Basics of Financial Investing - Part 1


If this title has caught your eye, you probably don’t need any convincing. You would rather be rich than poor. You also know that one way to improve your financial situation is to save and then invest what you save.

Saving may not be easy, but everyone knows how to do it: Spend less than you earn. Investing is also easy to describe. Anyone with some available savings can put it to work by investing. Put the money in a savings account at a bank and you become an investor. Take a little bit of savings and do a little bit of investing for a little bit of return, and you have made a start, but only a start. If you really want to become rich by saving and investing, you will need to begin to save some serious money and invest it for a serious return.

I shall leave to you the task of figuring out how to motivate yourself to undertake a serious savings program. This article focuses on the second matter: how to invest for a serious return. First, let’s understand what a realistically serious return is. An analogy will help.

Football is often described as a game of inches. Scoring, first downs and in- / out-of-bounds decisions frequently come down to a matter of inches or even fractions of an inch. A similar concept applies to investment management. With investing, however, a basis point, one-hundredth of a percentage point of return, replaces the inch as the unit of measurement. The difference between outperforming and under-performing the market may turn on accumulating a few additional basis points of return in each of a number of places. Apply the power of compounding to enough incremental basis points of return, and the difference becomes increasingly noticeable, particularly as the holding period is lengthened.

The primary objective of most investment managers is to earn an attractive return on their portfolios. A portfolio’s return performance is typically measured relative to some benchmark market index. For example, the performance of the S&P 500 index (an index of the stocks of five hundred major U.S companies) is thought to reflect what the stock market has done. An average investor who picks stocks at random ought to do about as well as the S&P 500 index. Consistently outperforming the appropriate market average is not an easy task, however. Most financial economists believe that securities markets (stocks, bonds, options, futures, and so on) are relatively efficient. The more effectively the market prices securities, the more difficult undervalued investments are to identify. An efficient market prices assets accurately vis-a`-vis what is known about their underlying intrinsic values. In other words, the market processes the publicly-available information effectively so as to produce prices that accurately reflect the available information. While the market does not always get it right, it does seem to put a realistic price on most securities, most of the time. Those pockets of inefficiencies (or anomalies) that do turn up tend to be of modest size and duration. Accordingly, investors who seek to outperform an appropriate benchmark return consistently need to exploit a host of relatively minor opportunities. Exploring how to take advantage of these relatively minor opportunities constitutes the primary focus of this series of articles. Taken one at a time and even as a group, these minor opportunities do not provide a panacea. And yet, paying careful attention to these little things offers the best chance most investors will have to achieve superior performance. Patience and the power of compound interest will take care of the rest.

To a very substantial degree, winning in investing is a matter of not losing. Much of what we know about successful investing is not so much how to make a killing but how to avoid being killed. Learning what strategies and practices are unlikely to succeed and then properly applying that knowledge is a large part of formulating a winning investment strategy.

Financial markets are much too uncertain and volatile for any risk-taking investor to hope to avoid losses entirely. Be assured that if you take risks, sooner or later you will incur losses. You will purchase securities whose market prices decline; sometimes the decline will occur shortly after your purchase. In some years your portfolio’s total market value may decline. Indeed, on occasion almost everything you own may trade for less than your cost. Risk-taking by its very nature implies that investment portfolios will lose value at least some of the time. Recognizing that you will experience some losses from time to time does not mean that you should just accept such losses as part of the ups and downs of being an investor. While you cannot avoid losses entirely, you can and should do what you can to avoid unnecessary losses. Much of what you will learn is how to avoid what an experienced, well-informed investor would recognize as an obvious mistake. Avoiding unnecessary losses will enhance your overall return every bit as much as getting an edge on the market in the relatively rare instances where that is possible.

Successful investing requires a commitment of time and a willingness to accept a certain amount of risk. Do not proceed with an active investment program unless you are willing to put some time in and take some risks. If you view investing as too much like work, you should probably hire an investment manager or put most of your investable resources into one or more mutual funds or similar types of investment vehicles. Similarly, if you are extremely risk-averse, active portfolio management is probably not for you. Buy treasury bills or FDIC-insured CDs and sleep at night. You should always sell down to the sleeping point.

Investing involves three types of activities: selection, timing, and execution. In other words, the investment process involves what to buy or sell, when to buy or sell it, and how to buy or sell it. Most resources on investing, such as books, articles, seminars, videos or websites focus on the latter two topics, selection and timing. Both matters are a central part to the investment process.

And yet the third activity, execution, should not be neglected. Accordingly, each of these three areas of investing is treated here: investment mechanics, investment selection, and market timing. First, however, we need to explore an important preliminary: the power of compound interest and how it relates to your investment program. Understanding how compound interest works is so important that the rest of this section is devoted to it.


Two important interconnected keys to getting rich slowly are patience and the power of compound interest. A patient investor avoids micromanaging his or her investments. Such investors allow their portfolios’ values to grow without undo interference. Many investment strategies take time to work. You should give them that time. Don’t expect too much too soon. If you do, you are almost certain to be disappointed.

The power of compounding your returns is amazing. It has been said that if the Native Americans had invested the $20 that the Dutch paid them for Manhattan at a reasonable rate of return, they would have earned enough to buy the island back. And indeed compounded at 9 percent over a 360-year period, $20 would have grown to $59 trillion, no doubt more than enough to repurchase Manhattan and all of its improvements (plus all the securities listed on the New York Stock Exchange). Compounding does indeed work wonders.

Let’s explore how compounding works. Suppose you invest $100 in an account that pays you $6 a year (a return of 6%). At the end of a year you will still have your original $100 plus an interest payment of $6. Your investment portfolio is now worth a total of $106. Invest the $106 total for another year and your original $100 investment will have grown to $112.36. You earned $6 more on the original $100 and $0.36 on the first year’s $6 in interest. In the third year your total will amount to $119.10, reflecting an annual income of $6.74. Of this amount $0.74 represents interest-on-interest. That is where the compounding comes in. You earn return in year two on the accumulated total from year one. The process continues. By the fifth year your investment has grown to $133.82 and $179.08 by the tenth. Invest the money for twenty years and the total grows to $320.71, more than three times the $100 that you started with.

Compounding results from reinvesting the already-earned interest payments so that they will earn still more interest. If the $6 interest payment had been withdrawn and spent each year, the $100 investment would, over the twenty-year period, have produced a total of $120 in interest payments (20x$6 =$120) and still be worth only its original value of $100. You would have your beginning $100 and have received an additional $120 in interest payments, for a total of $220. By reinvesting the interest payments, your total grows to $320.71 in twenty years. That sum includes more than $100 of interest-on-interest. Compound the sum for another ten years and the accumulated total grows to $574.36, almost six times the original amount. This sum compares quite favorably to an accumulated total of $280 that would result if the interest payments were not reinvested. Clearly, reinvesting your investment earnings and thereby allowing your returns to compound has a very positive impact on your investment portfolio’s accumulated value. Moreover, that compounding impact increases with time.

The Power of Compound Interest

Value of $100

After: Compounded @ 6% Not Compounded
One Year $106.00 $106
Two Years $112.36 $112
Five Years $133.82 $130
Ten Years $130.00 $160
Twenty Years $320.71 $220
Thirty Years $575.34 $280
Forty Years $1,028.56 $340
Fifty Years $1,842.00 $400

Having explored the power of compound interest applied to an initial sum, let’s now consider the impact of incorporating a savings element into the investment program. If, instead of investing a single sum of $100 for twenty years, you invested $100 a month for twenty years, what would be the result?

At the end of the first year you would have put aside $1,200 and earned a little bit of interest. What if you continue to put aside $100 a month for twenty years? If you earn 6 percent on the money, the total would grow to $44,142, of which $20,142 would be accumulated interest. Continue the process for another ten years and the total grows to $94,870, including $58,870 of accumulated interest.

