Many investors take a long-term approach to the stock market, buying stock in companies they believe will succeed and grow, and holding on to that stock for long periods of time. This “buy and hold” is a classic approach, both because of its historic rate of success, and the fact that it doesn’t require constant attention on the part of the investor. Because you’re not going to sell the stock the minute it dips below a certain price, you really don’t have to worry too much about it. It’s good, of course, to be aware of what your stock is doing, but you won’t need to spend hours a day fretting about what your next move should be.

Other investors, however, delight in playing with their stock. They sell it in order to buy it back, buy it back at a lower price, and employ other tricks and techniques with hopes of generating bigger gains than they could by buying and holding the stock. In this chapter, we’ll have a look at some of those tricks, and learn about their advantages and potential disadvantages.

This is a book written for beginning stock investors, and its content is kept intentionally simple in order to be understandable. You can buy entire books on each of the trading techniques discussed in this chapter, some of which are included in Appendix B. Our intent is to introduce you to concepts such as buying on margin and shorting a sale so that you understand the terms and how they relate to the stock market. If you think you want to employ any of the techniques discussed, you’ll need to acquire more information before doing so.

Having said that, learning your way around the stock market is fun, and pulling off a well-executed trade is an accomplishment you can be proud of. Investors do this all the time by using some techniques that allow them to maximize their money in order to acquire more stock, or to acquire stock at a more advantageous price.

Buying on margin is a strategy that enables certain investors to buy stock with borrowed money in order to increase the amount invested. It’s an especially useful technique for conservative investors who, while generally risk adverse, are willing to put a portion of their money into aggressive growth investments. An investor leverages his or her current portfolio for potential greater returns.

The point of buying on margin is that it allows you to buy more stock than you otherwise could. To buy on margin, you need to have a margin account established with your brokerage. When you set up an initial account with a broker, it would most likely be a cash account. Cash accounts are the most common type of brokerage account. With a cash account, when you buy stock you deposit the cost of the stock into the account. This has to be done within two days of purchase.

A margin account, on the other hand, requires that you make an initial investment of at least $2,000—and some brokerages set a higher initial investment. This investment is known as the minimum margin. After you trade, you’ll also need to keep a specified amount of money in your account. That’s called a maintenance margin, and the amount varies from broker to broker.

You’ll need to fill out an application to set up a margin account, which may require a credit check and reviews of your investment objectives and personal circumstances. Not everyone who thinks they’d like to buy on margin is approved for an account.

Once you’ve applied and the margin account is approved and set up, you’re permitted to borrow up to 50 percent of the cost of the stock you purchase. If you want to buy $4,000 worth of stock, you only need to come up with $2,000, and your brokerage will float you a loan to cover the other $2,000. This enables you to get twice as much stock, and doubles your returns.

It’s important to understand that when using a margin account, you don’t have to borrow 50 percent of the cost of the stock. You can borrow just 10 or 20 or 30 percent if you want. Some brokerages have rules stipulating that you need to borrow at least a certain percentage, however, so if you decide to set up this type of account, be sure that you understand all of the terms and requirements.

As long as you hold up your end of the deal, you can keep the money you’ve borrowed for as long as you wish. When you sell stock held in a margin account, the proceeds lower the margin balance until your loan is paid off. You also need to maintain a minimum account balance. You can then purchase new stock, as long as you haven’t exceeded the margin limit.

Now that you know what a margin account is, let’s look at how investors use them to increase their returns and capitalize on the stock market.

The beauty of buying stock on margin is that you can get twice as much stock as you could with a cash account, and the possibility of greater returns. Let’s look at an example.

Gretchen and her friend Leah decide they want to buy the same stock. The stock is for sale for $20 per share, and they each buy 100 shares. Gretchen, using a cash account, hands over $2,000 for her 100 shares of stock. Leah buys on margin, borrowing $1,000 from her broker and coming up with the other $1,000 on her own.

Gretchen and Leah are thrilled when their stock appreciates in value to $25 a share, and they decide to sell and each collect her $500 profit. So what was the advantage of buying on margin if both Gretchen and Leah realized a $500 gain?

Gretchen realized a $500 profit on a $2,000 investment. That’s a 25 percent return, and that’s great. Gretchen should definitely celebrate. Her party, however, will be much shorter than Leah’s, who has just realized a 50 percent return on her investment of $1,000.

