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Sunday, May 16, 2004
Good evening friends,
Market Recap
Sometimes you just have to say “heck with it all”, take the day off, and go out and enjoy life. With nothing much happening at all, Friday was just one of those days in the market. The Dow barely squeaked out a two point gain and the NASDAQ was down 21 points, closing just above that support area between 1890 and 1900.
This current sell-off could be interpreted as either
a) a mini bear in the bull market that began in March of 2003, or
b) the resumption of the great bear market, we saw in 2000 -2002.
In case (b), the bull market we saw between March 2003 and Jan 2004 was just a massive bear market counter-trend (mini bull within the great bear market) that may have peaked in January 2004.
I do not know which of those two scenarios we are in at this time. The big three (Dow, NASDAQ, and S&P) are all hovering around their 200 SMAs with only the S&P still above it. If and when the S&P falls below this average and becomes the 3rd of the three to do so, we will be set up for a major collapse in the market. The NASDAQ is in the worst shape of the three and could drop as low as 1650 in this next leg down. In that case, it would be preferable to see a rapid descent causing heavy capitulation selling that washes out many of the weak hands, hopefully resulting in a bottom formed from this type of fear and panic.
However, a much less desirable pattern may unfold, and that is a slow, steady bleeding, slightly down trending market over a period of months that feels like death by slow torture leading to a final capitulation melt-down after months of correction. What I have just described is what took three years to happen in the last bear market that took the NASDAQ down from 5000 to 1100 over that period. That was very painful for investors who did not know they could short the market. Knowing how to short stocks is important so you will never again fear a stock market collapse.
This leads into a topic I want to cover tonight in order to prepare you to be able to profit in case there is a down turn in the market that lasts for quite sometime.
Cash or Margin?
Many questions come up regarding the general use of margin accounts. I have also heard a lot of questions on when using a margin account is acceptable and what sort of rules and guidelines there are around using a margin.
Since we are looking at a potential bear market (and that means loading up on short positions), I thought it would be prudent to discuss margin accounts. You will need to have one if you plan to short sell stocks.
Settlement Periods
Before I get into the specifics, everyone needs to keep “settlement” in mind. When you buy a stock, you do not automatically acquire those shares. It is not like going to the supermarket, buying a gallon of milk, and walking out the door with your purchase. When you buy a stock, there is a settlement period of typically 2-3 day during which time the seller's broker determines that shares were sold. They then debit the sellers account, and credit the shares to your broker. Your broker then credits your account with the shares you purchased.
When you sell a stock, just the reverse happens. Your broker credits your account with the funds generated in the stock transaction and removes the shares from your holdings. The funds are credited to you in the form of “unsettled cash” or “unsettled trade activity”. Once they confirm that the shares no longer belong to you, they transfer those shares to their new owner, the trade is settled and you have the actual cash. You must have all transactions settled in order to have the cash available for new purchases.
Since you must have access to cash in order to trade, this is where the margin account comes into play. A margin account is basically an agreement between you and your broker. It is a revolving credit for the purpose of purchasing stocks. You borrow funds from your broker for a percentage payment, and you gain access to cash to trade with. This way you are no longer restricted by the settlement period. If we get a bear market, it would be very wise to have a margin agreement with your broker.
The Good, the Bad, and the Ugly of Margin Accounts
The Good
The good is obvious: when you want to make a purchase, the cash is available to do so. There is no worry about the settlement period, and you are free to trade as frequently as desired.
The Bad
The bad is often overlooked. You are buying stock with money that you do not have or if shorting, borrowing shares that you do not own. At some point, you will have to pay the money/shares back with an interest payment.
The Ugly
The ugly part is when you borrow money to buy a stock and that stock goes down (or up if you borrowed shares to short). Not only are you looking at a losing trading, but it is on borrowed money/shares. You have to pay back the loan, and you can not sell or cover the stock for what you paid for it. That situation can get ugly fast.
During the internet bubble, there were very loose requirements on margin borrowing. Investors borrowed many times the value of their account. During the internet bust, this wiped out a lot of investors who were on margin. Fortunately, we now have some very strict margin requirements to protect those who would other wise use margin foolishly.
Margin Requirements
The SEC and brokerage firms now require you to have a certain amount of equity in your account to balance the debt load from margin borrowing. The broker requirement is typically called a “house” requirement. The SEC requirement is typically called an “exchange” requirement. When you overextend your buying power, you face a margin call. You can get yourself into this situation by borrowing money and having your positions decline on you, giving you less equity. You typically have 5 days to settle the imbalance within your account. If you fail to do so, your broker will likely take action to cover the balance by selling shares in your account to get you back into a favorable equity position.
In these cases, the brokerage will sell your stocks, and they do not consider making the best selling decisions. Instead, they take the “sell anything at any price” approach, sell however many shares are required to cover your debt.
When we short positions, a margin account is needed, because you are borrowing shares to sell short. You are borrowing something that you do not own, and then selling it. The broker requires you to borrow from them on margin.
When using margin, you must be a very disciplined trader. You can not simply think you have money and start buying every stock you want to own like you would buy a list of items at Wall Mart. If you choose to use margin, you must be extremely cautious. When signing up for a margin account, you will probably read a lengthy description of what it means to trade on margin, and they will have some rather hefty requirements to make sure you do not lose all your money and then some.
Having a margin account can make all the difference in the world when you want to swing trade or short stocks in a declining market. Without margin, you are left on the sidelines during the settlement period. That is not the place you want to be if there is a sudden down draft in the markets. Active traders need margin accounts to be effective.
Bulletin Overview
Tonight we have 29 open positions, 7 long and 22 short. With 5% in each trade, this means we are running on about 50% margin. We could not have this many positions without a margin account. We are over loading on the short side to take maximum advantage of what I believe is a market heading south.
Reminder: One specialty coffee from Starbucks each day costs more than a TWPD subscription (and coffee's not good for you!)
Joke of the Week
There are primarily 3 different types of investors who post on Yahoo message boards:
1) Those who don't know anything
2) Those who don't know much
3) Those who don't know they don't know
As always, thank-you for your support past, present and future! Have a great night everyone; we will see you all Tomorrow evening.
OTC BB Watch List
- None
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