Stock Buying Techniques

Stock Buying Techniques

What are asset management accounts?

What are wrap accounts?

Should you give your broker trading authority?

Protection every stock investor should look for

When should you use margin?

How margin increases your potential risk and return

What's a margin call?

Is short selling for you?

What are asset management accounts?

If you plan to trade actively, you'll probably need to set up an asset management account and leave your stocks in street name

Asset management accounts (AMAs) are interest bearing money market accounts offered by brokerages

Regulatory changes are pushing individuals into opening asset management accounts

AMAs provide check writing and perhaps credit card privileges

The asset management account acts as a liquid place for your interest, dividends and trading proceeds

AMAs can also allow borrowing on margin

AMAs generally have high minimum deposits ($5,000 or more)

Leaving a security in street name means the broker acts as custodian for the shares

• You still own the shares
• Dividends are paid to the broker "swept" into your asset management account

You can also hold the shares in your name

• Dividend checks and proxy statements are sent to you
• You usually hold the stock certificates personally

What are wrap accounts?

Asset management accounts are fairly good products with low fees, but watch out for wrap accounts

In a wrap account, a professional directs your money into various stocks or mutual funds, including no-load mutual funds

The professional's direction may be worthwhile, but is usually overpriced

You'll be charged up to 3 percent of the money under management

Mutual funds purchased directly by you provide everything a wrap account can -- at much lower cost

Should you give your broker trading authority?

By granting you broker trading authority, you allow your broker to buy and sell securities in your account without your express consent

Broker may move you in and out of securities in a favorable manner

Or broker may just churn your account to generate commissions

Traders rarely beat market averages

Give your broker trading authority for convenience (e.g., if you travel a lot) but otherwise think twice about giving your broker this authority

Protection every stock investor should look for

If you do use an asset management account or wrap account, make sure your broker offers SIPC insurance

SIPC stands for Securities Investor's Protection Corporation

Similar to the Federal Deposit Insurance Corp. (FDIC) which protects bank deposits -- with one big difference

The FDIC protects your account against loss of principal

SIPC protection helps to insure that if your broker goes under, you can get the securities that the broker held in your name

The SIPC does not guarantee against losses in principal

SIPC insures accounts to $500,000 or more if additional insurance is provided

When should you use margin?

Margin allows you to borrow money to buy securities like stocks or bonds

The interest you pay is tax deductible to the exent of your investment income

Losses can also be carried forward to future years

Capital gains can count as investment income

For high-income taxpayers, you can not get the favorable capital gains rate and also offset the capital gain income with the interest expense

Brokers like to advise clients to use margin

Many brokers make more money on margin loans than they do on commissions

If buying stock on margin is such a good idea, why aren't the brokers, who should be experts, using margin themselves?

Brokers control the securities in your margin account

Broker can lend your securities to short sellers

How margin increases your potential risk and return

Initial conditions			Stock rises 10 percent		Stock drops 10 percent
Your investment	Margin	Total amount you control with margin	Your total after repaying margin	Return on $100 investment	Your total after repaying margin	Return on $100 investment
$100	$0	$100	$110	10%	90	-10%
100	10	110	111	11	89	-11
100	20	120	112	12	88	-12
100	30	130	113	13	87	-13
100	40	140	114	14	86	-14
100	50 (max)	150	115	15	85	-15

Notes on the above scenario

• Maximum amount you can borrow on stock is 50 percent
• Using 50 percent margin magnifies your potential losses or gains by 50 percent
• The upside and downside risk is magnified symmetrically
• The returns don't reflect the interest you'll pay to use margin

Pointers on using margin

Don't use margin to buy volatile stocks like small company stocks

The upside potential of small stocks bought on margin looks good, but the down side can wipe you out

Margin can be used as a way to avoid capital gains taxes

Say you need to pay a bill and expect some income in a few months

You could sell your stocks and pay your bills, but this would subject yourself to capital gains taxes

Or you could use the stock as collateral and borrow to pay the bill

Repay the margin when you get the income after a few months

But generally, you should avoid using margin

What's a margin call?

Is short selling for you?

Short sellers try to profit from a drop in a security's price

Example

Short seller borrows a security from a broker and sells it for $100

Weeks (or months) later, after security has dropped to $75, short seller purchases security on open market

Seller pockets $25 difference in price

But it's not that simple in practice

Brokers and institutions often don't lend securities for short selling

Interest payments and other technicalities make it different for individuals to sell short