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Wouldn’t it be great if you could improve your investment returns by owning securities when prices are increasing and selling them before they crash? If you learn how to read stock charts, you might have a chance at doing so.
People take many different strategies for investing in stocks. I rely on a mix of investments in mutual funds, exchange-traded funds (ETFs), and individual stocks. When I buy the last of these, I rely primarily on fundamental analysis, as discussed by Milan Kovacevic in his post, “How to Start Investing in 2021: A Complete Guide.”
Milan suggests investing for the long term, a strategy I generally embrace. To do this, I use the strategies set forth by Peter Lynch, described in my review of his book “One Up on Wall Street,” and my ability to read financial statements. Technical analysis or reading stock charts has always intrigued me. If I could use stock charts to help me sell a stock before the price falls too much or at least not buy it until it has hit its low price, it seems to me that the value of my portfolio would be higher than my current strategy of buying stocks and holding them forever.
In this post, I will teach you how to read stock charts. I then provide illustrations of how to interpret them using several commonly used technical analysis tools. To bring these techniques to life, I use a real-life example. The example is a stock I’ve owned for almost 30 years. I’ll close with a summary of the pros and cons of using stock market charts as part of your investing strategy.
Basic Stock Chart
There are two stock chart components – prices and volume.
Here is a price chart for Boeing for the first two and a half months of 2021.
The dates are on the x or horizontal axis moving from January 1, 2021, on the left, through March 12, 2021, on the right. The price is represented on the vertical- or y-axis. For each trading day, there is a box that often has whiskers above and below it. The color of the box tells you whether the stock price moved up (green) or down (red) that day.
On green days, the bottom of the box is the opening price. The opening price corresponds to the price of the first trade of the day. The top of the box is the closing price or the price of the last trade of the day.
On red days, the bottom of the box is the closing price and the top of the box is the opening price. That is, the opening and closing prices switch places on red days as compared to green days. Of course, this switch makes sense when we think about the meaning of the colors. On a green day, the stock price went up, so the opening price is lower than the closing price. On a red day, the stock price went down, so the opening price is higher than the closing price.
Regardless of the color of the box, the whiskers correspond to the highest and lowest prices of the day. If the highest price is equal to the opening or closing price on a particular day, there will be no whisker sticking out of the top of the box. Similarly, if the lowest price is equal to the opening or closing price, there will be no whisker sticking out of the bottom of the box.
Volume refers to the number of shares of the stock that were traded each day. The chart below shows the volume chart for Boeing for the same time period.
The x-axis is the same in this chart as in the price chart. The dates range from January 1, 2020, to March 12, 2021, going from left to right. The y-axis represents the number of Boeing shares traded each day. As with the price chart, the bars are color-coded. Green bars correspond to days on which the stock price increased; red bars, days the stock price decreased.
In these illustrations, I’ve used calendar days for the x-axes, so there are gaps on weekends. Many stock charts skip the weekends, so won’t have gaps.
Uses of Stock Charts
Support and Resistance Levels
A simple tool used by technical analysts in deciding when to buy or sell a stock is the combination of support and resistance levels.
When a stock has been volatile or decreasing in price, it sometimes drops to approximately the same price two or more times and then starts increasing. That price is called a support level.
The chart below shows Boeing’s adjusted stock prices from January 2002 through December 2004. To make the illustrations throughout this post comparable, I have adjusted all of the prices and volumes for stock splits and dividends, as calculated by Yahoo Finance. To make the discussion easier to read, I will not include the word “adjusted” when referring to prices or volumes.
The blue line in March 2003 shows a support level. On March 12, 2003, Boeing’s stock price hit a low of $16.77. About three weeks later, on March 31, 2003, the low was $16.85, or almost the same as the low on March 12. In between, the price went up to a high of $19.27.
In this case, the support level also corresponded to a turning point when the stock went from a decreasing trend to an increasing one. If you had been looking to purchase Boeing stock in this time frame and used this indicator, you would have benefited from the long run of increasing prices in the two subsequent years.
A resistance level is the opposite of a support level. Rather than looking at two low prices that are about the same, a resistance level is a price a stock hits more than once but doesn’t exceed. Boeing’s stock price hits a resistance level in late 2000 and early 2001 in the chart below.
