Stock Trading Blog
If you watch any financial news program or read investment-based articles, you might notice something interesting – they’re usually about stocks. There might be a bit about currencies, commodities and bonds, but by and large stocks get the most coverage.
There’s a good reason for it: stocks tend to be the first type of asset class anyone can invest in, generally through mutual funds and 401k’s. When you open up a brokerage account, you’ll likely trade stocks and not get access to more complex investments, like futures and currencies. The problem is that this unequal distribution can lead to investors neglecting other assets like bonds in favor of stocks. A portfolio made up of just one asset class – even if it’s internally diversified – can lead to big losses for those that aren’t aware of the risk they’re taking on.
Allocation and Risk Tolerance
Having a diverse set of assets in your portfolio is the key to maximizing returns without taking on undue risks. But, in order to know what kind of setup you need to have, you need to first ask yourself what kind of risk you’re willing to take on. You need to know what your risk tolerance is.
While there are a number of tools online that will help you figure out what type of investor you are, there’s a good chance you already know if you’re conservative or aggressive. A good rule of thumb for building a portfolio is to take your current age and subtract it from a number to figure out what percentage you should have in stocks and bonds.
Conservative investors should subtract their current age from 100 and use that number as the percentage of their portfolio that should be invested in stocks. For example, if you’re 30 years old and fairly conservative, you should have 70 percent of your portfolio in stocks and 30 percent in bonds.
More aggressive investors can subtract from 115. In that case, you would want 85 percent in stocks and 15 percent in bonds.
Following this simple rule can help you avoid unexpected losses without disregarding the importance of exposing your portfolio to profitable investments.
One thing to keep in mind when constructing a portfolio is what type of financial instrument you should be using. With stocks, there are a number of options, such as mutual funds, ETF’s and individual equities. But bonds are a little trickier to invest in. Typically, bonds are purchased in lots of $10,000 each per bond. So unless you have a large nest egg built up, you probably won’t get the kind of diversification you need by investing directly in bonds.
Instead, you should use mutual funds to get exposure to bonds. These investment vehicles hold portfolios made up of different types of bonds in multiple industries with a diverse range of maturity dates.
Finally, you should check your portfolio allocation at least once a year. Because stocks typically outpace bonds, over time your portfolio will become more heavily weighted in stocks, which could throw off your balance. You should make adjustments as needed so your portfolio doesn’t get off track as you approach retirement.
If you’re looking for another way to make your dollar grow, you might consider doing away with the dollar entirely and investing in foreign currencies. The Forex market, once the home of large institutional brokerages and hedge funds, is now available to everyday investors through margin accounts.
While it may sound risky and exotic, foreign currency exchanges are now part of the financial globalization process with instant access to virtually any type of currency to anyone with a computer. If foreign currencies sound like they might be for you, there are a number of ways you can invest in them right from your home.
The Foreign Currency Market
Most investors are accustomed to basing gains and losses on the value of the U.S. dollar, but thanks to globalization, there are now ways to profit from other currencies. The dollar’s value fluctuates on a daily basis against other foreign currencies like the euro and the yen.
A strong dollar means goods from overseas become cheaper by comparison, while a weak dollar means more goods can be exported as foreign currencies go further to buy American-made products. Investors can take advantage of these differences by holding foreign currencies and taking advantage of appreciation against the dollar or by shorting, or selling, those currencies against a rising dollar.
As the global marketplace becomes more interconnected, holding currencies of other countries can be a good way of diversifying against domestic economic downturns.
Here are a few ways you can invest in foreign currencies:
Forex Trading – If you want to invest in foreign currencies directly, you can open a Forex account. Initial deposits are generally very low, under $1,000, and allow you to trade leveraged currencies to boost returns. Investors should note, however, that many currency leverages can be in excess of 200:1, making it a high risk trade that could result in big gains or losses in a single trading day.
Exchange-Traded Funds – If taking on all the risk of Forex trading is too extreme for you, consider using ETF’s instead. These investment vehicles trade like stocks and are very liquid, letting you make changes easily. They’re also somewhat diversified, reducing risk while still giving you exposure to the foreign currency of your choosing.
Foreign Companies – Finally, you can get exposure to foreign currencies by investing in companies that operate overseas. Because their profits are calculated in their local currency, you can take advantage of arbitrage opportunities. When those profits are translated into U.S. dollars, you could see additional gains due to relative currencies value fluctuations.
