 5) - 60, which is $100 less $60 total commissions, for a net gain of $40.) What this says is that commissions can really hurt the small investor, and is a good reason for really small investors to consider investing via no-load mutual funds or direct investment plans (DRIPs) . --------------------Check http://invest-faq.com/ for updates------------------ Subject: Trading - After Hours Last-Revised: 12 Feb 2003 Contributed-By: John Schott (jschott at voicenet.com), Chris Lott ( contact me ), P. Healy, James Owens After-hours trading has traditionally referred to securities trading that occurs after the major U.S. exchanges close. Until 1999, after-hours trading in the U.S. was mostly restricted to big-block trading among professionals and institutions. Much of this sort of trading was supported by electronic trading networks (ECNs). One of the oldest and best known ECN is Instinet, a network operated by Reuters that helps buyers meet sellers (there's no physical exchange where someone like a specialist works). Another is Island ECN, a relatively new network that (interestingly) has applied to the SEC to be a new stock exchange. With the advent of these ECNs where trades can take place at any hour of any day, time and place have taken on a reduced meaning. Anyhow, until summer 1999, individual investors had no access to these trading venues. And it was only natural that some investors clamored for equal access to what the professionals had. Perhaps individuals felt that they would be able to pick up bargins in the after-hours trading as news announcements filter out and before stocks reopen on the following day. While that is highly unlikely (prices fluctuate after hours just as they do during the regular trading day), their wishes for equal access have been granted. As of early 2003, there are basically three types of before-hours and after-hours markets, as follows. U.S. exchange after-hour markets The NYSE and ASE provide crossing sessions in which matching buy and sell orders can be executed at 5:00 p.m. based on the exchanges' 4:00 p.m. closing prices. The BSE and PSE have post-primary sessions that operate from 4:00 to 4:15. CHX and PCX operate their post-primary sessions until 4:30 p.m. Additionally CHX has an "E-Session" to handle limit orders from 4:30 to 6:30p.m. Foreign exchange after-hour markets Several foreign exchanges also trade certain NYSE-listed stocks. Hours are governed by those individual markets. ECN after hour markets. Electronic communication networks (ECNs) have allowed institutions to participate in after-market trades since 1975; individuals joined the party in 1999. Typically, extended-hour trades must be done with limit orders. A short list of typical brokers that offer ECN access and the extended hours available is listed below. This list is meant to be illustrative, not exhaustive. * Ameritrade (via Island ECN) Hours: 8:00 a.m.-8:00pm Eastern, limit orders only during extended hours. * E*Trade (via Instinet ECN) Hours: 4-6:30pm Eastern * Fidelity (via Redibook) Hours: 7:30-9151m and 4:15-8:00pm EST; restrictions on order types. * Harris Direct (via Redibook ECN) Hours: 8-9:15am and 4:15-7pm Eastern; limit orders only; round lots. * Schwab (via Redibook ECN) Hours: 7:30-9:15am and 4:15-8pm Eastern, Monday - Friday; limit orders only. * TD Waterhouse (via ???) Hours: 7:30-9:30am and 4:15-7:00pm EST Most of the after-hours markets function as crossing markets. That is, your order and my opposing order are filled only if they can be matched (i.e., crossed). In an extreme example, the new Market XT requires ONLY limit orders. The concept of trading after exchange hours seems attractive, but it brings with it a new set of problems. Most importantly, the traditional liquidity that the daily market offers could suffer. I want to digress into a quick review of the mechanisms on the NYSE and NASDAQ that provide for liquidity and buffering, mechanisms that are mostly absent on the ECNs. In the case of the New York exchange, the specialist ("specs") there are required to act as buffers by buying and selling for their own accounts. This serves to smooth out market action. (Whether they do in times of stress is doubtful, but that's another matter entirely.) In the case of the NASDAQ, an all-electronic exchange, many firms may offer to "make a market" in a specific stock. They post buy and sell offers on a computer system and when there is a matching counter offer, the trade is made. Meanwhile, onlookers can see the trading potential of all available bid and ask quotations - a decidedly different situation than on the NYSE. But note that the NASDAQ system has no buffering built in (no market maker is required to buy or sell). Now, in the new, non-exchange operations with limited information, limited participation, and what is effectively unbuffered, person-to-person trading, it's quite reasonable to expect that liquidity will be poor. Unlike the