On December 8, 2000, Boeing hit a high price of $46.35. Five months later, on May 22, 2001, Boeing’s high was $45.30. After that, it decreased significantly until late October 2001. Interestingly, anyone who had used this resistance level as a sell indicator would not have owned Boeing stock around September 11, 2001. They would have avoided the almost 50% decrease in the stock price. Of course, that timing would have been fortuitous as the presence of the resistance level early in 2001 was not predictive of the events of September 11.
For more information on support and resistance levels, I suggest this article from Investopedia.
Bollinger bands are a refinement of support and resistance levels. They take into account recent trends and volatility in the stock price. The chart below adds Bollinger bands to the Boeing stock price chart from January 1, 2000, to early 2002.
Explanation of Bollinger Bands
This chart looks a lot like the one above that I used to illustrate resistance levels. In addition to the boxes with whiskers, there are two blue lines. The blue lines are centered around the average price for the previous 20 trading days. The lines themselves are drawn above and below that average price. The distance above and below the price is equal to two times the standard deviation of the price in the past 20 days.
Between January and July 2000, you can see that the spread between the bands is fairly stable. The stock price didn’t take any relatively large jumps in either direction. Now compare the spread between the lines in this part of the chart with the spread from August to October 2001. The large price drop in August and September 2001 increased the standard deviation which, in turn, increased the spread between the lines.
Interpreting Bollinger Bands
There are many ways that Bollinger bands are used to identify trends in stock prices. Briefly, three of them are:
- Double Bottom
- Three Pushes to High
- Classic M Top
The chart below illustrates these tools.
The Double Bottom is similar to the support level discussed above. Instead of looking for a single price below which the price doesn’t fall, prices are compared to the bottom Bollinger band. This concept is illustrated by the three green arrows in the spring of 2000 in the chart above. Had the prices fallen much below the bottom Bollinger band, it would be indicated a further decline in the price.
Three Pushes to High
The three red arrows in late 2000 identify an example of Three Pushes to High. This concept is similar to the resistance level discussed above. It differs, though, in that technical analysts look for three touches instead of two. Also, the price is compared to the top Bollinger band instead of a constant level. Three Pushes to High without the price exceeding the top Bollinger band can be an indication that the price might go down. Three Pushes to High, with the third one continuing above the line, indicates optimism about the stock price.
Classic M Top
The red circle in June 2001 identifies a Classic M Top. A Classic M Top is even closer to the resistance level concept than Three Pushes to High in that it looks for the price to touch or approach the upper Bollinger bands only twice. Note that, as in this case, the second peak does not need to reach the top Bollinger band. As with the resistance level, a Classic M Top is used as an indicator that the stock price will, at a minimum, not increase by much in the near term and may decrease.
Other Bollinger Band Tools
For more information on these tools and others, I suggest starting with this article from Schwab.
Some technical analysts look at how the stock price has moved compared to averages of its recent prices. I interviewed a technical analyst in this post who uses the following tests to inform his buy and sell decisions:
- Buy signals are identified by the stock price line going up through the line corresponding to the average of the prices for the previous 180 days. The average of a series of numbers is known as a simple moving average and, in this case, is often referenced as SMA 180.
- Sell signals are identified by the average of the prices for the previous nine days falls below the average for the previous 180 days. That is, the SMA 9 line crosses below the SMA 180 line.
Reading the Chart
The chart below shows the Boeing stock price and the nine- and 180-day moving averages.
The black line shows the closing stock price on each day from January 1, 2002, through the middle of 2006. The pink line is the average of the closing price for the previous nine days. As you can see, it follows the closing price fairly closely. The blue line is the average of the closing price for the previous 180 days. It follows the trends of the closing prices much more slowly. And, because there are more values in the average, is much smoother.
Interpreting the Chart
This stock chart shows the same information with four circles added
The two green circles show where the stock price (black line) goes up through the SMA 180 (blue) line. These crossover points are buy signals.
The two red circles show where the SMA 9 (pink) line crosses below the SMA 180 (blue) line. These crossover points are sell signals.
