What is the Stock Market?

Bulls and bears, Dow and Nasdaq, bubbles and crashes, Greenspan and economic numbers. You've probably heard these terms as well as many others associated with the stock market but do you really know what it is? Why do we have one? This course will answer all your questions on this mysterious system that has created fortune as well as ruin.

Public and Private Companies

In order to understand why we have a stock market, it helps to understand some basic forms of business. If you start a business, there are several routes you can take. First, you can start a private company and there are many forms it could take. The simplest is called a sole proprietorship. This is typically the way that many small, mom and pop, corner stores are formed. The owner makes all the decisions and reaps all the rewards. Sole proprietorships are the cheapest to form and easy to dissolve. However, they have a big disadvantage in that they expose the owner to potentially unlimited liability. The owner is legally responsible for all debts and even has personal assets exposed if a big enough lawsuit should arise. Sole proprietorships also have difficulty in raising funds to start or operate the business and are often limited to using their own savings or small business loans.

In order to overcome some of the disadvantages with sole proprietorships, entrepreneurs sometimes start a partnership. These are businesses that are run by two or more people. By allowing others into the business, they have greater access to money and diverse talents to run the company. But just like a sole proprietorship, partnerships have unlimited liability. What's worse is that partnerships are liable for the actions of other partners. If you start a partnership and one partner orders lots of inventory on credit and flees the country, you and the other partners are liable for his actions. Also, partners may disagree on how to run the business, which can result in a lot of time wasted resolving issues rather than running the day-to-day activities.

The major drawback to each of these forms of ownership is the unlimited liability to which the owners are exposed. In order to resolve that problem, corporations were created. Corporate owners usually have limited liability, which is usually limited to the amount they have invested into the company. When the corporation is formed, shares of stock are issued and you sell these shares to those you want to be owners. If you can only buy shares through other owners of the corporation, then it is privately held, or a private corporation.

Because owners can always issue more shares, another nice benefit of corporations is that they can easily raise additional money by selling shares of stock. By selling shares, they bring in money in exchange for having to split the profits with more owners. While splitting profits is not a good thing, raising additional capital certainly is. It's possible that, by taking on additional owners, the corporation becomes bigger and stronger thus making all owners are better off. Another reason that owners may desire to sell shares is to diversify their holdings. What does this mean? An example will help to illustrate. Assume that your family owns an expensive Renoir painting worth $5,000,000. You want to keep it in the family as it is has drastically increased in value and is expected to continue to do so. At the same time, there is risk in holding it. It could get stolen, lost in a fire, or the art market could collapse and drive its price down well below the current value. How can you protect yourself from having so much wealth wrapped up into one thing without having to sell it? One way is to offer a fraction of the painting for sale. You may, for example, offer an investor a 1/10th ownership in the painting in exchange for money, say $2,000,000 cash. All you have to do is have a contract drawn that states that the owner of the contract owns 10% of the painting and then sell them the contract. You get immediate possession of the cash and still get to keep 90% of all future increases in the painting. In the worst case scenario, the painting gets destroyed but at least you have $2,000,000 cash to show for it. That's the idea behind diversifying assets - giving up some of the future gains in exchange for reducing the risk of holding it. When Bill Gates started Microsoft, he was confident it would be a huge success. Why would he offer part of the company for sale? Because he didn't want all of his future wealth sitting in one company. He was more comfortable in selling some of the company in exchange for cash.

With the Renoir painting example, notice that the contract you have drawn up states that this new person has a 10% stake, or share, in the value of the painting. And this is exactly what a share of stock designates. A share of stock is simply a certificate printed on a piece of paper - a contract - that states that the owner is entitled to their share of the profits in the corporation.

Assume that the 10% Renoir painting owner, at a later time, needs the cash and cannot wait until the painting is sold. Even though the painting has not been sold, the contract, or 10% share, certainly has value. He could sell that 10% ownership to someone else at whatever price they can agree upon. Notice that your family would never get any of this money. You sold the 10% share for two million dollars and that's all you will ever get from it. However, there could be many other owners, hundreds or thousands, which keep selling that same certificate. Whether they make gains or losses is of no consequence to your family; the two million is yours to keep and that's all you will get. Your family just knows that it owes 10% of the profits to whoever is holding that certificate and it doesn't really matter who that person is.

Problems with Selling

Okay, the idea sounds good so far but there is a problem. If you are the one holding the 10% certificate, how easy will it be for you to find a buyer? Will you have to go knocking on doors? Will you have to take out an expensive ad in the Wall Street Journal? And if you can't find a buyer quickly, you may have to drastically reduce your price in order to entice someone to buy. This means there could be a great deal of value lost between what you think the certificate is worth and what you actually get from selling it.

There is another problem created by not readily finding buyers. That is, how much is the certificate worth? If the first person offers you $2.5 million, is that a fair price? If there is no trustworthy, accurate way to determine a fair price, then you will probably have to settle for less than you think it is worth. And If it's difficult to find buyers, it's not going to be easy being a seller. If there is no easy way for others to sell the 10% certificate at a later time, your family may not be able to get the $2,000,000 they think the certificate is worth. If potential buyers think they will be stuck holding it, you won't be able to sell it. This problem extends to the buyers: If you are in the market to become a part owner of an expensive painting, how can you find a seller? Will you have to go knocking on doors or take out an ad in the Wall Street Journal?

Centralized Meeting Place

The two problems we face then are 1) Finding buyers and sellers and 2) Determining the value of the certificate. In order to get rid of the first problem, it would be nice to have a centralized "meeting place" where all buyers and sellers could get together. To overcome the second problem, we'd need a way for all buyers and sellers to broadcast their opinions as to the value of the certificate. Well, we do have such a system in place, and that is called the stock market. It is a market for selling stock certificates of publicly traded corporations, which we'll talk about in the next section. At any given time, you can find buyers and sellers for all publicly traded companies at one location. In addition, you can look up the price of any publicly traded company to see the price at which people are willing to buy and sell. It is nothing more than a live auction house where the public can participate in the buying and selling of shares. Having a centralized meeting place where people can line up to buy or sell and broadcast prices is always a beneficial from an economic perspective. You can think of eBay as a modern day version of a stock exchange. They are an online auction company, which allows individuals to sell nearly anything. Here's why eBay is economically beneficial. Assume you have a camera you'd like to sell - maybe a Nikon F1 camera. How much is it worth? Prior to eBay, you'd have no way of knowing. To find out, you might ask a local camera shop owner or a few friends who know about cameras. But their opinions are a far cry from knowing what the world thinks it is worth. Even if the camera shop owner offers to buy it, he will have to bid far less than it is worth so that he can mark it up and sell it. So this presents a dilemma for you. Do you sell it at an unfavorable price or do you just let it sit in the closet and never use it? Notice that it takes a lot of work to gather information if you wish to get a good price. You can either travel all over town gathering opinions or you can take your chances by selling to the first person willing to buy it. That does not sound too efficient. But now you can just go to eBay and type "Nikon F1" and see what the world is willing to pay for that model. Nearly every buyer of used cameras will be watching the site, which means that all sellers will show up too. Whenever you have all buyers and sellers in one place, you've gotten rid of all the problems we would otherwise encounter. Larger numbers of buyers means that they must compete and bid prices higher, which is good for you as a camera seller. At the same time, other camera sellers will be present, which means they must compete by offering lower prices and that is good for the buyers. When people are confident in prices, they are eager to transact. And that's the idea behind a centralized meeting place and the very reason we have a stock market.

Publicly Traded Companies

A publicly traded corporation is one where anybody can be an owner. Unlike a private corporation, you do not need to be an insider or know one of the owners in order to participate. For example, the package courier United Parcel Service (UPS) used to be a privately held corporation. The only way to own shares was by being an employee. A share of stock traded through the company is called the primary market.

But that all changed in 1999 when they decided to "go public," which simply means UPS began offering their shares to the public through the stock market. They were now a publicly traded company. By going public, they greatly increased the ease and speed at which they could convert their shares to cash. Investors are also more willing to buy the shares since they are now confident that they have an outlet to sell. More buyers mean higher selling prices for the owners. Another benefit of becoming publicly traded is that UPS can always raise more cash by simply issuing more shares of stock. But the tradeoff to all of these benefits is that UPS is now publicly exposed. They must publicly announce earnings, outlooks, and many other data that they previously tried to keep away from competitors.

If you buy shares of Microsoft, you are buying a piece of the company; you are a part owner of Microsoft! Many people think that Bill Gates owns Microsoft and that's not true. He owns the majority of the shares so that he still controls the final decisions of the company; however, if you even own one share of Microsoft, then you are technically a partner of Bill Gates.

Figure 1: Microsoft Stock Certificate

Unlike the 10% certificate in the Renoir painting example, stock certificates do not state 10% or some other number. Instead, they just state the number of shares they are worth. Your percentage ownership is determined by how many shares you own relative to how many are issued by the corporation. If a corporation has 1,000,000 shares available for sale and you own 100,000 shares, then you are a 10% owner and are entitled to 10% of the profits. If you own 100 shares, then you own 1/100th of 1% of the company.

Taking it Public

When a company first offers its shares for sale to the public, it is called an initial public offering, or IPO. Shares sold on the IPO are called the primary market, since those are shares traded through the company. It is the only time that the company receives money from the transaction much like your family did in the painting example when they first sold the 10% Renoir certificate. IPOs are often met with much fanfare since there is often a lot of buying pressure on the opening day and the stock's price can increase quickly. In 1995, the web browser company Netscape had its IPO and was priced at $28 per share. That means that all the people who were able to get into the IPO paid $28 per share. However, the first trade of the day on the secondary market was around $75! IPOs often are often associated with wild price swings, up and down, largely due to big discrepancies between the number of buyers and sellers.

Any sales of those stock certificates after that point are out of the control of the issuing company. They are traded on the secondary market, which is the stock exchange. If you wish to buy shares of stock such as Microsoft, IBM, Intel, or any of the other hundreds of names you're familiar with, you are trading them through the secondary market. In other words, you are not getting those shares directly through the company; instead, you are buying from other investors. The secondary market is similar to the used car market. When Ford sells a Mustang to a dealership, Ford collects the money for that car. That's similar to the IPO market. Once that car is sold by the dealership though, it is on the secondary market and can be resold numerous times and Ford never sees a penny of that money.

Benefits of Secondary Markets

Why have secondary markets? Wouldn't Microsoft be better off by only allowing investors to buy through them? That's a big myth in many market places. Fortunately, many businesses are discovering that they are better off with a secondary market. For example, you can buy new books through Amazon.com. Recently though, they allow anybody to sell used books through their site. Why would they allow you to compete with them on their own site? If the used books weren't there, wouldn't you be forced to buy a new book through Amazon? The answer to that is not so easy to see but it turns out that Amazon is better off by allowing you to compete. For example, assume you find a book you'd like to have but it's rather expensive and sells for $60 new. Because of the high price, Amazon will sell fewer of these books as compared to the lower priced books. However, if you can buy the book for $60 and possibly sell it for $40 when you're done, then your cost is only $20, which means you're now more likely to buy it. But where will you sell it? Now you see why Amazon offers a secondary market. It encourages others to buy new books through them. Overall, Amazon's profits will rise by offering a secondary market, which at first glance, may seem counterintuitive. Car dealers do the same thing. Why does your local dealer have used cars on their lot? Wouldn't they be better off "forcing" you to buy a new one? By creating a secondary market, they are encouraging others to buy new cars since they now have an easy way - a secondary market - to sell it if they wish.

Stock Markets Make it Easy for Corporations to Raise Money

The biggest benefit of having a well-run stock market is that it makes it easy for corporations to raise money. The formation of capital is one of the most important functions of the stock market. For example, when Bill Gates started Microsoft, he could have walked door-to-door pitching the benefits of his idea, trying to get investors to buy into it. But who would hand over a sizeable check to a total stranger? You're starting to see the idea that it would be very hard to get the big companies, the ones that run America, off the ground. Instead, Bill Gates can file with the Securities and Exchange Commission (SEC) stating that he wants to start a publicly traded company. He can also state how many shares he's willing to sell. In fact, Microsoft had its IPO in March, 1986 and sold 2.8 million shares for $21 per share. Who did they sell them to? Microsoft will seek out an underwriter for the deal. In this case, it was Goldman Sachs that landed the deal. Goldman Sachs can quickly raise capital by reaching out to all of their account holders who agreed to pay $21 per share. That amounted to an instant check for $58,800,000 for Microsoft. In this case, Goldman Sachs acts like the Ford car dealership that cuts a large check to the Ford factory. In turn, Goldman's clients get to either hold the shares or can immediately sell them (usually at a hefty profit) on the secondary market. The point is that in a relatively short time and very efficiently, Microsoft created nearly 59 million dollars for them to grow. In return, they split the company into 2.8 million pieces and have to share to profits among all those owners. Yes, that's a lot of pieces but it can still be profitable. If you had purchased 100 shares at $21, you'd have 28,800 shares at $28, or a total of $806,400. (The increase in shares from 100 to 28,800 is due to stock splits. So even though the $28 price isn't very different from your original purchase price of $21, your total profit is enormously higher.)

Again, one of the reasons that investors were willing to pay $21 per share is because they knew there was a secondary market. If they wanted to sell, they could immediately see the going price of Microsoft and sell their stock within seconds. All they had to do was pull up a quote and place a trade through their broker. The stock market creates a way for every investor in the world to see exactly what the price is of a publicly traded share of stock. It is the eBay for shares of stock. No more knocking on doors or wondering if there's someone out there willing to pay more. The stock market, therefore, makes it very easy for large corporations to form, which in turn creates jobs. It is the quick formation of capital that allows the U.S. economy to grow strong. In fact, the presence of a well-functioning stock exchange is one of the factors that separate developed countries from the rest. Many small, lesser developed countries have great resources, products, or ideas to export but they just can't raise the money to get them off the ground.

Martha Stewart

You've probably heard about the Martha Stewart case where she was sent to prison for "insider trading," which means she was selling shares of stock based on information that was not publicly available. Actually, she didn't get pinned for the illegal sale but rather for lying to the authorities about it. They weren't able to prove the insider trading so they went after her for her dishonest statements about the sale. Many people wonder why we bother to prosecute someone for such a "victimless" crime. After all, who cares that she sold her shares illegally? She's a good citizen and has created lots of jobs so leave her alone. Hopefully, you're starting to see why it's not a victimless crime. Her dishonest sale undermines the confidence that investors have in the markets and that means people aren't going to be so willing to buy and sell anymore. If that happens, corporations cannot raise money and ultimately our entire financial system would collapse. If you don't believe it, think about this: What would happen if nobody was ever prosecuted for insider selling? What if it was perfectly legal to do? Martha Stewart walks out of prison and the general public is very happy to hear that we've all come to our senses.

Now assume that you invest $100,000 for your kids' college and to buy a new house in the future. You invest it in the biggest and best performing stock that we've seen in decades since you don't want to take a lot of risk. Three months later, your investment is worth pennies - your $100k is gone. It turns out that you invested in a company called Enron. How were you able to get such a good deal on the shares? The insiders knew the company was collapsing and were dumping their shares so that YOU would be left with the damage. They needed to unload those shares so they could maintain their 60-room mansions while your family is devastated. You decide to never touch the stock market again - and so does everybody else. That's why the authorities went after all the Enron insiders as well as Martha Stewart. If you shake the confidence in the market, then no more corporations are created. In fact, the corporation you may work for now could go under if it is not able to raise new capital by selling shares.

Confidence is a necessary ingredient to make the system work. That's why eBay gives users the ability to leave feedback about every transaction with each person. If you have no idea about the reliability of the other person, or heard that most of the items for sale are scams, would you trade through eBay? The ability to leave feedback allows eBay to weed out the bad users and keep the good users and is one of the main reasons it works.

So while Martha Stewart is not a "hardened criminal" nor a threat to society, her prison stint serves as a warning to other insiders who may decide to shake investors' confidence and undermine the money machine that funds America. When you think about it, it's kind of ironic that she attempted to weaken the very system that made her a billionaire.

New York Stock Exchange vs. Nasdaq

There are several stock exchanges and each one operates a little differently but the ideas are the same. The two most popular are the New York Stock Exchange (NYSE) and the Nasdaq. The NYSE, also called "The Big Board", operates as a live auction market where people shout buy and sell orders received from brokerage firms. The Nasdaq is a computerized system that links many "market makers" together. It is purely an electronic system with no trading floor. In fact, NASDAQ was an acronym that stood for "National Association of Securities Dealers Automated Quotations". However, in recent years, it has become recognized as an entity and the spelling has shifted from the all-caps spelling to Nasdaq. To make a comparison, the NYSE is similar to attending a live auction such as at Sotheby's while the Nasdaq is similar to eBay, which is an auction conducted through computer links.

Every publicly traded company has a unique symbol that identifies its shares. If that symbol contains three letters or less, it is traded on the NYSE. If it contains four or more, it is traded on the Nasdaq. For example, IBM Computer trades under the symbol "IBM" and that tells you it's traded on the NYSE. Microsoft, on the other hand, trades under "MSFT," which means it trades through the Nasdaq. There are some pros and cons to each exchange but they mostly apply to the corporations themselves rather than to investors. Years ago, it used to be prestigious to be listed on the NYSE because of the tougher listing requirements. Many new companies start trading on the Nasdaq but shifted to the NYSE once they met the new requirements. But that impression is fading. Most corporations that start on Nasdaq just end up staying there no matter how big they get. In fact, the NYSE still reserves the symbol "I" and "M" in hopes that Intel and Microsoft will list with them in the future. It hasn't happened so far and Intel continues to trade under "INTC" and Microsoft under "MSFT" on the Nasdaq.

Most quotation systems will bring up quotes from either exchange and you don't need to tell it the exchange where it is listed. All you have to do is type in the symbol of the company and it immediately shows you what the price of that certificate is at that moment in time. Unlike most prices, stock prices are never constant. The price you see right now will likely be a little different one minute later.

Hopefully you now have a better understanding of what the stock market is and why we have one. It is a centralized meeting place where buyers and sellers can trade shares of publicly traded companies. This secondary market creates investor confidence, which allows corporations, new or existing, to raise money. If you wish to become part owner of a public company, you can pull up a quote and see the going price. In a matter of seconds, you can either be a part owner or sell your share in the company to someone else.

Types of Investments

In the previous course, you learned that all investments carry different levels of expected reward. Those differences are strictly due to the different risks associated with each asset. This course discusses various types of investments and the associated risks and rewards. While this is not an exhaustive list, it does cover most of the assets you will ever come into contact with while you're building your portfolios.

Stocks

Stocks are one of the most common ways to invest in the capital markets. When people talk about buying or selling stock, they are usually talking about the "common" shares of stock as opposed to the "preferred" shares that we'll talk about in the next section.

When you buy common stock, you own a piece of the company. If you buy shares of Microsoft, you are actually part owner of Microsoft. Your percent ownership depends on how many shares you own in comparison to how many shares are available. For example, at the time of this writing, Microsoft has about 9.3 billion shares outstanding. If you own 100 shares of the company, you therefore own 100/9.3 billion percent of the company (which is nearly nothing). Regardless, you are technically in partnership with Bill Gates.

Benefits

There are several benefits in owning stock. First, you have the potential for unlimited gains. There is no limit to the value of a company and, as part owner, you participate in all future gains of the company.

Second, as a stock owner, your risk is limited to the amount you have invested. While the investment may be large, the limited risk feature is a nice benefit. Just ask any of the CEOs of Enron. If you bought stock in Enron, you may have lost a significant portion of that investment but you will never serve jail time or be forced to pay restitution to other investors as an insider to the company.

Another benefit is that many stocks pay dividends. In fact, even if they don't pay one now, they theoretically must at some time and that's actually what gives a stock its value. If a company were formed that never had to return any money to investors, it would be a financial black hole and would be completely worthless.

Drawbacks

Stock prices can be quite volatile so you're never really sure what your investment will be worth from day to day. It is this uncertainty that is probably the biggest drawback in owning stocks. For example, the drug manufacturer Merck recently faced a precipitous fall when they announced the withdrawal of the widely anticipated drug Vioxx. You can see the impact of the news in the following chart:

One day the stock was worth $45, the next day it fell below $33, which represents more than a 25% drop in value in one day. Price swings like this can be devastating. Imagine that you had a significant amount of money invested in this stock and needed that money for a down payment on a new home. Stock price swings can create - as well as destroy - wealth and that's why it's best to not put a significant portion of your wealth into any single stock - no matter how promising the reports may sound.

Another drawback is that it's much harder to understand individual company valuations and prices. Is Merck a good deal after it hit $33? Or is it going to fall further? There are so many factors that form the stock's value and it's tough to say which price represents a good buy - and which do not. And even if you have a grasp as to what value is right for a stock, you are still subjected to the risk that an insider is manipulating the books to make the company appear in better financial shape than it is.

The selection process for stocks is difficult too. There are nearly 10,000 stocks to choose from - which is right for you? To complicate it further, even if you do narrow down the list to a select few stocks, you must still monitor news, company reports, economic numbers, political environments, and industry trends to find determine if you should continue holding that stock. Proper stock analysis is very tough work.

While the rewards for owning stocks can be great, the most important consideration is the risk. It's because of these drawbacks that you shouldn't put a significant amount of your money into a single stock.

Historical Returns

The amount you make on your money is called a return. If you invest $100 and end up with $110 in one year, then your return is 10%. Investors love to look at statistics of "historical returns" as a way to measure what to expect in the future. For stocks, if you were to look back over the past 75 years or so, you'd find that the stock market has returned about 10% per year, on average. As with any average, there are fluctuations around that 10% number; some years returned far more than that while others actually lost money (had negative returns). So if you had invested in 1926 and held through 2001, you'd find that your money grew an average of 10% per year. Many investors use this benchmark as a predictor and assume that, if they hold for long periods of time, they will earn at about the same rate. Unfortunately, that's a misleading assumption. That 10% figure includes the effects of inflation, which we must back out of the equation if we're to compare apples to apples. Inflation during this period was about 3% per year, so the adjusted rate of return is more along the lines of 7% per year. This 7% figure is what economists call the "real return" since it more accurately measures the changes in your purchasing power and not the total number of dollars that you own.

There is another danger in using historical returns if you're selecting stocks as an investment vehicle. That is, these historical figures are based on a basket of stocks, that is, a large index such as the S&P 500 index. If you are buying only a few stocks, the 7% figure is even less likely to hold. Why? Because there's more risk. And if there's more risk, you're either going to end up with a much higher return - or much lower. The point is that you need to understand that historical returns do not necessarily apply to individual stocks. They are more representative of large baskets of stocks.

Risk

There are many ways to measure the risk of a stock. While it is probably safe to say that all stocks are risky, we need a way to measure the relative amounts of risk. Remember, when we speak of risk, we are talking about price instability, which is often called "volatility" by market professionals. If a stock is volatile, then that means its price tomorrow is likely to be very different from its price today - whether higher or lower. One way that investors use to assess the risk is to look at the Price to Earnings Ratio, or P/E ratio. If a stock is trading for $20 and earned 50 cents per share last quarter, the P/E would be $20/0.50 = 40. This P/E ratio would be considered relatively high since the historic levels hover around 14 to 16. The P/E ratio shows how much investors are willing to pay for one dollar in earnings. In our example, investors are willing to pay 40 times earnings, or 40 * 50 cents = $20 for the stock. While this ratio may appear to be high, we must really look at the industry averages rather than the overall average of 14 to 16. Some industries may command higher P/Es so it's not really fair to automatically assume that 40 is out of line. The more optimistic that investors are about the company, the higher amount they are willing to pay for one dollar of earnings and the P/E ratio rises in response.

Another measure of risk is more complicated and is called "beta." Beta is a measure of how a stock's returns measure up against a broad-based benchmark, which is usually the S&P 500 index. The S&P 500, by definition, has a beta of one. A stock with a higher beta rises and falls more rapidly by a factor of beta. A stock with a beta less than one will rise and fall less severely than the overall market. A stock with a beta of one is expected to mirror the overall movements of the market.

For example, assume that ABC stock has a beta of two while XYZ has a beta of one-half. If the S&P 500 rises 10% then we would expect ABC to be up 20% and XYZ up 5%. In other words, ABC returns at twice the rate while XYZ returns at half the rate of the broad based market. At first glance, it seems that high beta stocks are more desirable but, of course, the benefit of high betas can also destroy. If the S&P 500 falls 10%, then ABC is expected to fall 20% while XYZ is only expected to fall 5%.

Beta is calculated by using long-term averages and correlations. It does not mean, for example, that ABC must rise or fall by twice the amount of the broad-based market. It just says that ABC typically moves at about that rate. As market conditions and company outlooks change, so can beta. Just because your stock starts with a particular beta does not mean it will always stay there. Betas are a good way to determine if the stock you're investigating tends to move more or less than the overall market. The higher the beta, the greater the risk.

Why Buy

If stocks are so risky, then why do people buy them? The reason is usually for long-term returns. While there are no guarantees, if you wish to make money in the stock market, you need to have some exposure to stocks. People who invest for longer term reasons such as home buying, college, or retirement, will almost have to have some money tied to stocks.

How to Buy

Stocks are among the easiest assets to buy especially now with the Internet. All you need is an account with a brokerage firm and you're set. Most people buy shares in what are called "round lots" of 100 shares. The main reason is that it used to be far more expensive to buy fewer than 100 shares at a time but, with today's technology, that's not really true anymore. Most firms charge very low commissions, sometimes as little as $5, and they don't care if you buy one share or thousands. So don't think that you must buy in round lots. The better choice is to invest a dollar amount that you're comfortable with and let the share amount fall where it may. For example, if you have $5,000 to invest and want to buy a stock trading for $62, then buy $5,000/$62 = 80 shares. Don't spend your time looking for a stock trading for $50 just so you can buy 100 shares. That's letting the tail wag the dog. Instead, find companies that you're comfortable holding. The reason is that your money doesn't care how many shares are represented; it is only concerned with the return on that money. If your stock rises 10%, you will have $5,500. If it rises 20%, you will have $6,000. Notice that we do not need to take into account the number of shares! The only factor that matters to your money is the performance, or the return, of the stock - not on how many shares you own. Focus on the quality of the company and not the number of shares you can afford.