NYSE's specialist system and the NAQDAQÆs market-maker system, where the daily market can readily accomodate small orders, the after-hours market will be quite different -- operations are quite literally in the dark. What we can see is effectively a reduction in apparent liquidity in normal trading as we slide down the trading scale (from the NYSE to the after-hours ECNs). On the NYSE there theoretically is always a bid and ask about the present market price, but may not be the case in less liquid markets. Ultimately, as seems to be the case on some ECNs today, we get to the basest market - you and I trading privately. Either we agree or there is no transaction. It can get to be a jungle. Furthermore, Instinet, Island and all the other ECNs don't have a common reporting structure as do NASDAQ and NYSE. That is, the prices and volumes on one ECN might be different from that on another ECN. Since only a few of the biggies have access to multiple ECNs there can be a chance for arbitrage, which means buying in one place at one price and selling substantially the same thing somewhere else for a different price, all in essentially the same time frame in the case of ECNs. The effect is widened spreads, irregular trading, and a chance for the unwary (read you and me) to get slightly whacked. There are other issues as well, of course. At night, the information resources and public attention that the established exchanges offer today will be operating at a low level. Today, Microsoft, Intel, or Dell likely make important announcements during the quiet hours after the exchanges close. That gives the investment community time to access and evaluate the news. Now drop the same announcement into an environment of several uncoordinated after-hours exchanges. Favorable news may create such demand that it overwhelms the supply offered by now reluctant sellers. Prices could zoom, only to crash back as more sellers show up. Lack of full information and considered analysis could make the daily gyrations of hot stocks like Amazon.com and new IPOs look boring. Making things yet less transparent, if I understand it correctly, trades made on these markets are not part of the reported closing prices you see in the newspapers. The data is apparently reported separately, at least on professional-level data systems. Finally, consider the effect on both the industry and private traders who now face an extended trading day. Presumably the extended day will offer even less time for reflection, research, and consideration. Do the pros stay glued to the tube while eating carryout? Do they employ a night shift to babysit things? And what about the day workers who now come home to an evening of trading stress? Thus expanded market hours may not be the blessing that some expect, only another hazard in today's stressful life. Meanwhile the SEC is pushing for some rules and regularity. To get the blessing as a recognized exchange, expect that the SEC will insist on a public ticker system (ultimately IÆd expect ONE unified quote system incorporating all of todays exchange's and the ECNs.) Logically, this leads to expectation of a unified market, and represents a significant threat to existing markets like the NYSE. Certain indications suggest that extended hours will become even more extended (possibly approximating a 24 hour market) in the foreseeable, though perhaps remote, future. In the past few years, market forces have constricted efforts to further extend trading hours, but a strong enough future bull market would almost certainly reverse that trend. Finally, the term "after-hours" trading is becoming rapidly out of date. Consider DCX (Daimler-Chrysler), which is traded in identical form on 11 worldwide exchanges in Asia, Europe, and the Americas. For this stock, the winding down of the day's trading in New York seems an anticlimax to a day that's already over in Tokyo. Here are a few more resources with information. * Instinet runs a site with some information about their operations. http://www.instinet.com * The Wall Street Journal gave an update on Friday, 27 August 1999 on the front page of the Money and Investing section. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Trading - Bid, Offer, and Spread Last-Revised: 1 Feb 1998 Contributed-By: Chris Lott ( contact me ), John Schott (jschott at voicenet.com) If you want to buy or sell a stock or other security on the open market, you normally trade via agents on the market scene who specialize in that particular security. These people stand ready to sell you a security for some asking price (the "offer") if you would like to buy it. Or, if you own the security already and would like to sell it, they will buy the security from you for some price (the "bid"). The difference between the bid and offer is called the spread. Stocks that are heavily traded tend to have very narrow spreads (as little as a penny), but stocks that are lightly traded