If we assume that it takes you until the day after the crossovers to initiate your transactions and you do so at the opening price, you would have made the following transactions during this period:
- Buy at $29.13 on 4/30/02
- Sell at $27.30 on 7/18/02 for a $1.83 per share loss
- Buy at $20.73 on 5/29/03
- Sell at $55.42 on 8/23/06 for a $34.69 per share gain
So far, all of the technical analysis tools I’ve discussed have focused on price movements. Some analysts also look at how the volume changes in conjunction with prices. Here are two components of volume that some technical analysts consider.
- Relative volume at turning points.
- The trend in volume as prices continue in one direction or the other.
I’ll again use Boeing’s stock charts, this time from 2006 through 2010, to illustrate these points.
High Volume at Turning Point
Boeing’s stock price hit a turning point in late 2008, at about $80. When it turned from its upward trend to its downward trend, the volume was very high relative to the average daily volume as indicated by the very tall red bar on the volume chart. This relatively high volume at the turning point is often used as an indicator that the trend in prices will turn. This indicator can happen in either direction. That is, a green bar that stands out as being really tall can be indicative of a turn from decreasing to increasing stock prices.
The second indicator is the trend in volume when the stock prices are going in one direction or the other. In this example, the stock price decreases fairly steadily from late 2007 to late 2008. I’ve marked that trend with a red downward arrow on the stock price portion of the chart. At the same time, the volume is generally increasing. I’ve added a red arrow on the volume portion of the chart. An increase in volume, when the stock price is moving consistently in one direction or the other, is often used as an indicator that the stock price will continue to move in the same direction. In this example, you can see that the volume was much lower starting in late 2008 at the same time that the stock price flattened. For more details about this second indicator, you might check this article from Schwab.
To help understand the pros and cons of these techniques, I’ve tested them on Boeing’s stock prices during two periods of particular price disruptions – July 21 through September 24, 2001, and February 13 through May 15, 2020. The chart below shows the Boeing stock prices since 1995. These two disruptions, shown in the blue circles, are quite visible with the benefit of hindsight. The first time period doesn’t look as dramatic because of the significant rise in the stock price since 2001. However, the stock price decreased by 49% in a short period of time in 2001, not quite as large as the decrease in early 2020 of 67%.
As noted above, I am a long-term fundamental investor. However, I am always interested in learning about techniques that might help me avoid significant decreases in the value of individual stocks in my portfolio. To evaluate these techniques, I’ll assume I bought 100 shares of Boeing stock at the adjusted opening price of $10.62 on January 4, 1992. Those shares would have cost me $1,062. If I had done that and still held the same shares on March 12, 2021, they would be worth $25,386.
Let’s look at whether any of the price-based techniques discussed above would have helped increase the value of my Boeing position. I did not use the volume indicator in this comparison, as it tends to be better used to confirm trends rather than to identify turning points.
Support and Resistance Levels
The chart below shows Boeing’s stock prices around the large price drop in 2001.
As indicated by the blue line, this stock chart shows a pretty clear resistance level at the top in late 2000 and early 2001. If I assume it took me 5 days to recognize the Double Top, I would have sold the stock at $336. There was no Double Bottom, though, so I wouldn’t have repurchased it.
The chart below shows Boeing’s stock prices around the time of the 2020 decrease. In this case, there isn’t a clear support or resistance level, so I wouldn’t have made any transactions.
If I had used this approach, I would have sold my 100 shares at $336 in 2001 and had $33,600 to invest elsewhere. Even if I hadn’t reinvested, I would have had more money using this technique than the buy-and-hold strategy I used.
Other Applications of Support and Resistance Levels
As an aside, I have used support and resistance levels as a trading tool in a different way. Sometimes a stock price goes up and down between a support level and a resistance level. When I had time and money to risk, I took advantage of this pattern with two different stocks. In both cases, the stock price moved up and down within a range of $10 (e.g., between $80 and $90) several times over the course of six months. Every time the price got to the top of the range, I’d sell it. When it got to the bottom of the range, I’d buy the stock. In each case, I was able to buy and sell the stocks three or four times, giving me a $10 per share gain each round trip.
The chart below shows Boeing’s stock price, including the Bollinger bands, around the large price drop in 2001.