Now let’s assess the impact that the rate of return has on the value accumulated. The preceding calculations assume that you earn 6 percent on your investment. Six percent is a relatively attractive return. But suppose you could earn a higher rate of return. Clearly, the rate of return that you earn on your investment makes a difference in how much you are able to accumulate. The higher the rate of return, the faster the sum grows. Let’s see just how much a 2 percent increase in return affects the compound value. Suppose that instead of earning a 6 percent return on the money, you could earn 8 percent. At the 8 percent rate, the twenty and thirty-year totals increase to $54,944 and $135,936 (almost $100,000 of which represents accumulated interest).

Recall that these totals are the result of putting aside $100 a month. Saving and investing $100 a month would represent a good start. But putting aside a larger amount would be even better. Double the savings rate and all of the totals double. If you can afford to save $500 a month, the totals are five times as great. At 6 percent you would have $220,710 after twenty years and $474,348 after thirty. At 8 percent the twenty and thirty-year totals become $306,666 and $817,800 respectively.

The Power of Compound Interest and Savings I

Saving $100 a month

$100 a month @ 6% grows to: $100 a month @ 8% grows to:
$44,142 in 20 years $54,944 in 20 years
$94,870 in 30 years $135,936 in 30 years

To assess the impact of a 2 percent increase in returns, let’s compare the two thirty-year totals. Using a 6 percent rate of return, $500 a month for thirty years grows to $474,348. If the rate of return is increased to 8 percent, the thirty-year compounded total increases to $817,800. Thus we see that increasing the rate of return from 6 percent to 8 percent almost doubles ($817,800 versus $473,348) the value of the thirty years’ accumulation. Clearly the rate of return that you are able to earn makes a substantial difference in how large a total value your portfolio will achieve.

The value of your portfolio will grow even faster if you can periodically increase the amount that you save and invest. As your career develops, you should receive both promotions and raises. Your rising income level should allow you to grow the amount that you put into savings each year. Suppose that you set up a savings program in which you periodically increase the amount that you put aside. In other words, you not only save a regular amount, but you increase the amount that you save at a regular predetermined rate. Suppose you start with $100 a month, increase the amount by 6 percent each year, and invest it to earn 6 percent each year. At the end of twenty years your total becomes $76,970, and in thirty years $206,766. If you can grow your savings and compound your money at an 8 percent rate, the twenty-and thirty-year totals rise to $111,864 and $362,232. Begin with $200 a month and those totals double. Start at $500 a month with an 8 percent rate and the total grows to almost $2 million in thirty years. Thus, beginning with $500-a month savings rate, earning 8 percent on the money, and increasing the monthly amount set aside at an 8 percent rate per year, you would approach multimillionaire status in thirty years.

The preceding statement reflects nothing more than arithmetic. It does, however, illustrate a feasible path to getting rich slowly.

The Power of Compound Interest and Savings II

Saving $500 a month

$500 a month @ 6% grows to: $500 a month @ 8% grows to:
$220,710 in 20 years $306,666 in 20 years
$474,348 in 30 years $817,800 in 30 years

The Power of Compound Interest and a Growing Contribution Rate

  • $100 a month at 6% when the contribution also grows at 6% becomes: $76,970 in 20 years, $206,766 in 30 years
  • $100 a month at 8% when the contribution also grows at 8% becomes: $111,684 in 20 years, $362,232 in 30 years
  • $500 a month at 8% when the contribution also grows at 8% becomes: $558,000 in 20 years, $1,810,000 in 30 years

We see from the above discussion that a relatively modest savings program can, through the power of compound interest, produce impressive results for a patient investor. Setting aside $100 a month or even $500 a month is well within the range of many aspiring investors. The average long-term return on stocks has been in the range of 9 to 11 percent. Thus earning 6 to 8 percent on your investments, while taking no more than a modest amount of risk, should be a realistic objective. True, taxes may reduce the return. If, however, the savings program is part of a retirement plan, the money will grow untaxed until you start to draw it out. Even if the portfolio’s income is subject to taxation, careful tax management can substantially reduce the tax bite. Thus earning 8 percent after taxes is not an unreasonable objective. Many investors should also be able to increase the amount that they put aside as their professional career progresses. If you are a high achiever on a fast track professionally, an 8 percent growth rate in your earnings and savings should be well within reach. A modest savings program, patience, and a decent rate of return is all that is required to become reasonably wealthy.

Is $500 a month a realistic initial savings goal? The answer to that question will vary with individual circumstances. Perhaps you believe that putting this much money aside each month is an unrealistic objective. Maybe it is. But consider the following: Suppose you and your spouse have a combined income of $60,000 a year. Five hundred dollars a month amounts to $6,000, or 10 percent of that income. That may seem like a large fraction of your income to try to save and invest. But if you own your home and make mortgage payments of, let’s say, $1,200 a month, you are already putting aside at least $200 a month in amortization of the loan balance. If your house appreciates at 3 percent a year and you put 25 percent down, your investment in your home will be growing at 12 percent a year (4×3%=12%), well above our 8 percent target. Moreover, as you pay down the principal on your mortgage, the percentage of your mortgage payment that is applied to loan amortization (as opposed to interest) will increase. That mortgage pay-down of $200 a month takes care of two-fifths of your savings/investment program. Will your home’s value appreciate at 3 percent a year? Maybe or maybe not. But from 1975 to 2003 the average house’s market value increased at a rate of 5.6 percent. So, by recent historical standards, a 3 percent appreciation rate may actually be conservative.

Now for the other $300, consider the impact of taxes. You are already likely to be in at least the 25 percent tax bracket. If not, you will probably be there before long. That means that if you put $300 a month into a tax-sheltered retirement account (e.g., IRA, Keogh, 401K, etc.), you will reduce your tax bill by at least $75 a month. That tax savings takes care of another chunk of your savings/investment program.

Under the above circumstances, the out-of-pocket costs of a $500-a-month savings plan is reduced to $225 a month, or two thousand seven hundred dollars a year. That sum represents 4.5 percent of a $60,000 annual income, still a lot of money. But to put it into perspective, 4.5 percent is less than the amount already deducted from your salary for Social Security. Thus we see that beginning a savings/investment program by setting aside $500 a month should be well within reach for many. Now let’s turn our attention to how you might go about achieving that 8 percent (or better) return.


A useful place to start learning about investing is with the basics. Little could be more basic to investing than the mechanics of how to buy and sell securities. And yet most investment resources ignore or only lightly treat this important topic. This section addresses four topics related to understanding and making effective use of various aspects of the mechanics of the investment markets. First, we will discuss several issues that involve implementing security market trades, and the choice of brokers is discussed. Second, options contracts, including puts and calls and how to use them to buy and sell securities, are explored. Third, the uses of leverage and margin borrowing are considered. Finally, the complex but important topics of taxes, tax shelters, and tax management are addressed. Enhancing your understanding of each of these matters should help you manage your investment portfolio more effectively. If you are a relatively inexperienced investor, mastering these investment mechanics issues is especially important. Even if you are a relatively experienced investor, you still may be able to learn some useful tricks.


Buying and selling securities and other types of investment assets is different from, and more complicated than, buying and selling most other types of goods and services. The vast majority of the items that you buy as a consumer are purchased directly from the seller (e.g., supermarket or department store) at a fixed price. That fixed price is set by the seller. You pay the price that the seller sets or you don’t buy from that seller. You can shop around or wait for a sale, but at the end of the day, you still have to deal with whatever price the seller sets. The prices of securities, in contrast, (e.g., stocks or bonds) are not set by either the seller or the buyer. They result from competition in the marketplace. That is, security prices are determined by the direct interplay of supply and demand. Such prices are literally changing from moment to moment. Moreover, buying and selling securities rarely involves a direct exchange from the seller to the buyer. You must almost always utilize the services of a broker. And this broker will charge you a commission for facilitating your trade. Finally, the vast majority of security market transactions take place either on an exchange or through an organized over-the-counter market.

