Investing in Stock Market | Law Offices of Robert Wayne Pearce, P.A.

The Law Offices of Robert Wayne Pearce, P.A.
Over 25 Years of Experience with Broker / Investor Disputes
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(561) 338-0037

Boca Raton - West Palm Beach - Fort Lauderdale

FLORIDA STOCK MARKET ATTORNEY
FLORIDA STOCK FRAUD LAWYER

Introduction

The Law Offices of Robert Wayne Pearce, P.A. focuses its practice on securities, commodities and other investment disputes in courtroom litigation, arbitration and mediation proceedings. We have over 25 years experience representing domestic and foreign investors from offices located in Boca Raton, West Palm Beach, and Fort Lauderdale, Florida. We handle stock fraud and other stock broker misconduct claims involving the stock markets around the world. It is important for all investors to understand the fundamentals of investing and we are pleased to share some of the basics in investing in the stock markets to help you understand stocks and avoid disputes.

Stocks are a part, if not the cornerstone, of nearly any investment portfolio. When you start investing in securities, you need to have a solid understanding of stocks and how they trade on the stock market. Over the last few decades, the average person's interest in the stock market has grown exponentially. What was once a toy of the rich has now turned into the vehicle of choice for growing wealth. This demand coupled with advances in trading technology has opened up the markets so that nowadays nearly anybody can own stocks.

Despite their popularity, however, most people don't fully understand stocks. Much is learned from conversations with others who also don't understand stocks. Chances are you've already heard people say things like, "John made a killing in the market, and now he's got another hot tip ..." or "Watch out with stocks‑‑you can lose your shirt in a matter of days!" So much of this misinformation is based on a get‑rich‑quick mentality. Some people think that stocks are the magic answer to instant wealth with no risk. Stocks can (and do) create massive amounts of wealth, but they aren't without risks. The only solution to this is education. The key to protecting yourself in the stock market is to understand where you are putting your money.

Different Types Of Stocks

There are two main types of stocks: common stock and preferred stock.

Common Stock

Common stock is, well, common. When people talk about stocks they are usually referring to this type. In fact, the majority of stock is issued is in this form. We basically went over features of common stock in the last section. Common shares represent ownership in a company and a claim (dividends) on a portion of profits. Investors get one vote per share to elect the board members, who oversee the major decisions made by management.

Over the long term, common stock, by means of capital growth, yields higher returns than almost every other investment. This higher return comes at a cost since common stocks entail the most risk. If a company goes bankrupt and liquidates, the common shareholders will not receive money until the creditors, bondholders and preferred shareholders are paid.

Preferred Stock

Preferred stock represents some degree of ownership in a company but usually doesn't come with the same voting rights. (This may vary depending on the company.) With preferred shares, investors are usually guaranteed a fixed dividend forever. This is different than common stock, which has variable dividends that are never guaranteed. Another advantage is that in the event of liquidation, preferred shareholders are paid off before the common shareholder (but still after debt holders). Preferred stock may also be callable, meaning that the company has the option to purchase the shares from shareholders at anytime for any reason (usually for a premium).

Some people consider preferred stock to be more like debt than equity. A good way to think of these kinds of shares is to see them as being in between bonds and common shares.

Different Classes of Stock

Common and preferred are the two main forms of stock; however, it's also possible for companies to customize different classes of stock in any way they want. The most common reason for this is the company wanting the voting power to remain with a certain group; therefore, different classes of shares are given different voting rights. For example, one class of shares would be held by a select group who are given ten votes per share while a second class would be issued to the majority of investors who are given one vote per share.

When there is more than one class of stock, the classes are traditionally designated as Class A and Class B. Berkshire Hathaway (ticker: BRK), has two classes of stock. The different forms are represented by placing the letter behind the ticker symbol in a form like this: "BRKa, BRKb" or "BRK.A, BRK.B".

Understanding Various Ways Stocks Are Described

In addition to the distinctions a company might establish for its shares-such as common or preferred-industry experts often group stocks generally into categories, sometimes called subclasses. Common subclasses, explained in greater detail below, focus on the company's size, type, performance during market cycles, and potential for short‑ and long‑term growth.

Each subclass has its own characteristics and is subject to specific external pressures that affect the performance of the stocks within that subclass at any given time. Since each individual stock fits into one or more subclasses, its behavior is subject to a variety of factors.

Market Capitalization

You'll frequently hear companies referred to as large‑cap, mid‑cap, and small‑cap. These descriptors refer to market capitalization, also known as market cap and sometimes shortened to just capitalization. Market cap is one measure of a company's size. More specifically, it's the dollar value of the company, calculated by multiplying the number of outstanding shares by the current market price.

