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Using Stocks for Speculation

As I wrote in an earlier article, "Beyond Capital Preservation," there are many ways to use common stocks to try and increase your capital; some very risky and some not so risky. This piece is about some ways a person could conceivably use stocks for speculation purposes. I want to be very clear that I DO NOT, repeat, DO NOT advocate using these kinds of methods, but they're out there and you need to know about them if only to know what sorts of things to avoid.

Commodities:

Now, commodities aren't stocks, so it might seem like I'm getting off track here, so bear with me for a minute. I mention commodities because two or three times a year I get a "cold call" from some guy somewhere who wants me buy and sell gold, or tin, or coffee, or pork bellies, (truly there is such a thing as pork bellies you can buy and sell), promising really amazing returns if only I could see my way clear to open a trading account with him. If I get these calls, lots of other people get them too.

Commodities are things like metals of all kinds, agricultural produce, and other raw or semi-processed materials manufacturers use to produce the finished products we all use every day. The people who make money trading commodities are the companies that broker the trades and a very, very few individuals who trade professionally, do nothing else but trade commodities, and have spent years on the floor of the Chicago Board of Trade learning how to do it successfully. The thing about commodities is that the likelihood of you or me making money trading them is basically nil, zero, won't happen.

Never, ever get involved in commodities trading under any circumstances.

Enough said.

Day Trading:

Day trading is exceedingly time intensive and risky. What day traders try to do is spot trends-either up or down-in a few stocks and then ride the trends for a short time ranging from minutes to a few hours. The goal is to get in and out quickly with a profit, and the hope is that a small profit on many trades will result in a large profit overall. They are called day traders because they tend to close out all their positions by the end of the day since there can be fairly significant, and potentially negative, price changes overnight.

As a day trader, you spend virtually all day every day the markets are open glued to your computer screen monitoring your positions and looking for new opportunities. It's a full time job. Day traders use borrowed money to "leverage" their positions so as to control more stock than they could do with only their own funds and that further amplifies their risk. If the trend they are betting on doesn't materialize, they're on the hook for the borrowed money and one bad trade can easily wipe out their own funds and put them in serious debt.

To attempt this approach to using stocks requires a person to educate him or herself and it's going to be a very expensive education. You would need a ton of "free money," (money you don't need for any other purpose in life), and you're going to lose a lot of that during the year or so it will take you to learn to trade successfully.

So, when you read about or hear pitches about the sky high and quick profits to be made day trading-well, forget it. I don't think day trading is suitable for the average investor because it is too time intensive and the risks are far, far too high.

If you'd like a little more detail about day trading, read the bulletin published by the Securities and Exchange Commission titled, "Day Trading: Your Dollars at Risk," found on the following website. http://www.sec.gov/investor/pubs/daytips.htm

Options:

An option is a contract to buy or sell a specific stock, and they are written in lots of 100 shares. The contract establishes a "strike price" and an expiration date. Options take two forms, puts and calls. A call option entitles you to buy the underlying stock at the strike price any time before the expiration date, and a put option entitles you to sell the underlying stock at the strike price before the expiration date. The expiration date is always the third Friday of every month, and if the option is not exercised before that date, the option no longer exists.

To buy an option you pay what is called a premium and if you don't exercise the option you lose the premium paid. So, for example, if you pay the premium to buy a call option on the stock of Widget Manufacturing Corporation at a specific strike price and the stock price rises above the strike price, you could exercise the option, buy the stock and own 100 shares of the company. At that point you could sell the stock and make a profit which would be the difference between the strike price and the price at which you sold the stock less the premium you paid.

If, on the other hand, you buy a call option on Widget, Inc and the underlying stock decreases below the strike price, you could try and resell the option to another buyer, (and thereby regain a portion of your premium), or simply let the option expire. In the latter case, your loss is limited to the premium you paid for the option.

So, when you buy a call option, you're betting the underlying stock will rise; and when you buy a put option you are betting the stock price will decrease.