An exchange, such as the New York Stock Exchange (NYSE), provides an established centralized market for trading a specific list of securities. Such listed securities have qualified for trading on that exchange by applying for listing and meeting a set of pre-specified criteria. These criteria include the company issuing the securities having: at least the required minimum amount of capital, number of publicly traded shares outstanding, past record of profitability, and so on. Most relatively large companies list their securities on the NYSE. Somewhat smaller companies may choose to list on our second national exchange, called the American Stock Exchange, or AMEX. Regional exchanges located in various cities (Chicago, San Francisco, Philadelphia, Boston, etc.) round out the list of U.S. exchanges. Many foreign exchanges also permit U.S. securities to trade. During the trading day, European markets open well before those in the United States, while Asian markets continue trading long after U.S. markets have closed. Something close to twenty-four-hour trading takes place in many different assets (e.g., U.S. Treasury securities, gold, crude oil, actively traded U.S. and foreign stocks).

Most publicly traded securities (by number but not by dollar value) are not listed on an exchange. These securities are bought and sold in a less organized trading arrangement called the over-the-counter (OTC) market. Almost but not quite all of the OTC market is under the supervision of the National Association of Security Dealers (NASD) and are part of the market called NASDAQ. In this NASDAQ/OTC market, individual dealers located throughout the country ‘‘make a market’’ in selected unlisted securities. Such dealers make a market by standing ready to trade on either side of the market and quoting prices at which they are willing to buy and sell. NASDAQ provides an electronic connection among these dealers. Some exchange-listed securities also trade over the counter in what is called the third market. Small, obscure securities not listed for trading by NASDAQ may trade in a relatively inactive OTC market known as the pink sheets market.

A variety of mechanisms has been developed to facilitate the trading of securities. These mechanisms are designed to allow those who are interested in buying a particular security and those who are interested in selling that same security to find and conduct business with each other. Special arrangements have been developed for those who seek to buy or sell large amounts of a particular security.

In order to manage their buying and selling of securities effectively, investors need to understand the various ways that securities are traded. A poorly executed security market trade can cause you to pay too much for an investment that you buy or receive too little for an investment that you sell. The difference between an effectively or ineffectively handled transaction can have a significant impact on your portfolio’s overall return. I shall now discuss several rules designed to help you obtain the benefits of executing your trades efficiently.

To make the bid-ask spread work for you, use limit orders

In order to buy or sell a security (such as a stock or bond), you need to explain to your broker what you want to do. You do so by giving him or her an order that contains the information needed to implement your trade. All such orders will identify the specific asset and the amount of it to be traded as well as whether the asset is to be bought or sold. The vast majority of securities trades are implemented with what are called market orders. Such orders call for an immediate execution at the best currently available price. The order will be sent to the marketplace (exchange, NASDAQ, etc.) where the security is traded. Other investors will already be present in the marketplace offering to buy or sell the security at various prices, which they have pre-specified. If trading in that particular security is active, a number of different orders will already have been entered but not yet executed. Potential buyers (sellers) will be offering to pay up (sell down) to a pre-specified price. For example, would-be buyers may be offering to pay as much as $31.15 for the stock. Would-be sellers may be offering to sell the same stock for as little as $31.50. An interested investor observing this market would see buyers available at $31.15 and sellers available at $31.50.

A market order to buy will usually result in a purchase at the ask, which is the lowest currently available offer (from someone else) to sell. In the above example, someone is offering to sell at $31.50. Similarly, a market order to sell will generally be executed at the bid, which is the best currently available offer (from someone else) to buy. In the above example, someone is offering to buy at $31.15.

The bid will almost always be below the ask. Otherwise the two sides of the market would trade directly with each other. Such a trade would remove both the buyer and the seller from the marketplace. This process of matching buyers with sellers would continue until no one wanted to sell for as low a price as anyone was willing to pay. At that point, a gap would appear between the bid and ask prices.

The difference between the bid and ask is called the spread or bid-ask spread. In the above example the spread would be $31.50 - $31.15 = $0.35. The level of trading activity in the security largely determines the size of the bid-ask spread. For less actively traded securities, the spread can be quite wide. For actively traded securities, competition tends to drive the spread down to a narrow range. The arrival of decimal trading (as opposed to fractional pricing, in which the minimum increment was typically at one-eighth of a dollar, or 12.5 cents) has tended to reduce spreads. Most securities prices can now be quoted to the penny. For options the minimum increment is five cents.

Those who use market orders to implement their transactions generally will find that they have bought at the ask and sold at the bid. Such an investor incurs not only a commission (the broker’s fee for processing the order), but also the adverse impact of the bid-ask spread. Suppose a stock is quoted at $20 bid, $20.30 asked. If you entered a market order to buy the stock, you would probably pay $20.30 A market order to sell the stock would likely be executed at $20.00. With a market order you are almost certain to pay a higher price if you are buying than the price you would receive if you were selling. The difference between the bid and the ask in this instance is 30 cents ($20.30 - $20.00 = $0.30). Depending largely on how actively it trades, the spread on the $20 stock could range from no more than a few pennies all the way up to a dollar or more. Our example of a spread of 30 cents is in line with what you might encounter for a stock that trades in a moderately actively market. A spread of 30 cents on a $20 stock amounts to about 1.5 percent of the value of the trade. That 1.5 percent may not seem like a lot. If, however, a spread of such a magnitude is incurred on each trade, the impact will quickly add up. A 30-cent spread amounts to $30 on a hundred shares and $300 on a thousand shares.

One way to save a few basis points in transaction costs and thereby enhance your return would be to reduce the adverse impact of this bid-ask spread. Rather than relying on market orders, you could utilize more sophisticated trading techniques (to be explained), which have been designed to facilitate trading at more attractive prices. If those techniques allow you to save as little as fifty basis points (0.5%) on each trade and even if you hold stocks for an average of two years (a long time for many investors), their use will enhance your annual return by 0.25 percent. The more actively you trade, and the larger the spreads, the more money you are likely to save by executing trades more efficiently.

As previously noted, most trades are implemented with market orders. Using market orders to buy and sell securities is simple and easy but may result in your receiving less or paying more than is necessary. Less experienced investors are especially likely to use a market order for their trades. Stockbrokers also generally prefer that their clients use market orders. Such orders are certain to be executed and thereby result in a commission for the broker. But you can often do better on price by using a different type of order. A more opportunistic way to trade securities involves the use of a more flexible order type. A limit order provides that greater degree of flexibility. It allows you to specify the highest price that you will pay to buy or the lowest price that you will accept to sell your security. Using a limit order to implement your trade may allow you to reduce the adverse impact of the bid-ask spread. In the current example (bid = $20; ask = $20.30) you could enter a limit order to buy the stock at $20.01 or to sell it at $20.29. Such limit orders would place you in the front of what had been the market (by a penny).

You would then be waiting at the front of the line hoping to enter into a trade with the next incoming market order. In a somewhat more aggressive strategy, you could enter a buy order below the current bid or, if you are looking to sell, a sell order with a threshold price a bit above the current ask. If the market encounters some selling (buying) pressure, the market price could decline (rise) to the threshold level specified in your order. Such an order to sell (buy) would be executed only if the market for the stock were to rise (fall) a bit. So for the current example, with a bid of 20 and ask of 20.30, you might offer to sell (buy) at 20.40 (19.85). Such an order would, when entered, be 15 cents above (below) the current ask (bid). By placing your order at that level, you would be positioning yourself to take advantage of what you hope will be a rise (fall) in the stock’s price. Clearly such a hoped-for rise (fall) may or may not occur. The further away from the current market price that you place your order, the less likely you are to trade. On the other hand, the more aggressive your limit order placement, the better the price you will receive if you do trade.