There are no fixed cutoff points for large‑, mid‑, or small‑cap companies, but you may see a small‑cap company valued at less than $1 billion, mid‑cap companies between $1 billion and $5 billion, and large‑cap companies over $5 billion-or the numbers may be twice those amounts. You might also hear about micro‑cap companies, which are even smaller than other small‑cap companies.

Larger companies tend to be less vulnerable to the ups and downs of the economy than smaller ones-but even the most venerable company can fail. Larger companies typically have larger financial reserves, and can therefore absorb losses more easily and bounce back more quickly from a bad year. At the same time, smaller companies may have greater potential for fast growth in economic boom times than larger companies. Even so, this generalization is no guarantee that any particular large‑cap company will weather a downturn well, or that any particular small‑cap company will or won't thrive.

Industry and Sector

Companies are subdivided by industry or sector. A sector is a large section of the economy, such as industrial companies, utility companies, or financial companies. Industries, which are more numerous, are part of a specific sector. For example, banks are an industry within the financial sector.

Frequently, events in the economy or the business environment can affect an entire industry. For example, it's possible that high gas prices could lower the profits of transportation and delivery companies. A new rule changing the review process for prescription drugs could affect the profitability of all pharmaceutical companies.

Sometimes an entire industry might be in the midst of an exciting period of innovation and expansion, and becomes popular with investors. Other times that same industry could be stagnant and have little investor appeal. Like the stock market as a whole, sectors and industries tend to go through cycles, providing strong performance in some periods and disappointing performance in others.

Part of creating and maintaining a strong stock portfolio is evaluating which sectors and industries you should be invested in at any given time. Having made that decision, you should always evaluate individual companies within a sector or industry you've identified to focus on the ones that seem to be the best investment choices.

Defensive and Cyclical

Stocks can also be subdivided into defensive and cyclical stocks. The difference is in the way their profits, and therefore their stock prices, tend to respond to the relative strength or weakness of the economy as a whole.

Defensive stocks are in industries that offer products and services that people need, regardless of how well the overall economy is doing. For example, most people, even in hard times, will continue filling their medical prescriptions, using electricity, and buying groceries. The continuing demand for these necessities can keep certain industries strong even during a weak economic cycle.

In contrast, some industries, such as travel and luxury goods, are very sensitive to economic up‑and‑downs. The stock of companies in these industries, known as cyclicals, may suffer decreased profits and tend to lose market value in times of economic hardship, as people try to cut down on unnecessary expenses. But their share prices can rebound sharply when the economy gains strength, people have more discretionary income to spend, and their profits rise enough to create renewed investor interest.

Growth and Value

A common investment strategy for picking stocks is to focus on either growth or value stocks, or to seek a mixture of the two since their returns tend to follow a cycle of strength and weakness.

Growth stocks, as the name implies, are issued by companies that are expanding, sometimes quite quickly but in other cases over a longer period of time. Typically, these are young companies in fairly new industries that are rapidly expanding.

Growth stocks aren't always new companies, though. They can also be companies that have been around for some time but are poised for expansion, which could be due to any number of things, such as technological advances, a shift in strategy, movement into new markets, acquisitions, and so on,

Because growth companies often receive intense media and investor attention, their stock prices may be higher than their current profits seem to warrant. That's because investors are buying the stock based on potential for future earnings, not on a history of past results. If the stock fulfills expectations, even investors who pay high prices may realize a profit. Since companies may take big risks to expand, however, growth stocks may be very volatile, or subject to rapid price swings. For example, a company's new products may not be a hit, there may be unforeseen difficulty doing business in new countries, or the company may find itself saddled with major debt in a period of rising interest rates. As always with investing, the greater the potential for an outstanding return, the higher the risk of loss.

When a growth stock investment provides a positive return, it's usually as a result of price improvement-the stock price moves up from where the investor originally bought it-not because of dividends. Indeed, a key feature of most growth stocks is an absence of dividend payments to investors. Instead, company managers tend to plow gains directly back into the company.

Value stocks, in contrast, are solid investments selling at what seem to be low prices given their history and market share. If you buy a value stock, it's because you believe that it's worth more than its current price. You might look for value in older, more established industries, which tend not to get as much press as newer industries. One of the big risks in buying value stocks, also known as undervalued stocks, is that it's possible that investors are avoiding a company and its stock for good reasons, and that the price is a fairer reflection of its value than you think.