The Bollinger bands indicated sales in late 2000, early in 2001, in late May 2001, and then again in August 2001, with buy indicators in between. Because we are focusing on the large price drop from July 21 through September 24, I’ll just focus on the bands around that time period. The Bollinger bands indicated a sell around May 31 when the price was about $42 a share, as indicated by the first orange circle. They then indicated a buy at the low on September 24. If I assume it took me 5 days to recognize that low, I would have bought the stock at about $22.
The chart below shows the corresponding information around the 2020 price decrease.
In this example, the stock price approached the Bollinger band on February 13. Again assuming it took five days to recognize this point, I would have sold the stock at about $335. Using the same logic, I would have purchased it about five days after the low at a price of about $130.
If I had made these trades, the $1,062 with which I started in 1990 would have had a value of $132,000 in early 2021. This amount is only a very rough approximation, though, as I ignored all but these two buy and sell signals.
Simple Moving Averages (SMA)
The chart below shows Boeing’s stock price, including the SMA 9 and SMA 180 lines, around the 2001 price decrease.
The SMA lines indicate a sale on June 25, 2001 (when the pink line crossed below the blue line and circled in red). If I sold the stock the next day, I would have gotten about $37.50 per share. Because the crossing of the two lines is much easier to identify, I assumed I would make the trade the next day rather than waiting five days. The next buy signal came on February 22, 2002 (when the black line crossed above the blue line and circled in green). If I bought the stock the next day, I would have paid about $29.75 per share.
The chart below shows the corresponding information around the large price drop in 2020.
The SMA lines indicate a sale on December 9, 2019. If I sold the stock the next day, I would have gotten about $347 per share. The next buy signal came on November 9, 2020. If I bought the stock the next day, I would have paid about $185 per share.
If I had made these trades, the $1,062 with which I started in 1990 would have had a value of $56,000 in early 2021.
The table below compares my gains if I had used each of four strategies for dealing with the large price drops in 2001 and 2020.
|Strategy||Ending Balance||Annualized Return|
|Buy and Hold||$26,919||10.9%|
|Support & Resistance||25,386||10.7%|
As indicated above, these estimates only focus on the two time periods during which the price dropped significantly. As such, the ending balances for the strategies other than Buy and Hold would have been different if I had followed the buy and sell indicators consistently. Nonetheless, this comparison illustrates the benefits of being able to identify turning points in the price of a stock.
Knowing how to read stock charts can provide insights that might help you avoid owning a stock when the price drops significantly. That, in turn, can increase the total return on your portfolio.
However, as with any investing strategy, technical analysis can’t predict the future price of a stock or predict future price movements. Specific drawbacks to relying solely on technical analysis for your buy and sell decisions include the following.
- You need to look at the stock charts frequently, at least once a day, to avoid having the stock price change dramatically before you execute your trades.
- You will likely have many more trades in your portfolio. For example, there were several buy and sell indicators that I ignored on the SMA and Bollinger Band stock charts from 2001 and 2020, along with many more during time periods not included in these charts.
- The buy and sell indicators on your stock charts may not work in every situation. As you may recall, there was no support level after the 2001 Boeing price drop and no support or resistance level around the 2020 price decrease. And, the support-and-resistance-level approach performed worse than the buy-and-hold strategy in my comparison.
- If you hold your stocks in a taxable account, you will need to pay capital gains tax every time you sell a stock at a profit. These taxes will reduce your total return, possibly enough to offset the benefits of avoiding price decreases.
- Very few people have made money by timing the market or individual stock prices in the long term. Using technical analysis as the sole basis for your trading decisions is essentially a form of timing the market.
- Technical analysis can’t anticipate world events, such as the events of September 11, 2001, or the COVID-19 pandemic in 2020.
As such, you’ll want to consider these risks if you decide to incorporate your new knowledge of how to read stock charts into your trading strategy.
This article originally appeared on Your Money Geek and has been republished with permission.
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The financial news in the past week or so has been full of stories about GameStop, AMC Entertainment Holdings (AMC), Blackberry, Reddit, r/WallStreetBets, hedge funds, short squeezes, margin calls and Robinhood, among other things. Many of these stories explain parts of what is happening. However, they often use terminology that may be unfamiliar. My goal with this post is to help you better understand what is happening and what you are reading.