As with all other investments, foreign currencies are inherently risky. Investors should be aware of what macroeconomic factors influence currency values and understand the relationship between them and interest rates before investing. Government policies can also impact currency valuations, since they’re the basis of export and import trade. Investors should make sure that their entire portfolio is diversified in order to avoid unexpected losses.
It’s no secret that one of the primary focal points of the new Trump administration is going to be China. His ideals regarding the One-China Policy are just one of the many controversial plans he has regarding U.S. foreign policy. His recent telephone call with the Taiwanese leader was the first contact a U.S. President or (President-Elect) has had with Taiwan since the late 1970’s and has set the stage for what many believe could be a series of progressive economic escalations.
Business negotiation or thinly-veiled threat?
One of Trump’s platforms is to renegotiate trade deals the United States has with foreign nations in order to foster better terms for the U.S. On the surface, there’s nothing wrong with wanting to get the best deal possible, but Trump’s approach is abrasive and thoughtless when it comes to the potential ramifications his trade deals could have on the global economy and trade.
By using Taiwan as leverage, Trump hopes to negotiate trade deals with China, but the plan has many pitfalls. The benefits of fighting back against devaluation stemming from China seem to be outweighed by the possible negatives that could happen in retaliation.
While the United States might have Taiwan to use as leverage against China, China has many economic tools to use against the U.S. For one, Boeing is expected to deliver $11 billion worth of planes to China to service its growing airline industry. But China could easily cancel the deal and go with its European competitor, Airbus. China could also use its anti-monopoly laws to hurt American businesses, like it did with the $975 million fine on Qualcomm, which cited licensing infringements.
But aside from its impact on domestic businesses, a more disturbing bit of leverage is the amount of American debt China holds. The country holds around $1.3 trillion in United States treasuries and could dump them on the open market. That could cause a sudden jump in interest rates and send America’s economy into a downward spiral almost overnight.
China could also devalue its currency to make Chinese products even cheaper, something that Trump claims the country already does. They could also place embargoes and higher taxes on U.S. goods, as well as pull investments out of our domestic economy.
It’s still too early to tell what impact Trump will have on the Chinese and Asian markets. Certainly, his recent actions prove that he’s going to take an active role in trying to renegotiate trade deals, but his method of doing so seems questionable.
At best, it could simply be a huge bluff intended to bring China to the table. But the dangers of using Taiwan as a political play against one of the largest economies in the world could end up hurting investors in the long run.
If you’ve decided to take control of your own financial future by starting an investment account – congratulations! You’ve taken the first step toward gaining true financial independence. But before you open your first brokerage account and beginning trading stocks, there are a few things you’ll want to know first.
An investment portfolio is more than just stocks and mutual funds. It should work together to serve a common purpose. You might think all you need to do is spread around you money and invest in a number of different things, but there’s more to it than just that. While diversification is something you’ll likely hear repeated over and over, it means nothing if you don’t understand how diversification is supposed to be applied.
When designing your investment portfolio, you’ll want exposure to a diverse range of asset classes. That includes stocks, bonds, currencies, and commodities. Of course, you may find that investing directly in currencies and commodities presents a bit of a challenge. Many of these types of assets trade on the futures market – something that beginning investors are ill-prepared for. But there’s still a way to invest in them through other means.
Stocks are arguably the easiest asset to invest in. You can choose mutual funds to get exposure or invest directly through a brokerage account. Bond exposure is typically gained through mutual funds, although investors with significant assets can choose to buy bonds directly.
Rather than risking the highly volatile futures market, currencies and commodities can be invested in through ETFs, mutual funds, and stocks. Many of these types of commodity or currency-based investment vehicles come with managed portfolios, giving you a level of instant diversification within the asset class.
Many first-time investors skip over the risk tolerance step when setting up their investment accounts. These investors are usually the same ones that end up telling horror stories of losing it all when the market crashes.
In order to determine what your risk tolerance is, you need to first examine what your financial goals are and what kind of volatility you can bear. If the idea of watching your portfolio value drop 10-20% keeps you lying awake at night, you might want to consider a more conservative portfolio approach, limiting your exposure to blue-chip stocks and bonds.
However, if you’re a young investor, you might want to consider a more aggressive portfolio design. Any losses you might incur, you can recover from with a longer-term investment horizon. By focusing on growth investments like stocks, you can boost your returns and slowly allocate to a more conservative portfolio as you reach retirement age.
Putting It All Together
You portfolio shouldn’t be just about getting the most returns. There are other considerations to keep in mind, such as your personal risk tolerance and investment goals. It’s important to keep your long term objectives in mind when setting up your portfolio. Remember to stay diversified and keep a good mix of investments in your portfolio.