On the other hand, if you deliberately buy stocks that are out of fashion and sell stocks that other investors are buying-in other words, you invest against the prevailing opinion-you're considered a contrarian investor. There can be rewards to this style of investing, since by definition a contrarian investor buys stocks at low prices and sells them at high ones. However, contrarian investing requires considerable experience and a strong tolerance for risk, since it may involve buying the stocks of companies that are in trouble and selling stocks of companies that other investors are favoring. Being a contrarian also takes patience, since the turnaround you expect may take a long time.

Making Money With Stock

There are two main ways to make money with stocks:

1. Dividends. When publicly owned companies are profitable, they can choose to distribute some of those earnings to shareholders by paying a dividend. You can either take the dividends in cash or reinvest them to purchase more shares in the company. Many retired investors focus on stocks that generate regular dividend income to replace income they no longer receive from their jobs. Stocks that pay a higher than average dividend are sometimes referred to as "income stocks."

2. Capital gains. Stocks are bought and sold constantly throughout each trading day, and their prices change all the time. When a stock price goes higher than what you paid to buy it, you can sell your shares at a profit. These profits are known as capital gains. In contrast, if you sell your stock for a lower price than you paid to buy it, you've incurred a capital loss.

Both dividends and capital gains depend on the fortunes of the company-dividends as a result of the company's earnings and capital gains based on investor demand for the stock. Demand normally reflects the prospects for the company's future performance. Strong demand-the result of many investors wanting to buy a particular stock-tends to result in an increase in the stock's share price. On the other hand, if the company isn't profitable or if investors are selling rather than buying its stock, your shares may be worth less than you paid for them.

The performance of an individual stock is also affected by what's happening in the stock market in general, which is in turn affected by the economy as a whole. For example, if interest rates go up and you think you can make more money with bonds than you can with stock, you might sell off stock and use that money to buy bonds. If many investors feel the same way, the stock market as a whole is likely to drop in value, which in turn may affect the value of the investments you hold. Other factors, such as political uncertainty at home or abroad, energy or weather problems, or soaring corporate profits, also influence market performance.

However-and this is an important element of investing-at a certain point, stock prices will be low enough to attract investors again. If you and others begin to buy, stock prices tend to rise, offering the potential for making a profit. That expectation may breathe new life into the stock market as more people invest.

This cyclical pattern-specifically, the pattern of strength and weakness in the stock market and the majority of stocks that trade in the stock market-recurs continually, though the schedule isn't predictable. Sometimes, the market moves from strength to weakness and back to strength in only a few months. Other times, this movement, which is known as a full market cycle, takes years.

At the same time that the stock market is experiencing ups and downs, the bond market is fluctuating as well. That's why asset allocation, or including different types of investments in your portfolio, is such an important strategy: In many cases, the bond market is up when the stock market is down and vice versa. Your goal as an investor is to be invested in several categories of investments at the same time, so that some of your money will be in the category that's doing well at any given time,

What Causes Stock Prices To Change?

Stock prices change every day as a result of market forces. By this we mean that share prices change because of supply and demand. If more people want to buy a stock (demand) than sell it (supply), then the price moves up. Conversely, if more people wanted to sell a stock than buy it, there would be greater supply than demand, and the price would fall.

Understanding supply and demand is easy. What is difficult to comprehend is what makes people like a particular stock and dislike another stock. This comes down to figuring out what news is positive for a company and what news is negative. There are many answers to this problem and just about any investor you ask has their own ideas and strategies.

That being said, the principal theory is that the price movement of a stock indicates what investors feel a company is worth. Don't equate a company's value with the stock price. The value of a company is its market capitalization, which is the stock price multiplied by the number of shares outstanding. For example, a company that trades at $100 per share and has 1 million shares outstanding has a lesser value than a company that trades at $50 that has 5 million shares outstanding ($100 x 1 million = $100 million while $50 x 5 million = $250 million). To further complicate things, the price of a stock doesn't only reflect a company's current value, it also reflects the growth that investors expect in the future.

The most important factor that affects the value of a company is its earnings. Earnings are the profit a company makes, and in the long run no company can survive without them. It makes sense when you think about it. If a company never makes money, it isn't going to stay in business. Public companies are required to report their earnings four times a year (once each quarter). Wall Street watches with rabid attention at these times, which are referred to as earnings seasons. The reason behind this is that analysts base their future value of a company on their earnings projection. If a company's results surprise (are better than expected), the price jumps up. If a company's results disappoint (are worse than expected), then the price will fall.

