Stocks are the cornerstone of any investment portfolio – read all about them.

• What is a stock?
• What are bluechip stocks?
• Stock prices do not represent stock value
• Stock and ETF trading symbols
• How limit orders work.
• How market orders work.
• An explanation of short selling stocks
• Bid and ask prices
• Reverse stock splits

Dividend investing is very popular – read these posts to understand the basics.

• What are stock dividends?
• Should I invest in dividend stocks?
• Dividends – cash or reinvest? – Should you buy more with your dividends in your account or withdraw them as cash?
• Dividend yield – How to calculate it.
• Dividend increases and cuts – Dividends aren’t forever.

All individual stocks are traded on stock exchanges. Whether you own individual stocks, index funds, etfs or mutual funds – these articles are important to read.

• What is a stock market exchange?
• What is a stock market index?
• Different types of stock market indexes
• More information on stock market indexes

Short selling stocks is a method of betting against a stock. You borrow stocks from your broker and sell them a view to buying them back at a lower price. Short sellers hope to profit from market declines, or when a stock is hit with unexpected bad news leading to a tanking of the share price.

The mechanics are rather simple. You borrow the shares from your broker, for which you pay a financing fee, and return them when you them back at a lower price. For example, if you get news that stock XX is suffering from sharply lower customer orders and is currently trading at $50, you can sell 200 shares at $10,000. Two months later, you buy them back at $25.00 and pocket a gross profit of $$5,000, for a hefty 50% return.

Short selling is a short-term strategy that works best when the broader market is in decline. In 2008, any investor who shorted the banks would have done very well. However, this strategy requires monitoring prices closely so as not to be caught out by a reversal of trend. In an improving market, the headwinds are against short selling.

Your profits are limited to what you receive from the short sale, and these profits are subject to income tax, but the prospect for losses are pretty steep as a stock can fall to zero.

The SEC has in July 2009 permanently banned “naked” short selling where the investor looks to cover the stock only after the sale, to stop wild swings and market turbulence. Now the transaction broker has to promptly buy or borrow the stock. Stopping the abuse of short selling is a an announced SEC priority, and it is considering other rules including more public disclosure of short trades.

One of these is the Depression-era uptick rule which prevents short selling until the stock ticks at least 1 cent above the previous trading price.

In a previous post, the “market” order was discussed – if you haven’t done so, please read that post first.

If you want to buy an ETF (exchange traded fund) or a stock online,  it is important to learn about market orders and limit orders.  One of the potential problems with a “market” order is that you don’t have any control of the price.  If the ETF or stock you are trading is thinly traded, then you might get a poor price.

Limit order

A “limit order” takes care of this problem – basically you enter the trade like you would a “market” order but you also enter a “limit” which is the maximum price you are willing to accept.

Buy order limit example

If you want to buy a stock and the last trade was for $50, you might enter an order for 100 shares with a limit of $51.  This ensures that the highest price you will pay for the shares will be $51.  This doesn’t mean you are bidding $51 – the order is still considered a ‘market’ order with a limit so you will get the current price which will hopefully be less than $51.

Sell order limit example

If you want to sell an ETF and the last trade was for $60, you might enter an order for 50 shares with a limit of $59.  The sell limit is the opposite of the buy limit – you are instructing the brokerage to get the best price possible for the shares but don’t accept a price below $59.

No guarantee order will be filled

If you enter a buy “market” order then it is very likely that the order will get filled as long as there is someone else selling the same shares at that time.  If you use a limit – then it is possible the order will never get filled.

Photo by Noodlz55

Stock splits occur when a company decides that their stock price has risen to a level where it is getting harder for investors to buy it in small quantities.  Normally a company will replace 1 of its shares with 2 or more new ones (ie 2 for 1 split).  For example if the stock price of ABC Incorporated is $300 and the company wants to do a 2 for 1 split then each current share will turn into 2 new shares worth half as much or $150.

The important thing to note is that while the number of shares you own goes up, the value of each share goes down so your total investment will remain the same.  Jason Zweig who wrote “Your Money or Your Brain” said very aptly that a stock split is like trading in a dime for two nickels.

Berkshire Hathaway (stock symbol BRK-A) run by Warren Buffet, is a very famous example of a company that has never split its stock.  It currently trades for about $95,000 which makes it next to impossible for most investors to buy even 1 share!  Fortunately there is a cheaper version of Berkshire Hathaway (called the baby Berk) (stock symbol BRK-B) which trades for a mere $3200.

Reverse stock split

The opposite of a stock split is called a reverse stock split.  This is when a company decreases the number of shares and increases the value of each share.  This usually happens when a stock has gone down in price.  If the shares of a company trades at $0.50 then they might do a 10 to 1 reverse split which means that 10 old shares become 1 new share worth $5.00.

Can mutual funds split too?

In theory, mutual funds can split their unit prices, however since investors can buy partial units of mutual funds, there isn’t really any point in doing so.

An exchange traded fund or ETF is an investment that contains the same stocks of a stock market index, in the same proportion as the stock index. If you are thinking this sounds a lot like index funds, you would be correct!

How ETFs are priced

The price of an ETF is determined by the value of the stocks contained in the ETF.  For example Vanguard VTI is an ETF that covers most of the stocks available in the US.  As the price of the underlying stocks change value, the ETF price will also change because investors will bid the ETF shares higher or lower.  Keep in mind that ETFs can hold investment that are not stocks as well, such as bonds.

Differences between ETFs and index funds

One of the key differences between index funds and ETFs is that index funds are priced once a day.  It doesn’t matter what time you put your order in, the price you get will be set at the end of the trading day.  ETFs on the other hand are priced throughout the day in a similar fashion to stocks.  Every time some shares of an ETF are bought and sold, the price might be adjusted.

Another way that ETFs are different from index funds is the costs.  In theory, ETFs have a cheaper management fee than index funds but since you have to buy and sell them like stocks, there will be a trading fee every time you buy or sell an ETF.  Usually with index funds, there are no fees for purchasing or selling them.  Both ETFs and index funds are generally much cheaper than a managed mutual fund.

More information

Should I Buy ETFs Or Index Funds?

If you follow the news regularly then you have probably heard of the “Dow Jones” index and maybe the “S&P 500” index.  Let’s take a look at what a stock market index is and why you should know about them.

An stock market index (or just “index) is a number that measures the relative value of a group of stocks. As the stocks in this group change value, the index also changes value. If an index goes up by 1% then that means the total value of the securities which make up the index have gone up by 1% in value.

The most common indices such as the Dow Jones Industrial Average, are made up of stocks but there are indices of bonds, real estate and others.  Usually the index value is termed “points” – as in “the Dow Jones dropped 500 points today”.  This means that the index went from a value of perhaps 4000 points to a value of 3500 points.  The points don’t mean anything – the best way to look at an index number is to compare it with a previous value such as the previous day’s number.

Example of stock market index

The ABC index is made up of four companies.  As of the end of yesterday’s trading day the ABC index was set at 4,123 points.  Today, two of the companies went up in value, one company dropped in price and the fourth company stayed the same – the total value of those stocks went up by 2% so the ABC index is now 2% higher or 4205 points.

Why are indexes important?

If you invest in mutual funds or individual stocks then it’s important to measure the performance of your investments against a relevant market index.  If your investments consistently lag behind the index then it might be time to come up with a new investing strategy.

I recommend signing up for a free Morningstar membership, which will allow you to research more about stocks and other investments.