Need more stock tips? Check out our Top 5 Stock Trading Companies for more information.
Investors have always looked for an edge in the marketplace. Any detail, no matter how small, is an advantage if it could predict future stock movements. Aside from the obvious, like economic data and stock returns, one element in particular carries a lot of weight when it comes to predicting stock market corrections and crashes: margins.
Trading activity can reveal a lot about the economy – in particular, how leverage and margin accounts are used. Investors with an appetite for risk use leveraged strategies to boost returns by borrowing money at a predetermined interest rate and using it to invest at a higher rate of return.
When margin is high, it generally means that investors have a large risk appetite and are bullish about the future. But it also means there’s far more volatility in the market and a lot more debt. Any slight downward correction when margins are high can mean dramatic declines or even crashes, as investors desperately seek to cover their loans by selling out of their positions.
How Margin Acts as a Prognosticator
Margin levels in the stock market have a long and storied history of being able to predict market crashes. Investment activity in the 1920’s leading up to the Great Depression was a classic example of how margin debt can harm the market. Some levered positions were as high as 10 to 1, which was of the biggest reasons why the markets crashed so quickly.
But the truly insidious thing about high margin debt is the inverse association of available credit to lend to borrowers. When margins begin to be called, financial institutions simply don’t have the money available to lend out to businesses and a shortage of credit is what really takes down the economy. Investors saw a similar problem play out in 2008 when the sub-prime mortgage crisis caused credit to dry up as real estate holdings were being foreclosed on and people could no longer afford their homes.
Interestingly, margin debt levels pointed to a crash before it happened, just like the Great Depression. From January 2007 to July 2007, NYSE margin debt levels rose 22% before finally peaking in August – a month before the sub-prime mortgage crisis hit the markets.
As of September, margin debt levels are over $501 billion – the second highest level recorded, with June of last year coming in at $507 billion. Margin debt has climbed 12% so far this year and seems to keep climbing, despite the risks. If history is any guide, investors should be wary of their stock holdings and be prepared for a runaway correction if the markets start to decline.
Correlation Doesn’t Equal Causation
While high margins have a high correlation with upcoming stock market crashes, it’s important to remember that correlation doesn’t equal causation. Margin levels have been high for the last several years without any major correction. In fact, margin levels have been around $450 billion and $500 billion for the past two years.
But there also hasn’t been a correction large enough to reach the tipping point that could ultimately send stocks into a downward spiral. The absence of a market crash despite high debt levels shouldn’t be a reason to dismiss the correlation. Right now, investors would be wise to tread carefully with any leveraged positions and be prepared to act quickly should the bull market turn into a bear market.
It’s no secret that commodities have been an outcast asset class for years now. The three year annualized return on the Dow Jones Commodity Index is -12.14% with investors steering clear of anything related to commodities like steel, aluminum, coal, and especially oil. The strength of the US dollar has acted as a further headwind for commodities, and with interest rates on the rise the dollar should remain strong.
The slowing Chinese economy left a demand vacuum in the commodities space with no other economies with strong enough demand to make up for it. While investors have been looking at possible alternative countries like India for a replacement, it seems that any real commodity revival will have to come from some other source.
But despite all the headwinds, some commodities could see gains next year. A new President means a new political administration and policies that could benefit certain sectors of the US economy over others.
For value investors, these commodities could be surprise winners for 2017:
Typically associated with a growing manufacturing base, aluminum has been a bit of a roller coaster for investors lately. But aluminum has been a stealthy gainer so far regardless of its volatility. With Trump in office though, aluminum could be a big winner for 2017.
Aluminum had been gaining before Trump was elected, but after, aluminum spiked even higher. Better than expected data from China has helped fuel the rally and an increased expected demand from the US means aluminum should have a prosperous road ahead.
Oil’s been a blight for the market for the past couple of years but the end is in sight. OPEC’s cartel looks to be permanently broken and oil is beginning to trade more along natural supply and demand curves rather than by political manipulations.
US shale oil was a major reason why OPEC panicked and began depressing prices in order to eliminate competition. But with Trump in office, investors can bank on policies aimed at US energy independence and that means keeping shale oil in production. Keeping oil flowing from domestic reserves will be a key point in the new administration.
Gold and Silver
The traditional safe haven assets have had a red letter year for 2016. Gold is up around 12% while silver has logged even more impressive gains north of 18%. Lately precious metals have fallen but the drop may be merely a correction.
Despite the rise in interest rates, a new administration mean increased volatility in the markets. Trump’s ideas regarding foreign policy could result in higher than expected inflation. That means assets like gold and silver could benefit.