Most limit orders are structured so that they will remain available for execution throughout the day in which they are entered. If, however, the limit order remains unfilled at the end of that day, the order expires. Such limit orders are called day orders. Alternatively, the order may be structured to remain on the books until execute or canceled (a good till canceled or GTC order). Such a GTC order would remain available for execution day after day until it either results in a trade or the investor instructs his or her broker to cancel the order.

Carefully analyze the relevant facts in order to set the threshold price on your limit order advantageously

When you enter a limit order, you must specify the threshold price at which the order is to be implemented. Determining where to place your limit order’s threshold price is an important strategic decision. If you are seeking to buy, you want to set your threshold price as low as you can and still purchase the stock (or possibly other security). Similarly if you wish to sell, you want to set the threshold as high as you can get away with and still sell the stock in a timely manner. Deciding where to set the threshold price level on a limit order involves both analysis and guesswork. You should start by gathering as much relevant trading information as you can. Determining the current daily and weekly trading ranges (high, low) for a given stock may provide you with some idea about where to place your order. Stock price movements do not generally follow any particular pattern. Still, stocks do often seem to trade within a price range, at least for a time. A particular stock’s price may, for example, move back and forth between a range for the bid and range for the ask. The more volatile the stock, the wider the range. So identifying the recent range of trading is a useful place to start in trying to decide where to set the threshold price on a limit order.

Suppose that you wish to buy 100 shares of SS stock with a current quote of 15.30 bid and 15.45 asked, a daily high/low of 15.60 to 15.23, and a weekly high/low of 16.00 and 15.05. Where might you place your limit order for maximum advantage? Several possibilities present themselves: With a current bid of 15.30, entering an order of 15.31 would put you at the front of the line for any incoming market orders to sell. As long as no one enters a higher bid, you would continue to hold that front-of-the-line position until your order was filled. With an actively traded stock, such an order would very likely be filled. An offer in the 15.20–15.30 range, while below or equal to the current bid, would still be likely to be executed if the stock retraces its price levels of earlier in the day (prior low of 15.23). A weekly low of 15.05 suggests that any threshold price above 15 might have a reasonable chance of being executed, that is as long as the stock stays in the same range it has been in. So we see that, given this set of information, you might choose to enter a limit order to buy at prices ranging from 15.01 up to about 15.31 depending upon how willing you are to risk that your order will not be executed. A similar analysis would apply to the placement of the threshold price for a sell order. The lower (higher) you place the threshold on your limit order to buy (sell), the better the price you will pay (receive) if your order results in a trade, but the smaller the chance that your order will in fact be filled. Limit orders do not assure an execution. For an actively traded stock, however, the odds of a well-placed limit order being executed are generally quite good.

Another guide in the placement of limit orders is to get in front of focal point numbers. A focal point price is one where orders tend to congregate.

They are price levels toward which the threshold price of the typical investor tends to gravitate when placing an order. For example, if a stock is trading in a range centered around 20, relevant focal points would be 19, 19.50, 20, 20.50, and 21. Such numbers have the look and feel of being clear, clean, and round. An investor is much more likely to decide, ‘‘I will sell my stock when it gets to $20,’’ rather than, ‘‘I am waiting for the stock to reach $19.97.’’ Such an investor is likely to place his or her limit orders accordingly. If you are looking to sell, you might take advantage of the situation by entering a sell limit order at 19.99. At that price you would be just a penny below 20.00, where a substantial number of sell orders may have already accumulated. Your offer to sell at 19.99 would have to be executed before any of the orders to sell at 20 could be filled. Limit orders entered at identical prices are to be executed in the order of their receipt. A new order to sell at 20 would be placed in line behind all of those orders that preceded your order. Some shares of the stock could trade at 20 without your order being filled. Similarly, a buy order at 19.51 would be appreciably more likely to be filled than one at 19.50, where limit orders may have already started to accumulate.

Finally, you should check the stock’s recent volume history to see how frequently it trades. A stock that typically trades tens of thousands of shares daily will generally have a narrow spread. Because it trades actively, a strategically placed limit order is very likely to be executed. A stock that trades only a few hundred shares a day is likely to have a wider spread, but limit orders on such stocks are less likely to result in trades. And yet the wider spreads of less actively traded stocks may make limit orders particularly attractive to use in such situations.

Market and Limit Orders

Market Order: Must be implemented immediately at the best currently available price. A market order to buy will usually be executed at the ask price (the lowest currently available offer to sell). A market order to sell will usually be executed at the bid price (the highest currently available offer to buy). The ask will almost always be higher than the bid. The difference between the bid and the ask is called the spread or the bid-ask spread.

Limit Order: The trader specifies the minimally acceptable price level at which his or her trade can take place. Unless this level is reached, the order will not be executed.

A limit order to buy specifies the maximum price that the investor is willing to pay. A limit order to sell specifies the minimum price that the investor will accept.

GTC Limit Orders: Good until canceled. GTC orders remain on the books until they are either implemented or canceled. Day Limit Orders: Canceled at the end of the trading day if they remain unexecuted.

When obtaining a quote, be sure to ask for full details, including ‘‘size.’’

If you ask your broker for a quote on a security, he or she will usually report the last price at which the stock was traded. If you obtain your quote from the Internet, you will generally see only the last reported trade price, with a fifteen-minute delay. You can subscribe to any one of a number of services that provide real-time quotes (e.g., pcquote), but you must pay a fee for the service (about $10 a month). The last reported trade price, whether real-time or fifteen-minute-delayed, is not always representative of the current state of the market or, more important, the price at which you can trade. For example, the last reported trade could have taken place at the bid. If you enter a market order to buy, you will probably pay the ask, which will be above the bid by the amount of the spread. Indeed, the last trade price may be a stale quote from hours or even days earlier.

To trade effectively, you need access to a full set of relevant information on the current state of the market for the security that interests you. You should base your trading decisions on as much relevant up-to-date market information as you can obtain. In particular, you need to know not only the current real-time bid and ask prices, but also the ‘‘size.’’ The ‘‘size’’ is the amount of stock bid for at the current bid level as well as the amount offered for sale at the current ask level. Information on size may provide some indication of where the stock’s price is going to move next and thus where to place a limit order.

Suppose you contact your broker to request a quote on a stock that interests you. You are told that it has a bid of $18.25 and an ask of $18.40. That much of a quote provides you with some idea of the range where the next trade is likely to take place as well as the price level at which you might be able to buy or sell a small amount of the stock. Such a quote does not, however, provide you with any indication of the market’s depth or potential direction. Information on size, in contrast, may help with these matters. For example, a size of 25 #1(2,500 shares bid and 100 shares offered) suggests that buying interest is much greater than selling interest. A bidder (or perhaps several bidders) is (are) seeking to purchase a significant quantity of stock, but no large would-be seller is visible. Indeed, the very small size offer to sell 100 shares may be from the specialist (the person on the exchange charged with making a market in the stock). If the stock typically trades about 1,000 shares in a day, a bidder seeking to purchase 2,500 shares may eventually need to raise his or her bid in order to get some action.