Settlement/Liquidity

Stocks are generally considered very liquid, which simply means that you can buy or sell large dollar amounts without too much disruption in price. If you should need to withdraw a large amount from the market, you can do so quickly. However, if you sell shares of stock, there is a three-day waiting period for the money, which is called the settlement period. (Stocks used to have a five-day settlement but that was changed to a three-day settlement period in the mid nineties.) For stocks, the settlement period is now trade date plus three business days, or T+3. This means if you sell a stock on Monday, the money will be available three full business days later, or Thursday, assuming that none of the other days are holidays. So if you need to have cash out of the market by a certain day, be sure to take into account the settlement period. You'll need to sell the securities three business days before you need the money.

This settlement period also works for when buying stocks. If you wish to buy stock, most brokers will allow you to place the order without the money in the account. The reason is that you have three days to deliver the funds to the broker in order to meet settlement. Buying and selling stock is very easy. Once you decide on which stock you want to own, you can execute the order within seconds over the telephone or through the Internet.

Variables that Impact Price

There are many factors that cause stock prices to rise and fall and it's probably impossible to name them all. However, if you're a stock investor, there are several factors that you'll want to keep a close watch on.

First, make sure you follow company news and analyst ratings. You can find this information on nearly any quote service for no charge. The company news can keep you abreast of changes in the company such as earnings, new products, outlooks, and other information that will either confirm your reasons for buying the stock - or make you take a second look. Stock analysts follow select companies much closer than we ever could. They are privy to CEO conference calls and know nearly everything about what's going on with the company and industry. If they lower their ratings on a stock, you'll want to find out why, which can usually be found in published reports.

Interest rates are another important factor for stock prices. As interest rates rise, stock prices generally fall. While there are many explanations for this, the easiest is perhaps to realize that companies make money by spending money to create something of value. Whether it's building a new factory or just replenishing inventory, higher interest rates make it more costly for them to produce and that lowers their bottom line profits. As profits shrink, so does the value of the company. Of course, there may be companies that benefit from higher interest rates but overall, you will find that stock prices fall as interest rates rise.

Inflation is another factor to watch. If inflation is on the rise, you can bet that stock prices will fall for much the same reason as when interest rates rise. Inflation is nothing more than a rise in the general price levels. As price levels rise, then the bottom lines of corporations fall and so does their value.

Preferred Stock

A preferred stock is one that has priority over common stock on the distribution of earnings and assets. So if a company goes bankrupt, the preferred stockholders get paid before the common shareholders. Preferred stock actually works like a blend between common stock and a bond. If you buy a preferred stock, you receive a stated dividend at a specified interval (usually quarterly) for as long as you own the preferred stock. The company is not required to make these payments but, if they do, they must make them to the preferred shareholders before any money can be paid to common stockholders. Preferred stocks can be subdivided in to cumulative and non-cumulative. If you own a cumulative preferred and the company misses a payment, they must make up all past payments to the cumulative preferred holders before any payments can be made to the non-cumulative holders. (However, all preferred stocks, whether cumulative or non-cumulative, are subordinate to bonds). If you own a non-cumulative preferred and a payment is missed, then you're likely just out of luck and will never see that money.

Preferred stocks are usually issued by capital intensive companies such as utilities, airlines, automotives, and other large manufacturing businesses. Preferred stocks move in price more like a bond and are very responsive to changes in interest rates rather than company specific news. For example, if a significant announcement is made regarding the company, the common shares may spike through the roof whereas the preferred shares may just stay the same. The reason is that preferred holders do not get claims to future earnings other than their expected dividend payments. As long as the company appears solvent enough to continue making those payments, the preferred shares will stay about the same price. However, if interest rates move significantly, then you may see significant price changes in your preferred stock. For example, if you are holding a 10% preferred stock and interest rates fall, then on a relative basis, your 10% cash stream is more attractive since it will be harder to find those investments now that interest rates are falling. Investors will then bid up the price of the preferred stock. The reverse is true too if interest rates rise. As interest rates rise, investors will find investments with higher and higher returns and will be less interested in the 10% return, which means that the price has to be lowered to make it equally attractive as the new higher rate issues.

The point is that you should not buy preferred stock if you are expecting to profit from the growth of the company. Even though the word "preferred" sounds like it is better to own than the "common" stock, that's simply not true. They are two different investments for different means. If you are looking for income, preferred stock may be a great choice. But if you want to be part owner and participate in the growth of the company then common stock is the best bet.

Bonds

Bonds are nothing more than an IOU issued by a company. Corporations borrow money in order to produce products or services and often need to borrow money to continue their operations. If the company issues a bond, they must repay a stated amount of interest to the bondholder at fixed intervals, usually every quarter. Why would a corporation issue a bond and commit to interest payments when they can raise money by issuing stock without the interest payments? The main reason is that issuing shares of stock dilutes the value of each share. If the company continues to do nothing but issue shares of stock, they end up cutting the company into so many pieces that each share is virtually worthless. If a corporation really believes it will profit from its products or services, it may be a better choice to issue bonds. If their forecasts are correct, they will be better off by paying a little interest on the bonds rather than having to split all the profits with others, which is what would happen if they issued more stock.

Basic Bond Mechanics

A key feature of bonds is that they have a stated maturity date. During this time, the issuer must make fixed equal payments. Once all payments are made, the bond has "matured" and the issuer's obligations are met. In a similar way, if you get a five-year car loan you have, in effect, issued a five-year bond. You receive cash to buy the car and are now obligated to make fixed equal payments over the five year period. Once all payments are made, the loan is no longer in effect and your obligation is over. The fixed payment that the bond issuer makes is called the "coupon" since many bonds used to attach coupons to the bottom of the bond that had to be clipped and mailed by the owner in order to redeem. Today, bond payments are all made electronically but the name "coupon" has stayed. If you buy a new bond, the coupon payments will be automatically deposited into your brokerage account.

Another key feature is that bonds have stated face values. You can usually buy bonds in $1,000 increments. If the face value if $5,000, then you will receive $5,000 at maturity, which is simply the return of your principal. In addition, you will receive the coupon payments as interest.

The price you pay for a bond depends on interest rates. For example, assume you buy a five-year newly issued $5,000 face bond today that pays a quarterly coupon of $125. You will receive four payments throughout each year for a total of $500. This means you're earning $500 per year for a $5,000 investment, or 10%. (We have simplified the math to demonstrate the concept. If this were actually the way the payments were made, your return would be higher than 10% since you received some of the money earlier in the year). This bond would be sold as a $5,000, 10% bond. In order to buy this bond, you would pay $5,000 for it and receive $5,000 back at maturity. Because you paid the face amount, this bond is said to be trading at "par value" or just "par." Any bond that sells for its face value is trading at par.

But if interest rates fall while you are holding this bond, then its value will rise. The reason is that other investors would prefer holding your higher rate bond than what they can get in the open market for new issues. In other words, if they buy a similar $5,000 face bond, their payments will be less than $125 since interest rates have fallen. Investors would prefer to have your higher coupon payments so will actively compete in the open market for that bond. When people compete for purchase and there is no more supply, the price must rise. If someone pays more than $5,000 for the bond, then the bond is trading at a premium. If you pay a premium for a bond, your net result at maturity will be lower than the stated interest amount. In this example, we are dealing with a 10% bond but if you pay more than $5,000 for it, your net return will be less than 10%. It may, for example, be only 9%. If so, we would say this is a 10% bond with a yield-to-maturity of 9%.

Conversely, if interest rates rise, the value of your bond will fall. Because bond prices move in the opposite direction of interest rates, we say there is an inverse relationship between interest rates and bond prices. As interest rates fall, bond prices rise; as interest rates rise, bond prices fall. If you buy a bond for less than face value, the bond is trading at a discount. Keep in mind that bond price fluctuations only affect the bond prices and therefore your total return if you sell the bond before maturity. If you hold the bond to maturity, you will get exactly $5,000 for it.

At first glance, it may appear to be better to buy bonds at a discount. There is something appealing about paying less than face value while still collecting the full coupon payments. However, you must remember that the reason the price fell is because interest rates have risen. The additional money you gain by receiving more than face value compensates you for the higher interest rates. If you buy a bond at a premium, you'll pay more than the face value and receive less at maturity, which seems like a negative attribute. However, you will also receive much higher interest payments than you normally would under the current interest rates. That's the reason investor's will pay the premium. The point is that it doesn't matter whether you pay a premium or a discount for a bond; what matters is the interest rate, maturity, and credit risk of the investment. If you want a 10% bond, it doesn't matter if you buy one at a discount or a premium; a 10% bond is a 10% bond.

The previous paragraphs describe the mechanics of Treasury notes (also called T-notes), Treasury bonds (also called T-bonds), and many corporate issues (bonds issued by publicly traded corporations). The only difference is that T-notes and T-bonds pay their interest semi-annually rather than quarterly. Treasury bills, however, work a little differently. For these short-term issues, the government pays no coupon payments. Instead, they are sold at a discount to face value. For example, if interest rates are 10% and you buy $5,000 face Treasury bill, you will pay $5,000/1.10 = $4,545 for it and collect $5,000 for it at maturity, which nets you a return of 10%. The additional money you receive on top of your $4,545 investment is considered the interest.

There is a class of bonds similar to Treasury notes called zero-coupon bonds. These notes are usually issued by corporations and municipalities. Just like Treasury notes, these bonds are sold at a discount from face value but the investor collects the full face value at maturity. However, due to the longer maturities, these bonds can be priced significantly below face value.

T-bills, T-notes, and bonds can all be purchased in $1,000 increments (although, at this time, no new bonds are being issued). But there are certainly T-bonds that are outstanding and available for purchase.

Benefits

For the most part, bonds are the safest form of investing and that means that you'll get very little return on your money. If you have a large portfolio or are looking for a safe, supplemental income, then bonds may be your answer. You must understand that, even though the word "bonds" is associated with safe investing, there are many flavors to choose from and not all are necessarily safe. There are bonds issued by companies of questionable solvency that are usually "C" rated (or worse) by ratings agencies and are usually called "junk" bonds or "high yield" bonds. These bonds are highly speculative, which means their payoffs can be great - if they make it to maturity. But assuming you are investing in high quality corporate or guaranteed bonds then there are two big benefits: The first is that you have a fixed income stream to depend on. Second, you know that your principal (the amount you have invested) will someday be returned to you.

Drawbacks

Despite the low-risk or guaranteed status of most bonds, there are drawbacks. The first is that you're not going to make a lot of money unless there is a tremendous fall in interest rates and you can sell your bonds for a nice capital gain. Another drawback is that you could certainly take a sizeable loss even though the bonds are guaranteed. Remember, the guaranteed return of principal only comes at maturity. If interest rates rise, the price of your bond falls. And if you need to sell it to raise money for some other purpose, then you could certainly end up with a loss even though you may be holding a "guaranteed" bond.

Historical Returns

It's difficult to say what the historical returns for bonds are since there are so many classifications and risk categories. But for most "investment quality" corporate bonds (i.e., not including junk bonds), the long-term returns have been around 4.5%.

Risk

While investment grade bonds have little risk in terms of lost principal, there are many types of risks involved with bond investing. The biggest risk is, of course, an adverse movement in interest rates. If you buy a bond and interest rates rise, the price of your bond falls. Once again, this does not affect the face value of the bond; you will get that returned to you at maturity if you hold it that long. But if you should need to sell the bond before maturity, you would take a loss if interest rates fall.

Reinvestment risk is another type of risk. In the previous example, we assumed you bought a $5,000 bond with quarterly coupons of $125 each. If we ignore the time value of money, we said this would be a 10% bond. One of the assumptions in saying that this is a 10% bond is that all payments of $125 throughout the life of the bond can be reinvested at 10% -- and that's a huge assumption. You may be able to get 10% on your $5,000 investment, but it's unlikely that you could also get that for the $125 coupon payment. Regardless, that is an assumption used to simplify the yield computations. If you are not able to reinvest your interest payments at the same rate as the bond, then you face "reinvestment risk," which simply means that your overall return will likely fall somewhat short of the stated return on the bond.

Some bonds have "call" features that allow the issuer to "call" the bond in, which is another way of saying that they wish to pay off the loan early. Using the car loan analogy that we used earlier, if you pay off your car early, then you have effectively "called" the loan. If you buy a long-term bond thinking that you have locked in the stated interest rate for that time, you may be in for a surprise if the issuer calls the bond and you receive your principal back much earlier. In doing so, you miss out on all of the interest payments that you were counting on. Not all bonds have call provisions but, if they do not, they will likely be able to issue the bond at a lower interest rate.

Credit risk is another type of bond risk. You may buy an investment quality bond only to find that, sometime later, the company's creditworthiness has fallen. The rating agencies will lower their credit ratings and the price of the bonds will fall. In this case, you could lose money even though interest rates didn't change. Instead, changes in the company have made the ratings slip and that's something completely out of your control or ability to forecast.

Below are some guidelines as to the investment ratings you may see on bonds:

AAA - Highest quality and least likely to default.
AA - High likelihood of repayment. These bonds with AAA bonds are considered "high grade bonds."
A - Fairly safe although there is some risk if conditions become quite difficult.
BAA or BBB - Anything with BAA or higher is called an "investment grade bond." BAA or BBB rated bonds are respectable qualities although the yields will be a little higher since there is a small possibility of default. Overall though, these are generally decent investments if you're looking for a little higher yield.
BA or BB - Bonds in this category (or lower) are considered "speculative." The company's ability to repay the loan is questionable.
B - These bonds are fairly speculative. Significant risk of default if conditions become difficult.
CAA or CCC - These bonds are highly speculative. Bonds with this ranking or lower are considered junk bonds.
CA or CC - There is a significant risk of default and are highly speculative.
C - A very probable risk of default.
D - Bonds in default.

Another real risk with bond investing is called inflation risk or purchasing power risk. When you buy a bond, you are really loaning money to the company. In doing so, you are giving up your ability to buy something today in exchange for buying more tomorrow. That's why the bond issuer must pay you back the face value plus interest. It is the additional interest payments that, at the time of the loan, appeared to make it worth your while to not spend today. For example, you may give up the purchase of wine today if you can get wine plus bread tomorrow. However, if prices rise during the time you are holding your bond, you might find that you cannot even buy wine when the bond matures - even though you have more dollars than when you started. This is what economists call inflation risk or purchasing power risk. In other words, even though you have more dollars after making the loan, you really have less purchasing power available with that money and are really worse off after making the loan.

Why Buy

Bonds are purchased for a variety of reasons. Probably the most common is preservation of capital. As stated before, if you have a lot of money, then you will likely shift your investment preferences toward bonds. Another reason is to guarantee an amount for a distant future use. For example, if you think you will need $50,000 for your child's college education, you might decide to buy a deep-discount bond that matures to $50,000 when your child enters college. Bonds also provide income streams, which is why you often hear of retirees holding onto bonds. These people have often acquired a sizeable amount of money while working and are more concerned about losing that than seeing it grow. In addition, they often need income to meet living expenses and the bond payments are reliable and steady. In fact, there are even some bonds or bond mutual funds (which we talk about later) that pay monthly dividends, which can be a nice benefit for retirees.

Bonds are also used for stock investors as a means of diversification. Even if your investment horizon is far off into the future, it's not safe to think you should only invest in stocks. Instead, you're better off buying some bonds too. That way, if the stock market crashes, money will flow to the safe investments - bonds - and your bond portfolio will help recoup the losses on your stocks. So while bonds are sometimes seen as a slow, boring way to invest, they are actually necessary for all investors to some degree.

How to Buy

You can buy bonds through most brokerage firms, banks, or other financial institutions. Treasuries, as stated earlier, can be purchased directly through the Treasury without a brokerage account. Most bonds can be purchased in $1,000 increments although municipal bonds are generally issued in $5,000 increments. In addition, some bond dealers may impose higher minimums. Regardless of how you purchase bonds, it's important to remember that it is the yield-to-maturity and maturity date that you should focus on rather than whether the bond is selling at a premium or a discount. Premiums and discounts are just the market's way of pricing all like bonds so that they have the same yield-to-maturity.

For most investors, bond mutual funds may be the way to invest. We'll talk about mutual funds later but, for now, just realize that you can buy into a basket of bonds that is managed by another firm. The benefits are tremendous. First, you get diversification by purchasing many bonds in one basket. Second, you can usually place much smaller dollar amounts into the fund, maybe as little as $100 (although the initial investment may be $500 or more).

Settlement/Liquidity

Treasuries settle the following business day (T+1) while most others such as agency, municipal, and corporate bonds settle three business days after the trade date (T+3), which is the same for stocks. For treasuries, this means that you must have the payment to your broker by the close of business for the following business day after the trade. If you make the buy the bond on Monday, you must have the money to him by close of business on Tuesday (assuming that's a business day). For all other bonds, such as agency, corporate, or municipal, you have three business days to get the payment made. If you make a trade on Monday, you must have the money to him by close of business on Thursday.

Variables that Impact Price

The major factor affecting a bond's price is interest rates. The biggest source of fluctuations in price will likely come from changes in interest rates. But aside from that, there are other factors. For example, if the stock market begins a significant uptrend, especially after a long flat period, a lot of money may flow from bonds toward stocks as investors seek higher returns. As investors sell their bonds to shift into stocks, you will see bond prices fall. The reverse is true if the market falls and investors shift toward safe money. You will see a rise in bond prices. Other factors are the credit ratings. If a ratings agency suddenly reports a lower credit rating, you will likely see the price of your bond fall.

Mutual Funds

Mutual funds are basically a basket of stocks that are professionally managed. To understand the idea behind mutual funds, imagine that you have a wealthy uncle who has a multi-million dollar portfolio. He has a high level of investment knowledge and is able to go long or short, use futures or options to hedge, and pays very low commissions. If you are a beginning investor, these are all things that you will not be able to match. In addition, if you are investing on your own, you may have to invest $5,000 or more just to buy your first stock. But what if your uncle allowed you to "buy in" to his portfolio? You just pay him a sum of money that you wish to invest and you have effectively purchased a portion of his portfolio. He'll let you invest as little as $500. After that, there's nothing you need to do. He'll still manage it and you get all the benefits that you could not get by yourself.

Benefits

If this sounds like a good idea, that's basically what you're doing when you buy a mutual fund. Mutual funds may not be as exciting as buying and selling individual stocks but they do offer many benefits that cannot be matched. For example, if you invest in mutual funds, you get an immediate benefit of diversification. If one of the stocks in the fund goes "belly up," there's a chance it will not affect the price of the fund at all. But if that happens to be the one stock you hold, you could be financially ruined. Holding many stocks so that the effect of one stock does not weigh too heavily on the whole is the idea behind diversification. There's no way you can get a good level of diversification for $500 on your own. That figure may be more along the lines of $25,000 minimum and probably more like $40,000 to $50,000. But with mutual funds, for a small investment, you get all the benefits of diversification plus professional management.

There are mutual funds for every investment category you can imagine - and then some. For instance, you can invest in index funds that follow the S&P 500 or Dow Jones Industrial Averages. These funds are passively managed, which just means the fund does not institute a system that attempts to beat these averages. Instead, it buys and sells stocks that comprise each index in the same proportions so as to mirror the index. If the index is up 10% that year, your mutual fund will be up nearly 10% as well. The reason we say "nearly" is because there are some small fund fees and the proportions they buy and sell may not exactly match those of the index. But the point is that it will be very, very close.

There are even some companies that provide leveraged funds that double the returns (or losses) of a particular index.

Most mutual funds, however, are actively managed, which means they are trying to outperform the group or sector by superior stock picking skill as well as market timing skills (when to buy and sell). Within the actively managed funds, you can buy "sector" funds that invest in things like technology, energy, biotech, financial, pharmaceutical, consumer retail, and gold. You can also find funds that invest in other countries such as the Asia, Latin America, or Russia. There are the "socially conscious" funds that do not invest in things like tobacco or alcohol. There are bond funds, real estate funds, and commodity funds. You can even get funds that invest in both stocks and bonds for you, which are usually called balanced funds. You get the point: There are funds for every type of investment style you can think of. Whether you are a new or experienced investor, mutual funds will play a part in your portfolios.

Drawbacks

One of the drawbacks to mutual funds is that there are associated fees - and many of these are hidden. While these fees have come down quite dramatically, they are still present in many forms and you need to be aware of them when buying. These fees can be found in the prospectus, which is a legal document describing the characteristics of the fund, which must be presented to you before any licensed representative can talk to you about buying the fund. One section of the prospectus talks specifically about the expenses and they are outlined under "Shareholder Fees" and "Annual Operating Expenses."

Shareholder Fees are those fees associated with running the fund. One of the fees you'll want to watch out for are the "sales loads," which are basically commissions used to pay the selling brokers. Even if you buy these funds through the company, they may still charge you the load fee. Sales loads can be very expensive. In fact, the NASD (National Association of Securities Dealers) limits this load to 8.5%, which can be a large number if you're putting a lot of money into the fund. If this fee is paid to buy into the fund, it is called a "front load" fund.

Another fee is a "contingent deferred sales charge," or CDSC. These fees work like the front load but they are charged when selling the fund. Most funds that charge CDSC fees will calculate the value on your initial investment rather than on the current market value. However, that's not always the case so it's important to understand how all of these fees work if you're thinking of buying a load fund.

Some funds also charge a "purchase fee," which is considered separately from the front-end sales charge. Purchase fees are paid to the fund company to cover their expenses whereas front-load fees are used to pay the selling brokers.

There may also be "exchange fees" that are charged if you "exchange" on fund for another. Most mutual fund companies, however, will let you change from one of their funds to another without paying this exchange fee. Another fee you may see is an "account fee," which is a fee charged to cover their expenses with handling the account such as mailing statements etc.

Fees that fall under the "Annual Operating Expense" category include management fees and 12b-1 fees. Management fees are charged to pay the managers and others who run the fund. These fees range from a fraction of one-percent to several percentage points and can account for a significant portion of the fund's expenses.

Another category you will find under Annual Operating Expenses is the 12b-1 fee. These fees are charged by funds that are authorized by the SEC (Securities and Exchange Commission) under rule 12b-1 to charge such fees. These fees are used to cover expenses for advertising, mailing prospectuses, and other administrative procedures.

The one expense you'll want to check in the prospectus is the "Total Annual Operating Expense," which expresses the total expenses as a percentage of the funds average assets. That figure tells the picture in a nutshell.

Besides expenses, there are other drawbacks associated with mutual funds. One is that the fund managers who are performing well may end up leaving to go to another firm or start their own. So the manager that is responsible for a fund's performance may not be there shortly after you buy into it. It pays to check out who's responsible for the fund's performance and if they are still with the fund. To prevent this problem, many funds are now being managed by teams rather than by one person. Another disadvantage is that managers (or teams) develop styles and what works over some periods may not work in others. Just because the fund appears to be "doing well" does not mean that it will continue. For example, the "value investors" did very well for many years but posted horrible returns in the late 90s.

Other drawbacks are that mutual funds cannot short stocks. And when you're dealing in markets like the 2000 - 2004 periods this can be a real limitation on performance.

Another drawback is that the overwhelming number of mutual funds available (probably more than 7,000) make it a daunting task to sort and pick the right ones for your needs. Of course, there are computer sort programs that can narrow the search, but there is still a lot of work involved with making the right decision.

Mutual funds are also bound by a "charter" that dictates what they can and cannot buy. This is good in one sense in that it keeps the manager on track with the funds objective but, at the same time, can severely limit the manager's choices in certain markets.

Another problem is that funds often sell the losing stocks and buy "what's hot" at the end of each quarter. This way, investors who are interested in buying the fund will see they are holding the "good stocks" they've been hearing about and the fund manager appears to be doing a good job. However, in many cases, you'll find that the manager didn't own the stocks when it was hot and, instead, is only holding it after the fact so that the fund appears to be picking the best performers.

Taxes can be another problem. Fund managers do not know taking capital gains affects your tax situation and, if they sell, they may trigger a taxable event that may have been better off for you if it had been deferred. In fact, if you buy a fund near the end of the year and they make a distribution, you may have a taxable event.

No-Load Funds

Today, there are so many mutual funds that most investors shy away from load funds. They buy into a group of funds called "no load funds" which, as the name implies, do not charge any type of load fees. But even if you have a no-load fund, you can be sure that a management fee is charged. If you are thinking of buying a mutual fund with load fees, check if there is a no-load version even if it is offered by a different company. It may be worth the search.

Open-End or Closed-End?

The mutual funds we've been talking about so far are a class called open-ended funds. This just means that the mutual fund company is technically issuing new shares every time someone buys and buying back shares every time somebody sells. In other words, there is no theoretical limit as to the number of shares the company sell.

There is another class of funds called closed-end funds. These are technically a mutual fund that trades like a stock. Rather than having one (or a limited number) of closing prices per day, closed-end funds trade like a stock and have continuous bid and ask prices. Closed-end funds have a fixed number of shares and their price is determined by supply and demand for these shares. One of the big advantages with closed-end funds is that they can be bought or sold during the day. So for example, if you happen to see news that will adversely affect your mutual fund, you can sell it immediately if it is a closed-end fund. But if it is an open-ended fund, you may need to wait for the evening closing price and that means you could potentially lose significantly more money while waiting for the end of the day.

Despite their appeal, closed-end funds have drawbacks. The main drawback is that the NAV of the fund can, and often does, fall below the true NAV of the stocks they are holding. Because their price is determined by supply and demand, the closed-end funds can theoretically trade at a premium or a discount to NAV but, in most cases, they trade at a discount. While it may sound good to buy the funds at a discount, chances are you'll end up selling at a discount too. You can find funds trading at deep discounts in the Monday edition of The Wall Street Journal, in Barron's (a weekly journal you can pick up in news stands on Saturday), and the Saturday edition of the New York Times.