Of course, it's not just earnings that can change the sentiment towards a stock (which, in turn, changes its price). It would be a rather simple world if this were the case! During the dotcom bubble, for example, dozens of internet companies rose to have market capitalizations in the billions of dollars without ever making even the smallest profit. As we all know, these valuations did not hold, and most internet companies saw their values shrink to a fraction of their highs. Still, the fact that prices did move that much demonstrates that there are factors other than current earnings that influence stocks. Investors have developed literally hundreds of these variables, ratios and indicators. Some you may have already heard of, such as the price/earnings ratio, while others are extremely complicated and obscure with names like Chaikin oscillator or moving average convergence divergence.

So, why do stock prices change? The best answer is that nobody really knows for sure. Some believe that it isn't possible to predict how stock prices will change, while others think that by drawing charts and looking at past price movements, you can determine when to buy and sell. The only thing we do know is that stocks are volatile and can change in price extremely rapidly.

Volatility

If you've seen the jagged lines on charts tracking stock prices, you know that prices fluctuate throughout the day, week, month, and year, as demand goes up and down in the markets. You'll see short‑term fluctuations as the stock's price moves within a certain price range, and longer‑term trends over months and years, in which that short‑term price range itself moves up or down. The size and frequency of these short‑term fluctuations are known as the stock's volatility.

If a stock has a relatively large price range over a short time period, it is considered highly volatile and may expose you to increased risk of loss, especially if you sell for any reason when the price is down. Though there are exceptions, growth stocks tend to be more volatile than value stocks.

In contrast, if the range of prices is relatively narrow over a short time period, a stock is considered less volatile and normally exposes you to less investment risk. But reduced risk also means reduced potential for substantial short‑term return since the stock price is unlikely to increase very much in that time frame.

Stocks may become more or less volatile overtime. One example might be a newer stock that had formerly seen big price swings, but becomes less volatile as the company grows and establishes a track record. Another example might be a stock with a traditionally stable price that becomes extremely volatile following unfavorable or favorable news reports, which trigger a rash of buying and selling.

Buying and Selling Stock

To buy and sell stock, you usually need to have an account at a brokerage firm, also known as a broker‑dealer, and give orders to a stockbroker at the firm who will execute those instructions on your behalf, or online, where the firm's technology systems route your order to the appropriate market or system for execution. The kind of firm you use will determine how you convey your orders, what types of services you have access to, and what fees you pay to trade your stocks. In general, the more services the firm offers, the more you'll pay for each transaction. Brokerage firms may also charge fees to maintain your account.

Full‑service brokerage firms provide research as well as trade executions and may offer customized portfolio management, investment advice, financial planning, banking privileges, and other services. Discount firms offer fewer services but, as their name implies, generally charge less to execute the orders you place. The trick is to find the balance that's right for you. On the one hand, you don't want fees to cut into your returns, but on the other hand, you may benefit from more guidance. You'll want to check what effect the amount you have to invest-or what are known as your investable assets-will have on the level of service you receive and the prices you pay.

You can place buy and sell orders over the phone with your broker or you can trade stocks online. Many firms offer full account access and trading through their Web sites at lower prices than they charge for phone orders. If you do trade online, it's important to be wary of trading too much, simply because it's so easy to place the trade. You should consider your decisions carefully, taking into account the fees and taxes as well as the impact on the balance of assets in your portfolio, before you place an order.

There are ways to buy stock directly through certain companies without using a broker. For example, if you used a broker to purchase a share of stock in a company that offers a dividend reinvestment plan, or DRIP, you can choose to buy additional shares through that plan. DRIPs allow you to automatically reinvest your dividends and periodically write checks to buy more stock. Some companies also offer direct purchase plans, or DPPs, that allow you to buy shares directly from the issuer at any time.

DRIPs and DPPs are usually administered for the company by a third party known as a shareholder services company or stock transfer agent that can also handle the sale of your shares. Transaction fees for DRIP and DPP orders tend to be substantially less than brokerage fees.

Trading vs. Buy‑and‑Hold

The goal of most investors generally is to buy low and sell high. This can result in two quite different approaches to equity investing.

One approach is described as "trading." Trading involves following the short‑term price fluctuations of different stocks closely and then trying to buy low and sell high. Traders usually decide ahead of time the percentage increase they're looking for before you sell (or decrease before they buy).

While trading has tremendous potential for immediate rewards, it also involves a fair share of risk because a stock may not recover from a downswing within the time frame you'd like-and may in fact drop further in price. In addition, frequent trading can be expensive, since every time you buy and sell, you may pay broker's fees for the transaction. Also, if you sell a stock that you haven't held for a year or more, any profits you make are taxed at the same rate as your regular income, not at your lower tax rate for long‑term capital gains.

Be aware that trading should not be confused with "day trading," which is the rapid buying and selling of stock to capitalize on small price changes. Day trading can be extremely risky, especially if you attempt to day trade using borrowed money. Individual investors frequently lose money by trying to use this approach.