While some may argue that rising interest rates should curb any positive gains in commodity values, the truth is it may not impact them much at all. The small increases of a quarter of a percent on an annual basis won’t derail equity or commodity markets. However, China remains a key part of how commodities are viewed. Better than expected results tend to buoy commodity values, but China is still an economy in deceleration mode. Investors should bear in mind that time is ticking away until the global economy has a reason for improved commodity demand outside of China.
Bonds aren’t the most popular investment to talk about. Investors tend to view them much like a side of broccoli in a steak dinner. The steak (stocks) may garner all the attention, but experienced investors know that it takes a balanced portfolio to be financially healthy.
Maybe you can speak at length about the prospects of XYZ stock or discuss in detail how its valuation multiple makes it an attractive buy right now, but the moment someone mentions bonds, your eyes glaze over and you tune out of the conversation.
You aren’t alone. The bond market is arguably the most misunderstood market on Wall Street simply due to a lack of basic bond know-how. Once you understand what a bond is and how it’s valued, you’ll be able to speak about and invest in bonds with confidence.
Debt isn’t all bad
A bond is a loan issued to governments or corporations that comes with a fixed interest rate over a preset period of time. It works exactly the same as when you take out a loan to finance the purchase of something such as a car except instead of borrowing money from the bank, you become the lender the company or government is borrowing from.
These debt instruments typically pay out interest on a semi-annual basis and are known as fixed-income securities. Investors can trade bonds in several ways. They can hold the bond until maturity and collect the interest, or they can trade the bonds before maturity and take advantage of any price appreciation that occurs.
Bonds are issued with credit ratings as well with higher credit ratings paying less interest than those with lower credit ratings. Bonds that have a rating of AAA to BBB are known as investment grade bonds because the issuer has a high or medium credit quality and there is a low risk that the company will go delinquent on its debt. Bonds with a rating of BB or lower are called high-yield bonds or “junk” bonds because there is a higher risk of a company defaulting on its loans.
Pricing a bond
Bond prices and interest rates have an inverse relationship meaning that as one goes up, the other goes down and vice versa. If you’re buying a bond with no intention of trading it – you’re just holding it for the interest – then pricing changes won’t matter to you. But if you’re trying to take advantage of any opportunity that presents itself, then you’ll want to know how bonds can be profitable beyond yield.
Let’s say you bought a bond with a par value of $1,000 and offers a 5% yield netting you $50 semi-annually. Regardless of what happens with the face value of the bond, the semi-annual amount you’ll earn will not change. Now let’s assume that interest rates are hiked by 1%. In order for the bond to trade at parity, it will need to offer a 6% yield. In order to do that, the value of the bond needs to fall so that the face value will equal a 6% yield. In this case, the value would drop to $833. A 6% yield would then give an investor $50 semi-annually.
Bonds are considered one of the pillars of a balanced portfolio along with stocks and money-market assets. While bonds are often dismissed as an asset class that’s taken for granted, investors who understand how the bond market works can boost returns and improve their portfolio’s efficiency.
The markets have predicted a 50-50 chance that the Fed will raise rates again this December and investors are on the fence as to how this could benefit them. The election cycle has complicated matters leaving many investors on the sidelines until the vote comes in and uncertainty abates a little in the markets.
Last December the Fed raised the Federal Funds rate by 0.25% marking the first increase since 2006 in what was widely believed to be a series of hikes. However, the markets plummeted early in 2016 following the hike and the Fed’s statements have changed from hawkish to dovish with little consistency. Keeping a rate hike on a set schedule is critical to maintaining stability in the markets, but another rate hike in December without seeing a rise in inflation could also tip the scales in a bearish direction.
Regardless of the Fed’s decision next month, investors need to have their portfolio’s prepared for the worst while still positioning it to take advantage of any potential gains.
The relationship between interest rates and stocks
Interest rates impact the cost someone pays for the use of another person’s money. When the Federal Funds rate goes up, it increases the cost banks are charged in order to borrow from the Federal Reserve. The goal is to reduce the money supply in an attempt to curb inflation.
Increased rates have widespread implications though. Higher rates means that borrowers pay more for loans and reduces the amount of money they are able to spend on other goods and services. For businesses, that means there is less capital to put towards investments or growth and reduces earnings due to the increased amount spent on interest payments.
When earnings go down, so do stock prices. So when interest rates go up, the immediate effect is usually a decline in stock values since profits take a hit due to the increased borrowing cost. It also makes more conservative asset classes like treasuries and bonds more desirable since yields go up. Stocks have more risk, while bonds have less.