Historical Returns

It's impossible to say what the historical returns are, as a whole, for mutual funds. The reason is that there are so many classifications and each is taking a different set of risks. The best thing to check is the fund's history, whether online or in the prospectus, which will usually be broken down into a year-to-date, three year, five year, 10 year, and "since inception" return categories. While it may be interesting to check the short-term returns, you'll really want to focus on how they've performed over five-year and ten-year periods.

Risk

Because of the many stocks held in mutual funds, their risk is usually fairly low. However, there are many funds that specialize in speculation and their risks would be quite high. Another way to assess risk is to utilize ratings services such as Morningstar, which specializes in the ratings of mutual funds. Their website is www.morningstar.com, which shows the historical performances relative to the S&P 500 as well as several risk measures.

Why Buy

If you are investing for the long-haul, mutual funds will likely play an important role. They are not good short-term trading vehicles unless you're using some of the leveraged funds. Mutual funds are excellent way to diversify your portfolio efficiently.

How to Buy

Most mutual funds can be purchased either through a broker. If your broker does not carry the specific fund you're looking for, you should ask if there is another fund family they carry that offers a similar fund. If not, you can always purchase the fund directly through the mutual fund company. The downside is that you will have a separate account with them and receive separate statements regarding that fund rather than having it combined in your brokerage account.

Most mutual funds have one "settlement" price, which is called the "net asset value" or NAV. The NAV is similar to a closing price of a stock. While stocks have live prices posted at every second of the day, mutual funds usually only have just the single NAV, which is posted in the evening (there are some funds that post NAVs every hour but they are usually sector funds). Everybody who places a buy or sell order gets filled at that same NAV price. When you buy a mutual fund, you place an order with your broker to buy a specific dollar amount. You may, for example, say "put $500" into this fund today. If the NAV is $10, you will have $500/$10 = 50 shares of that mutual fund the following day. When you sell your shares, however, you must specify the number of shares you're willing to sell and let the dollar amount you receive fall where it may. So for mutual funds, you must "buy in dollars" and "sell in shares." This is important to remember when selling if you're trying to raise a specific number of dollars. You may need to sell of a few additional shares in order to make sure you get the amount of cash you need.

Mutual funds, unlike stocks, cannot be purchased or sold for limit prices (for example, buy only if I can get the shares for $30 or less). All mutual fund orders are "market orders," which means the orders will be executed but you will not be sure of what price until after the NAV is posted.

Selling Dividends

There is an illicit practice of some brokers you need to be aware of if you're shopping for mutual funds. Many funds pay dividends, which is simply cash paid to you usually on a quarterly basis. Let's say a fund has a NAV of $10 and pays a $1 dividend tomorrow. There are some brokers who will encourage you to buy the fund today since it will pay $1 on your money tomorrow thus apparently returning 10% on your money in a single day. The problem is that once the dividend is paid, the NAV is reduced by the amount of the dividend and will be $9 the next day. So for a $10 investment, you now have $9 in the mutual fund and $1 in cash - but that $1 is now taxable. Buying a mutual fund strictly for the reason of collecting the dividend only hurts you. The practice of pressuring customers to buy mutual funds because of an upcoming dividend is called "selling dividends" and is considered an illegal tactic by the NASD. Of course, it's tough to prove who said what and that's why many shady firms use this tactic. The best defense is to understand that buying a fund strictly for the dividend does not benefit you in any way but does benefit the broker.

Settlement/Liquidity

Most mutual funds settle the following business day. For most brokerage firms, this means you must have the money in the account before you place the order. Most firms only require that the check be deposited in the account prior to ordering; they rarely require the check to be cleared before the order. If you need to raise cash by selling a fund, the cash will usually be available the following business day. It's a good idea to check with your broker because there are some funds that have three-day (or more) settlement periods. Again, if you are selling a fund to raise cash, it's a good idea to sell of a few more shares than what you think are necessary to raise the cash since the price may fall for that evenings closing price.

Variables that Impact Price

Because mutual funds are comprised of either stocks or bonds (or both), all the variables we've discussed under stocks and/or bonds will apply. Also, if you're holding sector funds (banking, energy, transportation, etc.) you'll want to keep tabs on how these industries are doing. You can usually find a sector index such as the BKX (banking industry) to get an idea of where the sector has been - and possibly where it's going.

REIT

Another investment you'll likely hear about is the Real Estate Investment Trust, or REIT (pronounced "reet"). REITs are similar to a closed-end mutual fund in that they trade like a stock on an exchange. However, REITs strictly invest in real estate. There are a couple of categories you'll want to be aware of. The first is the "equity" REIT, which buys and sells properties and is thus profiting from the equity ownership. Another is called "mortgage REITs" and, as their name implies, make their money from issuing mortgages and earning the money from the interest on the loans. Then there are they "hybrid" REITs that make their money from both the equity and mortgage sides of the business. REITs receive special tax considerations and, consequently, can offer high yields.

In order to qualify as a REIT, the company must pass these tests:

REITs must be structured as a corporation with fully transferable shares.
REITs must have at least 100 shareholders and must have less than 50 percent of the outstanding shares concentrated in the hands of five or fewer shareholders during last half of each taxable year.
REITs must distribute at least 90 percent of its annual taxable income, excluding capital gains, as dividends to its shareholders.
REITs must have at least 75 percent of its assets invested in real estate, mortgage loans, and shares in other REITs, cash, or government securities.
REITs must derive at least 75 percent of its gross income from rents, mortgage interest, or gains from the sale of real property. And at least 95 percent must come from these sources, together with dividends, interest and gains from securities sales.
Less than 30% of gross income can come from sale of real property held for less than four years.

Benefits

One of the biggest benefits of REITs is that you can now easily invest in areas of real estate that may have previously been inaccessible to you such as office buildings, hotels, apartment complexes and shopping malls. In fact, you can even find REITS that specialize in areas such as residential, office and industrial, health care, self storage, and retail. There are even REITs that invest in local regions, which means you can, with a small investment, participate in the commercial real estate booms that may be occurring in your area. Another benefit is that many REITs offer dividend reinvestment plans (DRIPs), which means you can automatically have the dividends reinvested into additional shares usually at no cost to you.

The average dividend yield on REITs is about 8% and is roughly six times that of the Russell 2000 index. REITs also tend to have a low correlation with other assets and that makes them a great tool for hedging a portfolio. Even if you're not necessarily bullish on real estate, having some exposure to REITs can therefore make your portfolio less risky for the same amount of returns! Also, because properties generally rise with inflation, REITs provide a hedge against inflation too.

REITs offer tax benefits too. Because they are "pass through" security, they avoid the problem of double taxation. In other words, many corporations must pay taxes on their earnings and then distribute the remainder to you through dividends, which are then taxed again. REITs are structured to pass through nearly all earnings to investors, which means they are taxed only once at your level.

Drawbacks

Any tax losses do not pass through to shareholders. Another drawback is that REITs must meet substantial operating restrictions; they are not as free to pick and choose investments as many mutual funds are.

Historical Returns

From January 1976 to June 1996, REITs returned 13.8%. During this same period, the S&P 500 returned 15.7% and long-term corporate bonds returned 10.2%.

Risk

When you buy a REIT, you must remember that they are a company in the business for profit; they are not just a portfolio of real estate assets. Therefore, you must monitor the decisions of management and realize that, while real estate may be doing well for a given period, the REIT could still falter if managed poorly.

Why Buy

REITs provide and excellent source of diversification since there is very little correlation between their returns and those of stocks or bonds. They are also an excellent way to gain exposure to the real estate market for very little money. If you think real estate in your area will boom, you can buy and sell houses on your own (which requires lots of time and money) or you can simply buy a REIT that specializes in your area. With REITs, a $1,000 investment will increase in value close to the proportion of real estate in your area. There's no way you could get that exposure for so little money.

How to Buy

REITs can be purchased through any brokerage firm. Unlike mutual funds that may not be carried by your broker, REITs are traded on public exchanges and anybody with a brokerage account can buy them. You will pay a normal stock commission for the transaction.

Settlement/Liquidity

REITs settle in three business days just like stock. You therefore have three business days to deliver payment to your broker and, likewise, need to wait three business days to receive the cash once you sell. REITs are highly liquid and you can usually buy and sell large dollar amounts without disrupting the price.

Variables that Impact Price

The biggest variable affecting REITs is interest rates. When interest rates are low, people buy homes in large numbers. People who already own homes will usually "trade up" to a bigger home since they can now buy it for the same payments as the one they already own. In addition, because the monthly payments come down so much, you end up with a large pool of buyers that normally could not afford a home. The result is that you get a huge surge in demand for homes and no way to immediately increase the production on a proportional scale. The result is a big spike in home prices. Of course, home prices can crash too if there are sudden spikes in the interest rates. If you're holding REITs, you need to follow the news and analyst comments on potential interest rate movements.

Unit Investment Trusts

Unit investment trusts, or UITs, are a type of fund with some distinct differences between open-end or closed-end funds. UITs make a one-time offering on a fixed number of shares, or "units" and those are traded between investors. UITs have a termination date that is announced at the time the fund is created. These dates generally range from one year to thirty years. When the fund terminates, all remaining proceeds are distributed to investors. UITs have a pre-defined plan of action; they rarely are set up for active management that is trying to outperform the market. Instead, UITs have a stated goal and then hold the portfolio until maturity. If they do any kind of adjustments in the portfolio, they will follow a defined set of actions. In other words, if two separate managers were running the same fund, they should end up with the same results. The fund's performance should depend on its objectives and not on the manager's decisions. For example, there is a "Dogs of the Dow" UIT that follows a contrarian strategy by that same name. The idea is to buy the 10 worst performing stocks in the Dow (i.e., the "dogs"), which can be found by buying the stocks with the highest dividend yield and then holding them for a year. At the end of the year, that UIT is terminated and a new one is formed. The strategy was popularized by a recent book "Beating the Dow" by Michael O'Higgens. The author shows that this strategy returned an average of 18% from 1973 to 1989 as compared to 11% for the Dow over that same period. Rather than going out and buying all ten stocks on your own, you can simply invest a small amount into the UIT and the strategy will take care of itself.

Benefits

Compared to mutual funds, UITs are more flexible in their strategies and can hold very few stocks, bonds, or whatever assets they choose. Mutual funds, on the other hand, must adhere to certain rules of diversification, which is why you will not find a "Dogs of the Dow" mutual fund. So UITs can open the doors to other investment opportunities that may not be offered by mutual funds. UITs usually distribute income, either monthly or quarterly, to its shareholders so they can be used as a source of income as well.

Drawbacks

The price of a UIT is strictly determined by how many investors wish to hold the shares. Because there are a fixed number of units issued, the supply cannot change but investor demand certainly can. Mutual funds, on the other hand, determine their value by the value of all securities held in the portfolio less expenses. Mutual funds' values do not depend on demand. As money flows in and out of mutual funds, the size of the fund will grow and shrink but it has no bearing on the NAV. For UITs, money flowing in and out will directly affect their price.

Another drawback is that UITs are generally sold through dealers rather than on an exchange. This means the bid-ask spreads can be quite wide, which hurts if you should need to sell. But if you buy the UIT and hold it to maturity, then the spread is of no consequence.

Historical Returns & Risk

Because there are so many categories of UITs, it's impossible to say what the historical returns or overall risk is. That will be dictated by the fund's strategy.

Why Buy

Buy UITs when their investment strategy is in line with yours as well as the maturity date. If you buy and hold, you will achieve your goal for less money than trying to execute the strategy on your own.

How to Buy

UITs are usually purchased through a broker. These funds are not traded on an exchange so if you wish to buy one, you will not be able to place the order online. Instead, you'll have to speak to a broker to place the order.

Settlement/Liquidity

Most of the UITs will settle within three business days although there may be some longer exceptions. Liquidity is weakened by the fact that only a few dealers stand by to purchase shares and that is reflected in the wide bid-ask spreads.

Exchange Traded Funds (ETFs)

There is a group of UITs called Exchange Traded Funds, or ETFs. These funds are simply UITs that trade on an exchange rather than through dealers. Among the more popular ETFs are DIA and SPY, which are ETFs on the Dow and S&P 500 indices, respectively. You can find out more about ETFs by going to the American Stock Exchange's website at www.amex.com and clicking the link that says "ETFs."

Benefits

ETFs offer additional benefits over UITs. Most ETFs have lower expense ratios than their mutual fund counterparts. Also, ETFs are more cash efficient since mutual funds must keep some cash on hand to redeem shares if investors wish to sell. Consequently, that cash just ends up sitting there doing nothing. ETFs, on the other hand, are not buying and redeeming shares. Instead, investors are buying shares from each other and that means the ETF can utilize 100% of its cash.

Drawbacks

When you buy or sell an ETF, you are faced with a bid-ask spread. Normally, these are quite low but they can adversely affect your performance if the spread is wide enough and you are buying and selling frequently. For mutual funds, there is no bid-ask spread; everybody is filled at the same price. ETFs won't track indices as well either. The reason is that the ETFs value is affected by the demand for the shares. Mutual funds, on the other hand, are always priced at NAV. Remember, ETFs can theoretically trade at a premium or discount to the value of the assets its holding while mutual funds always trade at the true value. Last, you can only buy and sell ETFs in whole share amounts whereas you can "split" shares with mutual funds and place a specific dollar and cents amount into the fund. You will not be able to do this with ETFs. With ETFs, you must buy a whole number of shares and let the dollar amount fall where it may.

How to Buy

ETFs can be purchased through your brokerage account and can even be traded online just like a stock. You are charged a normal stock commission to trade ETFs.

Settlement/Liquidity

ETFs are generally highly liquid, which means they will have a small bid-ask spread. They will also settle in three business days just like a stock. Again, this means that if you sell the ETF, you will need to wait three business days before you can get a check for the proceeds.

Limited Partnerships

Limited partnerships are a form of business ownership. In a limited partnership, there are one or more "general partners" that are in charge of running the day-to-day operations of the business. The general partner(s) is liable for the actions of the business while the "limited" partners just contribute cash to fund their operations. If you invest in a limited partnership, you are acting as a limited partner, which means you are only liable for damages up to the amount you invested. If you invest $10,000 into a limited partnership then the most you can lose is $10,000. This is not true for the general partners. The general partners run the operation while the limited partners act as passive investors. In fact, if you are a limited partner, you cannot participate in the management of the company (other than to determine who will run it), otherwise you forfeit your limited liability status. This form of business ownership was created to give incentive for investors to contribute capital without the fear of unlimited liability.

Limited partnerships have limited life spans, just like UITs, although limited partnerships are generally shorter. They are formed to perform a specific goal and then terminated.

Limited partnerships used to be very popular in certain industries such as oil drilling, real estate, lease agreements, and movies. For example, in the early 1980s, the real estate and oil markets were booming and there is an estimated $130 billion of limited partnerships sold at that time.

Part of the appeal in forming a limited partnership was the tax benefits; however, much of those advantages have been removed since the Tax Reform Act of 1986. In fact, many limited partnerships were created for the sole purpose of generating tax losses. That was the reason many investors bought into them. It was not uncommon to see limited partnerships that had no apparent "economic benefit" but were still formed with the intent of generating passive losses for investors. (Passive losses are those that are generated without direct participation such as with a limited partnership.) Today, all limited partnerships must show that there is some sort of economic benefit in their formation. They cannot, for example, be formed for the purpose of drilling for oil in downtown Manhattan.

Benefits

Perhaps one of the biggest benefits of limited partnerships is that they allow investors to invest in a business that is run by someone with an excellent track record in a specific area. For example, imagine that a multi-millionaire real-estate developer decides he wants to start a new development. He may seek funding from other investors, the limited partners, and then plan, organize, and run all operations. All you need to do is sit back and collect the money if things work out. If not, you're only at risk for what you invested. Note that this would not be possible to do with a mutual fund or UIT; they are set up for holding portfolios of securities. But with a limited partnership, you can invest into the business - even in an IRA (Individual Retirement Account).

Also, since they are taxed as a partnership, they are excluded from corporate tax.

Drawbacks

While limited partnerships are excluded from corporate tax, this also creates a drawback; they must comply with partnership tax accounting. With partnerships, all profits filter down to you and you are taxed at your level. General partners must also contribute significant cash investments and, as stated earlier, have unlimited liability for the partnership's obligations.

Another drawback is that many limited partnerships have little or no marketable value. In some cases, "fair market" prices may only be 20% to 60% of the partnership's net asset value. Of course, this isn't a problem unless you need to sell but it is a potentially a significant drawback in holding a limited partnership.

Historical Returns & Risk

Because of the many various forms of limited partnerships, it's difficult to say what the historical returns are. However, in most cases, the risk is much higher than for investing in index funds such as the S&P 500 so investors should expect higher returns from limited partnerships than from broad-based indexes.

Why Buy

Because the tax benefits are virtually removed, it's best to not buy a limited partnership for the sole purpose of tax benefits. Buy them if you like the business opportunity it presents and you are willing to hold it to maturity. The reason it's important to hold it to maturity is because of the lack of liquidity, which is discussed shortly.

How to Buy

Limited partnerships are generally sold through retail brokers. Specifically, they are usually only available through the full service dealers such as Merrill Lynch rather than the commission discounters.

Settlement/Liquidity

Limited partnerships are highly illiquid. This means that if you wish to sell before the maturity, you're most likely going to take a big, fat loss. There are probably 10% to 15% that trade with any regularity. Even those are traded through independent dealers who use their own clearinghouses. This is a step above taking it to a pawn shop for redemption. Bear in mind that this doesn't mean that limited partnerships are bad; it just means that if you need to sell before the enterprise is done, then you're most likely going to have trouble selling it and will, consequently, receive very little for it.

Hedge Fund

Hedge funds are probably the most speculative of all investments. Many times, these are limited partnerships that are formed to speculate in the markets by using derivatives and a lot of financial leverage. Hedge funds are allowed to go long or short, trade futures and options, use risk arbitrage, and other forms of speculation. But perhaps and even bigger reason is that these funds and their managers are largely unregulated. Neither the fund nor the managers are required to register with the SEC. This opens the doors for fraudulent people to start their own fund based on some wacky scheme to beat the market. Many of these are outright frauds trying to get your money. But there are many that are legitimate and so you need to really check out what the fund is supposed to do and who is running it before you place your money with them. Because of their speculative nature, many hedge funds are only open to sophisticated investors, which are called "accredited investors." According to the SEC, an accredited investor must meet one or more of the following criteria:

a bank, insurance company, registered investment company, business development company, or small business investment company;
an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;
a charitable organization, corporation, or partnership with assets exceeding $5 million;
a director, executive officer, or general partner of the company selling the securities;
a business in which all the equity owners are accredited investors;
a natural person who has individual net worth, or joint net worth with the person's spouse, that exceeds $1 million at the time of the purchase;
a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or
a trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes.

Many of these funds also restrict their investors to small numbers; for example, some may only allow 100 investors. Because of the small numbers, many hedge funds require a minimum of $1,000,000 to invest with them. Despite these restrictions, the hedge fund business is big. There are currently over 8,000 different hedge funds with nearly $900 billion in assets.

There is a new breed of mutual funds that invests in hedge funds, which are known as "funds of funds" that attempt to diversify as well as allow non-accredited investors a way to invest in these assets.

Benefits

Hedge funds may be able to generate profits in rising or falling markets due to their ability to go long and short as well as use derivatives.
Using hedge funds in a balanced portfolio will reduce overall portfolio risk and volatility but not harm your returns. This is because of the high degree of negative correlation hedge funds have with stocks. Hedge funds can provide diversification not available with stocks and bonds.
There are many hedge funds to meet a variety of needs.

Drawbacks

Hedge funds charge enormous fees. In addition to the 1% or 2% operational fees, management's take is usually 20% of profits. This can seriously cut into the performance of the fund.
Hedge funds do not need to comply with the same standards of mutual funds. Consequently, there may be additional unforeseen risks.
While the performance of many funds may be impressive, they are not immune to risk. Remember, hedge funds are among the riskiest investments you can make. George Soros' Quantum fund was shut down in 2000 after taking enormous losses. This is the same fund that produced 30% gains for more than a decade. Long-Term Capital Management, which was run by PhDs and a Nobel Laureate had to be bailed out in 1998 by some of the largest banks to keep the financial system from crashing.

Historical Returns

Because of the various funds available, we can't say what the historical returns are overall. Just remember that these funds usually take high risk so it's not unusual for them to beat the market - and it's also not unusual for them to fold. Be careful in choosing your hedge funds!

Risk

As we said before, hedge funds are usually the most speculative of all investments. They are not regulated by the SEC, which makes it possible for people to start a hedge fund with little or no experience. Many hedge funds are started by day-traders with little experience but who want the thrill (not to mention the 20% management fee) of speculating in the markets with other people's money. This is not to say that all hedge funds are bad; there are many that are run by well-qualified people and have posted stellar track records. Just make sure you thoroughly check out the fund before investing.

Why Buy

Most people buy hedge funds as a means to speculate on the market. They want a professional trader to make leveraged investments and attempt to make big returns. This is one - but not the only - use for hedge funds. You can also buy them to diversify your holdings. Even though hedge funds are risky in nature, a little bit of money invested acts as a good hedge for a well-balanced portfolio.

How to Buy

Most hedge funds can be purchased through money managers, banks, or large brokerage firms such as Merrill Lynch or Prudential. Most of you online, discount brokers will not have access to them.

Money Markets

The financial markets are broadly categorized into two markets: Capital MarketsMoney Markets. The capital market is classified by all investments for more than a one-year period while the money market is used for all investments less than one year. The money markets arise out of our necessity to match cash flows with short-term operations. Investors who have idle cash can invest in the money market by dealing directly with T-bills or other short-term instruments. and

However, when you open an account with a brokerage firm, they will ask you to choose between several "money market" funds for your cash balances. These money market funds are similar to a mutual fund in that they invest in a pool of assets - usually 30, 60, or 90-day T-bills or other short-term products. The fund always maintains a net asset value (NAV) of $1. This means that the value of the fund is always equal to your cash balance. For example, if you deposit $1,000 to your brokerage account, it will most likely sit in a money market fund, which will show a value of $1,000. No matter what happens to the financial markets, this money market will always maintain the $1,000 value. It will not rise or fall with the overall market. Money markets generally pay interest in the form of dividends, which also fall into the money market. So the only time your money market balance will change (assuming you didn't add or withdraw money) is when interest is paid. Of course, with today's low rates, don't expect those interest payments to amount to much.

Some money markets invest in T-bills while others may use some tax-free instruments that pay a lower interest rate. But regardless of which money market you choose, the idea is the same: It is a place to park cash in between investments. There is no time frame on the money market either; you can leave the cash parked there for as long as you'd like.

Whenever you buy a stock or mutual fund, the money will automatically sweep out of the money market to pay for the trade. When you sell, the proceeds will automatically sweep into the money market. There is no commission to buy or sell from the money market.

Benefits

The biggest benefit of money markets is that there are no price fluctuations. The cash is readily available and there are no commissions for moving money in and out.

Drawbacks

Because the NAV is always maintained at $1, there is no way for your money to grow other than from the small amount of interest that is periodically paid.

Historical Returns

Money markets mostly invest in short-term guaranteed paper and may also buy short-term commercial paper (discussed later). This means that the historical returns of money markets will closely mirror that of the one-year, risk-free interest rates.

Risk

There is no risk by investing in money markets. Technically, there have been a few cases where the NAV dropped below $1 but that almost immediately led to the collapse of the brokerage firm. But if that happens, there is an insurance policy guarding your assets. If you do have a substantial amount of cash in money market or with a brokerage firm, you'll want to check what their policy covers in the event they go bankrupt. It's important to understand that these insurance policies do not guard against bad investments or adverse market moves; instead, they protect investors in the event the firm goes bankrupt.

Why Buy

Money markets are excellent investments for money that you know you'll need soon. You know the full dollar amount will be there and there are no commissions for getting the money out. Use money markets for cash that needs a safe parking place.

How to Buy

There is nothing you need to do other than be sure you have signed the account agreement to have a money market in your account. There is no charge for it but the firm needs in writing from you which money market you want. Incidentally, you are not required to have a money market to park cash. The downside to this is that you'll never receive any interest from it. Once the agreement is signed, the money will automatically sweep in and out of the account.

Settlement/Liquidity

The cash settles next business day. If you need a check, you should call your broker the day before you need the check so that the funds can settle.

Variables that Impact Price

The NAV is always maintained at $1 so there are no variables that impact the price of a money market. However, short-term interest rates will certainly affect the amount of interest that is paid.

Commercial Paper

Corporations need to borrow short-term money to meet the needs of their daily operations. Most companies can get these loans through lines of credit at banks or through other sources. However, that can be costly as there are long processes and hefty brokerage fees associated with raising money through the capital markets. Instead, many of these corporations raise money by issuing short-term IOUs called commercial paper. They are backed by nothing other than the company's good faith to pay it back. Because of this, commercial paper fetches slightly higher interest and is usually only offered by the most credit worthy corporations in America. Commercial paper is sold at a discount and then matures to face value.

Benefits

Commercial paper yields slightly higher interest rates than you can get in the money market and can also be purchased for very short maturities - usually as little as 2 days. You can also find paper for up to 270 days. Most commercial paper matures in 30 days.

Drawbacks

Commercial paper is usually sold in $100,000 denominations but, in some cases, may be broken down into smaller amounts. A commission is usually charged in the form of a markup; in other words, it is built into the price. So commercial paper does come with a cost unlike money market funds.

Historical Returns

Commercial paper generally pays a little higher interest rate than the risk-free rate.

Risk

Although it is unsecured debt, commercial paper is still pretty safe. Throughout history, there have only been a few corporations that have defaulted on their commercial paper. Most large corporations' cash flows are pretty certain for the next nine months so it's unlikely that something that unforeseeable would occur. Commercial paper receives credit ratings through Standard and Poor's and Moody's.

Why Buy

Commercial paper is a good choice for those who wish to park cash in a liquid instrument but also want a little higher interest rate. For example, maybe you have a sizeable amount from the sale of a home and are not quite sure what to do with it. Rather than leave it in the money market, you might wish to investigate the rates that commercial paper is paying.