can have spreads that are significant, even as high as several dollars. So why is there a spread? The short answer is "profit." The long answer goes to the heart of modern markets, namely the question of liquidity. Liquidity basically means that someone is ready to buy or sell significant quantities of a security at any time. In the stock market, market makers or specialists (depending on the exchange) buy stocks from the public at the bid and sell stocks to the public at the offer (called "making a market in the stock"). At most times (unless the market is crashing, etc.) these people stand ready to make a market in most stocks and often in substantial quantities, thereby maintaining market liquidity. Dealers make their living by taking a large part of the spread on each transaction - they normally are not long term investors. In fact, they work a lot like the local supermarket, raising and lowering prices on their inventory as the market moves, and making a few cents here and there. And while lettuce eventually spoils, holding a stock that is tailing off with no buyers is analogous. Because dealers in a security get to keep much of the spread, they work fairly hard to keep the spread above zero. This is really quite fair: they provide a valuable service (making a market in the stock and keeping the markets liquid), so it's only reasonable for them to get paid for their services. Of course you may not always agree that the price charged (the spread) is appropriate! Occasionally you may read that there is no bid-offer spread on the NYSE. This is nonsense. Stocks traded on the New York exchange have bid and offer prices just like any other market. However, the NYSE bars the publishing of bid and offer prices by any delayed quote service. Any decent real-time quote service will show the bid and offer prices for an issue traded on the NYSE. Related topics that are covered in FAQ articles include price improvement (narrowing the spread as much as possible), stock crossing by discount brokers (narrowing the spread to zero by having buyer meet seller directly), and trading on the NASDAQ (in the past, that exchange's structure encouraged spreads that were significantly higher than on other exchanges). --------------------Check http://invest-faq.com/ for updates------------------ Subject: Trading - Brokerage Account Types Last-Revised: 23 Jul 2002 Contributed-By: Rich Carreiro (rlcarr at animato.arlington.ma.us), Chris Lott ( contact me ), Eric Larson Brokerage houses offer clients a number of different accounts. The most common ones are a cash account, a margin account (frequently called a "cash and margin" account), and an option account (frequently called a "cash, margin, and option" account). Basically, these accounts represent different levels of credit and trustworthiness of the account holder as evaluated by the brokerage house. A cash account is the traditional brokerage account (sometimes called a "Type 1" account). If you have a cash account, you may make trades, but you have to pay in full for all purchases by the settlement date. In other words, you must add cash to pay for purchases if the account does not have sufficient cash already. In sleepier, less-connected times than the year 2002, most brokerage houses would accept an order to buy stock in a cash account, and after executing that order, they would allow you to bring the money to settle the trade a few days later. In the age of internet trading, however, most brokers require good funds in the account before they will accept an order to buy. Just about anyone can open a cash account, although some brokerage houses may require a significant deposit (as much as $10,000) before they open the account. A margin account is a type of brokerage account that allows you to take out loans against securities you own (sometimes called a "Type 2" account). Because the brokerage house is essentially granting you credit by giving you a margin account, you must pass their screening procedure to get one. Even if you don't plan to buy on margin, note that all short sales ("Type 5") have to occur in a margin account. Note that if you have a margin account, you will also have a cash account. An option account is a type of brokerage account that allows you to trade stock options (i.e., puts and calls). To open this type of account, your broker will require you to sign a statement that you understand and acknowledge the risks associated with derivative instruments. This is actually for the broker's protection and came into place after brokers were successfully sued by clients who made large losses in options and then claimed they were unaware of the risks. It's my understanding that otherwise an option account is identical to a margin account. Please don't confuse the type of account with the stuff in your account. For example, you will almost certainly have a bit of cash in a brokerage account of any type, perhaps because