Again, this approach to using stocks is study intensive because you have to educate your self about options and how they work, and spend a lot of time learning how to assess the stock of many companies before making a move. It is also time intensive to implement, and potentially very risky. I don't think dealing in options is something the average investor should be doing. There are better ways to grow your money. However, if you want to know more about options, the following website will provide additional details. http://www.888options.com/basics/whatis/default.jsp

Buying Newly Issued Stocks:

When a private company goes public, there is what is called an "initial public offering" (IPO). An investment bank underwrites the offering and stock is then traded on one of the stock exchanges. There are some problems for the average investor involved in buying such stocks.

First of all, you and I probably won't get the opportunity to "get in on the ground floor" because the brokerage house will initially offer the stock to its best, (read well healed,) clients.

Secondly, IPOs have no track record in the markets so you'll have a hard time getting objective information about the company. True, you'll have the company prospectus to read and most will try to be objective, but the prospectus will be written by company staff having a vested interest in presenting a good picture. The fairly recent dotcom bubble illustrates the problem. Investors were bidding up the stocks of new companies that had yet to turn a dollar in sales let alone make a profit. True, a few people made money with the stocks by selling early, but many more people-including professional institutional investors- lost a great deal of money.

Thirdly, in addition to reading the prospectus you will want to spend considerable time analyzing the industry in which the company is doing business in order to understand future prospects of the industry as a whole, the company place in it, and how the company will compete. For example, let's say in 1982 you had a chance to buy stock in an IPO of a company making dazzling new, more compact electric typewriters, would that have been a good idea? No it wouldn't because the whole typewriter industry was doomed by personal computers coming to the market place. On the other hand, had you bought stock in Intel, or Microsoft early on you'd have done rather well for yourself because the then toddler age computer age was about to take off big time.

Overall it is much more prudent to wait until the company you're interested in buying has built a track record, shown some stability, and produced a profit. A good new company will still be a good company in six months or a year from now.

Buying Hot Stocks on Tips:

All of us hear about hot-can't-miss-stocks from time to time at dinner parties, over after work drinks with friends, or while having our morning coffee at Starbucks-(well, I suppose there may be a few Americans that DON'T have morning coffee at Starbucks.) It makes for good conversation, but there are some problems with acting on tips without any other information.

To begin with, do you really want to risk your money on tips from people who don't know any more about the company or the stock than you do? Probably not-hopefully not. With tips, you'll want to consider the source and how well informed the person from whom you're getting the tip is.

Tips will usually be about stocks that are currently "hot" that lots of people are buying like sharks in a feeding frenzy. The fact is that by the time "everyone" hears about the stock and word gets around, profits will already have been wrung from the stock and it is about to drop in price. The feeding frenzy is what makes the stock so hot and it has nothing to do with whether the company is solid or not. The whole thing is like mob psychology in a way.

It's OK to take the tip, but before acting on it you'll want to do some serious study about the company. Otherwise your money will flee your account and "be in the wind" never to be seen again by you.

Buying Long and Selling Short:

When you buy stock "long" you are expecting the stock to rise over time. You own shares in a, hopefully, good company with a solid track record, and you expect to profit from its success-and that is what stock market investing is really about.

You can also sell stock "short" and that's a different story. What happens when you sell short is that you borrow stock from your broker, sell it, and then buy it back hopefully at a lower price. Your profit is the difference between your selling price and buy-back price less commissions. You're betting the stock price will drop. If it does, all is well. However, if the price rises rather than drops, you have to "cover" which is to say you have to make up the difference with your broker. That's not too bad so far, but the real issue is that your loss is potentially unlimited if the price keeps rising, so you'd better watch it like a hawk.

In my view as a self described conservative investor, short selling isn't something I would advocate for most investors.

Conclusion:

The problem I see with all these approaches is that they are all purely a play on price. They can't really be considered investments as such, though their promoters will present them that way, and are more akin to putting your money on a number at the roulette wheel in you local casino. You're making bets that the stock price you're interested in will move in the direction you want it to move, and THAT is nothing if not uncertain. On any given day a stock price has the same odds of dropping as it does of rising; the so called "random walk" you've probably read about.

In my view these methods are basically using your money to try and get a really big payday quickly—looking for the "pot at the end of the rainbow". The pot is there, and you can most assuredly find it through making real investment rather than gambling, if you are willing to put in time, effort, planning, and patience.

arley