A very different investing strategy-called buy‑and‑hold-involves keeping an investment over an extended period, anticipating that the price will rise over time. While buy‑and‑hold reduces the money you pay in transaction fees and short‑term capital gains taxes, it requires patience and careful decision‑making. As a buy‑and‑hold investor, you generally choose stocks based on a company's long‑term business prospects. Increases in the stock price over years tend to be based less on the volatile nature of the market's changing demands and more on what's known as the company's fundamentals, such as its earnings and sales, the expertise and vision of its management, the fortunes of its industry, and its position in that industry.

Buy‑and‑hold investors still need to take price fluctuations into account, and they must pay attention to the stock's ongoing performance. Naturally, the price at which you buy a stock directly affects the potential profits you'll make from its sale. So it makes sense to buy the stock at a price you believe is reasonable. While you hold the stock, it's also important to watch for signs that your investment isn't going the direction you planned-for example, if the company regularly misses its earnings targets, or if developments in the industry turn bleaker.

Sometimes you'll decide, after reviewing the company's fundamentals, that it's worthwhile to ride out a slump in price and wait for a stock to recover. Other times, you may decide you'll have better returns if you sell your holding and invest elsewhere. Either way, its important to stay on top of the stocks you own by paying attention to news that could affect their value.

Advanced Short‑Term Trading

There are a number of ways that some experienced investors seek increased returns by taking on more risk.

Buying on Margin

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

You can keep your loan as long as you want, provided you fulfill your obligations. First, when you sell the stock in a margin account, the proceeds go to your broker against the repayment of the loan until it is fully paid. Second, there is also a restriction called the maintenance margin, which is the minimum account balance you must maintain before your broker will force you to deposit more funds or sell stock to pay down your loan. When this happens, it's known as a margin call. We'll talk about this in detail in the next section.

Borrowing money isn't without its costs. Regrettably, marginable securities in the account are collateral. You'll also have to pay the interest on your loan. The interest charges are applied to your account unless you decide to make payments. Over time, your debt level increases as interest charges accrue against you. As debt increases, the interest charges increase, and so on.

Therefore, buying on margin is mainly used for short‑term investments. The longer you hold an investment, the greater the return that is needed to break even. If you hold an investment on margin for a long period of time, the odds that you will make a profit are stacked against you.

Not all stocks qualify to be bought on margin. The Federal Reserve Board regulates which stocks are marginable. As a rule of thumb, brokers will not allow customers to purchase penny stocks, over‑the‑counter Bulletin Board (OTCBB) securities or initial public offerings (IPOs) on margin because of the day‑to‑day risks involved with these types of stocks. Individual brokerages can also decide not to margin certain stocks, so check with them to see what restrictions exist on your margin account.

A Buying Power Example

Let's say that you deposit $10,000 in your margin account. Because you put up 50% of the purchase price, this means you have $20,000 worth of buying power. Then, if you buy $5,000 worth of stock, you still have $15,000 in buying power remaining. You have enough cash to cover this transaction and haven't tapped into your margin. You start borrowing the money only when you buy securities worth more than $10,000.

This brings us to an important point: the buying power of a margin account changes daily depending on the price movement of the marginable securities in the account.

The Margin Call

In the previous section, we discussed the two restrictions imposed on the amount you can borrow. First, the initial margin, which is the initial amount you can borrow. Second, the maintenance margin, which is the amount you need to maintain after you trade. These amounts are set by the Federal Reserve Board, as well as your brokerage. Individual brokerages can have stricter limits, but the Federal Reserve Board sets a minimum initial margin of 50% and a maintenance margin of at least 25%.

Our focus in this section is the maintenance margin. In volatile markets, prices can fall very quickly. If the equity (value of securities minus what you owe the brokerage) in your account falls below the maintenance margin, the brokerage will issue a "margin call". A margin call forces the investor to either liquidate his/her position in the stock or add more cash to the account.

Here's how it works. Let's say you purchase $20,000 worth of securities by borrowing $10,000 from your brokerage and paying $10,000 yourself. If the market value of the securities drops to $15,000, the equity in your account falls to $5,000 ($15,000 ‑$10,000 = $5,000). Assuming a maintenance requirement of 25%, you must have $3,750 in equity in your account (25% of $15,000 = $3,750). Thus, you're fine in this situation as the $5,000 worth of equity in your account is greater than the maintenance margin of $3,750. But let's assume the maintenance requirement of your brokerage is 40% instead of 25%. In this case, your equity of $5,000 is less than the maintenance margin of $6,000 (40% of $15,000 = $6,000). As a result, the brokerage may issue you a margin call.

