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Here Be Dragons! An Indian Guide to Investment

Steve Russell
8/14/14

Some people consider the Wall Street Casino too dangerous. I am not one of those people, but there are games in the casino I will not play. I will give my reasons, but the bottom line is that individuals have differing risk tolerances. I cannot deny that lots of people have made money doing the very things I will not do.  It’s also true that people with good intentions will warn you away from Wall Street generally. Risk tolerance is something you must decide for yourself, but if you decide to engage in the practices I shun, be careful.

Day Trading

Whenever you buy a stock, you should have a time horizon, because that will determine whether technical analysis (primarily chart patterns) or fundamental analysis (primarily financial figures of the specific company) should drive your decision. More about time horizons when I discuss picking stocks, but the shortest time horizon belongs to the day traders.

A day trader intends to exit every position he or she has opened that day by the bell (the close of trading) on the same day. One implication of this is that the investment value of the company does not matter. Trades are driven by technical analysis and the objective is to profit by short-term fluctuations in price rather than by discovering value others have overlooked.

Predictable fluctuations in price are most often small.  Therefore, you have to buy and sell very large numbers of shares to make money. A “full lot” is 100 shares. I had been in the market almost two years before I owned a full lot of anything.  A day trader buys and sells by the thousands of shares.

You need a lot of money to day trade effectively.  Each trade is “settled” on the third business day after the order is filled.  You can use money coming to you from a trade to buy another stock before settlement day. However, you cannot sell stock you have just bought before the trade settles. This is called “free-riding,” since it allows you to enter more trades than you have the money to cover.

Under Securities and Exchange Commission (SEC) rules, free-riding (also known as a “good faith violation”) results in a restriction of your account to a cash-only basis for 90 days. You can still trade, but you cannot trade with funds that have not yet settled.

Trading on Margin

The way day traders who are not wealthy commonly avoid good faith violations is by trading on margin.  They borrow money from their broker to cover trades.  They pay interest for this privilege, but the interest rate is normally pretty low because their portfolio is security for whatever they owe.

Using the cash you have to trade in a multiple of the amount you have is called “leverage.”

I believe that the stupidity of borrowing money with which to gamble is self-evident.  However, I do recognize that you can make more money that way.

If a stock you bought on margin goes down in value below what your broker considers safe, you will get a “margin call.”  This means you must immediately deposit cash to cover the trade or sell some other position to cover the trade.

The market periodically goes into a general decline.  These periodic fluctuations are way short of the crashes we call the Great Recession or the Great Depression, but they happen repeatedly and unpredictably. Since a general decline affects most stocks, everybody who is on margin is likely to get a margin call at the same time.  This contributes to the atmosphere of panic that attends a crash.

My friends who trade on margin claim they have never gotten a margin call at a convenient time.  A plethora of margin calls often portends a bear market, and a bear market benefits only traders who are short.

Selling Short

When you sell short, you are selling a stock you do not own but have “borrowed,” through your broker, for the purpose of selling.  You hope to sell high now and buy low later to cover the trade.

If the price of the stock goes down, your profit is the difference between what you got for the stock and how much you must pay later to deliver it.

If the price of the stock goes up, you still have to deliver the stock at the market price when the trade is settled, a process called “covering your short position.”

When you are long, there is no limit to your gains (how far up the stock can go), but your losses are limited to the purchase price of the stock.

The common risk of short-selling is a rise in the stock price while you are in a short position.  Most brokerages have a tool that will tell you what percentage of the “float” (total shares available) has been shorted, and this matters because every short position must be covered eventually, and when lots of short-sellers hit the market at the same time to cover you get a spike in share prices called a “short squeeze.”

The prospect of unlimited losses against limited gains puts short-selling outside my risk tolerance, but I’ve got a philosophical reason to stay long as well.  When you sell short, you are hoping for a business to fail, and anticipating a profit from the shattered dream of the owner and the misfortune of the employees. While there are a few businesses I would like to see fail—say, a White Clay liquor store or a tars sands oil company—I would not be fooling with their stock. I’d rather bet on success.

Options

Sometimes, a gambler will decide belatedly he or she is in too deep.  You can, if you have nerves of steel, “hedge” your long or short position by trading in options, commonly known as “puts” and “calls.”

A put gives the buyer of the option the right – but not the obligation – to sell the optioned stock at a specified price (known as the “strike price”) by a date named in the option (“maturity date”).  Buying a put option protects your long position because the strike price is yours even if the stock becomes worthless.  Buying a put can also be a short bet without the unlimited losses of selling short, because when you buy a put, your loss when the stock declines is limited to the price (“premium”) you paid for the put.

A call gives the buyer of the option the right—but not the obligation—to buy the optioned stock at the strike price by the maturity date. If you sell (“write”) a call, you pocket the price (the “premium”), but if the market price of the stock rises, you must still sell at the strike price, and you lose the difference between the strike price and the market price.  If the market price of the stock falls, the call is said to “expire worthless,” since the stock could be bought on the market for less than the strike price.

Puts and calls are written only on full lots, 100 shares. The ways to interlock puts and calls on the same stock to hedge a position are limited only by your command of algebra and your attention-span.  I am deficient in both, which would make options trading a very risky business for me.  As with so many games in the Wall Street Casino, your mileage may vary.

I confess that I have flirted with selling “covered calls,” meaning call options on stock I own.  There, the risk is of selling a stock I did not intend to sell at a time when the value of that stock is rising more than I anticipated and therefore I don’t like the price.  Call me a wimp.

The games I’ve described can possibly earn money for you if you have enough money to wager and you do so with a lot of skill and a little luck.  For me, the primary attraction of the stock market over my weekly game of recreational poker is the ratio of skill to luck. I prefer skill games.

This column has warned of dragons stalking Wall Street that I consider to be dangerous to your financial health, and I suggest that if you attack a dragon, you damn well better kill it.  While everything above is too dangerous for me to recommend, all of the trades I described are legal.  Next week, we’ll look at a more nefarious class of dragons that are not only dangerous but also illegal.

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Mojo Hand's picture
Mojo Hand
Submitted by Mojo Hand on
Mr. Russell, these are certainly the high risk/gambling aspects of investing. Thanks for highlighting these "dragons" of the investing world. The vast majority of the small investors should NOT be engaged in these investing activities. There are no quick methods to gain wealth, most of us do not have the time to do research and think we can make a quick buck using these methods. Rather, one needs the benefit of time to accumulate wealth, so the younger one starts saving and investing, the better...moreover, I think it's best to buy index ETF's and dollar cost average. Or follow Warren Buffett's philosophy of being a value investor, buying companies that are believed to be undervalued by the market. Don't ever buy a stock in a company which you don't really understand what the product is or what it does....get good blue chip companies, industry leaders, stocks that have a good competitive advantage and offer good dividends and reinvest those dividends to accumulate more shares....you can by pass brokerage firms and buy directly from some companies in a Dividend Reinvestment Plan, aka DRIP. Furthermore, this might not apply anymore since the Great Recession happened, but it's not how much money you earn, but how much you SAVE that will help you acquire wealth. It isn't easy and requires lots of sacrificing of today for tomorrow, but it can be done.
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