you received a dividend payment on a share held by your broker. This cash balance may be carried along as pure cash (and you get no interest), or the cash may be swept into a money market account (so you get a bit of interest). Presumably if you have a margin account, the cash will appear there and not in your cash account (see below for more details). It's an unfortunate fact that the words are overloaded and confusing. Margin accounts are the most interesting, so next we'll go into all the gory details about those. Access to margin accounts is more restrictive when compared to cash accounts. When you ask for a margin account, your broker will (if he or she hasn't already) run a credit check on you. You will also have to sign a separate margin account agreement. The agreement says that the broker can use as collateral any securities held in the margin account whenever you have a debit balance (i.e., you owe the broker money). Note that if you have a cash account with the same broker, securities held in the cash account (often non-marginable securities) do not help (nor can the broker sell them) if you have a debit balance in the margin account. Conversely, securities in the cash account do not count towards margin requirements. Another key feature of the margin account agreement is the "hypothecation and re-hypothecation" clause. This clause allows the broker to lend out your securities at will. So the ability to borrow money always comes with the trade-off that the broker can lend out ("hypothecate") securities that you hold to short-sellers. Although you will pay the brokerage when you borrow money from them, the brokerage house will *not* pay you (or in fact even notify you) if they borrow your shares. This seems to be just the way things work. Also see the article elsewhere in this FAQ about short selling for more information. As a general rule, a margin account will have all marginable securities, and a cash account will have all non-marginable securities. At some brokerage houses, non-marginable securities can be held inside a margin account (Type-2); however, those securities will not be included in the calculation of margin buying power. The insidious element here is that even though the non-marginable securities contribute nothing of value to the margin calculation, those same securities -- if there is even $1 of debit balance in the margin account -- will become registered as "type-2" by virtue of simply residing within a Type-2 acount, and, thus, can be made lendable to brokers for clients wishing to short-sell the stock. Having a margin account makes it possible to take a margin loan. You can use a margin loan for anything you want. The primary uses are to buy securities (called "buying on margin") or to extract cash from an equity position without having to sell it (thus avoiding the tax bite or the chance of missing a run-up). Some brokers will even give you debit cards whose debit limit is equal to your maximum margin borrowing limit (which is determined daily). The terms under which you borrow the money (i.e., the interest rate you must pay and the payment schedule) are determined by your portfolio. Subject to various rules on the amount you can borrow (discussed later), you just buy some securities and a loan will be automatically be extended to you. Or if you need cash, you just tell your broker to send you a check or you can use your margin account debit card. The interest rate charged is rather low. It is usually 0-2% above the "broker call rate" (which is usually at or below prime) quoted in the WSJ and other papers. It can change monthly, and possibly more often, depending on the details of your margin account agreement. It is probably lower than the rate on any credit card you'll be able to find. Further, there is no set payment schedule. Often, you don't even have to pay the interest. However, your margin account agreement will probably say that the loan can be called in full at any time by the broker. It will probably also say that the broker can demand occasional payments of interest. Your agreement will also give the broker the right to liquidate any and all securities in your margin account in order to meet a margin call against you. The interest rate is so low because the loan is fairly low-risk to the broker. First, the loan is collateralized by the securities in your margin account. Second, the broker can call the loan at any time. Finally, there are rules that set your maximum equity to debt ratio, which further protects your broker. If you fall below the requirements, you will have to deposit cash or securities and/or liquidate securities to get back to required levels. So you probably understand that it could be useful to get cash out of your account without having to sell your holdings, but why would you want to borrow money to buy more securities? Well, the reason is leverage. Let's say you are really sure that XYZ is going