Term of the Day

Trailing Stop

A Trailing stop order that can be set at a defined percentage away from a security’s current market price. A trailing stop for a long position would be set below the security’s current market price; for a short position, it would be set above the current price. A trailing stop is designed to protect gains by enabling a trade to remain open and continue to profit as long as the price is moving in the right direction, but closing the trade if the price changes direction by a specified percentage. A trailing stop can also specify a dollar amount instead of a percentage. Also known as a “chandelier stop.”

The trailing stop is more flexible than a fixed stop loss, since it automatically tracks the stock’s price direction and does not have to be manually reset like the fixed stop loss. Like all stop orders, the trailing stop enforces trading discipline by taking the emotion out of the “sell” decision, thus enabling traders and investors to protect profits and investment capital.

The following example illustrates how a trailing stop works. Assume you purchased a stock at $10. You could place a 15% trailing stop order (good ’til canceled or GTC) on it right away to protect your principal. This means that if the stock declines by 15% or more, the trailing stop will be triggered, thereby capping your loss. Suppose the stock moves up to $14 over the next few months, and while you have enjoyed its appreciation, you are a little concerned that it could retrace its gains. Recall that your GTC trailing stop is still in place, so if the stock plunges 15% or more tomorrow, it would be triggered. You decide to tighten the trailing stop to 10% to protect as much profit as you can, while still giving the trading position room to run.

Let’s assume the stock moves up further to $15, and subsequently declines 10% to $13.50. The 10% price drop would trigger your trailing stop, and assuming you were “filled” at $13.50, the gain on your long position would be 35% (i.e. the difference between $10 and $13.50).

Note that if the stock drifts down in up-and-down fashion, with single-digit declines every other day, the trailing stop would not be triggered since you have set it at 10%. The key is to set the trailing stop percentage at a level that is neither too tight (to prevent the trade being stopped before it has a chance to work) nor too wide (which if triggered, may result in leaving too much money on the table).

Stock Split

All publicly-traded companies have a set number of shares that are outstanding on the stock market. A stock split is a decision by the company’s board of directors to increase the number of shares that are outstanding by issuing more shares to current shareholders. For example, in a 2-for-1 stock split, an additional share is given for each share held by a shareholder. So, if a company had 10 million shares outstanding before the split, it will have 20 million shares outstanding after a 2-for-1 split.

A stock’s price is also affected by a stock split. After a split, the stock price will be reduced since the number of shares outstanding has increased. In the example of a 2-for-1 split, the share price will be halved. Thus, although the number of outstanding shares and the price change, the market capitalization remains constant.

A stock split is usually done by companies that have seen their share price increase to levels that are either too high or are beyond the price levels of similar companies in their sector. The primary motive is to make shares seem more affordable to small investors even though the underlying value of the company has not changed.

A stock split can also result in a stock price increase following the decrease immediately after the split. Since many small investors think the stock is now more affordable and buy the stock, they end up boosting demand and drive up prices. Another reason for the price increase is that a stock split provides a signal to the market that the company’s share price has been increasing and people assume this growth will continue in the future, and again, lift demand and prices. In June 2014, Apple Inc. (AAPL) split its shares 7-for-1 to make it more accessible to a larger number of investors. Right before the split, each share was trading at $645.57 and after the split, the price per share at market open was $92.70, which is approximately 645.57 ÷ 7. Existing shareholders were also given six additional shares for each share owned, so an investor who owned 1,000 shares of AAPL pre-split will have 7,000 shares post-split. Apple’s outstanding shares increased from 861 million to 6 billion shares, however, the market cap remained largely unchanged at $556 billion. The day after the stock split, the price had increased to a high of $95.05 to reflect the increased demand from the lower stock price.

Another version of a stock split is the reverse split. This procedure is typically used by companies with low share prices that would like to increase these prices to either gain more respectability in the market or to prevent the company from being delisted (many stock exchanges will delist stocks if they fall below a certain price per share). For example, in a reverse 1-for-5 split, 10 million outstanding shares at 50 cents each would now become two million shares outstanding at $2.50 per share. In both cases, the company is still worth $5 million. In May 2011, in an effort to reduce its share volatility and discourage speculator trading, Citigroup (C) reversed split its shares 1-for-10. The reverse stock split increased its share price from $4.52 pre-split to $45.12 post-split and every ten shares held by an investor was replaced with one share. While the split reduced the number of its shares outstanding from 29 billion to 2.9 billion shares, the market cap of the company stayed the same at approximately $131 billion.

The bottom line is a stock split is used primarily by companies that have seen their share prices increase substantially and although the number of outstanding shares increases and price per share decreases, the market capitalization (and the value of the company) does not change. As a result, stock splits help make shares more affordable to small investors and provides greater marketability and liquidity in the market.