By buying her stock on margin and paying only half the cost of the stock, Leah doubled her return on each dollar she invested. The $1,000 she didn’t have to pay for the stock could have been put to work elsewhere, perhaps also resulting in high returns, or she could have bought twice as many shares as Gretchen did for the same price.

Of course (you knew this was coming, right?), we’re talking about the stock market, and as you’ve read numerous times already, where there is potential for gain, there is also potential for loss.

When you receive a loan, the lender usually expects to be rewarded for his generosity. The reward is normally paid in the form of interest, which is the case with margin accounts. For as long as you keep the loan, interest is charged to your account. If you don’t pay off the loan, these interest charges add up and your debt level increases. As your debt level increases, the interest does, too.

Margin interest is floating and different for every broker. Interest is usually charged bi-weekly, directly from your brokerage account. You won’t see a bill; the charges just keep on happening until the loan is paid in full.

If circumstances don’t allow you to pay off the loan, charges continue to grow, meaning that you’ll need a big return on your investment just to break even. Generally, investors use margin accounts to buy stock they don’t plan to hold for a long time for this reason. The longer it’s held, the greater the return must be to pay off the loan and fees.

If the value of your stock falls below your maintenance margin (the minimum amount required that you maintain in your account), your broker issues a margin call. That means you either need to add more cash to the account or sell some stock or other investment in your brokerage account. You’ll be required to meet the call within a very short specified amount of time. If you don’t, your broker is entitled to sell your stock in order to increase your account equity until it’s greater than your maintenance margin.

Now, think back to the story about Gretchen and Leah. Remember how Leah’s return was 50 percent on her investment, while Gretchen’s was half of that? That was because Gretchen had invested twice as much money as Leah, and they both earned $500.

Well, what happens if instead of realizing a $500 gain they had realized a $500 loss? Gretchen would have been upset to lose 25 percent of her investment, but not nearly as upset as Leah, who would have lost 50 percent of her investment. The big danger of buying on margin is that, in the case of a dramatic downturn of a stock, you actually lose more money than you originally invested. And you’ll still owe the interest and commissions generated.

So to sum it up, while some investors swear by margin buys, particularly in up markets, they are best left to those with experience and nerves of steel. It’s better to start out with a cash account until you’re a more seasoned investor.

Another strategy often employed by investors is shorting a stock, or selling short. This is when an investor sells a stock he doesn’t even own, anticipating that he’ll be able to sell it, then buy it back at a lower price and make a profit. Sounds weird, doesn’t it? That’s because shorting is counterintuitive to the tried-and-true method of buying a stock at a low price and holding it until you can sell it at a higher price. And, you may ask, how can you sell a stock that you don’t even own?

When you short a stock you don’t own, you actually borrow a certain number of shares from your broker, again, through a margin account. These shares are sold, and the money generated is credited to your account. Remember, though, that you still owe your broker the same number of shares that you borrowed.

Normally, there’s no time limit on how long you can hold a short, though you need to settle the shares for settlement by three days. Remember, however, that you’ll be paying interest because the sale of the stock occurred in a margin account.

So you now have in your account the proceeds from the sale of stock you’ve borrowed from your broker. Let’s say you borrowed 100 shares of stock and sold them for $30 a share. That means you’re holding $3,000 in your account, less commissions and interest.

Sooner or later, though, you’ll need to buy back the 100 shares of stock so you can return it to your broker. Investors who short stock are betting that its value is going to decline, and that they’re going to be able to buy the stock back at a lower price than for what it was sold. If that happens, and you buy back the 100 shares of stock that sold for $30 a share for $20 a share, you get to keep the $10 per share difference. So you buy back the stock, return it to your broker, and pocket your $1,000 profit, less interest. Remember, though, that the broker’s fees and interest payments will be deducted.

While some investors have profited nicely from selling short, there are some definite risks. The first risk, of course, is that the value of the stock won’t drop, but it will increase in value. If the increase is substantial enough, you could risk losing all of the money realized from the sale of the stock, and more.

And as with trading on margin, you’ll be required to keep a minimum maintenance requirement in your account. If the maintenance account drops below the minimum required, your broker can issue a margin call, and you will need to come up with more cash or additional securities. If you can’t, your stock can be sold. Some investors place stop-limit orders to close out their positions in the event that a stock appreciates beyond a certain point in order to minimize the chances of that occurring.