Stocks need to be more valuable than the less risky bonds and treasuries in order to be more desirable to investors. For investors, that means a stocks return needs to be equal to or greater than the risk-free rate plus a risk premium. For example, let’s say the risk-free rate is 2% while XYZ’s risk premium is 8%. That means investors will expect the stock to generate a 10% return in order to be desirable. If the risk-free rate rise due to a Fed hike to 3% then the stock would need to produce a return of 11% to get the same result. As rates go up, stocks need to produce higher and higher return in order to compensate for the risk.
Not all stocks are affected the same by higher interest rates. Increased rates also mean greater returns on money market accounts and other conservative asset groups. This benefits financial companies the most like banks and insurers who keep significant sums of money in liquid assets in order to make loans and pay out insurance claims.
Investors who worry that a rate hike might hurt their portfolio might consider picking up some financial stocks to hedge against higher interest rates. Investors should also note that once the rate hikes stop, a new equilibrium will settle over financial markets with stocks compensating for the changes and producing higher returns in the long run.
There’s no worse feeling than watching a stock in your portfolio drop in value day after day with no end in sight. If it falls less than 10%, you say the markets are just going through a small correction. After it drops 20%, you tell yourself that it must have finally bottomed, but when it keeps falling, you may start to panic.
There’s one inevitable truth all investors must face: eventually, you will own a losing asset. The key to successful investing isn’t knowing when to buy a stock, it’s knowing when to sell it. That holds true whether the stock goes up or down, but understanding when you need to cut a losing investment loose is what separates good investors from great investors.
It comes down to simple math. If a stock drops 10%, you need to gain 11.11% in order to break even. After a 20% loss, the break-even point jumps to 25%, and if it has lost 50%, it’ll need to double in value just to prevent a loss.
In order to make a rational decision on whether you should keep a stock or sell it, you’ll need to answer three questions first.
Why Did You Buy the Stock?
If the reasoning behind why you bought the stock has changed, then you might consider getting rid of it – especially if its declining in value. If you bought a stock because it had a high dividend yield and management cuts the dividend, then the stocks circumstances have changed. If the stock is dropping in value along with most other stocks, it’s likely a macroeconomic reason and doesn’t affect the fundamentals of the stock you own.
Does Your Portfolio Need to be Re-Balanced?
Every so often your portfolio needs to be readjusted to keep in line with your risk tolerance. Some stocks gain more than others and subsequently take up more weight in your portfolio. As your risk tolerance changes, you may need to adjust how much money you have allocated to riskier stock picks. Investing in high risk speculative companies may be exciting, but too much of them in a portfolio can spell disaster.
Can You Use the Loss to Offset Gains for Tax Purposes?
If you have a losing stock in your portfolio, you might consider using tax-loss harvesting to reduce the amount of taxes you’ll need to pay at the end of the year. Selling a stock at a loss allows you to offset your income up to $3,000 in a single tax year. It might not be a profit, but at least it helps you reduce your tax burden.
One warning for those of you struggling to cut your losses: don’t bail out your money by throwing more money at a losing stock. Averaging down by purchasing more shares of a stock after its declined in value is dangerous. The idea is to lower your average cost per share, which on the surface seems like a good strategy. The problem is that averaging down can be a panicked reaction to seeing a stock drop in value. If its for fundamental reasons, then you’ll end up in a cycle of averaging down until you have a much larger percentage of your portfolio in that stock than you wanted just to bail out your original investment.
Investing the stock market takes discipline in order to be successful. Jumping in blind with no more idea of what to do other than “buy low, sell high” is the quickest way to lose your money. Without some guidelines to help you out along the way, it’s easy to make mistakes and get discouraged.
The good news is that investing isn’t rocket science. Even the smartest Ivy League college graduate knows that successful investing means following the rules. So before you start navigating the waters of Wall Street, here are 10 rules that every investor should be obeying:
- Know What You Own – The hottest new tech company may be all Wall Street and your friends are talking about but if you don’t understand what it is they do or how they actually make a profit, take a pass on it.
- Cash Is Also An Asset Class – Too many investors think that they need to be all-in in order to be a successful trader. Keeping cash on the sidelines though means that when an opportunity presents itself, you can act quickly without having to sell out of another investment before you’re ready.
- Diversify, Diversify, Diversify – This rule cannot be understated. Don’t keep all your eggs in one basket; diversify your investments to avoid getting hit by a single event that only affects a limited part of the stock market.