If for any reason you do not meet a margin call, the brokerage has the right to sell your securities to increase your account equity until you are above the maintenance margin. Even scarier is the fact that your broker may not be required to consult you before selling! Under most margin agreements, a firm can sell your securities without waiting for you to meet the margin call. You can't even control which stock is sold to cover the margin call.

Because of this, it is imperative that you read your brokerage's margin agreement very carefully before investing. This agreement explains the terms and conditions of the margin account, including: how interest is calculated, your responsibilities for repaying the loan and how the securities you purchase serve as collateral for the loan.

The Benefits Of A Margin Account

Why use margin? It's all about leverage. Just as companies borrow money to invest in projects, investors can borrow money and leverage the cash they invest. Leverage amplifies every point that a stock goes up. If you pick the right investment, margin can dramatically increase your profit.

A 50% initial margin allows you to buy up to twice as much stock as you could with just the cash in your account. It's easy to see how you could make significantly more money by using a margin account than by trading from a pure cash position. What really mailers is whether your stock rises or not. The investing world will always debate whether it's possible to consistently pick winning stocks. We won't weigh in on that debate here, but simply say that margin does offer the opportunity to amplify your returns.

The best way to demonstrate the power of leverage is with an example. Let's imagine a situation that we'd all love to be in ‑ one that results in hugely exaggerated profits:

We'll keep with the numbers of $20,000 worth of securities bought using $10,000 of margin and $10,000 of cash. Cory's Tequila Co. is trading at $100 and you feel that it will rise dramatically. Normally, you'd only be able to buy 100 shares (100 x $100 = $10,000). Since you're investing on margin, you have the ability to buy 200 shares (200 x $100 = $20,000).

Cory's Tequila Co. then locks in Jennifer Lopez as a spokeswoman and the price of shares skyrockets 25%. Your investment is now worth $25,000 (200 shares x $125) and you decide to cash out. After paying back your broker the $10,000 you originally borrowed, you get $15,000, $5,000 of which is profit. That's a 50% return even though the stock only went up 25%. Keep in mind that to simplify this transaction, we didn't take into account commissions and interest. Otherwise, these costs would be deducted from your profit.

The Risks Of A Margin Account

It should be clear by now that margin accounts are risky and not for all investors. Leverage is a double‑edged sword, amplifying losses and gains to the same degree. In fact, one of the definitions of risk is the degree that an asset swings in price. Because leverage amplifies these swings then, by definition, it increases the risk of your portfolio.

Returning to our example of exaggerated profits, say that instead of rocketing up 25%, our shares fell 25%. Now your investment would be worth $15,000 (200 shares x $75). You sell the stock, pay back your broker the $10,000, and end up with $5,000. That's a 50% loss, plus commissions and interest, which otherwise would have been a loss of only 25%.

Think a 50% loss is bad? It can get much worse. Buying on margin is the only stock‑based investment where you stand to lose more money than you invested. A dive of 50% or more will cause you to lose more than 100%, with interest and commissions on top of that.

In a cash account, there is always a chance that the stock will rebound. If the fundamentals of a company don't change, you may want to hold on for the recovery. And, if it's any consolation, your losses are paper losses until you sell. But as you'll recall, in a margin account your broker can sell off your securities if the stock price dives. This means that your losses are locked in and you won't be able to participate in any future rebounds that may take place.

If you are new to investing, we strongly recommend that you stay away from margin. Even if you feel ready for margin trading, remember that you don't have to borrow the whole 50%. Whatever you do, only invest in margin with your risk capital ‑ that is, money you can afford to lose.

Here's the bottom line on margin trading: You are more likely to lose lots of money (or make lots of money) when you invest on margin.

Short Selling

Short selling involves many unique risks and pitfalls to be wary of. The mechanics of a short sale are relatively complicated compared to a normal transaction. As always, the investor faces high risks for potentially high returns. It's essential that you understand how the whole process works before you get involved.

What Is Short Selling?

When an investor goes long on an investment, it means that he or she has bought a stock believing its price will rise in the future. Conversely, when an investor goes short, he or she is anticipating a decrease in share price.

Short selling is the selling of a stock that the seller doesn't own. More specifically, a short sale is the sale of a security that isn't owned by the seller, but that is promised to be delivered. When you short sell a stock, your broker will lend it to you. The stock will come from the brokerage's own inventory, from another one of the firm's customers, or from another brokerage firm. The shares are sold and the proceeds are credited to your account. Sooner or later, you must "close" the short by buying back the same number of shares (called covering) and returning them to your broker. If the price drops, you can buy back the stock at the lower price and make a profit on the difference. If the price of the stock rises, you have to buy it back at the higher price, and you lose money.