Investors should also be aware of the dangers of a “short squeeze,” which happens when there is a much greater demand for a stock than there is supply. When this occurs, traders with short positions might be forced to liquidate and cover their position by buying the in-demand stock in order to cut their losses. That can cause the price of the stock to go even higher.

As with buying on margin, selling short is tricky business and best left to experienced investors. The risks we’ve described are not the only ones associated with shorting, and, as mentioned earlier in this chapter, you can buy entire books on selling short. If you are tempted to engage in shorting, you’ll need to do much more in-depth research to educate yourself about the potential benefits and risks.

Some investors, usually very active traders who are willing to pull out all the stops in order to buy low and sell high, trade stock based on market timing, which is a strategy that attempts to predict the direction in which the market will move. Market timers believe that if you look long and hard enough, an investor can always find a market that’s on the rise or falling, and use those movements to his advantage.

Most investors who employ market timing base their predictions on technical analysis, although others rely on daily movements, multiyear cycles, or other economic data.

Advocates of market timing claim that investors can significantly increase their returns by getting in and out of markets as they rise and fall. While it’s smart to be in the market when it is rising, it’s safer to get out of the market when things start to look bearish.

Critics of market timing (and there are many) will tell you that successfully timing the market is next to impossible, especially if you attempt to do so over a long period of time. Historically, the market has always recovered and achieved new highs, meaning that if you’re patient you can be successful in the stock market without constantly monitoring and fretting about it.

There are no sure bets in the stock market. Or maybe it’s more accurate to say that the only sure bet is that there will be ups and downs, and periods in which you and your portfolio will fare better than others.

You read about stop orders and stop-limit orders in Chapter 16. They are orders to sell stock that has dropped to a specified price. This, of course, is done to limit the amount of loss you’ll experience. It also establishes guidelines that leave you out of the decision-making process. That’s a plus because it lessens the risk of you rethinking the limit or becoming emotional about a loss.

There are different types of stop orders, but all are intended to minimize your losses. A stop order can apply to just one stock, or you can have a loss limit system in place that allows you to limit losses on your total assets by stopping trading altogether, or by exiting a losing position without second-guessing yourself or being tempted to wait until things turn around. Let’s look at a few other methods of limiting loss in the stock market and keeping your portfolio healthy.

Keeping up with what’s happening in the stock market is the first step to limiting losses. If you can’t keep an eye on your portfolio because of an extended vacation, illness, or other reason, you should definitely have stop orders in place in case values fall significantly.

Broker triggers, which are simply messages your broker shoots out when something newsworthy is happening in the stock market or within a particular business or industry, can help you be proactive with your stock. You may be able to customize your broker’s trigger system to only receive alerts regarding the stock in which you’re interested. You can receive alerts on your e-mail or phone.

Also, with a signup, websites like Bloomberg, The Wall Street Journal, or MarketWatch will send you market alerts that keep you up to date with breaking news and allow you to manage your portfolio in a proactive manner.

Another means of limiting losses is by hedging your bets. You’ll hear people talk about hedging their bets in a variety of circumstances other than the stock market, but hedging applies to stock trading as well.

Generally speaking, hedging can be thought of as insurance. It doesn’t stop a loss from occurring, but it reduces resulting damages. If you buy car insurance, for instance, you’re hedging your bets in the event you get in an accident or your car is stolen or otherwise damaged. The damage is done, but your losses are limited because the insurance company will pay (or at least partially pay) for repairs or replacement of the vehicle.

For investors, hedging usually involves investing in two stocks that have negative correlations. By doing so, you offset the risk of unfavorable price movements by hedging one investment against the other. Hedging is usually accomplished with the use of complex financial instruments such as options and futures, both of which are derivatives. Entire books have been written about hedging, and it’s a particularly complicated topic for beginning investors. Having an idea of what it entails, however, will increase your overall knowledge of investing, which is always a good thing.

Employing trading strategies and attempting to limit losses are smart moves for investors, and you should learn as much about these things as you can and decide what is applicable to you and your stock portfolio.

Understand, however, that no one can be successful in the market 100 percent of the time, because the market is unpredictable and subject to unexpected twists and turns that are caused by circumstances completely out of your control.

So set your financial goals, do your homework, invest wisely, learn all you can, and employ trading strategies when it makes sense to do so, realizing that despite all your best efforts, there will be rough spots along the road of stock investing.

The Least You Need to Know