If, in the above situation, you also want to buy the stock, you would have a strategic decision to make. One approach you might utilize would be to enter a limit order of $18.26, a penny above the bid. Entering that kind of order is called pennying. Placing such an order may put you in the front of the line. Pennying frequently works well when the other would-be orders are small. Pennying may well be worth a try, even when you are competing with a large order. Often, however, the large buyer offering to pay $18.25 will turn around and penny you with a bid of $18.27. The two of you could then play penny Ping-Pong with the bid. As each of you is raising the other’s bid by a penny, those on the sell side will see what is going on and may well raise the ask. And meanwhile, you would not have bought any stock. Under these circumstances you might consider using alternative strategies. You could, for example, either enter a limit order well above the current bid or just to pay the ask. Yet another approach to consider, particularly if the size of the bid is small, is to match the existing bid. Thus if the current bid is $18.25, you can also offer to buy stock at $18.25. That bid level puts you behind the earlier bid but does not set up a penny Ping-Pong.

A Full Quote

  • Last: Last price at which the stock was traded.
  • Bid: Highest currently available offer to buy the stock.
  • Ask: Lowest currently available offer to sell the stock.
  • Size: Amount of stock currently bid for and offered for sale. A size of 10 x 20 means that 10 lots of 100 shares each (1,000 shares) are bid for, and 20 lots (2,000 shares) are offered for sale at the current bid and ask prices respectively.
  • Volume: Number of shares traded so far today.
  • High: Highest trade price reached today.
  • Low: Lowest trade price reached today.

On the other hand, if you are looking to sell stock and a large buyer has appeared, you may want to offer your stock at a somewhat higher price than otherwise. In any case, you should ask for a detailed quote before you enter an order. More knowledge on the state of the market is always better than less. Effective use of that knowledge can help you trade more efficiently. And the more effectively you implement your trades, the higher your return.

Don’t be too aggressive in your limit order placement.

Patience and the use of limit orders can help you to obtain a better price on many trades. You do not, however, want to miss out on an attractive investment opportunity because you were holding out for a few extra cents per share. Suppose you have reason to believe that the price of a stock in which you are interested is to about to make a major move. Perhaps the company will soon announce earnings that you believe will be better than the markets expect. Perhaps you think the company is an attractive takeover candidate and likely to receive an offer. In either case the stock’s price could quickly start to move up. Clearly you don’t want to wait around with an aggressively placed limit order and thereby risk not buying into an attractive investment situation. You can still use a limit order to buy the stock, but you should enter it with a limit price threshold at or near the ask. That way you are still likely to buy the stock but you have protected yourself against the possibility of an adverse price change between the time your order is entered and when it is executed.

Understand the uses and limitations of stop loss orders.

The vast majority of orders to buy or sell securities are either market or limit orders. Several other types of orders exist, but are much more rarely used. The stop loss order is one such order type. On relatively rare occasions it may be advantageous to employ such an order. Stop loss orders, like limit orders, are contingent orders. Such orders are implemented only if a pre-specified threshold price level is reached. Limit orders are generally entered in an attempt to take advantage of a hoped-for favorable price move (down if you seek to buy, up if you seek to sell). Stop loss orders, in contrast, are designed to provide protection from an adverse price movement (e.g., down if you already own the stock).

To understand how stop loss orders work, consider an example. Suppose you purchase 500 shares of XYZ at a price of $20 per share for a total cost of $10,000. While you hope to make a profit on the investment, you would also prefer to limit your potential losses. Perhaps you would like to put a floor that would limit your losses to no more than 20 percent, or $2,000 of the $10,000 that you have invested. In other words, you want to ensure that you preserve at least $8,000 of the $10,000 that you put at risk when you made the investment. In this type of situation you could use a stop loss order. Such an order can be designed to provide a degree of protection against a large loss. For example, you could enter a stop loss sell order with a stop loss threshold price of 16. If a decline in the stock’s price triggered your stop loss order, selling out your position at 16 would yield proceeds of $8,000 (less commissions), thereby recovering about 80 percent of the amount that you invested.

The contingent stop loss order would be entered into the books of the specialist. As long as the market price stays above 16, the stop loss order would not cause a trade to occur. If the stock’s price either rises, stays at 20, or falls a couple of points but remains above 16, the sell order would remain on the books, unimplemented. If, however, the stock does drop to 16 or lower, the stop loss order immediately comes into play. If and when the market price first touches 16, the stop loss order requires that the stock must immediately be sold at the highest currently available price. The price received for the stop loss sale could be exactly 16, but it may be a bit lower. For the stop loss order to be implemented, the stock must have already dropped from 20 to 16. If the stock continues falling, the very next trade after it touches 16 will be below 16. Sometimes the sudden and unexpected release of bad news causes a stock’s price to drop like a stone. If such bad news has just been released, the stock could quickly sell through this stop loss threshold. The next trade after the stop loss order is triggered by a trade at 16 could be 15 or lower. Most of the time a stop loss order, if implemented, will result in a trade at a price that is close to the stop loss threshold. But such a result is not guaranteed.

A stop loss order is used to protect the investor from an adverse price change, usually to limit exposure to a potential loss. Sometimes, however, a stop loss order is used to protect an existing gain. Suppose that the stock you bought at 20 (and entered a protective stop loss order for at 16) rises to 30. For a stock trading at a price of 30, a stop loss order with a threshold price of 16 is rather far away from the market. Having such a stop loss order in place at that level is essentially irrelevant. If you want to continue to protect your position, you could probably safely raise your stop loss threshold to 25. If the stop loss order is later implemented at 25, you will almost certainly sell your stock at a profit (above 20). If the stock’s price continues to rise, you can continue to increase the threshold price level of your stop loss order. If, for example, the stock’s price rises to 40, you could put in a stop loss order at 35. This strategy of raising your stop loss price threshold as your stock’s price increases is called the crawling peg approach.

Stop loss orders may seem like an attractive mechanism for limiting your loss exposure while leaving open the potential for gain. You should realize, however, that the market never gives anything away. A stop loss sell order will indeed ensure that if the pre-specified price is reached, your stock will be sold. But this type of order also has some drawbacks. It’s protection is bought at a price.

First, the price that you receive will depend upon the state of the market at the point when the order is activated. Sometimes the relevant stock’s price may blow through the stop level with such force that the very next trade after the stock first trades at the threshold price is much lower still. Indeed, if bad news is released after the market has closed, the stock may open well below its previous close, and perhaps well below your stop loss threshold price.

Second, because stock prices often fluctuate widely, having a stop loss order in place may cause you to sell out your position too soon. You may buy a stock and see it fall dramatically and then rise just as dramatically. If your stop loss order is implemented by the dramatic price decline, your position will be liquidated. You will have limited your losses. You won’t, however, remain an owner even if this volatile stock rebounds.

Continuing with our prior example, the stock that you bought at 20 could fall to 15 and then rise to 25 on its way to 40. Your stop loss order with a threshold price of 16 would have limited your loss when the stock was falling but also prevented you from earning a profit when the stock’s price turned around and rose dramatically. To reduce this type of threat, you should not set your threshold price too close to the current level. The more volatile the stock, the greater is the threat of being whipsawed by a down and up price move.

Third, stop loss orders are structured to work efficiently only for stocks that trade on exchanges. Stocks that trade on NASDAQ are not well suited for stop loss orders. Your broker may accept the order but will not guarantee its execution. NASDAQ stocks do not have a specialist to keep track of such orders (stop loss or limit). No one among the multiple market makers of OTC stocks is identified as responsible for implementing stop loss orders.

To minimize your current tax liability, use ‘‘versus purchase’’ orders.

You are required by the IRS to report the profit or loss on any investment asset sale on your tax return. Your results from this trade will have an impact on your overall tax liability. To determine that profit or loss, you must report what you paid for the asset that you sold. Your cost for tax purposes is called your tax basis in the investment. The tax basis is the amount that is subtracted from your sales proceeds in order to determine the size of the capital gain or loss that you must report on your tax return. If all of the initial position was acquired at the same time for the same price, the basis is easy to determine. It is the total amount paid (including the commission) for the investment. If you sell only a part of your position, the total amount of the basis is prorated. If the total position was acquired for different prices at different times, different bases apply to different parts of the position. If the entire position is sold, the basis is the total cost of the position regardless of whether or not it was purchased all at once. Sometimes, however, only part of a position is sold. When that happens, identifying which per share cost to use for the basis is not clear-cut. This is one type of situation where understanding investment mechanics can help you save some serious money.