- Stay Calm And Keep Investing – Panicking when the market is behaving erratically is the quickest way to big losses. Don’t get sucked up in the hype and remember when everyone is selling, you should be buying and vice versa.
- Don’t Fall In Love – Remember that stocks are just investments. You may really like a certain company, but if a better opportunity comes along, you can’t be afraid to chase it down.
- Filter Out The Noise – Wall Street always has a new crisis or a new big opportunity for you to worry about. Ignore the pundits and stay focuses on the fundamentals.
- Explain Why You Own A Stock – Know why you want to own a particular stock. Is there a reason you think it’s going to appreciate? Before buying, be able to explain to a stranger why you think the stock is worth owning.
- Due Diligence – It might not be fun, but sticking to your due diligence will keep you from making costly mistakes. Always do your homework before buying a stock or could end up with an ugly surprise down the road.
- Don’t Be Afraid To Cut Your Losses – It’s never fun to admit defeat and even less fun to sell a stock at a loss. But if you own a loser, you need to cut it loose before it does more damage to your portfolio.
- Hogs Feast, Pigs Get Slaughtered – Once a stock you own has made the profits you expected, it’s time to move on. Don’t hold on and try to squeeze every last drop of profits from a stock or you could end up losing all the gains you thought you had in the bag.
It’s a lot easier to maintain discipline by following these simple rules for trading. As you become more experienced with trading, you may decide on a few more rules to help you stay focused as well. As long as it helps you become the best investor you can be, rules are a great way to keep your portfolio in check.
Owning a winning stock that’s worth more than when you originally purchased it is a great feeling. As long as it keeps going up, you’ll want to hold on for the ride. But knowing the right time to sell a stock is arguably more valuable than knowing when to buy one.
It might seem counter-intuitive to sell a winner, but there’s one key point you need to keep in mind: until you actually sell a stock and pocket those profits, you haven’t actually made any gains. On paper it may look like you’re successful, but don’t let that distract you from the fact that those gains aren’t real. If you sell a stock at a profit and it keeps rising, you still made a profit. But if you hold a stock too long, it can decline in value faster than you think erasing those gains in the blink of an eye.
There’s an oft-repeated phrase in Wall Street circles, “bulls make money, bears make money and pigs get slaughtered. Experienced investors know how to buy a stock before it becomes too expensive – smart investors know how to sell a stock before it falls.
Signs it’s time to make an exit on a stock you own
One of the first things you’ll want to do when buying a stock is to have an exit strategy already mapped out. Know beforehand what price you expect it to hit and when you think the stock will have made its possible gains. Once the stock hits that price, you’ll know that it’s time to go ahead, take your profits and move on.
Of course there are times when a stock’s outlook changes by the time it hits the price target you placed on it. Sometimes the stock is still undervalued with room to run. In those cases there’s nothing wrong with placing a new price target on the stock and continuing to hold it. But usually as a stock appreciates in value it becomes more expensive to own.
Once a stock approaches parity and there’s no hidden value left in it, the stock may simply stagnate. It won’t go up, but it doesn’t retreat either. There’s an opportunity cost to holding on to it. In these cases selling the stock in favor of something that’s currently growing is the best course of action.
Paying attention to your investments is important. Sometimes a company announcement of surprise economic data can change your original plan with a stock making it more or less valuable than you thought. The market is a living breathing organism that’s constantly in motion so staying on top of the latest developments will help you spot potential pitfalls before they become serious problems.
Remember that you can’t lose money by selling a stock at a profit no matter what it does afterward. Don’t be afraid to sell a winner and move on to another undervalued opportunity or you could end up costing yourself higher returns in the long run. Greed is the biggest killer of value in most investor portfolios – take the win when it’s there, don’t second guess your decisions and you’ll be well on your way to becoming a successful long term investor.
There’s one simple rule when it comes to investing: buy low and sell high. It’s a simple enough philosophy in theory, but much harder to implement in practice. In order to actually make a profit, you need to purchase a stock at a cheaper price than when you sell it. The problem lies in knowing what price a stock should be trading at and when you should buy it – and conversely, when you should sell it.
Knowing what price a stock should be valued at is something Wall Street analysts excel at uncovering. Through rigorous research they are able to estimate data in advance and place target prices on stocks so investors know where a stock will be trading at in the future. It may seem like pseudo-science to guess what the future will bring, but the actual methods for predicting where a stock will be trading aren’t quite as complex as you might think. With a little due diligence, you’ll be able to track your own stock picks and make estimates as to where they’ll be trading a year from now or even longer.