How to Buy

Commercial paper can be purchased through most brokerage firms.

Settlement/Liquidity

Commercial paper settles the same business day. The pricing and availability of commercial paper depends on many factors but largely on the demands of the institutional buyers. If there are a lot of buyers, then the commercial paper will be very liquid.

Variables that Impact Price

There are many factors that can affect commercial paper but the most common are interest rates, credit ratings, and availability of competing products.

Options

Options are a popular means of investing or speculating in the market. Options are contracts between two people - the buyer and seller - to buy and sell stock. There are two types of options: calls and puts. Call buyers have the right to buy stock at a fixed price while the call seller has the obligation to sell. Put options work in the other direction. The put owner has the right to sell stock at a fixed price while the put seller has the obligation to buy. Option contracts derive their value from the underlying asset (or index) and are consequently called derivative instruments.

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Benefits

Options allow you to buy or sell stock for a fraction of the cost. This means that investors can spread their investment dollars over a wider range of investments thus diversifying their portfolio. The amount you spend on an option is also the maximum you can lose. This property makes options a great money management tool since you know up front what your maximum loss is. This is not true for stock investing.

Drawbacks

Options convey rights to buy stock (with calls) or sell stock (with puts). If you buy an option, you are not required to use it. However, you must pay for this option in the form of a time premium, which means that your total cost to buy or sell the stock is increased. Another drawback is that options expire and this means that the time premium you pay for the option slowly gets chipped away with the passage of time. In other words, part of its value is lost with each passing day for no other reason than the passage of time. This time decay property of options does not exist for stocks. Because of the time decay, owners of options need to have the underlying stock move quickly in order to be profitable. Again, this is not required for the stock owner. If you own stock, you will make money regardless of how long it takes for the stock to move - as long as it moves in your favor. This is not true for the option owner. You could buy a call option and lose money even though the stock rises.

Historical Returns

There are not many long-term studies on the performance of options. But one thing is for sure: Their returns will be far more volatile than the underlying stocks or indices. One study published in the Journal of Financial and Strategic Decisions (Vol. 13, No. 1) cites that the S&P 500 during 1986 to 1989 had returns ranging from -1.7% to 5.4% while the at-the-money call options posted between -64% and 48% for the same period. Because of the leverage with options, their potential returns are much higher than the underlying assets and this necessarily means that they will exhibit far greater swings in prices - both positive and negative.

Risk

The risk in options is purely a function of how they are used. It is certainly possible to use options in a gambling type manner as well as protective insurance. It all depends on which side of the trade you are taking and what your goals are. For example, a speculator may sell a put option because he has a gut feeling the stock is going to rise; this is a highly speculative use of selling puts. Another investor may actually wish to buy the stock. He may sell a put as a way of getting paid to acquire a stock he was willing to buy anyway. This would obviously be a conservative use of the put option. Two people selling puts on the same underlying stock can have vastly different risk profiles. This is why it is so important to study and understand options and strategies as the risk involved in options is highly dependent on how they are used.

Why Buy

Options are a great way to speculate or hedge your positions in the market. If price volatility is a concern, you may wish to hedge with puts. If you have some speculative money, then options may provide a way to control a lot of stock while limiting your downside risk.

How to Buy

Options can be purchased through most brokerage firms. However, they will require that you fill out a separate application before you trade. Depending on the option approval level for which you are approved, you can select from various strategies. Option can be bought and sold just as easily as stock.

Settlement/Liquidity

Options settle the next business day. This means that if you sell an option, you can get your cash the following business day.

Variables that Impact Price

Any variable that impacts the stock's price will obviously affect the option's price. However, in addition to those variables, there is the effect of time decay that can greatly affect an option's price. Once again, this variable is not present with stock prices so it can be a tough concept for new traders. Another variable is the volatility or the jumpiness of stock prices. If stock prices become more uncertain and we see bigger price swings during the day, then all option prices become more expensive. These are covered in more detail in our option course.

Futures

Futures contracts are one of the oldest forms of derivative instruments. A derivative instrument is one whose value is tied to another. The option contracts discussed in the previous section are derivative instruments as well but this does not mean they are the same thing as futures contracts. Options give buyers rights to buy and sell stock while futures contracts are obligations to buy and sell. If you buy a futures contract, you will pay a small percent of the stock or commodities value but then must take delivery of the underlying asset - assuming you do not close out the contract prior to expiration. In other words, if you buy a futures contract and then sell it, you are not obligated to take delivery. Buying futures contracts is similar to buying something on layaway since you place a small deposit on it but then must take delivery at expiration. However, if you buy a futures contract and the underlying stock or commodity rises, you can profit from that move by simply selling the contract. As with options, this means you can buy and sell stocks or commodities by depositing only a fraction of what the asset is really worth.

Benefits

There are several benefits associated with trading futures contracts rather than the underlying asset. First, if you buy a futures contract, your account is credited daily with cash - assuming the underlying asset is moving in your favor. If you buy the contract, your account is credited with cash every day the asset rises. The amount of the credit depends on the size of the move and the number of contracts you own. Conversely, if you short a contract and the underlying asset falls, your account will be credited daily too.

Because you get daily credits for favorable movements in the underlying, a futures contract is more cash efficient than the underlying. For example, if you buy a stock and it rises, you have an unrealized gain. The only way to get your profit is to sell it. But if, instead, you owned a futures contract, your account would be credited with cash on a daily basis effectively "cashing in" on your profits but allowing you to stay in the position.

Futures contracts also allow you to control a given number of shares for less money. Investors and traders can therefore spread their risk out over many stocks for the same amount of money.

Futures contracts also allow traders to move from long to short instantly. For instance, if you own 1,000 shares of stock and wish to go short 1,000 shares, you must first sell your 1,000 shares and then enter a separate order to sell short. And before you can short those shares, you'll need to get approval from stock loan - assuming they can even locate the shares to borrow.

But with futures contracts, the process is much simpler. The number of futures contracts does not depend on the number of shares in the underlying; it only depends on how many people are willing to buy and sell the underlying. Therefore, you know that futures contracts will always be available to short. So if you're long 10 futures contracts (1,000 shares) and wish to go short 10, you only need to enter one order to sell 20 contracts and that makes you short 10 contracts at that instant.

Drawbacks

The daily crediting of cash to your account works in the reverse direction too. If the underlying asset moves adversely, then your account will be debited some cash. Once again, the amount of the debit depends on the size of the move and the number of contracts you own. Some traders, however, view this as a benefit since it forces you to make a daily decision on whether or not to hold the contract. If you own the underlying stock, it's easy to talk yourself into holding the position even when it's losing. But if you see cash debited from your account on a daily basis, it will certainly make you think twice about holding the futures contract. Any daily debits will force you to actively decide if you wish to continue holding the position - and that can be a good thing.

Historical Returns

The historical returns on futures contracts will be a magnified version of the underlying stock or commodity. The reason is that the futures contract is an agreement to buy or sell the underlying so it is directly tied to that asset; the overall variability will be the same. However, because the trader only places a small fraction of the cost of the commodity, the gains and losses will be magnified.

You can learn more about single-stock futures contracts by taking our free course.

Risk and Reward

Will Rogers once said, "Why not go out on a limb? That's where the fruit is." This is one of the simplest ways of expressing the relationship between risk and reward. He was, of course, referring to the fact that in order to get the fruit (reward) you must venture out onto the tiny, unstable limbs. In other words, you must take some risk. The same concept applies to every financial decision you will ever make. In financial terms, if an investment is risky then we mean there is a chance you might lose some or all of your initial investment. The greater the chance for loss then the greater the risk of the investment.

Risk and reward is the inseparable dynamic duo of finance and always increase and decrease together. If the potential reward from an investment is great, you can be sure that it comes with a lot of risk. And if the risk is low, you can forget about making a lot of money.

While the concept of risk and reward may make intuitive sense, it is one of the most overlooked concepts among investors and causes many problems for those who only consider the reward side. If you want to succeed in investing, it is crucial that you understand the risk-reward relationship and why this pair cannot be separated. We can easily convince you why risk and reward go hand-in-hand by playing a simple game.

Pricing Game

Imagine that you are offered the chance to play the following three games. An auction is held to play each game. The highest bidder is allowed to play the game one time and does not get his bid amount back. If you win, you get a $100 cash prize. Think about each of the games and then jot down your answers on a piece of paper:

	1. For the first game, the highest bidder is guaranteed to win $100 cash. No risk. No hidden strings attached. If you are the high bidder, you walk up and collect $100. How much would you bid to play this game?
	2. For the second game, you must correctly call heads or tails at the flip of a coin in order to win the $100 prize. How much do you bid to play the game now?
	3. For the third game, you must draw the ace of spades from a well-shuffled deck of cards in order to win $100. How much would you pay to play this game?

Even though we don't know the particular answers you chose for each game, we are 100% certain that you elected to pay the most for the guaranteed game, the next highest amount for the coin game, and the least amount for the card game. How do we know this? It's because of the relative risks involved in each game. The first game has no risk; we know that the winner always wins $100. And because of this, most people will bid this game up fairly close to the $100 reward. For the coin toss, we know that you would win $100 half the time and lose half the time, which is certainly not as good as winning all of the time. In other words, we are less confident in the outcome - there is risk. There is no chance of losing with the first game but a significant chance of losing with the coin game. Because of this, you should be willing to spend less for this game. For the card game, we know you would win $100 only once out of every 52 tries, on average. This means you are almost certain to lose your money. On a comparative basis among the three games, this is the riskiest so you should be willing to spend the least to play it.

We just reviewed each game in terms of risk and find that the higher the risk, the lower the price you are willing to pay. We can look at the three games in a positive light as well and say that the more desirable the game, the higher the price you should be willing to pay. The guaranteed game is more desirable than the coin game and that's why its price is higher. Or conversely, the coin game is riskier than the guaranteed game so it is cheaper.

It doesn't matter which dollar amounts you picked for each game but, just for the example, let's assume you bid the following amounts:

Guaranteed game: $99

Coin game: $49

Card game: $1

Once we have some prices to work with, we can look at the three games in a different way. If you were willing to pay $99 for the first game, that's the same thing as saying you were willing to invest $99 in order to make a $1 profit. The coin game, on the other hand, represents a game where you could invest $49 for the chance to make a $51 profit while the card game represents an opportunity to invest $1 in hopes of making a $99 profit.

Notice the relationship between the prices and the rewards: The higher the price, the lower the reward. The guaranteed game carries the highest price of $99 yet comes with the smallest reward of $1. The coin game has a bigger reward and a correspondingly lower price. The card game has the biggest reward of all and also has the lowest price.

The reason for this price and reward relationship should now be obvious to you. It is solely due to the risk of each game. The bigger the risk, the less you are willing to pay, and that allows for a bigger reward.

Price is the Equalizer

The market places a lower price on riskier assets as a way to equalize the risks. In the pricing game, you placed a higher price on the coin game than the card game. This doesn't mean that the coin game is necessarily the better game. If the coin game and card game were priced the same, then we could say for sure that the coin game is better. After all, it wouldn't make sense to pay the same price to play the card game. But because there is more risk with the card game, you will bid a lower amount. Once the prices are established for all three games, then all games are theoretically equally attractive. Your decision on which one to play just depends on how much risk you wish to take (or on how much reward you're looking for). If you don't like the $51 payoff of the coin game, you can certainly jump to the card game and go for $99. But just understand that this decision means you are taking more risk and therefore have a higher chance of losing your investment. You cannot jump to a better payoff and take less risk. If you want more reward, you must be willing to take more risk.

As you build your investment portfolios, it's important to never forget the risk-reward relationship. However, investors and traders unintentionally neglect it all the time and it causes many losses and misleading beliefs.

For example, many investors think that you're better off buying low-priced stocks since a $1 gain represents a much bigger percentage return on your money. If a $1 stock rises $1, then you've doubled your money. But if a $100 stock rises $1, then you've only made one percent on your money. Many traders assume that the $1 stock is therefore the better investment. After playing the previous pricing game, you hopefully understand why that's not true. Both stocks have a chance of making a $1 gain just as any of the pricing games had a chance of making $100. But as the chance of making the $100 falls, so does the price. And that's why the market will price some stocks at $1 and others at $100. The market places a higher price tag on the investments that are more likely to produce a profit - just as you did with the pricing game. Traders who believe the $1 stock is the better investment make the mistake in believing that both the $1 and the $100 stocks have the same chance of rising $1. And that's an easy mistake to make since we do not have little pictures of a coin or deck of cards next to each investment to remind us of the risk involved. But you can be sure the professionals are assessing the risks of each investment and pricing them accordingly. If you're still not sure, a casual following of some stock quotes will quickly demonstrate that prices of cheap and expensive stocks do not move equally. You will find that stocks in the $100 price range rise and fall $1 all the time for no apparent reason. However, you will never see that type of daily activity on a $1 stock unless there is significant news. The chances of moving $1 are therefore not equal for the two stocks and that's why they are not priced the same.

This is not to say that you should never buy a $1 stock. We're just saying that you should not buy a $1 stock on the belief that it must be better than a more expensive stock just because the percent return would be greater for any given price increase. It's true that the percentage return will be greater but you need to understand that the "benefit" does not come for free. The benefit comes at the increased risk of losing some or all of your money. Investors who do not understand these relationships inevitably make the mistake of continually reaching for the riskiest assets - and also end up taking lots of losses.

Stock Advisors

Understanding this inescapable risk-reward relationship can keep you from being misled by those who tout stocks, strategies, or their stock picking skills. For example, at a recent seminar, the speaker said that investors "had it backwards" because they are, for example, willing to spend several thousand dollars on a stock in hopes of making a few hundred dollars. "Why not," he continued, "spend a few hundred on some options in hopes of making a few thousand dollars." Many traders immediately bought into his idea not realizing that there is a very real cost. The investment in the stock and options are not directly comparable because the chances of losing your few hundred dollars in options are far greater than for losing a few thousand on the stock investment. From the speaker's viewpoint, the options appeared better since he could "pay a little" in order to "make a lot." But notice that's the same relation that you were offered in the card pricing game. With the card game, you could pay $1 to make $99, which certainly sounds like the most favorable risk-reward schedule. Most people would refuse to play the card game; however, they are all too eager to jump into hidden variations in the stock market. The speaker at this seminar was unknowingly getting investors to switch to a riskier strategy. Using our earlier games as an analogy, he was trying to get people to switch from the coin game to drawing the ace of spades.

You'll hear other fallacies too. For instance, some will tell you to stay away from bonds since you cannot make a lot of money. After all, why spend $9,900 on a government bond that matures to $10,000, thus netting you only $100 profit on your investment? The reason that investors do is because it is guaranteed. Because of its no-risk structure, the market places a very high price on that investment. The market does this for government bonds for the same reason that you probably bid very close to $99 to win the guaranteed $1 profit in the pricing game.

Options

Option traders make similar risk-reward mistakes with options. If an option trader wants to buy a call, he will most likely buy an at-the-money or out-of-the-money strike. The main reason traders like these strikes is because they are cheaper than the lower strikes. Once again, traders erroneously assume that all options have equal chances of rising or falling $1 and so feel that it only makes sense to buy the cheapest options. You should now understand that all cannot have equal chances of rising $1, otherwise they would cost the same. The market bids up the prices of the lower strike calls because they are less risky. But if you do not understand the risk-reward relationship, you will be tempted to buy higher strike prices thinking that you are doing yourself a great service by only putting a little bit of money into the trade, which gives the appearance of lowering your risk. The cheaper the option, the higher the risk.

Options can also be used in combination to create limited profit structures. For example, you may hear traders talk about a strategy where they paid $3 that can make a maximum of $5 (a $2 profit). The benefit to limiting the maximum upside is that the price to create the position is much cheaper. But many will tell you they prefer cheaper structures with higher payouts such as one where they may pay $1 to make $5 ($4 profit). They often argue that it is just makes sense because of the "better" risk-reward ratio. The mistake in believing that the cheaper one is "better" is based on the faulty belief that both strategies are equally risky. The cheaper the investment, whether it is a single option or a combination strategy, the higher the risk.

Lotteries

Our basic risk-reward relationship can be found in many other areas outside of the financial markets too. As long as there is a price paid in exchange for a possible financial reward, the risk-reward relationship holds. Take, for example, the state lotteries. Why do you suppose that you can pay $1 for a ticket for the chance to make $7 million or more? The reason is that the chance of making that huge reward is very small and so the price will also be low. It does not mean that it must be a great investment because of the "great risk-reward ratio" that so many traders talk about. If there is a great reward, there is a low price - and also a lot of risk.

The Florida lottery offers two versions of a scratch-off Monopoly game: Super Monopoly and Instant Monopoly. Super Monopoly offers a $100,000 grand prize while Instant Monopoly only offers $5,000. However, both cards cost $1 to play. Does it follow that Super Monopoly is the better game since it is better to bet $1 to make $100,000 rather than $5,000? The answer is no since better payout is a reflection of the higher risk involved in that game. In fact, you can even verify this is true by going to the lotteries website and looking at the odds. For Super Monopoly, the odds are 1:2,520,000 and are 1:890,000 for Instant Monopoly. Although neither odds are good, there is no doubt that, on a relative scale, you are more likely to win at Instant Monopoly and that's why the payout is lower.

Comparing Returns among Funds and Managers

Another reason for understanding the risk-reward relationship is that it will keep you from choosing your investments in a misguided way. You will be persuaded by different types of investments or individual stock pickers to put your money with them because they "beat" the Dow or some other index. While their returns may be higher, it does not mean that they necessarily beat it on a risk-adjusted scale. As an example, assume the Dow increases 10% over the year but a money manager tells you to put your money with him since he earned 20%. On the surface, it seems like he did better. However, we haven't considered the risk. What if this manager invested all his clients' money into Super Monopoly to get the 20% gain? Now it doesn't appear too impressive. If he is taking that much risk, you'd certainly want better than a 20% increase on your money. We'd say that, on a risk-adjusted scale, this manager didn't perform as well as the Dow even though his return is higher. Traders and money managers who place their money in high-risk investments will do better than the Dow or S&P 500 or other broad-based index from time to time. But the chances that they will sustain that record are very low. People who place their money with a fund or manager just because they posted the highest numbers are mistakenly assuming that all of them took the same amount of risk. Before you place your money with them, find out what they are investing in before you get too impressed with the numbers. At any given time, there are thousands of speculators and hedge funds who speculate with high-risk investments. It shouldn't be a surprise that many of them will beat the Dow or S&P 500 during the course of a year. This doesn't mean that they are more skilled than the manager who returns a smaller number.

Make sure you understand the risk-reward relationship before you start investing. Risk and reward never separate. They are joined together by a rational force - the same force that caused you to price the earlier games in the order you did. If you always seek the investments that have the highest potential for return, you are by default, seeking the ones with the highest risk.

How Prices Are Determined

A financial company called Admiral Financial Corporation (ADFK) trades for $.0001, or 1/10,000 of a penny per share. It has a little over 10,000,000 shares outstanding, which means you can buy the entire company for just over $1,000. Another financial company, Berkshire Hathaway (BRKA) trades for over $86,000 per share and has 1,272,000 shares outstanding. To buy this company would cost $109 billion dollars. Why the difference in prices? How do we decide on how much to charge for one share of stock? In other words, how are these prices determined?

As you continue to learn about the stock market, you will hear many different stories about the ways these prices come about and most of the answers are simply false - they are myths that have been spread from investor to investor over many years that eventually become accepted as truth. As often said, it is easier to believe a lie that one has heard a thousand times than to believe a fact that no one has heard before. Stock price formations, unfortunately, have fallen victim to this path. You will hear people say that stock prices are purely manipulated by the stock exchanges, whether those shares are traded through true auction markets such as the New York Stock Exchange, or electronic markets such as the Nasdaq. People continue to believe that these exchanges have complete control over what you pay but, as we will show later, these exchanges are better off not having that control. They are better off responding to the current bids and offers rather than trying to create them. It is crucial to understand the process otherwise your investment decisions will be clouded by the widespread false beliefs that continue to float across every conversation about the stock market.

Basic Economics

So what - or who - does control stock prices? The answer is that all of us do. Prices are formed by our desire, or demand, for buying in relation to the supply that is available. If the demand for anything rises, the price will rise (assuming the supply stays the same). If the supply of anything rises, the price will fall (assuming demand stays the same). Changing the supply or demand affects price. Conversely, we can affect supply and demand by changing price. If we raise price, the supply will increase and the amount we want to buy will fall. If we lower price, the supply will fall and the amount we wish to buy will increase.

In economic terms, it is the supply and demand of stock that determines its price. Most of you have heard this answer before - it is the answer to every question that has ever been asked about price. But if you just accept "supply and demand" as the explanation, then it limits your understanding as well as your acceptance of the fact. So let's take a little closer look at what we mean when we say that supply and demand determine price.

Lemonade for Sale

Assume that you wish to run a lemonade stand. One of the decisions you must make is how much to supply, or make, over a given time period. Will you make one gallon or five gallons per day? This decision in itself is not easy. The amount you produce depends on how much you think you can sell. And the answer to that question depends on price, which is what we're trying to determine. The higher the price, the less you'll sell. The lower the price, the more you'll sell.

How much you decide to produce also depends on many factors including how much time and money you have available. For instance, you may be willing to make 50 gallons per day but do not have that much money available to buy the necessary ingredients. In addition, you'd also have to have a way to store it and haul it around if you do not sell your entire inventory. All of this requires time and money.

But let's just say that you are willing and able to take 100 glasses to the stand each day. You think you can sell them for $1 each; in other words, you'd be willing to operate the stand for $100 per day. This is the supply side of the equation and that's all you can control.

The Demand Side

Now let's look at the demand side. That's the side that the customers control. The price they are willing to pay for your lemonade does not depend on your cost. In fact, any buying decision for any product is completely independent of cost. For example, the amount of gas you buy each week depends on your needs and what you're willing to spend. If gas prices jump to $5 per gallon, economists are certain you'd buy less gas no matter what the reason for the price hike. You wouldn't buy the same amount of gas just because the store owner incurred a justifiable increase in cost. You don't care about their cost; you just know what you're willing to spend and for how much. Once you see the store owner's price, then you make your decision on how much to buy.

So while we have solid reasons for why you might be willing to supply a certain amount of lemonade at a give price, we really have no basis for determining how much people are willing to spend to get it. Value is based on personal tastes and is subjective. Some people may be willing to spend $5,000,000 on a Renoir painting even though the cost - the paint, canvas, and time - was likely to only be a few bucks. By the same reasoning, if I wish to sell thoroughbred horse stew, my costs would be enormous but I may not be able to sell any even if I sell below cost. People do not care what your costs are in determining the value to them so it's really tough to predict what value people will put on any product.

A recent example occurred in August 2004 right here in South Florida where a man called FEMA (Federal Emergency Management Agency) after Hurricane Charley nearly destroyed his mobile home. He received a check for $1.69. The agency claimed he didn't qualify for aid but sent him the check so that he could buy one gallon of gas for his generator since the electricity had been knocked out (by the way, gas was $1.83 at the time). The man was infuriated and he called a local radio station to criticize the agency. After some humorous conversations with the DJs along with comments from callers, the check started to take on a personality of its own. Eventually someone offered him $24 for the check! Now why would someone pay $24 for something that we can definitely say is only "worth" $1.69? The reason is that the check had more value, at least to that person, than the $1.69 intrinsic value. Maybe he wanted it as proof of the humor and irony of the situation. Or maybe it was to demonstrate the inefficiencies of government for a college course. We don't know why and it doesn't matter. All we know is that he was willing to pay dearly for that check, which would probably never be cashed. The value that people see in things is purely subjective; it is a value that exists in their heads.

Supply Meets Demand

You show up for your first day on the street with the lemonade stand. This is the first day where your supply is introduced to the customers' demands. But just before you hang the "open" sign on the front, you get an idea. Why charge only $1? After all, your friend told you about how the stock market is manipulated and that "they" put up outrageously high prices when you want you to buy and then "they" place ridiculously low bids when you want to sell. You realize you're now in control so why not learn from their little game and play along? You quickly change your price from $1 to $5 per glass.

But at the end of the day, you're a little dismayed. You didn't have a single sale and you're stuck with the entire inventory. It turns out that all the passersby had choices - and they chose to not patronize your stand.

The next day you reopen and decide to drop your price to $4 in hopes of getting people to try your stand. This time you get a couple of sales. The following day you drop your price to $3. You get a few more sales but are still stuck with the majority of the inventory.

Now you're really frustrated so you drop your price back to your original idea and charge $1. To your amazement, the tide has turned and people are flocking to the stand - but this time the problem is in the opposite direction. You have run out of supply and there are still people in line. Once they hear that you've run out, you've got mad customers on your hands and they may never return. So how can you strike a happy medium and sell 100 glasses without turning people away? The answer is to keep changing price until only 100 glasses are sold. Another way of saying this is that you want to charge a price where only 100 glasses are demanded; that is, you need to find a price where your supply equals demand.

When you charged $4 or higher, there was an excess supply and you ended up with unwanted inventory. With the price at $1, you ended up with excess demand and had extra people standing in line who were not able to buy. At some price between $1 and $4 then, you must be able to balance the two forces of supply and demand and that is the price where supply equals demand. That is the price that will leave you with no inventory as well as no remaining customers. That price is called the market clearing price.

Rationing

Price acts to ration things. Like the gas and brake pedals of your car, price allows you to regulate the speed at which your products flow. If you raise the price, you can slow down the flow since people buy fewer things when prices are high. On the other hand, if you lower the price, you can increase the flow because people buy more when prices are low.

For example, when you charged $4 per glass, you had excess supply of lemonade. And when you charged only $1 per glass, you had excess demand and were forced to close up shop early. You did leave with $100 in your pocket but you also had extra customers in line who were willing to buy but were turned away. If you keep your price at $1 tomorrow, you will likely have the same outcome. However, if you charge more than $1, you will find that some of these customers will not want the product at that price and will get out of line. By raising price, you are tapping the brakes and your lemonade will not leave the stand so quickly now.