The IRS permits you to determine the taxable basis in one of three ways. Normally the cost of the longest-held position is identified as the basis. Alternatively, the average cost may be used. If, however, the earliest purchase is not also the highest cost, using it as the basis will cause you to report a higher taxable gain (or smaller taxable loss) than would be the case if a more advantageous basis had been selected and applied. Similarly, using the average cost will result in a higher tax liability than necessary, if the position was acquired for different prices over time.

Versus purchase orders provides the investor with a third way of determining the basis. Using a versus purchase order allows you to specify for tax purposes which unused cost basis to apply to a particular trade. You simply instruct your broker to enter the order as versus purchase and then select the unused basis that you wish to apply (normally the highest cost). Suppose, for example, that you bought five separate 100-share blocks of stock at prices of 12, 17, 23, 19, and 27, and then sold 100 shares at 30. Your reported taxable gain could be anywhere from $1,800 (basis of 12) to $300 (basis of 27). In this example, if you used the first in, first out (FIFO) approach (the approach that the IRS would expect you to use if you did not employ a versus purchase order), you would report the highest taxable gain possible for this set of facts. Reporting the highest gain will cause you to pay the greatest amount in taxes.

Using a versus purchase order to minimize the reported size of the gain (or maximizing the reported loss), allows you to reduce your current tax liability.

Calculating the Basis: An Example

Shares Purchased Price Per Share Basis
100 12 1,200
100 17 1,700
100 23 2,300
100 19 1,900
100 27 2,700
Total $9,800

Average Cost 9,800/500 = 19 Basis if the cost of first purchase is used $1,200 Basis if the highest cost is used $2,700

Reported gain on sale of 100 shares at 30

Average cost basis 3,000 - 1,900 = $1,100 Tax @ 15% = $165
First cost basis 3,000 - 1,200 = $1,800 Tax @ 15% = $270
Highest cost basis 3,000 - 2,700 = $300 Tax @ 15% = $45

This strategy of minimizing your current reported gains will, to be sure, use up the lowest basis. You can use the high-basis trades for tax purposes only once. As a result, you will have to report greater gains and incur larger tax liabilities when additional shares are sold at a later time. Nonetheless, you are usually well advised to use this strategy to put off the higher tax liability.

Paying lower taxes now and putting off the higher tax liability until later is like receiving an interest-free loan from the IRS. Read on.

Defer tax liabilities when possible.

Deferring tax liabilities is very generally advantageous for the investor. Using a higher basis, when it is available, allows the investor to report a lower tax liability currently and put off the realization of a greater tax liability into the future. Putting off having to pay taxes until the following year will thereby free up, for a year, the amount of money that was deferred. As a result, you can save a year’s interest cost on that sum of money.

Most investors are also borrowers in one capacity or another. You may, for example, owe money on an auto loan, home equity loan, credit card loan, and/or margin debt. If so, you will be incurring an interest charge on each of these debts. If you defer what would otherwise be a current tax liability, you can (and perhaps should) use the freed up funds to pay down such a debt, particularly the one with the highest interest rate. Suppose you are carrying a credit card balance of $1,000. Deferring a tax liability for a year could free up enough money to allow you to pay off that debt. You will save $180 in interest cost (assuming an 18 percent rate). In effect you earn an 18 percent after-tax return on that transaction. If you (wisely) don’t carry a balance on your credit card, perhaps you do at least have an auto or home equity loan balance that you can pay down. Even if you don’t have any outstanding debts that you could pay off or pay down, having an extra thousand dollars to invest for a year is at least worth the amount of interest (or other return) that you could earn on the freed-up funds.

Another advantage to deferring a tax liability may apply. Moving a tax liability into a subsequent year may also mean that the tax rate applied to the income will be lower when the tax is due. Indeed, if you are nearing retirement, putting off a tax liability until after you have retired could place you in a lower tax bracket when you begin to receive your (typically lower) retirement income. If, however, you expect to be in a higher tax bracket next year, you may want to use the lowest reportable basis in order to accelerate the tax liability and thereby take advantage of this year’s lower rate.

Be aware of the existence of stop limit, all-or-nothing, and fill-or-kill orders. You may occasionally find them to be useful.

We have already discussed the three primary types of orders: market, limit, and stop loss. We have also explained how an order can be specified as day, GTC, and/or versus purchase. For the sake of completeness, we shall now explore three other variations in orders: stop limit orders, all-or-nothing orders, and fill-or-kill orders. Very rarely will the typical small investor need to use these variations. Nonetheless, you might as well have them in your bag of tricks.

Stop limit orders are much like stop loss orders. With a stop loss order, if the relevant stock trades at or through a particular pre-specified threshold price, your contingent (stop loss) order to sell or buy is immediately converted into a market order. Thus, if you have a stop loss sell order on a stock with a threshold price of 21, your stock will be offered for sale (at the highest currently available price) immediately after the next time that the stock trades at 21. Your stock may be sold for 21. If, however, the market for that stock is moving quickly, it may end up being sold at a lower price. A stop limit order is structured to avoid this scenario. Once the stock trades at 21, a stop limit sell order with a threshold price of 21 would activate the entry of a limit order at 21. Your stock would be offered for sale at 21. Using this type of order would protect your position from being sold out at a price lower than 21. But the stop limit order would not ensure that your position was liquidated. The market could trade right through your threshold price level without stopping to allow your stop limit order to be executed at the pre-specified limit price.

An all-or-nothing order requires that your securities be traded as a single block. Suppose you want to sell 700 shares of a particular stock. Normally, if you enter a limit order to sell the block at a pre-specified price, anytime a buyer appears at that price for as little as 100 shares, part of your block will be sold. You would often be able to sell most or all of your position one piece at a time during the course of the day. On other days, however, you may achieve only a partial sale and, as a result, you would frequently be left with the remainder. Selling pieces at a time over the course of several days is likely to result in a higher total commission charge than what would be incurred if all of the trade occurred on a single day. Moreover, you may just want either to liquidate your entire position or, if that is not possible, hold on to all of it. To be sure of selling (or buying) the entire amount or if not, none at all, you can enter your order as all-or-nothing. Such an order must be executed as a single block or not at all. With such an all-or-nothing order, you give up the chance of selling (buying) all of your position a piece at a time, but you achieve the certainty of knowing that if you do trade, you will sell (buy) it all at once.

Generally, limit orders are entered as day or GTC. A rarely used third option is to enter the order as fill-or-kill. A fill-or-kill order is to be presented to the market, and if it is not executed upon its arrival, it is immediately canceled.

Stop limit, all-or-nothing, and fill-or-kill order types are only seldom useful to the small individual investor. You may never need to use them or, if you do, you will find them useful to employ only on rare occasions.

Stop Limit, All-or-Nothing and Fill-or-Kill Order

  • Stop Limit Order: A contingent order to buy or sell at a pre-specified price. The order becomes executable when a pre-specified threshold price is reached.
  • All-or-Nothing Order: An order that must be filled in its entirety or not at all.
  • Fill-or-Kill Order: A limit order that must either be executed upon reaching the floor or if this is not possible, it must immediately be canceled.

Use discount/Internet brokers in order to minimize commissions.