to go up 20% in 6 months. If you put $10000 into XYZ, and it performs as expected, you'll have $12000 at the end of six months. However, let's say you not only bought $10000 of XYZ but bought another $10000 on margin, and paid 8% interest. At the end of 6 months the stock would be worth $24000. You could sell it and pay off the broker, leaving you with $14000 minus $400 in interest = $13600 which is a 36% profit on your $10000. This is significantly better than the 20% you got without margin. But keep in mind what happens if you are wrong. If the stock goes down, you are losing borrowed money in addition to your own. If you buy on margin and the stock drops 20% in 6 months, it'll be worth $16000. After paying off the debit balance and interest you'd be left with $5600, a 44% loss as compared to a 20% loss if you only used your own money. Don't forget that leverage works both ways. The amount you can borrow depends on the two types of margin requirements -- the initial margin requirement (IMR) and the maintenance margin requirement (MMR). The IMR governs how much you can borrow when buying new securities. The MMR governs what your maximum debit balance can be subsequently. The IMR is set by Regulation T of the Federal Reserve Board. It states the minimum equity to security value ratio that must exist in your account when buying new securities. Right now it is 50% of marginable securities. This number has been as low as 40% and as high as 100% (thus preventing buying on margin). What this means is that your equity has to be at least 50% of the value of the marginable securities in your account, including what you just bought. If your equity is less than this, you have to put up the difference. The definition of marginable stock varies from one brokerage house to another. Many consider any listed security priced above $5 to be marginable, others may use a price threshold of $6, etc. Let's look at an example. If you have $10000 of marginable stock in your account and no debit balance [thus you have $10000 in equity -- remember that MARKET VALUE = EQUITY + DEBIT BALANCE, a variant of the standard accounting equation ASSETS = OWNER'S CAPITAL + LIABILITIES], and buy $20000 more, your market value including the purchase is $30000. Your initial required equity is 50% of $30000, or $15000. However, you only have $10000 in equity, so you have a $5000 equity deficit. You could send in a check for $5000 and you'd then be properly margined. Let E and MV be equity and market value immediately after the purchase, respectively (but before you make arrangements to be properly margined). Let the equity deficit ED be the difference between the required equity (which is MV*IMR) and current equity (E). Let E1 and MV1 be equity and market value, respectively, after making arrangements to be properly margined. The initial requirement means that E1/MV1 >= IMR. Let C, S, and L be the amount of a cash deposit, a securities deposit, and a securities liquidation, respectively. 1. You deposit cash: E1 = E + C MV1 = MV So you need to solve (E+C)/MV >= IMR for C. 2. You deposit securities: E1 = E + S MV1 = MV + S So you need to solve (E+S)/(MV+S) >= IMR for S. 3. You sell securities: E1 = E MV1 = MV - L So you need to solve E/(MV-L) >= IMR for L. Using ED [which we previously defined as (IMR*MV - E)], the answers are: 1. C = ED 2. S = ED/(1-IMR) 3. L = ED/IMR If ED is negative (you have more equity than is required), then that makes C, S, and L negative, meaning that you can actually take out cash or securities, or buy more securities and still be properly margined. So, now you know how much you can borrow to buy securities. Having bought securities there is now a MMR you have to continue to meet as your market value fluctuates or you pull cash out of your account. The MMR sets the minimum equity to market value ratio that you can have in your account. If you fall below this you will get a "margin call" from your broker. You must meet the call by depositing cash and/or securities and/or liquidating some securities. If you do not, your broker will liquidate enough securities to meet the call. The MMR is set by individual brokers and exchanges. The MMR set by the NYSE is 25%. Most brokers set their MMR higher, perhaps 30% or 35%, with even higher MMRs on accounts that are concentrated in a particular security. The MMR calculations are very similar to the IMR calculations. In fact, just substitute MMR for IMR in the above equations to see what you'll have to do to meet a margin call. However, here a negative ED does NOT necessarily imply that you can make withdrawals -- the IMR rules govern all withdrawals (though the Special Memorandum Account (SMA) adds some flexibility). For more details and examples of margin accounts, see the FAQ article about margin requirements . --------------------Check http://invest-faq.com/ for updates------------------ Compilation Copyright (c) 2003 by Christopher Lott.