Most of the time, you can hold a short for as long as you want, although interest is charged on margin accounts, so keeping a short sale open for a long time will cost more. However, you can be forced to cover if the lender wants the stock you borrowed back. Brokerages can't sell what they don't have, so yours will either have to come up with new shares to borrow, or you'll have to cover. This is known as being called away. It doesn't happen often, but is possible if many investors are short selling a particular security.

Because you don't own the stock you're short selling (you borrowed and then sold it), you must pay the lender of the stock any dividends or rights declared during the course of the loan. If the stock splits during the course of your short, you'll owe twice the number of shares at half the price.

Why Short?

Generally, the two main reasons to short are to either speculate or to hedge.

Speculate

When you speculate, you are watching for fluctuations in the market in order to quickly make a big profit off of a high‑risk investment. Speculation has been perceived negatively because it has been likened to gambling. However, speculation involves a calculated assessment of the markets and taking risks where the odds appear to be in your favor. Speculating differs from hedging because speculators deliberately assume risk, whereas hedgers seek to mitigate or reduce it.

Speculators can benefit the market because they increase trading volume, assume risk and add market liquidity. However, high amounts of speculative purchases can contribute to an economic bubble and/or a stock market crash.

Hedge

The majority of investors use shorts to hedge. This means they are protecting other long positions with offsetting short positions.

Hedging can be a benefit because you're insuring your stock against risk, but it can also be expensive and a basis risk can occur.

Restrictions

Many restrictions have been placed on the size, price and types of stocks traders are able to short sell. For example, penny stocks cannot be sold short, and most short sales need to be done in round lots. The Securities Exchange Commission (SEC) has these restrictions in place to prevent the manipulation of stock prices.

As of January 2005, short sellers were also required to comply with the rules set in place by "Regulation SHO", which modernized the rules overseeing short selling and aimed to provide safeguards against "naked short selling." For instance, sellers had needed to show that they could locate and get the securities they intended to short. The regulation also created a list of securities showing a high level of persistent sales to deliver.

In July of 2007, the SEC eliminated the uptick, or zero plus tick, rule. This rule required that every short sale transaction be entered at a higher price than that of the previous trade and kept short sellers from adding to the downward momentum of an asset when it was already experiencing sharp declines. The rule has been around since the creation of the SEC in 1934. One of the reasons it was put in place was to slow rapid and sudden declines in share prices that can occur as a result of short selling.

In July of 2008, the SEC used its emergency powers to put an end to market manipulations, such as spreading negative rumors about a company's performance and sharp price declines. The markets had been volatile as a result of the of mortgage and credit crisis, and the SEC wanted to establish a renewed confidence. For a month, it didn't allow naked short selling on the stocks of 19 major investment and commercial banks, which included the mortgage finance companies Fannie Mae and Freddie Mac.

The SEC took further measures in September of 2008, once again using its emergency authority to issue six orders to minimize abuses. This included a move to halt short selling in shares of 799 companies in cooperation with the United Kingdom's Financial Service Authority. 170 companies were later included in the ban, which ended after the passage of the $700 billion U.S. bailout plan in October 2008. Another order required short sellers get a sale and immediately close it by making sure the shares were delivered. It later became a rule.

Who Shorts?

Some insiders indicate that it takes a certain type of person to short stocks.

Many short sellers have been depicted as pessimists who are rooting for a company's failure, but they've also been described as disciplined and confident in their judgment.

Sellers are typically:

wealthy sophisticated investors
hedge funds
large institutions
day traders

Short selling isn't for everyone. It involves a great amount of time and dedication. Short sellers need to be informed, skilled and experienced investors in order to succeed.

They must know:

how securities markets work
trading techniques and strategies
market trends
the firm's business operations

The Transaction

Suppose that, after hours of painstaking research and analysis, you decide that company XYZ is dead in the water. The stock is currently trading at $65, but you predict it will trade much lower in the coming months. In order to capitalize on the decline, you decide to short sell shares of XYZ stock. Let's take a look at how this transaction would unfold.

Step 1: Set up a margin account. Remember, this account allows you to borrow money from the brokerage firm using your investment as collateral.

Step 2: Place your order by calling up the broker or entering the trade online. Most online brokerages will have a check box that says "short sale" and "buy to cover." In this case, you decide to put in your order to short 100 shares.

Step 3: The broker, depending on availability, borrows the shares. According to the SEC, the shares the firm borrows can come from:

the brokerage firm's own inventory
the margin account of one of the firm's clients
another brokerage firm

You should also be mindful of the margin rules and know that fees and charges can apply. For instance, if the stock has a dividend, you need to pay the person or firm making that loan. (To learn more, read the Margin Trading tutorial.)