The brokerage commission that is assessed on a given securities market trade can vary enormously depending upon which type of broker is used. The commission charge can amount to a substantial percentage of the monetary value of a transaction, particularly on a small trade. Full-service brokerage firms (Merrill Lynch, Solomon Smith Barney, etc.) generally charge the highest commission rates. They utilize a formula based on both the number of shares and the dollar value of the trade. The formula produces a commission charge that increases at a decreasing rate as both the number of shares and the dollar value of the trade rises. Thus the commission on a large-value trade is greater in dollar terms, but less as a percentage of the trade’s monetary value than that of an otherwise similar, smaller-value trade. Similarly, for two trades having the same dollar value, the one involving the largest number of shares would incur the highest commissions. For modest-sized trades, the commission charged by these firms can easily amount to 2 to 3 percent of the money involved, and even more for very small trades and/or low price per share stocks. Furthermore, many full-service firms have commission minimums of $35 to $50. Applying such a minimum to very small dollar value trades can result in commission charges equal to 5 to 10 percent or more of the money involved in the trade (e.g., a $35 commission on a $300 trade). Indeed, penny stocks, stocks that trade for less than a dollar per share, can be particularly costly to buy and sell. Penny stocks typically not only incur high commissions, but also have large spreads.

As Table 1.1 illustrates, the highest full-service commission rates (in percentage terms) apply to small dollar value trades of low-price stocks. This table shows that a full-service firm’s commission on a 100-share trade of a one-to five-dollar stock amounts to about 20 percent of the cost of the stock itself. A 1,000-share trade of a one (five)-dollar stock still incurs a rather high 7 percent (4.3 percent) commission. Commission rates decline to the 2 percent range on 500-share trades of stock priced at $20 per share or higher.

A commission is charged on both the purchase and the sale of a securities position. So if you end up paying commissions of 2 percent, 7 percent, or 20 percent on a trade, the corresponding round-trip cost for both buying and selling the position amounts to 4 percent, 14 percent, or a whopping 40 percent of the security’s principal value. Such costs, particularly at the high end, could take a huge bite out of any gross profit (or perhaps turn it into a loss) that might be made on the transaction. Clearly commission costs are a drag on portfolio performance that need to be managed carefully and effectively.

TABLE 1.1. Typical Full-Service Commissions

Price Per Share 100 Shares 500 Shares 1,000 Shares
$1 $20.60 (20.6%) $70.00 (14.0%) $70.00 (7.0%)
$5 $50.00 (20%) $120.00 (4.8%) $218.45 (4.3%)
$10 $50.00 (10%) $171.95 (3.4%) $293.86 (2.9%)
$20 $65.02 (6.5%) $247.36 (2.5%) $433.77 (2.2%)
$50 $110.50 (2.2%) $443.28 (1.8%) $669.00 (1.4%)
$100 $110.50 (1.1%) $552.50 (1.1%) $988.55 (1.0%)

Discount brokers charge less than full-service brokers. Rates vary, but discounts of 30 to 50 percent or more from the standard rates of full-service brokers are common. Full-service brokers will provide similar discounts to customers who give them a substantial amount of business. The lowest commission rates, however, are generally those charged by Internet brokers. Rather than applying a formula that can result in a large commission rate on sizable trades, Internet brokers generally charge a set fee of as little as $7 per trade. Clearly $7 per trade is much less than the $50 minimum that some full-service brokers charge. Similarly, the commission on a large dollar value trade may amount to several hundred dollars at a full-service firm compared with $7 at an Internet broker.

If Internet and discount brokers process trades for so much less than full-service brokers, why do so many investors still use full-service brokers? What do the full-service brokers have to offer in return for their much higher commission rates? A full-service broker is a flesh-and-blood account manager. This person is trained in the areas of financial planning, portfolio management, and investment selection. The brokerage firm itself has a research component that generates analysis and recommendations on the set of stocks that the firm covers. The firm is also involved in underwriting, which may allow the investor access to new issues and the like. You should not, however, expect to be allocated any of the hot new issues. These tend to go to the firm’s favorites. Clearly, you need to decide whether the extra services available from a full-service firm are worth the extra cost. Often you will find that, once you gain a bit of experience, you have relatively little need for their help.

One could have the best of both worlds by opening accounts at both a full-service firm (for occasions when the extra service is needed) and at an Internet broker (when all that is needed are the tools to implement a trade).

Such an approach, however, makes sense only for investors who have relatively large accounts.

Avoid unnecessary trading.

Transaction costs are incurred every time you undertake a trade. These transaction costs include commissions, transfer fees, and the impact of bid-ask spreads. Additionally, for a large-size transaction, an order to buy may (temporarily) bid up the market price while a sizable sell order may push the price down. Each round-trip transaction (buy and sell) also has a tax implication. Unless the transaction involves securities that are part of a tax-sheltered retirement account (e.g., IRA), a tax will be due on the amount of any gain. If the gain is short-term (asset is held for less than a year), the tax liability is based on a much higher rate (your marginal tax rate on ordinary income, which could be as high as 35 percent or even more) than if the asset is held long enough to qualify for long-term tax treatment (a maximum of 15 percent). The more one trades, the greater are the transaction costs incurred and the greater are the tax impacts. Thus, overly active trading can have a substantially negative impact on returns.

You should limit your trading activity as much as you realistically can. If you trade excessively, your broker may make money (commissions) from your activity. But you probably won’t. Moreover, a large number of small purchases and sales complicates record-keeping. If you don’t already realize the importance of keeping well-maintained records, you will when you start to fill out your tax returns.

Take advantage of those dividend reinvestment plans that allow you to add to your holdings of a stock that you like.

Many companies offer their shareholders an opportunity to participate in a dividend reinvestment plan (DRIP). Such plans permit their stockholders to recycle their dividends into the purchase of additional shares or even fractional shares of the dividend-paying company. Some plans allow the shares to be purchased at a small discount (e.g., 5%) from the current market price. Under almost all such plans, little or no commission fee is charged on the purchases. Many plans also permit optional additional purchases. Thus DRIPs allow the shareholder to add to his or her position while incurring little or no transaction costs. Similarly, the sale of shares acquired in a DRIP will incur little or no commission charges if sold through the plan. The shareholder should participate if he or she wishes to acquire additional shares anyway, particularly where the stock can be bought at a discount. One caveat: Even though the dividend is being reinvested in the stock of the same company that paid it, income taxes are still due on the dividend-supplied funds that were used to buy more shares. The IRS always demands its cut.

Block trades, tender offers, secondary distributions, and the super DOT system are used for large trades. Understand how they work and how they may impact the market.

The vast majority of stock market trading takes place on an exchange or in NASDAQ in the ordinary way, in small quantities of one or a few hundred shares. The exchanges and NASDAQ are not, however, set up to facilitate the execution of very large trades. A trade of up to several thousand shares can usually be accommodated by the marketplace without undue difficulty. Nothing more than standard trading mechanisms, such as market or limit orders, are required in order for the trade to be implemented. If, however, ten thousand or more shares are to be traded, the standard mechanisms often do not work very effectively. The specialist, who manages trading in assigned stocks on an exchange, is tasked with providing liquidity when temporary market imbalances arise. If someone wishes to sell (buy) 500 or so shares and no buyer (seller) is readily at hand, the specialist is expected to step into the market and buy (sell). Specialists are expected (by the exchange) to buy or sell at or close to the current price levels when no one else will. The specialist does not, however, typically have enough capital to take (or enough shares to sell) a substantial position in a large block of a single stock. Even if the specialist does have sufficient capital available, he or she is unlikely to want to assume the risks inherent in acquiring a very large position in a single stock. Similarly, a sufficient number of readily available (nonspecialist) market participants willing to take a large enough position to absorb a sizable block of stock may not be quickly available. Thus, the market can usually supply or absorb up to a few thousand shares of most stocks without great difficulty, but encounters problems with larger quantities.