But what incentive do you have to change your price? The answer is that you will produce your maximum profit at the point where supply equals demand. And that's a powerful incentive. Let's assume that you find that by charging $1.50 that you sell exactly 100 glasses per day.

How do you know that $1.50 is the market clearing price and not some higher price such as $1.60? Assume you increase the price by 10 cents to $1.60. You are thinking that your revenues will now increase by $10 to $1.60 * 100 glasses = $160. However, once you announce the new higher price, you find that seven people back out of the line, which means your revenue at the end of the day is now $1.60 * 93 sales = $148.80, which is $1.20 less than the $150 revenue you had by charging the lower price of $1.50 per glass. The price increase did bring in an additional $0.10 for the 93 buyers, or $9.30. However, that additional revenue came at the expense of losing 7 people willing to pay $1.50, or $10.50. The net loss is $9.30 - $10.50 = $1.20, which is exactly how the amount of revenue you're missing. You quickly find that you're better off charging $1.50.

Why did seven people back out of the line? We're not sure. All we know is that at the new higher price of $1.60, seven people felt there were better choices elsewhere and chose to not buy. Remember, the buyers' perception is the side of the puzzle that you cannot control. But by changing prices, you can control who gets what and the incentive you have to find this point is the self-serving interest of maximizing your revenues. And notice that in order to maximize revenues, you did not charge the highest price that people were willing to pay. We found out earlier that you did, in fact, have buyers at $4 and even more sales at $3 but you have settled on a price of $1.50. Even though you had complete control to "charge whatever you want," you have chosen to settle on a relatively small amount. You have chosen the market clearing price of $1.50, which is what any profitable business owner would have figured out to do.

Hopefully this has convinced you that deliberately raising prices above their market clearing price is not advantageous to the business owner. But the economic myth persists in many in nearly every topic about prices. For example, people firmly believe that the reason movie theaters charge so much for popcorn is because "they have you captive" once you enter the gates. If that's true, why not charge twice as much for popcorn? Why not charge another price for the bag? People also believe that monopolies can exercise great pricing powers but, upon some thought, you will find they're really not that much different from other types of businesses. If they were, your utility company would charge thousands of dollars, perhaps millions, per month. Why do think they settle on a relatively minor amount? The answer is that movie theaters and utility companies must act within the constraints of consumer demand. They must price within what we are willing to pay because, just like we found with the lemonade stand, people do have choices. And even though there would certainly be people willing to pay the higher prices, movie theaters and utility companies choose not to because they earn more money by clearing the market.

If you understand this simple example of how markets clear, then you are ready to find out how stock market prices are determined.

The Stock Market

Stock prices are formed very much like the lemonade stand example with one big difference. With the lemonade stand, you knew how much product you were willing to supply but did not know how much of it would be demanded at that price. With the stock market, we know at all times how many people are willing to buy and sell and at what prices. And that makes it very easy to find the optimal price.

Let's look at the stock market business by assuming you are now the market maker for ABC stock. The market maker is the person who stands between all buyers and sellers to ensure an orderly market. If, for some reason, there are no buyers or sellers then the market maker will step in to provide liquidity.

It is your first day on the job and you need to determine the opening price of ABC stock. Unlike the lemonade stand, you are not bringing the supply to market - other stock traders are. But in a similar way, it is still your job to balance the two forces of supply and demand. To make the example easy, we're going to assume that there are 11 people who want to buy ABC stock and 11 who wish to sell and they all wish to trade 100 shares.

The market hasn't opened yet, but you are already receiving orders. Let's say you receive an order to buy 100 shares for $20. In market terms, we would say this person is bidding $20 for 100 shares. Buyers submit bids. This means the person is willing to buy 100 shares for no more than $20. The order does not need to be filled for exactly $20. If you can fill the order for less money, the trader will presumably be happy. Another trader sends in an order to buy 100 shares at $19.50, which means he is willing to pay up to $19.50 for the 100 shares; he will certainly be happy to pay less. We'll assume that nine other buyers send in orders to their brokers with each order decreasing in price by 50 cents.

At the same time, sellers are sending in orders too. Assume that one trader sends an order to sell 100 shares for $15. In market terms, we would say this person is submitting an offer or is asking $15. This means that the trader will sell for no less than $15; he will certainly accept more. Another trader sends an order to sell 100 shares for $15.50, which means he will accept no less than $15.50 for his sale. Nine other traders place sell orders too with each one increasing their price by 50 cents.

Your computer program organizes all of these trades from the highest bidder (buyer) to the lowest offer (seller), which are summarized in Table 1 below:

Table 1: Buyer and Sellers of ABC Stock

Based on the information in Table 1, which price should you charge for ABC stock at the opening bell? You know that someone is willing to spend $20 for the stock as demonstrated by the highest bidder so why not exercise your power and set the price at $20? Won't that maximize your profits? But this sounds familiar and you are having flashbacks of running the lemonade stand. You quickly remember that charging $5 - even though you were allowed to - was not the optimal price. Maybe you should check the numbers to see how this will turn out.

If you charge $20, you could match the top bidder (#1) with any of the eleven sellers (all of them are willing to sell for $20 or less) and you will only sell 100 shares for $20 and generate $2,000 revenue. Why will only 100 shares be sold? Even though there are eleven traders willing to sell for $20 or less, there is only one buyer so only one trade of 100 shares can be completed.

What will happen if you lower your price to $19.50? At this price, you could match buyers #1 and #2 with any of the sellers #1 through #10 , which generates 200 shares * $19.50 = $3,900.

At a price of $19, you can match buyers 1 through 3 with any of the sellers #1 through #9. This generates 300 shares * $19 = $5,700. Note that each time you lower price, the number of buyers increase while the number of sellers decrease. Table 2 summarizes all the possibilities:

Table 2

You can see that your maximum revenue is generated at a price of $17.50. At that price, your revenue is $10,500 and no other price combination can get you a higher amount (that's true even if we were to try price increments other than 50 cents). It's also true that $17.50 creates the highest number of trades (600 in this example). The maximum profit is therefore a balancing act between price and volume. Lower prices may sound bad at first but you have to consider the additional sales, or trades, that it will generate. At some point, it will not pay to lower prices anymore since the additional trades do not cover the loss in price.

So one way we can find the optimal price for this opening stock price is by trial and error. We can try different prices and see what the revenue outcomes will be and then pick the combination that nets the highest return. However, there is an easier way for us with the stock market. We can simply look at the price where the number of buyers equals the number of sellers and that is our market clearing price. Remember, you have that power to do that here since you can see what the bidders are willing to pay (the demand side) as well as what prices traders are willing to sell for (the supply side) as shown by the offer prices in Table 1. You didn't have that luxury with the lemonade stand and had to find the optimal price by trial and error.

Let's see how it works and how simple it really is. At a price of $20, you have one buyer (#1) but eleven sellers. Everybody is willing to sell at a price of $20 or lower. At $20, there is a mismatch between the number of buyers and sellers. Specifically, there are too few buyers in comparison to the sellers. In order to evenly match them, we must hit the gas pedal to accelerate the buyers. And we do that by lowering price.

At $19.50 you have two buyers (#1 and #2) but have ten sellers (#1 through #10). Our lower price is working since we have increased the number of buyers and decreased the number of sellers but we're still not balanced yet.

At $19, there are three buyers and nine sellers. We're moving in the right direction but still not there yet. As you move through the list of prices, eventually you'd find that at a price of $17.50, there are six buyers and six sellers and that must be our optimal price. In the real world of stock trading, computers do these calculations instantly. Depending on the orders that are arriving, they will find the clearing price of the stock and that is the price that you see quoted.

Picture Your Profits

We can find the same answer by graphing the list of bid and offer prices in Table 1. If you do, you'll get the following chart:

You can see that the two lines - supply and demand - cross at $17.50 and at a quantity of 600 shares. That is the point where supply meets demand and the market is cleared.

Marginal Traders

When you first look at Table 1, it's easy to think that all traders are influencing the final price of the stock. But the truth is that it's only buyers and sellers # 6 that are the ones determining the final price. If their prices had been a little different - even by one cent - we would have a different clearing price. While the highest bidder was willing to pay $20 and the lowest offer was $15. Their prices, ironically, have no bearing on the final price. If these prices were instead $30 and $10 respectively, you'd still find that the clearing price is $17.50. Because of this, we say that it is the marginal traders - the ones on the edge of the current price - that are solely responsible in determining a stock's price. The final quoted price has nothing to do with the highest bidder or lowest offer. And it definitely has nothing to do with the market maker. The market maker simply finds the optimal price based on the orders received. It is the marginal traders who determine the price of a stock. If you don't believe it, you can do a little test the next time you submit an order. For example, assume a stock is bidding $29.90 and asking $30. If you place a limit order to buy above the current asking price, you'll find that you'll be filled at the current asking price (or at least very close). If you place an order to buy 100 shares for $40, you'll find that the order is filled for the $30 asking price and not for $40 (be careful in after-hours trading though, it would be filled at $40 since it is not a live auction!) Why won't the bid jump to $40 since you're now the highest bidder? That's because your order has no bearing on the price of the stock; your order is outside the marginal prices. In fact, many traders will tell you the quote represents the highest bidder and lowest offer but that's not quite right. It really represents the highest bidder and lowest offer at the margin. If the quote represented the true highest bidder and offer, then the quote would be bid $40 and asking $30. The same is true for the sell side. If you place an order to sell for $20, you'll be filled for the current bid of $29.90 (or very close). It is the marginal traders who determine price. And when you look at a stock quote, you're really looking at the highest bidder and lowest offer at the margin.

Thoughts about Price

The price of anything you buy is determined in a similar manner as the way we found the optimal stock price. It is the price that equalizes buyers and sellers. Whether you buy a gallon of milk or a gallon of gas, prices will vary depending on the supply and demand at that time. If there is a sudden surge in demand, we can apply the brake by increasing prices and reducing the flow. If there is a sudden increase in supply, we can press the gas pedal by lowering price and increasing the flow.

If there is ever an imbalance between supply and demand then one of two conditions will occur: You will either find that the supplier is out of product (price is too low) or that the supplier has excess product to sell (price is too high). Obviously, it is difficult for most retailers to exactly match buyers and sellers as peoples' tastes and preferences change constantly. That's why stores occasionally run out of items or have to run clearance sales to encourage buying and clear the shelves of unwanted inventory. But for the most part, everybody who wants the good at that price should be able to get it; otherwise someone is not properly setting prices.

As an example, the Citrix Open Tennis Tournament is held every year here in Delray Beach. Last year, the grandstand for the final was probably 30% filled. That's an obvious sign that prices are too high. Despite the advertising efforts, the tournament was willing to supply far more seats than what people wanted at that price. Lowering the price would have filled the seats - and increased their revenue as well.

On the flip side, during hurricane Frances, our shelves were cleared of food, drinking water, batteries, and other essentials. Gas stations had enormous lines and all eventually ran out of gas. Those are signs that prices are too low. Why don't stores increase prices to adjust for the increase in demand? They would except for the fact that the government imposes "price gouging" rules, which are mistakenly intended to keep the retailers from "taking advantage" of the consumers during times of emergency. The prices stores charge for a product must not exceed the average price for the preceding 30 days otherwise they can be charged with price gouging. Artificially keeping low prices during a surge in demand is the recipe for an immediate mismatch in supply and demand. You have far more buyers (demand) than goods available for sale (supply) and the shelves will be swept clean.

So who cares that the stores are sold out? Should retailers be allowed to profit by charging higher prices and keeping more products on the shelf? The answer to that is easy once you understand marginal values. When you decide to buy anything, the question is not "how much should I buy" but rather "how much should I buy at this price." For example, if water is expensive, say $100 per gallon, you would probably only buy what you need to survive. But as the price gets cheaper, you will find other uses. Say the price falls significantly so you decide to buy some more in order to take showers. The additional use of showers is called the marginal use of water since that is the newly added use to the list. It is the marginal value that determines price just as the marginal traders determine stock prices. As the price continues to fall, you may decide to water plants, wash the car and, finally, wash the dog. Every time price falls, new uses are added. Fortunately, water is so plentiful that the marginal value is pretty low. That's why we'll use it to wash windows or start a fish aquarium.

But during a hurricane, the marginal use of water rises. Everybody knows that supplies are tight and we should be stocking up on water for drinking; that is, to stay alive. If we're buying water for the marginal use of staying alive then its price should be high. But when the government tells the store owner they cannot raise prices, then people will buy water for other uses whose marginal values are much lower. People will stock up on water to cook, clean dishes, wash their hands, water plants, wash the dog, and fill the windshield wiper reservoir in their cars. As a result, others are left without water to drink. Governments sometimes attempt to keep product on the shelves by running public advertisements to "buy only what you need" but those ads tell us what we already know. Remember, people always "buy what they need" but that is based on the current price. And if the current price allows it, they will buy for all sorts of needs that are probably not deemed to be "necessary" by most people during a pending natural disaster.

Batteries are another example. During a hurricane, everybody should have some batteries to listen to a radio for emergency alerts or to run a flashlight if the electricity goes out. But when you get to the store, it is not uncommon to see people in line with 20 packs of batteries. The reason is that, at the artificially low price, people are certainly buying them for radios and emergency lighting but also to run electronic games, television, DVDs, CDs, and other forms of entertainment. Because the stores cannot raise prices, these people will be fully entertained during the hurricane while many are left in the dark.

The Market Never runs out of Stock

If prices were allowed to adjust, the stores would always have water and batteries available for everybody. Sure, they would be expensive, but at least you'd have water to drink at the expense of someone's dog not getting washed. And you'd have a flashlight to get around in the dark because the higher battery prices will force someone to go without GameBoy. The price gouging laws actually hurt consumers despite their sympathetic intention. Stock prices are allowed to change and they do - rapidly. Prices plunged upon hearing the news of the September 11 attacks. And in early 2000, the biomedical company Entremed (ENMD) spiked from $30 to $70 in two days. (Why isn't this considered price gouging?) These price swings are not due to the exchanges taking advantage of critical situations but rather to make sure that all buyers can be matched with all sellers at that price. It is the most efficient way to run a market. Because prices are allowed to change, the stock market never runs out of stock. We cannot say the same about store inventory during hurricanes.

So when you hear someone blame the market makers because the price jumped just before they bought the stock or that the price fell the second they placed their sell order, you'll hopefully now understand that it is a misperception. The market maker is better off finding the price that clears all buyers and sellers and not in finding the highest price that someone is willing to pay or the lowest price for which someone is willing to sell. While erratic price changes may appear to be price manipulation, it is simply the result of the marginal traders trying to do the same thing as you. If you think it is a good time to buy or sell, chances are that others do too and that's why the price moves are usually adverse - everybody's trying to do the same thing at the same time.

As you get involved with stock trading, don't spend your time trying to "beat the market makers." They are not the ones to beat; they are there to match buyers and sellers. Instead, try to figure out how news and events will affect the supply and demand for your stock and use that knowledge to trade with. If you do, you will be happy to see the market makers doing their job to clear the markets - and you will profit in return.

What is Short Selling?

You are probably familiar with the concept of "buy low, sell high." If you buy a stock for $30 and sell it for $40, you pocket the $10 difference as a profit. In stock market lingo, if you buy a stock, you are "long" the stock. Traders who are long stock hope to sell it at a later time for a higher price. A trader who is long stock is "bullish" on the stock, which is just another stock market term describing the upward expected price movement of the stock. A bull attacks by lowering its horns and then raising them high, which is what long stock traders hope will happen to the price of the stock - move from low to high.

We can also reverse the "buy low, sell high" equation and "sell high, buy low" and effectively do the same thing. In order to do this, you must first sell stock and then buy it back at a later time. In order for this to work though, you cannot already own the stock. If you already own the stock and then sell it, you're out of the position. This means that, in order to sell first, you must sell stock that you do not already own. How can you sell something you don't own? You must borrowobligation to buy the shares at a later time to return to the owner. Hopefully you will be able to buy them back at a lower price thus pocketing the difference. the shares. Once you sell the borrowed shares, you will collect the cash from the sale but then have the

If you sell a stock for $40 and buy it back later for $30, you will pocket the $10 difference as a profit. You have effectively bought low and sold high but just in the reverse order. Traders who sell the stock first are "short" the stock. If you short a stock, you are "bearish" on the stock, which is a stock market term describing the downward expected price movement on a stock. Bears attack by lowering their paws from high to low, which is exactly what short stock traders hope will happen to the price of the stock - move from high to low.

As a recap, if you are bullish on a stock (think its price will rise) you'd "go long" the stock. If you are bearish on a stock (think its price will fall), you'd "go short," which is also called "selling short," or just "shorting."

If you choose to only buy stock, then you can only make money on stocks whose prices rise. But if you also add short sales to your arsenal, then you can profit from stocks whose prices rise or fall.

How Does a Short Sale Work?

In order to short a stock, you must borrow shares from your broker. While this may sound like a complicated process, it actually takes a matter of seconds. The reason is that when you sign a margin agreement, you are giving your broker the right to hypothecate stock, which is just a fancy term for loaning. So for example, if you have shares of Microsoft in your margin account, it's possible that the broker may loan those shares to another trader to short. But don't be worried, your account will always show those shares available for you to sell even though they technically may not be there. The entire process will be completely transparent to you. As far as you'll know, the shares are always in your account. If you decide to sell them, the broker will get the shares from yet another account, which will allow you to place the sale.

If this is the first time you've heard about the process of shorting, it may leave you feeling a little uneasy. The idea of stock moving from your account to someone else's without you even knowing about it sounds fishy. But if you think about it, you already do this everyday - whenever you deposit or withdraw money from your bank. If you deposit $1,000 to your account, that money is not sitting in a special box with your name on it so that only you can access it. On the contrary, it is immediately loaned to someone else even though your account will always show that the $1,000 cash sitting there. If you decide to withdraw it, your banker will get the money from yet another account and it will make no difference to you. This is exactly what happens when your broker loans your shares to others for shorting.

Once you get the shares from your broker, you simply enter an order to "sell short" those shares and then you have an obligation to buy an equivalent share amount of the same stock back at some time in the future. In most cases, you can enter a short sale online but your broker must locate the shares first before allowing the sale to go through. Short sales can be executed with nearly the same speed and ease of buying stock. In order to short stock though, you must have a margin account.

Short Sale Example

Let's take a look at an example of a short sale and assume you think that ABC stock will fall. You'd simply call your broker or log onto your online account and "sell short" a specific number of shares of ABC stock. In order for that sale to go through, it must be done on an uptick, which simply means that the price you sell at must be higher than the previous price on the tape. This rule was created to prevent traders from shorting into downdrafts, which would only accelerate the downward motion. By selling on an uptick, it shows that there was some buying pressure at that time. The uptick rule is nothing you need to watch for as the computer will automatically take care of whether the trade is on an uptick or not. Just be aware that this little technicality makes it possible to not get filled even if you place a market order. But in most cases, short sales "at market" are filled within seconds of placing the trade.

Let's assume you sell short 100 shares of ABC, which is currently $50 per share. Your account is credited with $5,000 cash (100 shares * $50 per share). But you don't just get the $5,000 for nothing; you must also post the 50% Reg T requirement that we talked about in the "Cash vs. Margin Accounts" course. This means you must come up with half that amount, or $2,500, of your own cash so that the total credit to your account is $7,500. Your account will also show that you are short 100 shares of ABC. This is just telling you that you owe 100 shares back to the broker at some time to replace the shares you borrowed. There is no time limit as to how long you have to buy the shares back; however, if there are adverse movements in the stock, you may be forced to close out the position early if you cannot continue to meet the maintenance calls.

After you short the stock, the accounting looks like this:

Credit Balance = $7,500

- Market Value Short = $5,000

Equity = $2,500

The credit balance is the sum of the $5,000 cash you received from the short sale plus your $2,500 cash that you had to post for margin. Your equity percentage is found by dividing the equity into the market value short. In this example, your equity percent is $2,500/$5,000 = 50%. The credit balance never changes; that is all the cash you will ever get from the sale of that stock. So how do you make money? By looking at the above equation, you can see that your equity will grow only if the market value short declines. And this is exactly what you expect to happen if you are short the stock. You are hoping to be able to buy back the stock at a cheaper price.

Let's assume that the price of the stock does decline from $50 to $40. The market value short then falls from $5,000 to $4,000 and your equity will increase by $10 * 100 shares = $1,000 as well:

Credit Balance = $7,500

- Market Value Short = $4,000

Equity = $3,500

You started with $2,500 equity and now have $3,500 equity for a $1,000 increase. If you buy back the shares now at $40, you will spend $4,000 out of your $7,500 credit balance and be left with $3,500.

The reason that short sales work is because you are obligated to buy back a fixed share amount - not a fixed dollar amount. This is no different than when you, for example, borrow a cup of sugar from your neighbor; you have the obligation to return a cup of sugar - not a specific dollar amount of sugar. When you shorted the 100 shares of ABC at $50, you created an obligation to return 100 shares to your broker - not an obligation to return $5,000 worth of stock. If the price of the stock drops, it becomes cheaper for you to replace the shares and you will profit from the difference in prices.

Adverse Price Movements

We said earlier that there is no time limit for you to buy back the shares. That's true assuming that you are able to meet any maintenance calls that might occur while holding the shares short. If you cannot, your broker will require that the position be closed at a loss. For example, let's assume you short 100 shares of ABC at $50 and post the $2,500 margin requirement as you did in the previous example:

Credit Balance = $7,500

- Market Value Short = $5,000

Equity = $2,500

Your equity percent is $2,500/$5,000 = 50%, which is where it should be right after the trade. But now let's assume that the stock rises to $60 per share and your broker has a 30% house requirement:

Credit Balance = $7,500

- Market Value Short = $6,000

Equity = $1,500

Your equity percent is now $1,500/$6,000 = 25% and you have a maintenance call since you have fallen below your broker's house requirement of 30%. You must either buy back shares, deposit money, or deposit shares of stock (it doesn't have to be the same stock). Let's take a look at how each of these methods will affect your account.

Depositing Money

If you choose to meet the maintenance call by depositing money, you will increase the credit balance and the equity dollar-for-dollar. If your broker requires a 30% minimum equity percent, we know that you should have 0.30 * $6,000 = $1,800 equity. Since your equity is only $1,500, we know you are short by $300. If you deposit $300 cash, your credit balance will increase to $7,800 and your equity will increase to $1,800:

Credit Balance = $7,800

- Market Value Short = $6,000

Equity = $1,800

Your account is now at $1,800/$6,000 = 30% equity and you have met the maintenance call. But if the stock continues higher from here, you'll be back in maintenance.

Buying Back Shares

Let's go back to the original setup where your account is at 25% equity:

Credit Balance = $7,500

- Market Value Short = $6,000

Equity = $1,500

This time, however, we will assume that you buy shares back to get out of maintenance. If you buy back shares, you will reduce the credit balance and market value short dollar-for-dollar. In other words, you're using some of that cash to buy back shares. If you wish to get back to 30% equity, you must buy back 1/0.30 = 3.33 times as many shares. In the last section, we figured out that your account should have $1,800 equity, which means you're $300 short. In this example, you'd therefore need to buy back 3.33 * $300 = $1,000 worth of stock. Your credit balance will be reduced to $6,500 and your market value short will be reduced to $5,000:

Credit Balance = $6,500

- Market Value Short = $5,000

Equity = $1,500

Note that your $1,500 equity does not change; however, the percentage equity does change and you're now at $1,500/$5,000 = 30% equity. You are out of maintenance for now.

Depositing Shares of Stock

You can also meet a maintenance call of a short position by depositing shares of stock. If you do, you increase your credit balance in a similar way as depositing cash. If you remember back to the "Cash vs. Margin Account" course, when you deposit stock to your account, you get a "cash release" to your account since you're only required to have 50% equity in the stock. So when you deposit stock, you are, in effect, depositing cash. However, you're not getting cash released in an equal amount as the value of the stock.

The accounting can look a little tricky when you consider long and short positions but it's actually straightforward. All we do is add the equities of the long and short sides and then divide by the total market values. Let's assume you deposit $2,000 worth of stock and get $1,000 released from that deposit. You're now short $6,000 worth of stock and long $2,000 worth for a total market value of $8,000. Your equity is $1,500 on the short side and $2,000 on the long side:

Your total equity is now ($1,500 + $1,000)/($6,000+$2,000) = 31% and you are out of maintenance.

These examples are designed to show you the mechanics of how a short sale works. Fortunately, you'll never need to calculate these figures as your broker or online information will show that to you automatically. But at least you'll have an idea of how these numbers are found.

Why Allow Shorts Sales?

Many traders wonder why short sales are allowed. After all, there is something that doesn't seem right about profiting from the misfortunes of a publicly traded company. There is a good reason, though, why the exchanges created short sales. It is because it makes the market more efficient. If you are a good stock picker and have a feeling that a particular company is too highly valued, you now have a great incentive to short the stock for profit. And by shorting the stock, you put a little downward pressure on the price thus helping the rest of the market discover the true value of the company. If you were not allowed to short it, the value of the stock could possibly stay at unfair valuations for sustained periods and that is clearly not good for the market. Just as buyers can come to the rescue of a stock that is apparently oversold, short sellers come to the rescue when stocks are apparently overbought. Short selling allows all market participants a way to "cast their vote" as to the value of a security.

Short sales are popular among speculators since stocks tend to fall much faster than they rise. It may take months for a stock to rise 20% but can take seconds for it to fall that far. There is potentially a lot of money to be made for those who can correctly short stocks.