The 4 Elements of Setting a Target Price
In order to place a target price on a stock, you’ll want to know four fundamental pieces of data: sales, profit margin, earnings-per-share, and valuation multiple. These four items will allow you to make predictions about where a stock is headed and understand exactly why the stock will be trading at a given price in the future.
You can a company’s sales (revenue) history on its Income Statement. Going back 10 years and comparing its quarterly revenue will give you a pretty good idea of its sales growth rate and allow you to calculate where sales will be in the future.
Estimate Profit Margin
Much like calculating future sales, you can find historical net profit margin information on the Income Statement. To find the net profit margin, you need to know the company’s operating expenses, cost of goods sold (COGS), interest and tax from revenue and dividend’s from preferred shares (be careful not to include dividends from common stock). Once you have that figure, simply divide net profit by revenue to get the total net profit margin.
Once you know the company’s net income, you’re ready to convert it into earnings-per-share (EPS). To calculate it, you need to subtract preferred dividends from net income and then divide by the number of shares outstanding. As with sales and profit margin, you can also get an idea for the company’s long term EPS history as well to get an idea of how fast EPS growth is.
Decide on a Valuation Multiple
Finally, you’ll need to place a valuation multiple on the stock to determine its value. This is done via the price-to-earnings ratio (P/E). You can get an idea of what multiple to use by looking at the company’s 10-year average P/E or base it off of its competitors and industry average. Once you figure out what P/E to use for the stock, all you need to do is multiply it with the estimated EPS and that will give you your stock target price.
Remember that even the best analysis can be proven wrong if a company changes the way it does business, changes how it figures taxes or makes new acquisitions. As a result, you’ll want to keep your target price analysis to 12 months and not try to estimate too far out unless you have an in-depth understanding of how that business operates.
Once you can determine your own target prices though, you’ll be able to make better investment decisions and avoid jumping into stocks that don’t have any room for price appreciation. It’s also a good way to time your trades – once you hit your target price, you know that you can sell it unless new data shows a change in the stocks target price.
In order to determine a stocks value, analysts pour over company financial statements in order to find trends, strengths and weaknesses. They break down the data and present it to investors through different ratios designed to help them make quick comparisons and make predictions about where a stock is headed.
These financial statements include the balance sheet, income statement and cash flow statement. They reveal information about the financial health of the company including efficiency, profitability, liquidity, and numerous other details.
Let’s take a closer at each financial statement and see what kind of information we can find.
The Balance Sheet
This statement contains details on a company’s assets, liabilities and shareholder’s equity. It will tell you what kind of assets it owns and what types of debt the company owes. The numbers on the balance sheet will always add up according to the following equation: assets = liabilities + shareholder equity.
This relationship means that assets (what the company owns) must be paid for using either debt financing (liabilities) or investor money (shareholder equity). Key things to note on the balance sheet include the following:
Cash and cash equivalents: This is most liquid money a company has and is beneficial for paying off unforeseen expenses.
Total assets: The total of all assets listed on the balance sheet. This number should be higher than total liabilities – ideally with room to spare.
Current liabilities: Debt or expenses that is due within 12 months. A good thing to watch for is how cash and cash equivalents compares to current liabilities.
Long term debt: The interest and principal on issued bonds.
Total liabilities: All the debts and expanses of a company. This figure should be lower than total assets.
The Income Statement
The income statement is also known as the profit and loss statement and generally contains information about the company on a quarterly basis. It tells you what kind pf profits the company makes, the profit margin and the expenses being paid – either on a regular basis or a one-time charge.
The income statement is vital for figuring out the company’s earnings-per-share and can be used to place target prices on a stock. Comparisons made to prior time frames give analysts the ability to see how a company is performing quarter-over quarter or year-over-year.
The Cash Flow Statement
The most often overlooked statement is the cash flow statement which tells investors how a company is spending its money on a quarterly and annual basis. Cash flows can be broken own by where its being generated: from operations, from investment activity and from financing.
This statement is critical for determining a company’s free cash flow – a statistic used to calculate how much money a company has accounted for capital expenditures. Put another way, free cash flow shows investors how much excess money a company can generate to make new acquisitions or invest in new opportunities.
Many financial ratios are calculated using a mix of all three financial statements. Once you understand how to read them, you can make historical comparisons on your own and make predictions about where a company is heading. Knowing what the financial statements mean for a company gives you the ability to make smarter investment decisions and avoid costly mistakes.