Consider the hypothetical case of XYZ, a $20 stock that typically trades 5,000 or so shares a day. Dumping 30,000 shares of XYZ onto the market could trigger a very substantial drop in the stock’s price. A block of 30,000 shares of a $20 stock represents a total market value of $600,000 or so. That sum represents about six times the value of an average day’s trading in XYZ. Six hundred thousand dollars is likely to represent a lot of money for those who follow that particular stock closely. Some investors may be looking for a buying opportunity. But they are unlikely to want or be able to come up with such a sum quickly. The specialist is also very unlikely to want to risk that much money on a single stock. A sufficient number of interested buyers may be available on short notice to buy such a stock only if the price is much lower. If you are seeking to sell such a large block, you don’t want the process of unloading your position to drive the price down dramatically. The lower the price goes, the less you will receive for the sale of your position. You could try to sell the block in pieces, a little at a time over the course of several days. The marketplace, however, tends to recognize that a piecing-out sale is under way when it sees a seemingly endless stream of sell orders. When that happens, interest on the buy side tends to dry up. Once again, the market price would be driven down. And again, the more the price is driven down, the less value you, as a large seller, will derive from your position.

Mindful of the difficulty of using the normal market arrangements, the securities markets have developed several specialized mechanisms to sell (or buy) larger blocks of stock. These mechanisms are designed to mitigate the adverse market price impact of large trades. One such specialized mechanism relies upon an investment market professional called the block trader. To explore how block traders work, return to our situation where 30,000 shares need to be sold. Suppose the stock is now trading on the market with a bid-ask of 21.40/21.55 and a size of 10 x 10. Thus, a thousand shares are bid for at 21.40. You could indeed sell a thousand shares at that price. But selling only a thousand shares would leave you with 29,000 more shares to sell. Dropping 30,000 shares onto the market all at once could easily drive the price down into the mid-teens. Selling such a large block, if mishandled, would be very disruptive to the market. Such an approach might well result in a sale at a substantially lower average price than could otherwise have been obtained. Clearly you would prefer to avoid such an outcome. An experienced professional is needed in order to identify and seek out buyers who are willing to absorb the position.

That is where the block trader comes in. He or she would be retained to undertake the task of identifying sufficient buying interest to facilitate the trade in a way that would not disrupt the market. The block trader could start by checking with the specialist in order to see how much potential demand is on the books (in other words, how many unfilled limit orders are available to purchase the stock at various prices). Institutional and large individual investors, particularly those who already have a position in the stock, could be contacted to see if any of them have an interest in adding to their holdings. The company itself might also be contacted in an effort to identify potentially interested investors. In this way the block trader would usually be able to generate some additional interest in the stock and thereby identify a number of potential buyers. After perhaps thirty minutes of calling around, the block trader would return to the seller with an offer to move the issue at a price somewhat below the current 21.50 price range. If enough interest was shown on the buy side, the block trader might propose to move the 30,000 share position at 21. A 50-cent-per-share discount ($21.50 - $21.00 = 50¢) to move a block of this size is likely to represent a significantly better result for the seller than the average sale price that would otherwise result. The block trader would receive a standard commission from both buyers and sellers as compensation for facilitating the transaction.

Block traders are able to handle positions in the tens of thousands, perhaps up to a hundred thousand or so shares. They cannot, however, be expected to find buyers (or sellers) for quantities that reach into the millions. Nonetheless, those wishing to sell such quantities do sometimes appear. For example, a foundation might need to sell several million shares of the founder’s company, or an existing company may wish to raise capital by selling a large number of additional shares. Such a seller would not be able to use a block trader for such a large quantity. The block trader is simply not set up to handle trades of such a magnitude. Rather, the seller would need to utilize what is called a secondary distribution. An underwriter (investment bank/brokerage firm) or syndicate of underwriters would be assembled for the purpose of selling a large quantity of shares via a secondary distribution. The underwriters would offer the shares to their customers in a special sale at a specified fixed price. This offer price is usually set a bit below the range where the stock was trading before the offering. The buyer is not charged a commission directly, but the seller gives up a portion of the purchase price to the underwriter as an underwriting fee. The sale usually takes place over the course of a day. Prior to the sale, the underwriter prepares an offering statement designed to explain the terms of and relevant information on the offer to potential buyers. This offering statement must be approved by the SEC for relevance, accuracy, and completeness before the sale can proceed.

We have already seen that very large sellers need special help to accomplish their desired transaction. Similarly, substantial buyers often need special help to accomplish their purchase of a very large block of shares. As with the sale of a large block of stock, an attempt to use the standard market mechanisms to purchase a substantial quantity of stock would be very likely to disrupt the market. As the buyer bought more and more shares, sellers would tend to disappear and the price in the marketplace would be likely to be bid up higher and higher. The buyer would start acquiring shares at the current level. Sooner or later, however, the relentless buying might cause the price to rise so high that the overall cost of the purchase would be much greater than planned or expected. Experienced investors would conclude that someone was trying to acquire a significant position. They would then be inclined to hold out for ever higher prices. Indeed, the buyer might get part way into his or her buying program and realize that the total cost was going to be so great as to make following through with the full purchase unattractive.

The use of a tender offer is designed to allow the buyer to avoid such problems. A tender offer is used to facilitate a very large purchase without unduly upsetting the market. Such a purchase offer may, for example, be structured to acquire shares by the company itself (self-tender) or may be used as part of a plan to take over control of a targeted company. As with a secondary distribution, an underwriting syndicate is organized to manage the offer. A price offered by the purchaser is set, usually at a level that is a bit above what had been the market price. The buyer specifies other terms, such as how many shares will be accepted and how long the offer is to remain open. The seller receives a net price, and the buyer pays a fee to the underwriter.

One more special trading mechanism to explore in this segment is the super DOT system. Sometimes traders wish to buy or sell a large number of different securities simultaneously. Such traders may, for example, wish to purchase (or sell short) each of the stocks making up the S&P 500 index in the proportions that correspond to those of the index. In essence, they want to buy (or short) a matched set of the index stocks for an overall price that reflects the level that the index is currently registering. Entering and executing 500 separate trades individually would take time. Before all 500 separate trades could be completed, the individual stock prices may have moved about quite a bit. Instead of assembling a portfolio of the securities making up the index at the expected cost, the actual cost could be rather different. Similarly, a set of trades designed to liquidate such a portfolio, if accomplished one position at a time (even if the entire process took only a few minutes), could result in a rather different set of prices from those prices that were available when the sale process began. Such a level of uncertainty is unacceptable where the trade is designed only to capture a rather modest price disparity. The super DOT system is structured to overcome this problem. It provides for the simultaneous electronic entry and implementation of many individual orders.

Mechanisms for Trading Large Quantities of Stock

Block Trader: Assembles one side of a trade involving 10,000 up to 100,000 shares in order to minimize market disruption and obtain a satisfactory price for the active side of the trade.

Secondary Distribution: An underwriting syndicate is assembled in order to manage the sale of a large quantity of stock (typically a million shares or more). The stock is sold at a fixed price that is usually set a bit below the pre-distribution level. The seller pays the underwriter a per-share fee for handling the marketing of the transaction.

Tender Offer: An underwriting syndicate is assembled in order to facilitate a large purchase, sometimes as part of a takeover attempt. As with a secondary distribution, the underwriters receive a per-share fee for their efforts.

Super DOT system: Facilitates the placement and execution of trades on many different securities simultaneously. Often used to implement an index arbitrage program.

You, as an individual small investor, are not likely to be a seller using a block trader or secondary distributions; a buyer using a tender offer; or a trader using the super DOT system. You may, however, be on the other side of the trade or you may be on the sidelines but own or be interested in acquiring the affected stocks. Accordingly, knowing how these types of trades work may well be useful as background information.

Categories: Finance

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