Trading Equities

By: Darrell Jobman

The following is an excerpt from Darrell Jobman's Profitable Trading the Turtle Way

Perhaps the most common exposure that most traders have to markets, other than some type of savings account or other interest-bearing instrument, is probably the stock market, either in individual company equities or in mutual funds of many different types.  For many, that may involve a 401(k), an IRA, or some other kind of retirement plan.

When you buy a stock, you are actually getting a piece of the company, collecting dividends as income, and gaining from any appreciation in the value of the stock.  This is the company’s means of raising capital for all kinds of reasons instead of borrowing money and paying interest.  Unlike many derivative instruments, stocks do not expire and can be held indefinitely.

The supply of a company’s shares is fixed.  With a limited number of stocks, competitive buying and selling determines the price of the stock.  The Federal Reserve sets the margin amounts for stocks, requiring investors to have a minimum of 50 percent of the price of the stock in their account as a down payment to own the stock.

Selling short is not as common a practice in the stock market as it is in the commodity markets.  In stocks, if you do own the shares already, it is much more difficult to sell stocks than buy them, as shares have to be borrowed from a brokerage firm’s inventory if you want to sell shares naked.  If you borrow margin money to buy shares or borrow shares to sell, you pay the broker interest.

You have a number of alternatives to become involved in the stock market as either an investor or trader.

Individual Company Shares: You have thousands of companies from which to choose if you buy stocks, and the biggest challenge is to pick the right stock from the right sector from the right overall market environment at the right time.  Much of the analysis for investing in individual stocks involves scanning through the vast array of stocks to find those that meet the criteria you select.  Problems with getting accurate data and reliable information about a company in a timely manner can make it difficult to get an edge.

Stock Options: Instead of buying shares in the company, you can use options to buy or sell the right to be long or short the company’s shares at a specific price.

Single Stock Futures: Futures on major individual stocks began trading in November 2002, but still trade on a relatively small scale.  Single stock futures do provide greater flexibility and tax advantages for those wanting to buy or sell selected major stocks.

Mutual Funds: Many investors have neither the time nor expertise to evaluate and select the “right” individual stocks, so various instruments have been developed to capture the performance of a broader spectrum of stocks.  Mutual funds package stocks from a sector, from a region, the market as a whole, or many other ways to provide a diversified fund based on a collection of individual stocks.

Basing performance on a number of stocks reduces risk and can enhance profits compared to investing in a few individual stocks.  Funds can be geared to provide aggressive growth, growth and income, long-term appreciation, or a number of other investment goals; and their performance is often measured against some benchmark.

Mutual funds have become so popular and the number of funds so numerous that it is as difficult to pick a “good” mutual fund as it is a stock.  Although these funds offer diversity and professional management for investors, they usually charge management and incentive fees and have limitations on when investors can buy or sell, so they may not be the best vehicles for active traders.

Index Funds: Rather than select individual stocks for a fund, some funds just include all of the stocks in an index such as the S&P 500 Index or one of the sector indexes.  Their performance should roughly coincide with the performance of the index.

Index Options: These derivatives are also based on an actual cash index such as the S&P 500 Index (SPX) and the S&P 100 Index (OEX), which cover a number of stocks.  Overall market direction and time are important elements to consider.

Exchange-Traded Funds (ETFs), Index Shares, Index Trading Stocks: These products act like an index but are traded like a stock and have become very popular since they were introduced by the American Stock Exchange in 1993.  Hundreds of ETFs are available today covering almost every segment of the stock or commodity markets.  These include:

“DIAMONDS”, based on the Dow Jones Industrial Average; QQQQ or “Qubes”, based on the Nasdaq-100 Index; various “SPDRs”, based on components of the S&P 500 Index or on commodities such as gold (GLD).  Pick any market and it’s probably available as an ETF somewhere.

ETF instruments offer traders a number of advantages that have made them very popular in the competition for investor funds, such as:

• Invest in a portfolio of stocks represented by an index with a single transaction in one stock-like instrument.
• Provide diversification of a stock index – one trade buys or sells “the market”.
• Trade short-term or long-term – no time factor, no expiration like futures or options, no penalty fee for getting out before the 6-12 month minimum time period that some mutual funds require.
• Trade continuously throughout the trading day, unlike mutual funds, which can be purchased or redeemed only at the end of the day.
• Margin-able just like stocks.
• Short selling allowed on a downtick any time during the trading session, unlike many common stocks.
• Limit orders can be used to sell or buy at a specific price without having to wait for whatever the close is on a given day.
• Dividends accrue to stocks in the index.
• Move into and out of positions quickly as a proxy for stocks.
• Lower cost than buying multiple stocks in an index.