Risks in Short Selling

We found out in the earlier sections that your short position will lose money as the stock rises. Because of this, there is a potentially big risk with short selling in that there is no theoretical limit as to how high a stock's price can rise. If you buy $5,000 worth of stock, the worst it can do is fall to zero and you're out $5,000. But if you short $5,000 worth of stock, there is no limit as to how much you could lose since there is no maximum price for a stock. Of course, it is unlikely that a stock will rise infinitely high in a short period of time and, in most cases, you can close out the short position before things get too out of control. However, there is a psychological danger in holding short positions. Traders despise taking for-sure losses and will often hang on hoping that the stock will fall. The higher the stock rises, the greater the loss - and the greater their belief that it now must fall, which makes them hang on longer. Here's a true story of a trader I observed while working on an active trader team for a large brokerage firm:

America Online

In that late 90s, a trader believed that America Online (AOL) was way overvalued, as did all the analysts, at $80 per share. The articles in every financial publication stated that this stock was so far above its earnings growth that there was only one way for it to go - down. The trader shorted 1,000 shares in hopes of riding the ominous big wave down. The stock, however, climbed higher. And then it went higher. Eventually, the trader had a huge maintenance call and was looking at a large loss if he closed the position. Rather than take the huge for-sure loss, he decided to hold on because he felt it now must really be overvalued now and will surely come down. It didn't. He continued to hang on after meeting numerous maintenance calls as he felt he'd more than make up for the losses once it fell. Before he knew it, the stock had doubled and was trading for $160. Rather than close out the short for a catastrophic loss he averaged into the price and shorted another 1,000 shares - and the stock climbed higher. Then one day AOL announced a 2:1 split, which means the trader was now short 4,000 shares. That announcement propelled it to new highs. After several frustrating months of inexplicable price rises, the trader was forced to close the position. What was the cost? He nearly wiped out a one-million dollar account. So what started out to be a simple, "sure thing" short sale became an incredibly tough psychological battle between the trader's perception of the value of the stock and the market's valuation of it.

The above story illustrates an important point of any successful trading strategy. That is, have some type of exit or hedging plan. Use stop orders, call options, or other ways to prevent losses from escalating. It's very easy to let them get out of control and that is the bigger danger of shorting stocks rather than an instantaneous price rise to astronomical levels. If you short a stock, make sure you have an exit plan - and stick to it.

Options 101

Whenever a new product or idea is created, there are always variations designed to fill different needs that will follow. For example, when the automobile was first invented, it answered the broad question of transportation. But once the working model appeared, other people made modifications to resolve slightly different problems. Since the automobile's invention, we've seen many variations such as trucks, SUVs, compacts, hybrids, and others through the years come to market. While they are all forms of transportation, they fill different needs.

The financial markets are no different from other products. As new products come to market, modifications are made in order to solve slightly different problems. One of the more popular inventions is a set of assets called options.

In order to appreciate the value of options, you need to consider the pros and cons of stock investing. If you buy shares of stock, you are buying a piece of the company. And with that purchase comes the potential for high rewards. Many investors who bought shares of Microsoft when it was first offered in 1986 are millionaires many times over today. But with that potential for high reward also comes the potential for high loss. In early 2001, Enron was regarded as a market leader in the energy trading business and one of the largest corporations in the world. Later that year, it filed for what was to become the largest bankruptcy in United States history. Many investors lost their life savings by investing in Enron.

So are stocks good or bad? Obviously, it depends on what happens to the stock but that is something we cannot know beforehand. In other words, there is risk associated with stock investing. In order to make the financial markets run smoother, options were created to manage the risks and rewards of stock investing, which is a good thing.

However, if you talk to investors or traders about options you will find there is no financial asset that is more misunderstood than options - and there is good reason for the misunderstandings. To some investors, the word "options" relays the feelings of risk, gambling, speculation, and reckless investing. To other investors though, options means hedging, safe, insurance, good money management, and prudent investing. How can the same asset cause two completely opposing thoughts? The reason is that both views can be correct; it just depends on how you're using the options. Credit cards are a good example. One person can use them to spend excessively and end up in bankruptcy while another uses it to pay for an emergency auto repair after being stranded at midnight on a deserted road. Are credit cards good or bad? Just as with options, it depends on how they are used.

The options market was designed to let investors buy and sell risk. In doing so, the stock market can run smoother and more efficiently. The options market is a necessary addition to manage the growing complexities involved with stocks. The options market works on a simple principle in that, while many investors wish to reduce risk, there are some people who actively look for risk. These people are called speculators. Speculators are willing to gamble for big profits; they aren't afraid to take a long shot if there is a potential for big money. People who patronize casinos and play state lotteries are acting as speculators. If there are speculators out there who are willing to accept risk, wouldn't it make sense to be able to sell them some? In other words, it would be nice if we had a way to transfer some of the unwanted risk associated with stocks over to those who do want the risk. Of course, in order to make it worth their while, we will have to pay them some money to accept that risk. So if there is a risk you wish to avoid, you can do so by purchasing an option. Conversely, if there is a risk you're willing to assume, you can get paid through the options market to accept the risk for someone else. So while one investor may be using options to avoid risk, it is possible that the person on the other side of the trade is a speculator in search of greater profits. Investors who do not understand this interplay between investors and speculators hear both sides of the story and that's where the confusion comes in.

Unfortunately, this confusion often makes many investors avoid options altogether. And this is a big mistake in today's marketplace. As our economies expand, our financial needs increase and that's why you see so many new financial products coming to market. They are all different and each one provides the solution to a problem. If you choose to not learn about options, you are overlooking what may be the most important and powerful investment tool available to you. Options allow you to selectively pick and choose the risks you want to take or avoid, which is something that cannot be done with any other financial asset. At least take the time to understand them; you can always elect to not use them.

Chances are that you're reading this because you're new to options. If so, you've come to the right place. We just ask that you approach them with a clear mind and forget everything that you've heard about them in the past - chances are it is wrong or very misleading. As many times as we've presented introductory seminars to options, it never fails that the investors who thought they would never use them are the ones who come up with the most questions because they see so many possibilities. We are quite confident that you will find at least one beneficial use that you never knew existed. And if that's all you get out of this, at least it's more than what you started with.

We'll take you through the basics of options in a way that is easy to understand. At the end, you will know if they're right for you or not. So with that, let's get started!

What is an Option?

There are two types of options: calls and puts. A call option gives the owner the right, not the obligation, to buy stock at a specific price over a given period of time. In other words, it gives you the right to "call" stock away from another person. A put option, on the other hand, gives the owner the right, not the obligation, to sell stock at a specific price through an expiration date. It gives you the right to "put" the stock back to the owner. Options only convey rights to buy or sell stock. If you own an option, you do not get any of the benefits that come with stock such as dividends or voting privileges. Options are simply agreements between two people to buy and sell stock.

While options may sound complicated and appropriate only for sophisticated investors, they are quite easy to understand and actually quite commonly used in everyday life - although they are called by different names. In fact, we're sure that everyone reading this has used a call or put option at one time or another. If you don't believe it, keep reading!

Call Options

You're probably thinking that you've never used anything remotely close to a call option but think about the following:

pizza coupon

A pizza coupon? Yes, that's really all a call option is. The above coupon gives the holder the right to buy one pizza. It is not an obligation. You use the coupon only if you choose to do so. Notice we've been saying that the owner has the right - not the obligation - to buy stock (with a call) or sell stock (with a put). In other words, it is your option to choose what to do with it and that's where these assets get their name.

Put options, on the other hand, can be thought of as an insurance policy. Take, for example, your car insurance. When you buy an auto insurance policy, you really hope that you will not wreck your car and that the policy will "expire worthless." However, if you should total your car, you can always "put" it back to the insurance company in exchange for cash. Put options allow the holder to "put" stock back to someone else in exchange for cash. It is important to remember that buyers of options, whether calls or puts, have rights, not obligations.

Sellers of options, on the other hand, have obligations. They have an obligation to fulfill the contract if the call or put holder decides to use their option. If you sell a call option, you have the potential obligation to sell stock. If you sell a put option, you have the potential obligation to buy stock. You have a "potential" obligation since you do not know whether or not the buyer will use the option. Notice that the buyers and sellers are on opposite sides of the deal. The call holder has the right to buy while the call seller has the obligation to sell. This arrangement is necessary in order for it to work. First, we have a buyer matched with a seller of the call. Second, if the call buyer wishes to buy stock, we know the deal will go through since the call seller has the obligation to sell stock. The put buyer has the right to sell stock, while the put seller has the obligation to buy stock.

Long and Short

If you own a call option, you are "long" the option ("long" is just a market jargon meaning that you own it). If you sell an option, you are "short" the option ("short" is just market jargon meaning that you sold something you don't own and will have some sort of obligation. By selling it, you receive money up front for accepting the obligation).

The following table might help to understand the rights versus obligations relationships:

call put diagram

Using our pizza coupon example, if you are holding the pizza coupon, you are "long" the coupon and have the right to buy one pizza. The pizza store owner would be "short" the coupon and has an obligation to sell if you choose to use the coupon. In the real world, pizza store owners do not receive money for their coupons; they are handed out for free (we'll find out why later). But in the real world of options, the seller does receive money from the buyer in exchange for accepting that obligation.

Using the insurance example for put options, if you buy an auto insurance policy, you are "long" the policy and have the right to "put" your car back to the insurance company. The insurance company is "short" the policy; they receive money in exchange for the potential obligation of having to buy your car from you.

Before we can understand how to use options, we need to cover some additional terminology.

Option Terminology

In the coupon example, we would say the underlying asset is a pizza. Notice that we are limited to how many pizzas we can purchase; we cannot purchase all we want. The underlying asset for a call or put option is 100 shares of stock. The value, or price, of an option is tied to, or derived by, the underlying asset. Because of this, options are considered to be one of many types of derivative instruments. A derivative instrument is one whose value is derived by the value of another asset.

The pizza coupon also states a specific purchase price of $7.99. No matter what the price of pizzas may be when you get to the store, you are locked in to the price of $7.99. If this were a call option, we'd call this "lock in" price the strike price, which is really a slang term that got its roots from "striking" the deal at that price. Notice too that the coupon also has an expiration date. You can use this coupon at any time up to and including the expiration date. After that, it's no longer valid.

The pizza coupon simplifies the idea behind a call option. Notice that the pizza coupon gives the holder the right, not the obligation, to buy a specific amount of the underlying asset for a fixed price over a given period of time, which is our exact definition of a call option. The major difference between a real call option and a pizza coupon is that you must buy the call option while pizza coupons are handed out for free. The price you pay for an option, whether a call or put, is called the premium. (Note that the term used for the price of an auto insurance policy is also the premium. There really are lots of similarities between puts and insurance!)

While the pizza coupon gives you the right to buy one pizza, call options give the owner the right to buy 100 shares of the underling stock. If you have a $30 Microsoft call option, you have the right, not the obligation to buy 100 shares of Microsoft stock for $30 per share. Just like the pizza coupon "locks in" your purchase price, so does the call option. This call gives you the right to buy 100 shares of Microsoft for a fixed price of $30 per share - no matter how high that stock may be trading. You are locked into that price if you choose to use the coupon.

Because you can buy 100 shares of stock, the premium of the option must be multiplied by 100 in order to find the total cost of the option. For instance, your broker may tell you that a $30 Microsoft call option costs $4 (again, that is the premium of the option). But what the broker really means is that it costs $4 per share. If you wish to buy the call, you must pay $4 * 100 shares = $400 plus commission to buy one contract. You would pay $800 for two contracts and so forth. Now, if you choose to use your coupon and buy 100 shares of Microsoft, that would cost $30 strike price * 100 shares = $3,000 plus commissions.

Put options work the same way as call options but in the reverse direction. With an insurance policy, you have a stated value that you are insuring. You may get a $30,000 auto policy or a million dollar home policy. That's similar to the strike price. The insurance policy has an expiration date and specifies what is being insured. If you buy a $30 Microsoft put option, you have the right, not the obligation, to sell 100 shares of Microsoft for $30 per share. If your broker tells you the put costs $2, then the total cost is really $2 * 100 shares = $200 plus commission. If you use your put to sell your Microsoft shares, you will receive the strike price of $30 * 100 shares = $3,000 less commission.

Options are standardized contracts. This means they must conform to certain specifications. For example, there are only a limited number of strike prices we can choose from as well as expiration months. In most cases, stock options are available in a limited range of $5 increments. So for Microsoft, you may find a $25 call, $30 call, $35 call, and so on.

Pizza coupons and auto policies, on the other hand, are not standardized. They can be written to expire anytime the store owner or insurance company wishes and can be made to control two or more pizzas or cover numerous autos. They are completely flexible. Technically, there is nothing illegal about two people having a contract drawn up by an attorney that specifies the terms on which they agree to buy and sell stock. You could therefore have an attorney write a contract for you and another thus creating your own call or put option. A contract drawn in this manner is completely flexible - but it is also very time consuming and costly. In addition, even though you may have a legally binding contract, it is possible that the seller decides to not fulfill their obligation if the buyer wishes to use their option. If that happens, now you've got your hands tied up in court trying to get them to conform to the terms of the contract. With standardized options though, the Options Clearing Corporation (OCC) stands between each buyer and seller and guarantees that delivery will be made if you choose to use your coupon. By using standardized contracts, we lose some flexibility in terms (such as strike prices and expiration dates) but increase the ease, speed, and security in which we can create the contracts. Because options are binding contracts, they are traded in units called contracts unlike stock which is traded in shares. While it may sound like a time consuming, complicated process, you can buy one option contract just as quickly as you can buy 100 shares of stock. You place the order and in seconds the order is filled.

One of the most important aspects about options is that they expire at some point. While you can generally find options with expiration dates as short as one month and as long as three years, they all expire on their expiration date. You can buy and sell contracts at any time prior to their expiration date. The expiration date is very easy to find; it is always the third Friday of the expiration month and year. Technically speaking, equity options (that is, options on stock) expire on Saturday following the third Friday but that is really for clearing purposes. That extra day gives the OCC time to match buyers and sellers while the contract is still legally "alive." But as far as trading is concerned, the last day to buy, sell, or use your option (to buy or sell the stock) is the third Friday. The third Friday is always the last day to trade; it's one of the limitations of having a standardized contract. There are some index options, such as options covering the S&P 500 Index that expire on the third Thursday of the expiration month. But if you're trading stock options, the last day to trade the option is the third Friday of the expiration month.

Understanding a Real Call Option

Okay, we have enough of the basic terminology to understand real call and put options so let's take a look at an example using real eBay option quotes in Figure 1:

Figure 1: eBay Option Quotes

eBay Option Quotes

The call options are listed on the left while the put options are listed on the right. These quotes were taken from the Chicago Board Options Exchangewww.cboe.com. (CBOE), which is the largest options exchange in the world. You'll find that most of the option contracts you trade will be filled at the CBOE. You can read more about the CBOE or find other option quotes at

At the time these quotes were taken, eBay stock was trading for $93.60, which you can see in the upper right corner of Figure 1. The first call option in the list is 04 Oct 80. The "04 Oct" tells us that the contract expires in October '04 and the "80" designates that it is an $80 strike. The last trading day for this option will be the third Friday in October '04. All you have to do is look at a calendar and count the third Friday for Oct '04 and that is the last day we can trade the option (this happens to be Oct 15). All 04 Oct options will expire on this date regardless of strike price or whether they are calls or puts.

The 80 strike, again, means that the owner of this "coupon" has the right, not the obligation, to buy 100 shares of eBay for $80 through the third Friday of Oct '04. No matter where eBay may be trading, the owner of this coupon is locked into an $80 purchase price. Now this seems like a pretty good deal since the stock is trading for $93.60. It appears that if you got the $80 call, you could make an immediate profit of $93.60 - $80 = $13.60. In other words, if we could get our hands on this coupon, we could buy the stock for $80 and immediately sell it for the going price of $93.60 thus making a $13.60 profit. However, you must remember that call options, unlike pizza coupons, are not free. How much will it cost to buy this coupon? If you look at the "ask" column, you'll see that it will cost $14.30 to buy the call, which means the free $13.60 is no longer free. In fact, you will find that you must always pay for any immediate advantage that any "coupon" conveys. Remember, the $14.30 price (or premium) really means it will cost $14.30 * 100 = $1,430 plus commission to buy this contract. Two contracts (200 shares) would cost $2,860 plus commissions etc.

Let's try the next one on the list, which is 04 Oct 85. If you buy this call option, you have the right, not the obligation, to buy 100 shares of eBay for $85 per share through the third Friday in May '04. Since eBay is trading for $93.60, we know that anybody holding this option has an immediate advantage of $93.60 - $85 = $8.60 by holding the call and we now know that this advantage must be reflected in the price. You can verify that the asking price is $9.80, which means the apparently free $8.60 benefit is not free. If you want to buy this contract, it will cost you $9.80 * 100 shares = $980 per contract + commissions.

You may be starting to see some advantages of options. If you want to buy 100 shares of eBay, you must pay $9,360 and you could possibly lose nearly that entire amount. Instead, you could buy the $85 call option and pay only $980 but still control 100 shares. The worst that could happen is for the stock's price to fall below $85 by expiration thus making the call option worthless to you and you'd be out $980. This limited downside risk is one of the biggest advantages of call options. Why would the $85 call be worthless? If the stock's price is below $85 at expiration and you wanted to buy the stock, you'd just buy the stock in the open market and not use your coupon. Think of the pizza coupon analogy. If you have a coupon that gives you the right to buy one pizza for $10 but, when you arrive at the store, you find the same pizza is selling for $9 on special, what would you do? Now there's no use in using the coupon and you'd just let the coupon go and buy the pizza without using the coupon. The same idea is true for call options. If you wish to buy the underlying stock and the stock is trading at a "better deal" than what your strike price allows, you just forget about your call option and buy the stock. Remember, it is your right to use the call option if you wish; you are not required to use it. Options allow traders to capitalize on up or down price movements in the stock but only expose them to a limited amount of risk.

Understanding a Real Put Option

In Figure 1, the Oct 80 put option gives the buyer the right to sell 100 shares of eBay for a price of $80 per share. Why would someone want this right when the stock is trading for over $93? Because the $80 strike price is so far below the stock's price, anybody buying this put is really buying it for "disaster" insurance. You can think of it as someone who wants $80 of insurance of something that is worth $93. In other words, the person is assuming the first $93 - $80 = $13 worth of risk, which is similar to a deductible for insurance. If you have a $200,000 home but only want coverage for $195,000, you are accepting a $5,000 deductible and assuming that first $5,000 in risk. In exchange for assuming some of the risk, you will pay a lower premium. Similarly, the $80 put holder is willing to assume the first $13 in "damage" and, in exchange, will pay a lower premium. Notice that the $80 put is the cheapest of all since its strike is furthest below the current stock price. As you increase the level of the insurance with your insurance agent, the price goes up and the put option market is no exception. Notice that the puts get more expensive as the strike price increases. The holder of this put can always sell his stock and receive $80 per share through expiration. By holding this put, the trader knows this is the worst that could happen. What will it cost for this protection? We see the premium is 60 cents, or 0.60 * 100 = $60 plus commissions per contract. The Oct 85 put will cost $1.15 * 100 shares = $115 plus commissions and the owner is guaranteed to receive $85 per share for his stock through expiration if he chooses to use the put option.

Just as with call option, a put option's price must be worth any immediate value it conveys. For example, the $100 put is apparently very advantageous to hold since it gives the holder the right to sell eBay for $100 rather than the current price of $93.60, which gives an immediate benefit of $100 - $93.60 = $6.40. Notice that the put costs $7.50, which means the "free" $6.40 benefit is no longer free. The put will always be worth any immediate value it conveys, just like call options.

You've got the basics of how call and put options work! Now let's take a look at some more terminology and mechanics of options.

Strike Price Increments

Notice that the call and put strikes are available in $5 increments, which is true for most stocks. If the stock's price is below $25, you will find options available in $2.50 increments. And if the stock's price is over $200, you will find option strikes in $10 increments. But because most stock prices are between $25 and $200, most options will be listed in $5 increments. Also, at the time Figure 1 was taken, there were many more strikes available that what is shown. We just shortened it to make the list more manageable. It just so happens at this time that the highest strike for October was $115. It is up to the CBOE to decide on which strikes they think are needed by the market. Because eBay is trading for $93.60, you will probably not find a $150 strike expiring in the next couple of months, but you may possibly find out two-years out. There is always a paired call and put for every strike price.

More Time Means More Money

In Figure 1, you may have also noticed that the longer term calls and puts are more expensive. For example, the 05 Jan $80 call is $17.40 while the 04 Oct $80 call is $14.30. Why does the January option cost more? The reason is that the January call allows more time for the option to become valuable. Since all other factors between the two calls are the same, traders are only bidding up the value of the additional time. Why $3.10 extra value? That's a question for which we will never know the answer. That is up to the market to decide; it's up to people like you and me. Every day we place orders to buy and sell options, we're either putting upward or downward pressure on their prices. At the time these quotes were taken, the market was placing $3.10 cents extra value on the January $80 call over the October $80 call. We can be sure that longer term options will always cost more than shorter term options but we cannot be sure by how much. With all else constant, longer term options will cost you more money.

Option Symbols

The letters XBAJP-E listed after 04 Oct 80 call represent the symbol for that option. Just as you need a symbol to buy a stock or mutual fund, you need a symbol to buy an option. For the October $80 call, XBAJP is the symbol. The dash "E" after the symbol is the CBOEs designation for their exchange; in other words, it shows the quotes are coming from the CBOE.

You Don't Ever Have to Purchase Stock

It is important to understand that if you buy call or put options, you do not have to have shares of the underlying stock in your account nor do you ever need to buy or sell shares. Most option contracts are opened and closed in the open market without a single share of stock changing hands. Even though you're allowed to purchase or sell stock with your options, most traders never do. Instead, they just buy and sell the contracts in the open market amongst other traders.

This is a great advantage of trading options since they allow you to participate in the movements of the underlying stock without having to have the full amount of cash. For example, assume you buy the eBay $95 call in Figure 1 for $2.90, or $290 for one contract. Now assume that eBay moves up to $100. Because there is a $5 advantage to the owner of this coupon, the $95 call must be worth at least $5. This means you can just sell the $95 call in the open market and receive at least $500 for it thus leaving you with at least a profit of $500 - $290 = $210, or 72%. Notice that if you had wanted to invest in eBay, you would have had to pay $9,360 to buy 100 shares. But because of the options market, you can now invest in 100 shares of eBay for only $290. The big difference between the two choices is that the stock never expires while the option certainly does. Even though you only pay $290 to buy the call, you could end up losing 100% of the investment if the stock's price does not move sufficiently in your favor by expiration. We'll show you how to figure where that point is at a later section when we talk about breakeven points.

Exercise vs. Assign

If you wish to use your call or put, you must call your broker and submit exercise instructions. This means nothing more than telling him that you wish to use your call option to buy stock or your put option to sell stock.

If you exercise a call option, three business days later you will receive 100 shares of the underlying stock in your account for each contract you exercise and, at the same time, will pay the strike price * 100 shares, which is called the exercise value of the contract. For example, assume you had purchased the eBay $90 call and now wanted to exercise it. You would call your broker and say, "I'd like to exercise my eBay $90 call." That's it. Three business days later you will receive 100 shares of eBay and your account will be debited for $90 * 100 shares = $9,000 + commissions. (Most brokerage firms charge the standard stock commission to exercise an option.) If you exercise a call, you receive shares of stock in exchange for cash. The exercise value of this contract is $90 * 100 = $9,000 per contract.

If you exercise a put option, three business days later you will lose 100 shares of the underlying stock and receive the exercise value of the contract. If you exercise a $90 put, your account will be debited for 100 shares and you will be credited $90 * 100 shares = $9,000 less commissions.

Because the strike price is the price you pay if you exercise your option, it is also referred to as the exercise price. So if you hear the words strike price or exercise price they mean exactly the same thing.

We just found out how the long call or put holder can exercise their options. What happens to the person who sold the call or put? That person is required (remember, the short option has an obligation) to sell shares (if they sold a call) or buy shares (if they sold a put). The short position is said to be assigned. If you are short a call, you have no rights; you have an obligation to deliver the shares if you are assigned. If you were the one who sold the eBay $90 call, you could receive an assignment notice requiring you to give up 100 shares of eBay in exchange for $90 per share, or $9,000 cash less commissions. Your broker will notify you the next business day to inform you on an assignment. This is just an informational phone call and there is nothing you need to do. Your broker may say something like, "Just letting you know that you were assigned on the eBay $90 call and have sold 100 shares for $90 per share." If you sell a $90 put, you could receive an assignment notice through your broker and be required to buy 100 shares of stock for $90 per share.

Intrinsic Values and Time Values

We said earlier that an option's price must trade for a minimum amount if there is an immediate value in holding it. To really understand intrinsic value, it helps if you learn to substitute the word "immediate benefit" or "immediate value" for intrinsic value. For example, the holder of the eBay $90 call has an immediate benefit of $3.60 by holding the call since the current stock price is $93.60. This immediate benefit is called the intrinsic value. In other words, it is value that can be readily determined. If there is any value over and above this amount, it is called time value or time premium. The time value is due to the fact that there is still time remaining on the option.

Any option's price can be broken down into the two components of intrinsic values and time values. We just determined that the eBay $90 call has an intrinsic value of $3.10; however, its price is $5.90. This means the remaining value of $5.90 - $3.10 = $2.80 is due to time value. If this $90 call were to expire this very second, the time value would be zero and the option would only be worth the $3.10 intrinsic value. It is only the time value portion of an option's price that gets chipped away with the passage of time. Some people will tell you that all options expire worthless and that's not true. It's only the options with no intrinsic value that are worthless at expiration. Of course, any option with intrinsic value can expire worthless too - but that's due to the stock moving adversely and not because time has passed.

Okay, let's try another one. Can you break down the Oct $85 call into intrinsic and time values? The holder of the Oct $85 call has an immediate advantage over someone who just buys the stock for the current price of $93.60. How much of an advantage? It is a beneficial difference of $93.60 - $85 = $8.60. Therefore, $8.60 is the intrinsic value. Since the Oct $85 call is trading for $9.80, the remaining portion of $9.80 - 8.60 = $1.20 is time premium. The Oct $85 call would only be worth $8.60 if it were to expire today. But because there is time remaining, market participants are willing to bid the price higher by an additional $1.20. Again, that $1.20 figure is determined by the market. It's just a value that exists in the minds of traders. We don't know why traders are paying $1.20; we just know that they are. All options must fully reflect their intrinsic values but the time values can vary greatly.