 

‘Animal Spirits’

A term used by John Maynard Keynes used in one of his economics books. In his 1936 publication, “The General Theory of Employment, Interest and Money,” the term “animal spirits” is used to describe human emotion that drives consumer confidence. According to Keynes, animal spirits also generate human trust.

There has been a resurgence of interest in the idea of animal spirits in recent years. Several books and articles have been published on this topic. Keynes believed that animal spirits were necessary to motivate people to take positive action.

 

Super Bowl Indicator

An indicator based on the belief that a Super Bowl win for a team from the American Football Conference (AFC) foretells a decline in the stock market for the coming year, and a win for a team from the National Football Conference (NFC), or the old National Football League (NFL) before the merger of NFL and American Football League (AFL) in 1966, means the stock market will be up for the year. The Super Bowl indicator was first introduced in 1978 by Leonard Koppett, a sportswriter for The New York Times.

This year playing we have the New England Patriots from the AFC and the Atlanta Falcons from the NFC.

Though historically speaking the Super Bowl indicator boasts an 80% accuracy rate. However, the last 10 years the indicator was right 6 times and wrong 4. Remember the old maxim: correlation does not imply causation. In 2008, despite the New York Giants (NFC) winning the Super Bowl (indicating a Bull Market), the stock market suffered one of the largest downturns since the Great Depression. Though the indicator is an interesting take on predicting the stock market, by no means should the correlation dictate your investment or trading decisions.

Enjoy the game! And the coming year in the market.

 

NAFTA

What is the North American Free Trade Agreement? A regulation implemented January 1, 1994 in Mexico, Canada and the United States to eliminate most tariffs on trade between these nations. The three countries phased out numerous tariffs, (with a particular focus on those related to agriculture, textiles and automobiles), between the agreement’s implementation and January 1, 2008. NAFTA’s purpose is to encourage economic activity between the United States, Mexico and Canada.

About one-fourth of U.S. imports, (especially crude oil, machinery, gold, vehicles, fresh produce, livestock and processed foods), comes from Canada and Mexico, which are the United States’ second- and third-largest suppliers of imported goods. In addition, about one-third of U.S. exports, particularly machinery, vehicle parts, mineral fuel and oil, and plastics are destined for Canada and Mexico.

The Clinton administration, which signed the law that was developed under the George H. W. Bush administration, believed NAFTA would create 200,000 American jobs within two years and 1 million within five years because exports played a major role in U.S. economic growth. They anticipated a dramatic increase in U.S. imports to Mexico under the lower tariffs. Critics, however, were concerned that NAFTA would move U.S. jobs to Mexico. While the United States, Canada and Mexico have all experienced economic growth, higher wages and increased trade with each other since NAFTA’s implementation, experts disagree on how much NAFTA contributed to these gains, if at all.

NAFTA was supplemented by the North American Agreement on Environmental Cooperation (NAAEC) and the North American Agreement on Labor Cooperation (NAALC). These side agreements were intended to prevent businesses from relocating to take advantage of lower wages, more lenient laws about worker health and safety, and less strict environmental laws.

NAFTA did not eliminate regulatory requirements on companies wishing to trade internationally, such as rule of origin regulations and paperwork requirements that determine whether a good can be traded under NAFTA. The free trade agreement also contains administrative, civil and criminal penalties for businesses that violate any of the three countries’ laws or customs procedures.

 

Limit Order

A limit order is a take-profit order placed with a bank or brokerage to buy or sell a set amount of a financial instrument at a specified price or better; because a limit order is not a market order, it may not be executed if the price set by the investor cannot be met during the period of time in which the order is left open. Limit orders also allow an investor to limit the length of time an order can be outstanding before being canceled.
While the execution of a limit order is not guaranteed, it does ensure that the investor does not miss the opportunity to buy or sell at the target price point if it is dealt in the market. Depending on the direction of the position, a limit order is sometimes referred to as a buy limit order or a sell limit order. For example, a buy limit order that stipulates the buyer is not willing to pay more than $30 per share, while a sell limit order may require the share price to be at least $30 for the sale

 

Market Order

An investor makes a market order through a broker or brokerage service to buy or sell an investment immediately at the best available current price. A market order is the default option and is likely to be executed because it does not contain restrictions on the price or the time frame in which the order can be executed. A market order is also sometimes referred to as an unrestricted order.
A market order guarantees execution, and it often has low commissions due to the minimal work brokers need to do. Avoid using market orders on stocks with a low average daily volume. These stocks usually have large spreads and result in large amounts of slippage when executing trades at the market price.