Once you’re confident trading stocks, you may want branch out into options trading. Adding options to your investment strategy can add depth to your portfolio, boost gains and reduce risk. You may already know how puts and calls work. Now you need to figure out how to use them effectively to take advantage of all the benefits option trading possesses.
A covered call is bullish option strategy that helps reduce downside risk. It works in conjunction with owning the underlying stock but limits overall upside. Let’s use a hypothetical stock as an example:
Let’s say you own 100 shares of XYZ stock trading at $25 and you think the stock is going to go up in the next few months but you want to protect yourself if the stock drops as well. You sell a call for $50 a few months out at $30 per share and pocket the $50 gain.
If the stock closes higher than $25 but less than $30, the call will expire worthless and you’ll keep the $50 profit plus you’ll still own 100 shares of XYZ. If the stock climbs above $30 per share, you’ll be forced to sell the call at $30 but you keep the $50 profit plus the $5 gain in the stock’s rise for a total of $550. That means you lose out on any upside beyond $30 so if it suddenly umps up to $40 per share, you won’t get the $10 increase past $30.
Because you sold a call for $50, this also helps reduce downside risk by making your breakeven price $24.50. If the stock falls below that price then you’ll realize a loss, but there’s a bit of wiggle room where you’ll still have a gain even if the stock does nothing or even drops a little.
There are two types of spreads: bullish and bearish. In this type of option strategy, you use two options with the same expiration date but different strike prices. This can be a good way to reduce the cost of entering into a trade or betting on a potential rise or drop in price without actually buying a stock or selling it short.
Let’s use an example to illustrate how this works:
XYZ stock is currently trading at $25 per share and you think it might go up in the next few months but aren’t willing to buy 100 shares of the stock. You could purchase a call option for $250 a few months out at $25 and sell another call for $50 at a higher strike price of $30. Your total cost for entering into this trade is $200 making this the total amount you could lose.
Your total possible profit is $500 minus the $200 cost of purchasing the two options. Using this strategy allows you to leverage your money and increase profits while reducing your total monetary investment while doing so. This works the same way with bear spreads as well except instead of using calls you would use puts.
Covered calls and spreads are simple option strategies that can help your investment portfolio reach its full potential. But there are dozens of possible combinations and strategies you can use in addition to these. Once you get a feel for spreads and covered calls, you may want to look into more complicated strategies that can help you profit no matter what direction the market goes – up, down or even when it does nothing at all.
As a beginning investor you might already have some familiarity with mutual funds, stocks, ETF’s and even options. Most online brokers have services that allow you to trade a combination of those assets and you understand how to put basic combinations together as part of your investment strategy.
But trying your hand in the commodities market is a different story.
Commodities trade on the futures market – a market that obeys rules that are very different from the one’s you might be used to with stocks and options. You’ll also need to find a broker that allows futures trading. Because of the complexities involved, many online brokers won’t deal with futures contracts so doing your homework before opening an account is critical.
Playing the futures market
A basic futures contract is simply an agreement to buy or sell an asset on a future date for a predetermined price. Let’s use a hypothetical situation as an example of how this works:
XYZ Copper Mining is a company that wants to make sure the price of copper doesn’t go down in the future. The company might agree to sell copper 3 months out at today’s price. If in 3 months the price of copper drops, the company won’t be affected by the loss since they already agreed to sell at a higher price.
While much of the commodities market is made up of hedge contracts like the above example, other traders act as speculators betting on whether prices will rise or fall in the future. Commodity investing could be a way of managing overall portfolio risk while others may simply be placing a bet on prices in the hopes of quick gains.
Technically, futures contracts are for the physical delivery of a commodity. While investors can choose to deal with just the contracts, its important to note that delivery and storage costs are all part of the equation when determining where prices will go.
Futures contracts come with far more risk than trading stocks or options though. While margin accounts may allow you to leverage your portfolio to a degree, futures contracts are designed with leverage in mind. Contracts are leveraged at 10:1, 20:1 or even 200:1 ratio depending on the underlying asset involved.
With leverage so high a small percentage change can result in huge gains or losses. A 5% loss in the contract may be the equivalent of a 50% loss on your investment. Volatility this high means that you won’t be able to hold positions for a long time. Even if you end up being right about price in the long term, even a few days of volatility could cost you your entire investment.
Opening up an account to trade futures isn’t the only way to invest in commodities. Mutual funds and ETF’s that trade only commodities are another option as are companies that rely heavily on commodities such as mining companies. While these types of investments might not be “pure plays” on a commodity, they’re far less risky and could be the right move if the idea of losing your entire investment in one day is unacceptable.