Notice that the intrinsic value plus the time value equals the total value of the option. We just figured out that the Oct $85 call has $8.60 intrinsic value and $1.20 time value. Therefore, the total cost of the option must be $8.60 + $1.20 = $9.80.

For those who like mathematical formulas, you might remember intrinsic value better with this: Stock price - Exercise price = Intrinsic Value (assuming you get a positive number). If the number is negative, there is no intrinsic value. For instance, if we're trying to figure out the intrinsic value for the $85 call, we'd take the $93.60 stock price and subtract the $85 strike price, which gives us a positive $8.60. Since this is a positive number, we know this is the intrinsic value. However, the $90 call has $90 - $93.60 = -$3.60. Since this is a negative number, there is no intrinsic value.

There is an alternate formula you may find useful too. That is, Premium - Intrinsic = Time. The May $85 call's premium is $9.80, of which $8.60 is intrinsic value. Therefore, $9.80 - $8.60 = $1.20 in time value.

If there is no intrinsic value in an option, then its entire price is due to time value. For example, the Oct $95 call is trading for $2.90. Since there is no immediate benefit in holding this option, there is no intrinsic value. In other words, if you wanted to buy the stock, you'd rather pay the current price of $93.60 rather than buy the option for the right to pay $95. On the surface, it may seem that the $95 option has no value. That's partly true. But the real way to say it is that it has no intrinsic value; the $95 call has no immediate value.

For the Oct $95 call, the entire $2.90 premium is made up entirely of time value. If this option were to expire immediately, it would be worthless and you would lose 100% of your investment. So why would anybody buy the $95 call? The main reason is due to downside protection. If you buy the $95 call, or any call option for that matter, the most you could lose is the amount you paid, which is far less than what you will pay for the stock. And because the $95 call is one of the cheapest calls, there are many traders who want to buy it so that they only have a little bit of money at risk.

For example, assume you buy 100 shares of eBay and spend $9,360. You could theoretically lose it all even though that is an unlikely event. Still, it is a lot of money that could potentially be lost. However, if you buy one of the call options, the most you could lose is the amount you paid. If you buy the $85 call, the most you could lose is $980 + commissions. If you buy the $90 call, the most you could lose is $590. And, as we just saw, the most you could lose with the $95 call is $290. Why, then, would anybody buy any call option other than the cheapest one available? The reason is that all options do not behave the same when the stock price rises. We'll talk more about this later but, for now, just understand that you're not comparing apples to apples when you look at the various strike prices of options.

It is very important to understand how to break an option's price into intrinsic and time values as you get into strategies. The reason is that it is the time value that wastes away with time and not the intrinsic value. You need to know how much of each value is present in your option.

Wasting Assets

Because options lose some value with each passing day, options are called wasting assets. There are some traders who refuse to use options because of the fact that part of the option's price deteriorates over time. But that is a shortsighted reason. The car you drive loses value over time. The same is true for the fruits and vegetables that you buy. What about the computer you use? So it doesn't make sense to say that it's not worthwhile to invest in an asset whose value depreciates over time. You just have to be careful in the way you use them. If you think about it, most assets you buy deteriorate over time so don't back away from options just because of a portion of their value depreciates over time. Even the expensive factories that General Motors is using are losing value with each day but the CEOs would tell you they have been very productive assets.

Moneyness

Option strikes are generally classified as in-the-money, out-of-the-money, or at-the-money. An option with intrinsic value is in-the-money while an option with no intrinsic value is out-of-the-money. An option that is neither in nor out of the money is at-the-money. For example, in Figure 1, the $85 call and the $90 call are in-the-money since both have intrinsic value. Both coupons give the holder the right to buy the stock for less than it is currently trading. The $95 call is out-of-the-money since there is no immediate benefit in holding it; there is no intrinsic value. Technically speaking, an at-the-money option has a strike that exactly matches the price of the stock. But since that is pretty rare, we usually call the at-the-money strike as the one that is closest to the current stock price. In Figure 1, we'd say that the $95 strike is the at-the-money call option.

For the put options, all strikes higher than the stock's price are in-the-money. In Figure 1, they are the $95 and $100 strikes. Most option exchanges, such as the CBOE, always maintain at least one in-the-money and one out-of-the-money option for each month. In general, in-the-money options will have a small time premium and so will out-of-the-money options. At-the-money options have the greatest amount of time premium associated with their strikes.

The terms in-the-money, out-of-the-money, and at-the-money are sometimes referred to as the moneyness of an option. These terms are used just for description purposes; it just makes it easier for option traders to describe types of options and strategies. For example, rather than tell someone that you are currently looking at "call options whose strike prices are lower than the current value of the stock," it's easier to say you are considering in-the-money calls.

The following diagrams may help you to understand the differences in the moneyness of calls and puts:

call options
put options

Options Must be Worth at Least Intrinsic Value

When an option expires, it is worth one of two values: It is either worth the intrinsic value or it is worth nothing. Many people think that all options expire worthless at expiration and this is definitely not true. It is only the time value of the option that becomes worthless. If there is any intrinsic value it stays with the option!

How do we know that an option has to be worth at least intrinsic value? Think back to the pizza coupons. Imagine that pizza coupons do have value and they are traded in the streets (the marketplace). Now assume that pizzas are $20 and a $10 coupon is only selling for $5. We know that it "should" be worth $10 since that is the intrinsic value. Can anything be done about this? The answer is yes. The way the market corrects for this missing value is that enterprising individuals would buy the pizza coupon for $5 and then take it to the store and buy the pizza for $10. They would have spent a total of $15 to get the pizza ($5 for the coupon + $10 for the pizza). Then they'd walk out in the street and sell the pizza for $20, thus making a $5 guaranteed profit. As individuals figure this out, they will compete in the market for these coupons thus raising their price. At what point will the competition for coupons stop? When the price of the coupon reaches $10, which is the intrinsic value.

All options must trade for their intrinsic value otherwise a similar set of transactions would take place in the market by arbitrageurs, which are people who look to capitalize on mispricings just like these. For instance, assume that the Oct $90 call was trading for $2 in Figure 1. We know that it "should" be trading for at least the intrinsic value of $3.60, which means there is a minimum missing value of $1.60. Arbitrageurs would buy the call and simultaneously sell the stock. They will spend $2 on the call but receive $93.60 from selling the stock, which leaves them with a net credit of $91.60. They also must buy back the shares they are short, which they would do by purchasing with the call option for $90, which leaves you with a free profit of $91.60 - $90 = $1.60, which is exactly the amount of missing intrinsic value. The arbitrageurs' actions put buying pressure on the call and selling pressure on the stock. Obviously, they would continue to do this as long as the "free money" is available; that is, until the intrinsic value is restored. The moral to this story is that arbitrageurs provide a very important economic function in that they assure that option prices will always reflect intrinsic value for the rest of us.

Breakeven Points

We said earlier that the underlying stock must move sufficiently in your favor in order to make money. How far is sufficiently? That's easy to figure out. For call options, all you have to do is add the price you paid for the option to the strike price and that's how far the stock's price must move by expiration in order to break even. For example, if you paid $2.90 for the eBay $95 call, then the stock must get to $95 + $2.90 = $97.90 at expiration in order for you to break even on the trade. If you understand the previous section about intrinsic values, you will understand why. If the stock is $97.90 at expiration, then the $95 call must be worth the intrinsic value of $97.90 - $95 = $2.90. This means you could sell the call for $2.90, which is the exact amount you paid and therefore you would just break even. (In the real world of trading, the bid-ask spread will actually make this value a little less.) Now, prior to expiration, you could break even without the stock's price moving to $97.90. The reason is due to the time premium. For example, assume that eBay moves from $93.60 to $95 tomorrow. You might see that $95 call trading for $4, which means you could sell for a nice profit. Remember, we have no way of knowing what price the market will bid for the time premium so it's certainly possible you could make a profit without the stock's price ever hitting the breakeven point. Still, the breakeven point is a good guideline for the risk associated with a particular option.

For put options, the breakeven point is found by subtracting the price you paid from the strike price. If you bought the eBay $95 put for $4.30, then the stock must fall to $95 - $4.30 = $90.70 at expiration in order for you to break even on the trade. With the stock at $90.70, the $95 put must be worth the intrinsic value of $95 - $90.70 = $4.30, which is the price you paid. As with calls, you could certainly make a profit without the stock ever falling to $90.70 but that would require that it at least starts falling quickly so that there is still some time premium left on the option.

In a previous section, we said that different strikes behave differently and that's why some traders might choose a higher priced option when, on the surface, it doesn't seem sensible to buy anything but the cheapest one. Now that you understand breakeven points, you can gain some more insight into why that's true. If you buy the $95 call, the stock must rise to $97.90 to break even. But if you purchased the $90 call for $5.90, then the stock must only rise to $95.90 in order for you to break even. It's always a good idea to check that the break even point is in line with your outlook on the stock before buying the option. For instance, if you think the stock will rise from $93.60 to $95, then it's probably not a good idea to buy the $95 call since its breakeven point is $97.90, which is higher than your outlook on the stock.

Lower Strike Calls and Higher Strike Puts are Always More Expensive

In Figure 1, notice that the $80 strike call is more expensive than the $85 call. The lower strike calls will always be more expensive than the higher strikes regardless of which underlying stock you're looking at. Why? There are many mathematical reasons why this relationship must hold but you know already know enough to figure it out intuitively. Imagine that you walked in to buy a pizza and found the following two coupons lying on the counter. Which would you choose?

2 pizza coupons

Notice that both coupons control exactly the same things and have the same expiration date. The only difference is that the coupon on the left allows you to buy the pizza for $7.99 while the one on the right gives you the right to buy it for $10.99. Obviously, you'd rather pay $7.99 so would pick up that coupon. A similar process happens in the financial markets. Traders recognize the advantage in paying fewer dollars for the shares (just as you did in deciding which coupon to pick up) and will actively compete for these coupons in the market thus driving their price higher relative to the higher strike coupons. Because these coupons allow traders to buy stock at advantageous prices, they become more valuable as the strike price is reduced. How do we know that will always be the case? Assume that, for some reason, the $90 call was cheaper than the $95 call, arbitrageurs would buy the cheap $90 call and simultaneously sell the expensive $95 call thus guaranteeing a profit. If you look at Figure 1, you'll see that the lower strike calls for a given month are always more expensive. Another way of saying the same thing is that the coupons get more valuable as the underlying stock rises. It is the relative difference between the strike price and stock price that matters. If you buy a call option, you want the stock price to rise!

For put options, higher strike puts must be more expensive with all other factors the same (the same underlying stock and time to expiration, etc.). Figure 1 verifies this relationship. If, for example, the $95 put were cheaper than the $90 put, arbitrageurs would buy the cheap $95 put and simultaneously sell the expensive $90 put thus guaranteeing a profit. These actions would continue until the $95 put is more expensive than the $90 put. As with call options, it is the relative difference between the strike price and stock price that matters. If you buy a put option, you want the stock price to fall!

Closing Options at Expiration

We said in an earlier section that you're not required to ever buy the shares of stock if you own a call option. Most traders just take their profits by selling the contracts in the open market without buying the shares. Now that we understand how to exercise a contract, as well as intrinsic values, we'll show you that there really is no difference between the two choices of either exercising or closing in the open market at expiration.

Assume you buy the eBay $90 call for $5.90 and, at expiration, the stock is trading for $100. You could exercise your call and pay $90 for the stock and immediately sell it for $100 thus capturing the $10 difference. Because you paid $5.90 for the call, your net gain is $4.10. How would you do if, instead, you just closed (sold) the option in the market? With the stock trading for $100 near expiration, the $90 call must be trading for its intrinsic value of $10. Rather than exercise the contract, you'd just sell the contract for the going price of $10. Since you paid $5.90, your net gain is $4.10. Notice that your net gain is $4.10 regardless of whether you exercise the call (buy stock and immediately sell it), or just sell the call in the open market. Of course, there is a big difference what happens after that moment in time. If you think the stock will continue higher, you may wish to exercise the call so that you can get the shares. If you close out the call in the open market, your position is closed and you will no longer participate in additional upside moves. When we say there is no difference between exercising a call verses closing it in the market at expiration, we are talking about that specific moment in time. So just because your call option is about to expire does not mean that you must purchase shares. This means you do not need the full exercise value of the contract (strike price * 100 shares) in your account at any time. All you need in your account is the amount of cash to buy the options.

For puts, the result is the same. Assume you bought the eBay $95 put in Figure 1 for $2.25. At expiration, the stock is $90. We know the $95 put must be worth the $5 intrinsic value, which is what you'd receive if you sold the put in the market. You could also buy the stock for $90 and then immediately exercise the put and receive $95, thus collecting a $5 profit. Either way, you collect $5 at expiration. Because you paid $2.25, your net gain is $5 - $2.25 = $2.75, or 122% return on your money.

Closing Options Prior to Expiration

Okay, so there's no difference to us whether we close an option at expiration when compared to exercising it and selling the stock. What about if we wish to close the option prior to expiration? Now there is a difference - and sometimes a big one. Assume you bought the May $90 call in Figure 1 at an earlier time for $3. The stock is now higher and that option is bidding $5.80. If you wish to take your profits, there is a big difference in the choice you take. Let's look at both of them.

If you sell the call option, you'll receive $5.80. After subtracting your cost, you have a net profit of $2.80. But now let's assume that you exercise the call and sell the stock. You would pay $90 for the stock and could immediately sell it for $93.60, which is a gain of $3.60 gain. After subtracting your $3 cost, you have a 60-cent profit. By selling the option in the market, we captured a $2.80 gain when compared to only a 60-cent gain by exercising the stock and selling it. Why is there a $2.20 difference between the two choices? The reason is that when you exercise a call option, you only get the difference between the stock's price and the strike price - you get only the intrinsic value - which in this case was $93.60 stock price - $90 strike = $3. When you sell a call though, you must get the intrinsic value plus you get some time value back. The May $90 call has $3.60 intrinsic value and $2.20 in time value. By selling the option in the open market, you capture that $2.20 time value, which is something you don't get by exercising. This $2.20 time value is exactly the difference between the two choices.

The important point is this: Do not exercise a call option early! You are throwing away the time value. And as if that's not bad enough, you're also holding the stock, which has a much greater downside risk than the long call. And don't forget that you paid for the stock earlier than you could have if you had waited until expiration even though you locked in your purchase price. No matter how you cut it, there's no advantage to exercising a call option early. The reason there is no difference between exercising a call at expiration when compared to selling it is because the time value is zero. There is no time remaining at expiration and the time value is therefore nothing. But prior to expiration, time value does count and there can be significant differences between the two choices.

As you become more familiar with options, you'll hear caveats to the "don't exercise early" rule such as only exercise early to capture a dividend. Exercising early may make sense but it really only offsets some small losses. Most dividends are small and usually not our concern as traders of call options (unless it is a large, surprise dividend). But for now, just understand that in the vast majority of cases, it is never to your advantage to exercise a call option early. If you wish to take profits, simply sell the call option in the open market. Now you see why the majority of contracts are just closed in the open market. Most traders never intend to buy the shares and just buy and sell the contracts by themselves.

For put options, though, there may be times when exercising early may help you. That will occur if the stock's price is significantly below the strike price. For example, assume you have the eBay $80 put and the stock tanks and is trading for $70. You see no hopes for the stock coming back above $80 by expiration of your option. Now you have a choice: You can wait until expiration and sell your shares for $80 or you can sell you shares today for $80. What do you do? You exercise early and sell your shares today. Early exercise for puts has advantages over early exercise for call. The first is that, with puts, you're receiving cash into your account, which allows you to earn interest earlier. Second, you're getting rid of stock. If you exercise a call early, you're buying stock and accepting the full downside risk.

Volatility

Why do you suppose that pizza coupons have no value whereas call options do? Many are inclined to say that it's due to the prices; stocks are far more expensive than options. That's partly true but the bigger reason is due to the uncertainty of prices. You can be pretty sure that the $7.99 pizza price we saw earlier will be the same price next week. And as competitive as the pizza market is, there's even a good chance that price may fall. Because we're pretty certain about the prices we'll pay next week, next month, or even next year for pizza, there's no reason we'd want to "lock in" the price of a pizza. Consequently, pizza coupons have no value.

Options, on the other hand, do carry value since stock prices can change so unpredictably. One day the stock is up 2%, the next it could be down 10% and we're never really sure what's going to happen. Because of the uncertainty, traders are very willing to pay for the right to buy the stock - their goal is to avoid holding the stock. Stock prices that exhibit radical price changes are considered to be more volatile than one that does not. Using an everyday example, we would say that gas prices are more volatile than milk prices. We're pretty sure that a gallon of milk will cost about the same next week or next month but we're not nearly so sure about gas prices. While there are many ways to measure the volatility of a stock, that's getting a little ahead of our goal. Just understand that the more volatile the stock's price - the more uncertain we are about it's price from day to day - the more money you're going to pay for an option.

Why are options on volatile stocks more expensive? Don't we associate radical price changes with risk? And if stocks are riskier, shouldn't the options be cheaper? While it's true that risky assets are bid down as risk increases, options do not behave that way. The reason is because of the asymmetrical payoff of options compared to stock. For example, if you buy eBay at its current price of $93.60, you gain point-for-point if it rises and lose point-for-point if it falls. You participate fully to the upside - and downside - of the long stock position. You have symmetrical possible gains and losses. But now consider the $90 call. If you buy the call, you participate fully to the upside but have only a limited downside risk. In other words, your payoffs are not symmetrical as they are for the trader holding stock. With the option, you get all of the upside profits but are only exposed to a fraction of the downside risk. Assuming all option prices were the same, you'd be better off holding an option of a very risky stock since it may be worth a lot of money but can only lose what you paid for the option. Traders compete for the call options on the volatile, or risky, stocks and consequently bid their prices higher. Bear in mind that it does not follow that we should therefore only buy options on risky, or volatile, stocks. The reason is that the market places a higher price on those options and, consequently, that makes it harder to break even on the trade. We're just trying to show why riskier stocks have correspondingly higher option prices.

You now have enough option basics to take a look at some basic strategies!

Strategies

As you get more familiar with options, you'll realize there are hundreds of variations of strategies. If you find one of the following that might sound appealing, you should investigate further as there are probably many variations you'll also like. The world of option strategies is very large; we're just trying to get you to see some basic uses in hopes that you will investigate further.

Long Calls

Let's start with the basic long call option. We've shown that call options get more valuable as the stock price rises. For any given strike or "coupon" price you hold, the higher the stock price, the more someone will be willing to buy your coupon and will, consequently, bid higher to hold it.

Let's compare two investors, A and B, who are trading 1,000 shares of eBay. Investor A uses stock while B uses options. Using Figure 1, you can see that investor A must spend $93,600 to buy the stock. Of course, putting this much money on the line means that it is possible to lose a substantial chunk if eBay should crash. Investor B can accomplish the same thing with less risk by purchasing one of the call options. Assume he buys the January $95 call for $7.40. He buys 10 contracts (1,000 shares worth) for only $7,400. No matter what happens to the price of eBay between now and January expiration, investor B has a defined maximum loss of $7,400. Notice that investor A cannot accomplish this same defined goal even if he uses stop orders. Stop orders do not prevent losses. Call options give us a very good way to create defined maximum losses, which is good money management.

Investor A is now long 1,000 shares of eBay while investor B owns 10 $95 calls. If eBay falls more than $7.40 (to $86.20 or lower) by expiration, investor A is going to wish he had purchased the calls. Investor A will continue to take losses for all stock prices below $86.20 whereas investor B will no longer take losses; his losses were defined to the first $7.40 in price movement. That was the price paid for the call option.

However, let's assume that the stock rises to, say, $110 at expiration. Investor A purchased at $93.60 and sells for $110 for a $16.40 gain, or 17.5% increase. With eBay at $110, the $95 call must be worth the intrinsic value of $15. Investor B paid $7.40 for the call and can sell it in the open market for the going price of $15, which is a $7.60 gain, or 103% increase. So the same move in the stock from $93.60 to $110 makes the stock investor up 17.5% and the option investor up 103%. Options are therefore a way to gain financial leverage, which means we can magnify our gains (and losses) in the market. Tiny moves in the stock mean large moves on a percentage basis for the option.

But let's look at that rise in price another way. Investor A gains $16.40 while investor B makes $7.60, which leaves him with $8.80 less profit. Where did the $8.80 go? In this case, there are two reasons: The first $7.40 of that $8.80 is due to the time premium paid for the $95 call. You never get your time premium back. That leaves $1.40 still missing. That missing $1.40 is exactly the amount that the call was out-of-the-money. The $95 call is $1.40 out-of-the-money with the stock at $93.60. The stock buyer pays no time premium and therefore keeps the entire $16.40 move in the stock. Investor B pays a $7.40 time premium and gives that amount up in upside profits in exchange for smaller, defined losses.

So the leverage of options does not come for free. There is a time premium that must be paid and you never get that back. This is not to say you can't recover it with movements in the underlying stock; it's just saying that when compared to the stock buyer you will always fall short in terms of the total dollars in profits, assuming you are controlling an equal number of shares.

Options Need Speed

What happens if the stock moves from its current price of $93.60 to $101 at expiration? Investor A gains $7.40 while Investor B loses the $7.40 time premium, or a 100% loss on significant movement in the stock. It is this characteristic of value versus speed that separates options from stock. Long options need the underlying stock to move quickly in order to make money. If the stock doesn't move at all or moves too slowly, then substantial losses can develop. When trading options, you need to pick the direction the stock will move and the speed at which it will get there. That is a much more difficult game than determining if the stock will rise or fall.

It is the time premium of the option that causes this "speed component" to be present. The larger the time premium, the quicker the stock needs to start moving in order to be profitable. If you're new to options, it will help to buy in-the-money options so that you reduce the amount of time premium you pay and therefore reduce the speed component that you need to assess. For example, assume Investor B had picked the January $90 call for $10.30, his breakeven point would then be $100.30 and he would have made 70 cents with the stock at $101 at expiration. Lower strike calls have lower breakeven points and are therefore less risky.

Now you know why we said earlier that options are not created equally. You can't just look down the list of option quotes and trade the cheapest one thinking that it is the best. The cheapest option needs the highest amount of speed in order to be profitable and is therefore the riskiest in the bunch. New option traders often make the mistake of thinking that all options profit in the same way. If that were true, then the cheapest option would be the best one. But experienced traders understand that they are not the same and will bid the riskier ones lower.

What if, instead, Investor B, purchased the same dollar amount of call options as the stock investor? In other words, what if Investor B buys $93,600 worth of options? In this case, Investor B will win in terms of total dollars but that is because he'd be controlling far more than 1,000 shares of stock. Using equivalent dollar amounts for your stock and option trades is reckless and not recommended by anyone (although many traders will do it). Remember that we said at the beginning that options can be used in good and bad ways; this is a very bad way! If you are comfortable buying, say, $10,000 worth of stock, you should not be a buyer of $10,000 in options.

Placing Your Order

If you wanted to buy 10 January $95 calls, you'd just need to tell your broker the following instructions: Buy to open, 10 eBay January $95 calls, symbol XBAAS, at market. Of course, you could also specify a "limit order" and say to buy them "at a limit of $7.40" or some other number. As with stock, market orders on options are guaranteed to fill - we're just not real sure at what price. It should be pretty close to the current asking price but that's not always the case. Limit orders guarantee your price but not the fill. If you place a limit order at $7.40, your order can only be filled for that price or lower. Most of the orders, contingencies, and qualifiers that you're used to using with stocks such as: market and limit order, stop, stop limits, all-or-none, not held, etc. can be used with options.

Your broker will require that you have the full purchase price in cleared funds (or margin cash available) in order to buy options. For this hypothetical order, your broker would require that you have $7.40 * 10 contracts * 100 shares per contract = $7,400 of cleared cash in your account. That's all there is to it. You'd be long 10 eBay $95 calls.

Notice that the previous instructions state "buy to open." The words "to open" are a quirk in the options market that is different from any other market. Because options are contracts, we are either entering into an agreement or exiting from one. If we just said we wanted to "buy" the option, the clearing firm has no way of knowing if we are entering into an agreement (buying to open) or exiting from one (buying to close). In order for the clearing firm to keep accurate track of how many open contracts are out there at any given time, we need to specify if we are opening or closing the position.

Let's assume that eBay rises and the price of your contract is now more valuable and trading for $9.00. If you wish to get out of the contract, you would call your broker and say, "Sell to close, 10 contracts, symbol XBAAS, at market." You would then be sold at the current price of $9 and have captured a $1.60 profit on 10 contracts, or $1,600. At this point, you're out and have no rights to buy stock - you've sold the coupon to someone else and collected a profit in between the transactions.

Long Puts

Let's assume that you're bearish on eBay and wish to short shares of stock. If you short stock, you're borrowing shares that you don't own with the obligation to buy them back later - hopefully at a lower price. Shorting stock has unlimited upside risk since there is no limit as to how high a stock could rise. Rather than short shares of eBay, you could instead buy a put option. Assume you buy 10 October $95 puts listed in Figure 1. You would call your broker and say, "Buy to open, 10 contracts, eBay October $95 puts, symbol XBAMS, at market." You'd probably be filled at the current asking price of $7.80, which means the trade would cost $7,800 and you'd be required to have this amount in cleared funds in your account.

You're now long an asset that behaves like a short stock position. The nice benefit about being long (owning the asset) is that the most you can lose is the amount you paid - in this case, $7,800. This limited risk benefit is far from true for someone who shorts stock. If the stock closes above $95 at expiration, the most you can lose is $7,800.

But let's assume the stock does fall as we expected. At expiration, the stock is down from $93.60 and trading for $85. The trader who shorted 1,000 shares of stock at $93.60 would make a profit of $8.60 per share, or a total of $8,600. With the stock at $85 at expiration, the $95 put would be worth the intrinsic value of $10. Since you paid $7.80, your net gain is $2.20, or $2,200 for 10 contracts. The stock fell just over 9% but your put option gained 28%, which again shows the leverage with options.