Step 4: The broker sells the shares in the open market. The profits of the sale are then put into your margin account.

Clearly, short selling can be profitable. But then, there's no guarantee that the price of a stock will go the way you expect it to (just as with buying long).

Shorter sellers use an endless number of metrics and ratios to find shortable candidates. Some use a similar stock picking methodology to the longs, but just short the stocks that come out worst. Others look for insider trading, changes in accounting policy, or bubbles waiting to pop.

One indicator specific to shorts that is worth mentioning is short interest. Short interest is the total number of stocks, securities or commodity shares in an account or in the markets that have been sold short, but haven't been repurchased in order to close the short position. It serves as a barometer for a bearish or bullish market. For instance, the higher the short interest, the more people will anticipate a downturn.

The Risks

Now that we've introduced short selling, let's make one thing clear: shorting is risky. Actually, we'll rephrase that. Shorting is very, very risky.

You can think of the outcome of a short sale as basically the opposite of a regular buy transaction, but the mechanics behind a short sale result in some unique risks.

1. Short selling is a gamble. History has shown that, in general, stocks ave an upward drift. Over the long run, most stocks appreciate in price. For that matter, even if a company barely improves over the years, inflation should drive its stock price up somewhat. What this means is that shorting is betting against the overall direction of the market. So, if the direction is generally upward, keeping a short position open for a long period can become very risky.
2. Losses can be infinite. When you short sell, your losses can be infinite. A short sale loses when the stock price rises and a stock is (theoretically, at least) not limited in how high it can go. For example, if you short 100 shares at $65 each hoping to make a profit but the shares increase to $90 apiece, you end up losing $2,500. On the other hand, a stock can't go below 0, so your upside is limited. Bottom line: you can lose more than you initially invest, but the best you can earn is a 100% gain if a company goes out of business and the stock loses its entire value.
3. Shorting stocks involves using borrowed money. This is known as margin trading. When short selling, you open a margin account, which allows you to borrow money from the brokerage firm using your investment as collateral. Just as when you go long on margin, it's easy for losses to get out of hand because you must meet the minimum maintenance requirement of 25%. If your account slips below this, you'll be subject to a margin call, and you'll be forced to put in more cash or liquidate your position.
4. Short squeezes can wring the profit out of your investment. When stock prices go up short seller losses get higher, as sellers rush to buy the stock to cover their positions. This rush creates a high demand for the stock quickly driving up the price even further. This phenomenon is known as a short squeeze. Usually, news in the market will trigger a short squeeze, but sometimes traders who notice a large number of shorts in a stock will attempt to induce one. This is why it's not a good idea to short a stock with high short interest. A short squeeze is a great way to lose a lot of money extremely fast.
5. Even if you're right, it could be at the wrong time. The final and largest complication is being right too soon. Even though a company is overvalued, it could conceivably take a while to come back down. In the meantime, you are vulnerable to interest, margin calls and being called away. Academics and traders alike have tried for years to come up with explanations as to why a stock's market price varies from its intrinsic value. They have yet to come up with a model that works all the time, and probably never will.

Take the dotcom bubble, for example. Sure, you could have made a killing if you shorted at the market top in the beginning of 2000, but many believed that stocks were grossly overvalued even a year earlier. You'd be in the poorhouse now if you had shorted the NASDAQ in 1999! That's when the NASDAQ was up 86%, although two‑thirds of the stocks declined. This is contrary to the popular belief that pre‑1999 valuations more accurately reflected the NASDAQ. However, it wasn't until three years later, in 2002, that the NASDAQ returned to 1999 levels.

Momentum is a funny thing. Whether in physics or the stock market, it's something you don't want to stand in front of. All it takes is one big shorting mistake to kill you.

Conclusion

Investing in the stock market can become very complicated and oftentimes brokers are not as knowledgeable or trustworthy as one might be misled to believe. Investing in stocks gets even more complicated and risky when you buy on margin or engage in the short selling of stocks. As a result, investments in stocks can be mismanaged, misrepresented and unsuitable investments offered and sold in violation of federal and state securities law or breach of a broker's fiduciary duty. Stockbrokers can also be held responsible for their negligence and failure to abide by commodities industry rules and regulations. At the Law Offices of Robert Wayne Pearce, P.A. we know the nature, mechanics and risks of investing in stocks as well as the applicable laws, rules and regulations governing those investments. Please contact us for a free consultation if you believe you have been harmed by brokers misconduct in connection with your stock market investments.