On a total dollar basis, the short stock trader makes $8,600 but the long put trader made $2,200, which is a $6,400 shortfall, or $6.40 per contract. Where did it go? Hopefully you remembered that the missing amount is exactly equal to the time premium. The $95 put cost $7.80 but had $6.40 time value ($95 strike - $93.60 stock price = $1.40 intrinsic value. If we subtract the $1.40 intrinsic value from the $7.80 cost of the option, were left with $6.40 time value). Remember, you never get that time value back. That's the reason there is a $6.40 shortfall in your put option profit as compared to the stock trader in this example.

This example also shows the "speed component" of the option that we spoke about earlier. If eBay falls by less than $6.40 at expiration, you'll lose money on the option even though you were correct about the direction. For example, assume that eBay falls exactly by $6.40 to $87.20 at expiration. With the stock at $87.20, the $95 put is worth exactly the intrinsic value of $7.80. You could sell for $7.80, which is exactly the same price you paid so you just broke even on the trade. However, if the stock fell by less than this amount ($87.21 or higher) then you'd lose money on the trade.

If you wanted to close your position, you'd just call your broker and say, "Sell to close, 10 contracts, eBay $100 puts, symbol XBAMS, at market." Your contracts would be sold to someone else. You have no more rights and you're out of the contract but collected a nice profit in the process.

Short Put

The long put has the right to sell shares of stock. The short put seller has the obligation to buy shares if the long put decides to exercise. Here's a nice strategy for traders looking for a way to acquire stock.

In Figure 1, ebay is trading for $93.60. Assume you want to buy 300 shares but think it will fall a little bit in the next month. How can you use options to capitalize on this? Rather than wait for the pullback, which may not happen, you could sell a put. Let's say you decide to sell the October $90 put, which is bidding $2.15. By selling 2 contracts (200 shares worth), you will receive 2 contracts * $2.15 * 100 shares per contract = $430. This cash is yours regardless of what happens to the stock. These funds can be used immediately to either withdraw or even buy other options.

If eBay stays above $90 at expiration, the contracts expire worthless and you keep the money. But let's assume that eBay falls to $88 at expiration. You would be assigned on the short put and would be required to buy 200 shares of stock at $90. Your account will be debited 200 * $90 = $18,000 and will be credited with 200 shares of eBay. Using short puts in this way is like getting paid to place a limit order for $90. If you thought eBay was going to fall but didn't know about options, the only thing you could do is to place a limit order to buy shares at, say $90. If eBay rises, you get nothing. But with the short put, at least you get the $430, which is something the limit order user does not receive. Both you and the limit order user are long stock at $90 but you get $425 to boot. Also notice that the initial credit from the sale of the put reduces your cost basis on the stock by the amount of the time premium, which is $2.15 in this case. The trader who uses the $90 limit order would be long shares at $90. Since you received 2.15 to sell (short) the put, your cost basis, assuming you are assigned, is $90 - $2.15 = $87.85. In this example, even though the stock is trading for $88 and you're assigned, you're still up 15 cents since your cost basis is $87.85. The initial credit from selling the puts acts as a nice downside hedge.

Notice that by selling puts, you're now acting as the insurance company. You took in the premium and are now on the hook if the long put owner "wrecks" their stock and wants you to buy it back. However, you were intending to buy stock anyway. That was a risk you were willing to assume but now the options market allows you to get immediate cash for assuming a risk you wanted to take. At the beginning of this course, we said that you will hear all different kinds of beliefs about the risks of options. We said it really depends on how they are used and this example demonstrates that. If you are willing to buy 200 shares of eBay, why should it be considered "risky" to sell puts and collect money to accept the obligation to buy 200 shares of eBay?

Short put options are a great way to acquire stock that you want to own. However, if you don't want to own the stock and are simply selling puts because you think the stock will rise, then you're speculating and are using options in a risky way. Whether options are risky or safe depends on how you use them.

Covered Call

Most traders new to options will always hear about the covered call since it is considered to be a basic, safe strategy. Let's take a look at how it works.

Let's assume you own 200 shares of eBay at $90 (maybe you got assigned on the short put in the earlier example - hopefully you're starting to see how you can combine option strategies to gain even more flexibility). You're willing to hold the shares and are now waiting for it to rise. Rather than wait, you can sell calls against your shares. By selling a call, you have an obligation to sell shares if the long call holder decides to exercise their right to buy. You could sell 2 contracts of the June $90 call XBAJR at $5.80, which is a total credit of 200 * $5.80 = $1,160. Again, this cash is available for your immediate use to use however you wish.

You would just call your broker and say, "Sell to open, 2 contracts, of the eBay October $90 calls, symbol XBAJR, at market." You would then be long 200 shares of stock and short 2 $90 calls.

If the stock rises above $90 at expiration, you would be required to sell for $90. If the stock stays still or falls, you still get to keep the $825, which is something that the long stock holder will never see. Remember, the cash you receive from selling an option is yours to keep regardless of what happens. Notice that this credit provides a little downside protection too. If the stock falls $5.80 below your cost basis, you're still at break even. The initial credit from the sale acts as a cushion against adverse stock price movements. If your cost basis is $87.85 on the shares (assuming you sold the put to acquire the 200 shares of eBay) and then sold the $90 calls for $5.80, your total cost basis is $87.85 - $5.80 = $82.05. If you are assigned on the short calls, you will sell your stock for $90, thus capturing a profit of $7.95, or 9.7%. Think about what happened though. You bought stock for $90 and sold it for $90 and still made a nice profit. It was the time premiums that made you profitable, which is something that stock traders will never enjoy.

Options allow traders to profit whether the stock rises, falls, or just stands still. We can control our risk, leverage our money, diversify our portfolio, and create risk profiles that cannot be done with any other asset. Options truly are a necessary asset that makes an already complex market more manageable.

These are just a small fraction of the strategies available to you. Options were created as a way to buy and sell risk. If there is a risk you're willing to assume, you can now get paid to assume it. If there is a risk you don't want, you can pay someone to assume it for you. The options market is the only forum that allows us to meet speculators and trade risk. If you think you've found some interesting aspects to options trading, we encourage you to find out more about the fascinating world of option trading and strategies through our free online Options 201 course.

Placing Orders

Once you're ready to start trading stocks, you must understand the many terms associated with placing orders. This is especially critical in today's market where most people place trades online and there is no interaction with a broker. While trading online does provide you with a greatly reduced commission, the drawback is that you are 100% responsible for the trade. If you are not fully aware of what a particular order or qualifier means, you could end up with a very different outcome than what you were expecting. This course takes you through the basic terms you will encounter when placing your first trades.

Making the Trade

Whenever you buy or sell stock, you must specify five basic pieces of information:

Action (Buy or Sell)
Quantity (Number of shares)
Symbol (Ticker symbol)
Price (Market or Limit)
Time (Day or Good-til-Cancelled (GTC))

The action, quantity, and symbol are all straightforward and really don't need any detailed explanation. These fields are simply telling your broker whether you wish to buy or sell, how many shares, and of which security. But the price and time fields are the ones that create the most questions - and unexpected surprises - for new traders so that's what we're going to focus on in this course. Each of these orders carries a different set of possibilities and, depending on the situation, one will probably be a better choice than the other. We'll go through each so that you understand them fully.

Price

When you place an order to buy or sell, you must provide some information about the price at which you're willing to make the deal. There are two ways to provide price information: market order or limit order.

Market Order

A market order guarantees that your order will be filled but does not guarantee the price at which the transaction will be made. If you place an order to buy 300 shares of Intel "at market," then you know for sure that you have purchased 300 shares. But in order for this transaction to be guaranteed, it means that you must be flexible on the price. The reason you must be flexible on price is because stock prices change nearly every second of the day; they do not stay constant throughout the day such as when you're shopping at a retail store. If the stock's price is $25 when you place your order, it's quite possible that your purchase price will come back at a different price (whether higher or lower) than $25 even though it will only take a few seconds for the trade to get filled. When you place a market order, you're really stating that you want to be filled at the best price (which is the prevailing price at that moment) when your order reaches the trading floor. The simplest way to describe a market order is this: A market order guarantees the execution but not the price.

New traders often wonder why they cannot guarantee that the deal goes through but at a predetermined price. After all, whenever you buy a house or car, you can guarantee the deal at a stated price. The reason for the apparent inconsistency is due to the fact that the stock market is one continuous live auction where traders place bids to buy and offers to sell. The stock's price depends on the supply and demand of the stock at that moment in time. If you place an order "at market," you're telling the broker to fill the order but the price at which the order is filled depends on the time your order arrives. There is no way to be sure to get the shares while also stating a maximum or minimum price. Think about it this way: Imagine that you are a buyer for a billionaire who sends you to an auction to purchase a Picasso painting. There is no way he can tell you to definitely come back with the painting but to not spend more than $10 million. If the painting must be purchased, the buyer must be flexible on price.

Liquidity

Some stocks have a lot of shares being traded daily (also called the volume), while others are thinly traded. Stocks that have a lot of volume are said to be highly liquid. If you place a market order for a liquid stock, you will most likely get filled at a price very close to the one you see on your computer screen when placing the order. Of course, this assumes that the number of shares you're trading doesn't represent a significant part of the daily volume. For example, you could place an order for 10,000 shares of Microsoft or Intel, which are both highly liquid, and probably get filled at a price very close to the one you saw when you placed the order. But if you buy 10,000 shares of a stock that has almost no daily volume, such as many penny stocks, you could be in for a big surprise when the fill comes back. It's always important to understand the size of your order relative to the liquidity when deciding whether to place a market order or limit order.

Fast Markets

No matter how liquid the stock, it is possible for a lot of traders to rush in with orders at the same time thus making the quote you see somewhat stale. (By the way, stale quotes can happen even though you may be looking at "real time" quotes.) When quotes are stale, the condition is called a "fast market" and can happen to any stock regardless of liquidity. However, the more liquid the stock, the less severe the price swings will be during a fast market. A fast market is one where trade orders are flowing so fast that the market makers cannot accurately quote the true price based on all buy and sell orders. Fast markets usually occur when there is a big news announcement or event and many traders rush in at the same time to place orders. During a fast market, there can be long lines of orders to get filled and, by the time your order reaches the front of the line, the stock price could be very different from what you thought you were going to get.

It is important to understand that a market order carries no implied or "reasonable" limits. Even though most market orders are filled at prices close to the current price, there are no guarantees. There are no minimum prices (for sell orders) or maximum prices (for buy orders). You cannot come back to your broker and say, for example, that the stock price was $25 when you sent the order and a fill price of $27 is unreasonable. If you place your order during a fast market, an "unreasonable" price becomes a possibility.

Multiple Fills

If you place a market order, it is possible that the order comes back filled at multiple prices. This just means the traders were only able to get a certain number of shares at one price and had to fill the balance at one or more prices. For example, assume Microsoft is trading for $30 and your order is to buy 500 shares of Microsoft at market. It is possible that your order comes back as follows: bought 200 shares at $30 and 300 shares at $30.10. When you are filled at one or more prices, it is called a multiple fill. These happen for the sheer fact that market orders must fill and, just as there's no guarantee as to the price, there's also no guarantee that the price will be the same for all shares traded.

Despite the small risk of adverse price movements, if you must get in or out of a trade, then the market order is still your best choice. It is the only way to be sure you are in or out of the trade. However, there may be times when you want to ensure that your buy price does not rise past a certain point or that your sell order does not fall below a certain price. If so, then you can use another type of price called a limit order.

Limit Orders

A limit order is one where you specify a price. If you are buying stock, your purchase price cannot exceed the limit price. If you are selling stock, the sale price cannot fall below the limit price. But if that limit price cannot be realized, then your order remains open, which means it is possible you never get filled. Limit orders guarantee the price but not the execution.

For example, if you place an order to buy 300 shares of Intel at a limit price of $25, then the order will only be filled if the market maker can fill it for $25 or less. If your order is to sell 300 shares of Intel at a limit price of $27.50, then the order can only be filled for $27.50 or higher.

Most traders use limit orders to buy stock at a lower price (or sell it at a higher price) than the current market price. If Intel is $25 per share and you think its price will fall in the near future, you might place a trade to buy shares at a limit of $23.50, for example. That way you'll have a standing order on the books if the price should hit $23.50. If the stock never hits that price (or lower), the trade goes unexecuted. If you place the order with the limit price equal to the current market price, it is called a "marketable limit order." In this example, if you placed an order to buy Intel at a limit price of $25, it would be a marketable limit order. This just means that you are willing to pay the current price or lower but will not get filled it if should move one cent above $25 when your order reaches the floor.

Limit orders are a great tool for discipline. If you just bought 200 shares for $25 and wish to sell them when it hits $30, you can immediately place an order to sell 200 shares at a limit of $30. The only way the trade will get executed is if the stock's price hits $30 or higher.

Why Can't I Guarantee the Execution and Price?

It is important to understand that when you place orders you can either guarantee the execution (market order) or the price (limit order) but you cannot guarantee both. Why can't a trader guarantee both the price and execution? That would be too good to be true. If we could guarantee both, we would be guaranteed to buy an expensive stock for a very low price and guaranteed to sell it for a very high price, which is simply not possible. You only get one choice between price and execution. If you must have the order executed then use a market order and be flexible on price. If you must have a certain price, then use a limit order and accept the risk of not getting filled.

Or-Better Orders

The price risk associated with market orders leaves some traders uncomfortable especially if they have a relatively small account and do not wish to risk having to send in additional money to pay for a trade. Placing a limit order alleviates this risk but then you run the risk of not getting filled. Is there some way to blend the two orders? Is there a way we can be reasonably certain of getting filled but, at the same time, not be at risk for a price we might find unsatisfactory? The answer is yes and we can do that with an "or-better" qualifier. An or-better qualifier is a type of limit order where your buy price is stated above the current market price and your sell limit is placed below the current market price.

For example, assume that Microsoft is trading for $30 and you want to buy 200 shares but do not want to be totally flexible on price. You could place an order, for example, to buy 200 shares at $31 or-better. This means that you are willing to pay up to $31 per share even though the current price is $30. This order qualifier gets its name from that fact that you are willing to buy the shares at $31 or a better price, which is lower. Some new traders think the "or better" qualifier is suggesting that you will buy the shares at $31 "or higher" and that's not true. That would be better for the seller, not you. You're telling the broker you'll buy for $31 "or better" for you.

By using the or-better qualifier, if the price should move up a bit after you send the order, at least you'll get filled assuming the price doesn't move above $31. The or-better qualifier allows for some price fluctuation between the time you send the order and the time it is filled. Of course, this is still a type of limit order so it is possible (although unlikely) that you do not get filled. By using the or-better qualifier, you have a much better chance of being filled as compared to a trader that places a marketable limit at $30 per share.

You can use or-better qualifiers on the sell side too. If Microsoft is $30 and you place an order to sell shares at $29.50 or-better, you could get filled for any price at $29.50 or higher. The or-better designation on the sell side just tells the broker you're willing to take less than the current market price if necessary to get the trade executed.

When entering an or-better order online, most firms require that you check off a little box that says "or better" so they know that you are willing to buy above the current price (or sell below the current price). The reason they require you to check off the box is because, otherwise, they're not sure if you mean to sell the stock (since most traders would place a limit order above the current price if they are selling the stock). By checking off the or-better box, it lets your broker know that you are not making a mistake in the order.

Some traders find or-better orders a little unsettling to use. They feel that the market makers will take advantage of them and fill the order at the higher price. That's not true since the market makers are bound by the "time and sales," which is a recording of all sales (trades) and the times they occurred. Market makers cannot arbitrarily fill your order at the higher price just because you're willing to pay it. They could only do so if the "time and sales" recording shows that was the going price for the stock at the time your order was filled.

Limit Orders and Quantity

Another fact about limit orders is that you are really stating to buy or sell up to that many shares at the limit price. If you place an order to buy 400 shares of Microsoft at $30, you could get filled for any number of shares up to 400 (minimum lots of 100 shares). Your order is filled for fewer shares than you requested, it is called a partial fill. With a stock as liquid as Microsoft, it is unlikely that the market makers could not fill all 400 shares at any given price but it is a possibility. The less liquid the stock or the faster the market, the more likely it is that you may get a partial fill.

All-or-None (AON)

If you do not wish to get a partial fill, you can place an all-or-none (AON) restriction on your order. This is simply done by checking off the AON box when you enter the trade. This just tells the market makers to not fill your order unless they can fill the entire number of shares you requested. While this may sound like a good restriction to place on all orders, there are many drawbacks. First, your order is handled differently and market makers are not required to show your orders to the public if they are marked AON. This means that you will reduce your chance of getting filled. Second, multiple fills are not a possibility with AON orders. For instance, assume you place an order to buy 500 shares of a stock at $20. It's possible that all 500 shares are filled but at different times of the day. However, if you marked the trade AON, then you may never get any shares filled. Third, you must ask yourself if a partial fill is really a bad outcome. Will you be upset that you only bought 300 out of 500 shares if the stock shoots up 10 points? There are times for AON restrictions but, for most traders, it acts as a hindrance.

Time Limits

In addition to setting a price when entering your order, you must also specify a time limit for which the order is good. This is true for any bid to buy or offer to sell. If you place a bid on a new home and the seller rejects it, he or she cannot come back a week later and force you to accept it. There is only so long that a bid or offer can stand. In the same way, when you place an order to buy or sell stock, you must specify for how long the order is valid. There are two basic choices for time limits: Day Order and Good 'til Cancelled (GTC). There are two others, which are Immediate or Cancel (IOC) and Fill or Kill (FOK) but those are rarely used, especially if you are new to trading. For this course, we'll only consider the "Day" and "GTC" orders.

Day Orders

A day order is good only for the trading day. If you place a day order after the market close, then it will be good only for the following business day. Any order placed "at market" can only be entered as a "day order" for the fact that market orders are guaranteed to fill. There is no reason that the order would roll over to another day. Most computer programs will automatically select the "day order" time limit if you enter a market order. However, if it doesn't and you manually select GTC, the order will likely be rejected since it raises questions for the floor traders; they are not sure if you meant to use a limit order or meant to make the time period good for the day.

We just found out that a day order is the only acceptable time limit for a market order. However, if you enter a limit order, then the "day" time limit makes the trade only good for the trading day and is cancelled at the end if it is not filled. If you wish to reenter the trade, you must retype a new order and submit it.

Good 'til Cancelled Orders (GTC)

Good 'til cancelled order may only be used for limit orders. GTC orders can be a handy tool that keeps you from having to retype orders that do not fill. If a GTC limit order does not fill today, it will automatically renew itself the following business day.

A GTC order is good for a period of time not to exceed six months (it is up to your broker as to how long a GTC order lasts). If the order is ever filled in its entirety, it is then considered executed and will not be reinstated the following day. If the order is never filled throughout the GTC time period, it is then cancelled for good.

Partial Fills

We said earlier that limit orders imply that you are willing to buy or sell up to the number of specified shares. Because of this, it is possible to receive a partial fill on an order. For example, assume you place an order to buy 400 shares of Microsoft at a limit price of $30 GTC. This means you are willing to buy up to 400 shares at a price not to exceed $30 per share. It is possible that during the day the stock's price may drop to $30 but that only 300 shares are available. You would receive a confirmation that you have purchased 300 shares at $30 and now have an open order to buy the remaining 100 shares at $30 GTC. The time remaining on the GTC order starts from when you first placed the original order for 400 shares; the time does not reset because of a partial fill. The important point to understand is that just because part of the order executes does not mean that the remainder is cancelled. If you wish to cancel the remaining shares, you must do that separately.

Pros and Cons of GTC Orders

GTC orders can simplify your life by automatically renewing trades that do not fill. However, GTC orders can also be a source of trouble if you forget about them. Using the earlier example, assume you place an order to buy 400 shares of Microsoft at a limit of $30 GTC. Let's also assume that the order hasn't filled after several months and that your broker allows a GTC order to stand for six months. It's possible that the stock's price may start to fall rapidly several months later and you forget that you still have this open order on the books. The stock could fall well below $30 - and fill your order on the way down. Alternatively, you may forget about the order and then place an entirely new order thus doubling up on the order. It is because many traders forget about open GTC orders that most brokers only allow them to stand for only 90 days or less. Still, 90 days are a lot of time for things to change in the stock market. If you use GTC orders, it's important to check your account on a daily basis.

Change/Cancel

If you have placed any limit order and wish to change it, you must enter a change/cancel order. This is true whether you placed a day or GTC time limit. For example, let's assume you bought stock at $30 and placed a sell limit order at $35 GTC. At a later time, the stock hits $34 but appears to hit some resistance and you decide to sell for $34. Many new traders make the mistake of entering a new order to sell the shares for $34 and forget that they still have an open order to sell for $35. In this case, there are two choices you have. First, you can cancel the GTC order. After it is cancelled, you can then place the new order to sell for $34. Second, most brokers allow you to enter a change/cancel order. You would simply tell the computer to change the GTC order. It will allow you to change several fields such as number of shares and the time limit. It will probably not allow you to change the action or the stock symbol. Once the order appears, you would just change the limit order from $35 to $34 and then enter that order. This tells the computer to change the order from $35 to $34 assuming it is able to cancel the original order. If the original order is confirmed cancelled, then the new limit at $34 stands. By using the change/cancel feature, it will prevent you from doubling up on your orders.

You generally cannot cancel a market order once it has been placed. Once again, the reason is because the order is guaranteed to fill. I have seen cases where market orders were cancelled but this was due to a delay between the time the broker sends the order and the time it was sent to the floor. You can certainly try to cancel a market order, but no broker is required to allow you to cancel it.

Stop and Stop Limits

"Stop" and "stop limit" orders are generally used to exit a trade although they could certainly be used to enter one. These are the two types of orders that cause more confusion than any other - even among brokers. Make sure you understand their differences before using!

A "sell stop" is used if you already own the stock. Sell stops are used as a risk management tool because it will sell your stock if the price falls but allow you to hang on if it should rise. Let's assume you bought stock at 300 shares of stock at $50 and do not want to lose more than $1 per share, or $300 total. After buying the shares, you could enter a stop order to protect your downside. The order would look like this: Sell 300 shares at a stop price of $49.

In addition, you'd have to specify a time limit, which is either a "day" or "GTC." If the stock should rise you still own the shares and profit from the additional price increases. However, if the price falls to $49 or lower, the trade becomes a live "market order" and you are sold at the prevailing price. This brings up an important point about stop orders - they do not in any way guarantee that you will receive $49. Remember, a market order is guaranteed to fill and, because of this, it cannot guarantee the price. The stop price of $49 is really seen as a "trigger point" in that the order is activated if the stock hits $49 or lower.

In most cases, if the stock price slowly falls and eventually hits $49, you will have no trouble getting that price. But let's say the stock closes at $49.01 today and opens at $45 tomorrow. In that case, you're going to get a price closer to the prevailing $45 price.

Stop Limits

Continuing with the previous example, let's say the stock does open the next day at $45. Would you still wish to sell or would you rather hold? In order to prevent unwanted sales due to large price swings, you could place a "stop limit" order rather than a stop order. For example, if you wish to sell your stock at $49 but would rather hold it if you cannot get at least $48, you could place a sell stop limit, which would look like this:

Sell 300 shares at a stop price of $49 with at stop limit of $48 (good for the day or until cancelled).

This order says to sell the stock if it hits $49 but only if you can get $48 or higher. As with the stop order, the $49 price acts as a trigger point. If the stock hits that price or lower, the order is activated and becomes a live "limit order" to sell if you can get $48 or higher. So in this example, if the stock opens at $45, you'll still end up holding the stock. But be careful, if you have a GTC time limit, the sale will occur if the stock rises to $48 or higher while the GTC order is active! If you don't want to sell, you'll have to cancel the order.

Notice that neither the stop nor stop limit prevents a loss. In this example, if the stock opens at $45, you'll end up selling at $45 even though you wanted to limit your loss to a stock price of $49. And if you used the stop limit, you'd end up holding the stock at the current price of $45.

Despite these risks, stop and stop orders are generally seen as a helpful risk management tool. It's easy to say that you'll sell if the price hits $49 but, in most cases, people hang on hoping to get their money back - and often end up losing more. Stop and stop limit orders can create good discipline in selling.

READY TO LEARNING STOCK TRADING AND INVESTING

Thursday, December 13, 2007

Basic Investing

What is the Stock Market?

Public and Private Companies

Problems with Selling

Centralized Meeting Place

Publicly Traded Companies

Taking it Public

Benefits of Secondary Markets

Stock Markets Make it Easy for Corporations to Raise Money

Martha Stewart

New York Stock Exchange vs. Nasdaq

Types of Investments

Stocks

Benefits

Drawbacks

Historical Returns

Risk

Why Buy

How to Buy

Settlement/Liquidity

Variables that Impact Price

Preferred Stock

Bonds

Basic Bond Mechanics

Benefits

Drawbacks

Historical Returns

Risk

Why Buy

How to Buy

Settlement/Liquidity

Variables that Impact Price

Mutual Funds

Benefits

Drawbacks

No-Load Funds

Open-End or Closed-End?

Historical Returns

Risk

Why Buy

How to Buy

Selling Dividends

Settlement/Liquidity

Variables that Impact Price

REIT

Benefits

Drawbacks

Historical Returns

Risk

Why Buy

How to Buy

Settlement/Liquidity

Variables that Impact Price

Unit Investment Trusts

Benefits

Drawbacks

Historical Returns & Risk

Why Buy

How to Buy

Settlement/Liquidity

Exchange Traded Funds (ETFs)

Benefits

Drawbacks

How to Buy

Settlement/Liquidity

Limited Partnerships

Benefits

Drawbacks

Historical Returns & Risk

Why Buy

How to Buy

Settlement/Liquidity

Hedge Fund

Benefits

Drawbacks

Historical Returns

Risk

Why Buy