I’ll start with a brief overview of the news, in case you’ve seen only bits and pieces of it. I’ll then explain and provide examples of the important aspects of the story.
GameStop and Other Companies
GameStop, AMC, Blackberry and a handful of other companies have not been doing well financially for various reasons. Many investors expect the prices of these companies’ stock to go down.
Some hedge funds, most notably Melvin Capital, have been betting that the stock prices will go down by using various tools that make them money if the price goes down.
A large number of individual investors have been buying stock in these companies. Many of these investors “connected” with each other on social media, primarily in the Reddit group, WallStreetBets. When there are more buyers than sellers, the stock price goes up.
These increases cause problems for investors who have bet that the stock price will go down. In fact, due to certain rules, some of these investors are forced to buy the stock to make whole on their bets which pushes the stock price up even further.
Brokers have to have cash to cover the value of any trades that haven’t been settled. Behind the scenes, it takes two business days for each trade to settle. The high volumes of trading over the past several days have increased brokers’ cash requirements.
Robinhood is a relatively new online-only trading platform that is attributed with being the first to offer free trades. Because of its relatively small size and business model, it didn’t have a lot of cash available relative to the volume of trades.
As such, Robinhood and some other brokers had trouble meeting their cash requirements. Some of them therefore halted trading in the high volume stocks. In a few cases, brokers sold the stock of some of their clients without asking.
The Wall Street Journal has a summary of what has happened in the past week with some great analogies, if you have a few minutes for a different perspective.
The companies targeted by WallStreetBets, including GameStop, have two common characteristics. First, they are all facing financial difficulties. Second, there have been a lot of transactions, measured by something called “short interest,” that take the bet that the price of these stocks will go down.
GameStop primarily sells video games from its stores. In recent years, people increasingly buy video games online or play in games that are hosted online. In addition, many of its stores are in malls that have been shut down or forced to limit traffic due to COVID-19 restrictions. As such, GameStop’s business model has become outdated. Unless the business model is updated, GameStop is unlikely to return to being a successful company.
AMC Entertainment Holdings
AMC’s primary business is ownership of AMC movie theaters. Even before COVID-19, streaming services were significantly cutting into audiences at movie theaters in general. In the past year, attendance has decreased dramatically at most movie theaters if they are allowed to even open.
Blackberry was an innovator in smart phones, but has transitioned its business to focus on security software and services. It hasn’t made a profit in the past seven quarters and its revenues have been substantially flat.
Bed, Bath and Beyond
Bed, Bath and Beyond is a retailer of home goods. As with AMC, it wasn’t doing well prior to COVID-19 due to competition from stores like IKEA and target. With the advent of COVID-19, Bed, Bath and Beyond started closing a significant portion of its stores.
Why These Companies?
As you read these stories, you’ll see the common theme that the companies aren’t doing well financially, especially in the current environment. As such, many investors have bet that the stock prices will go down.
On the other hand, these companies are making changes that could turn around their financial situations. Certain other investors, in part prompted by the r/WallStreetBets forum on Reddit, recently started investing in these companies. Their purchases of stock in these companies have driven their prices up substantially.
What are Hedge Funds?
A true hedge fund is a pool of money (like a mutual fund) that hedges its investment risk. A hedge is an action that is expected to reduce the risk of your primary activity.
Examples of Hedging
About a year ago, a friend of mine began to think that the valuation differential between Home Depot and Lowe’s was too great. He thought Home Depot was overpriced and Lowe’s was underpriced. He sold his position in Home Depot and replaced it with Lowe’s. By comparison, a hedge fund might have bought Lowe’s and entered transactions that allow it to profit it Home Depot stock went down.
The hedge or offset does not necessarily have to be a stock. For instance, you might like gold mining stocks but are concerned they might decline if the price of gold falls. To hedge this risk, you offset your stock position using one of the techniques discussed below that wins when the price of gold goes down.
The term “hedge fund” has morphed into a term that describes fat cats that viciously undercut the market with false rumors in an attempt to drive share prices down. There are a few of them. In reality, though, a hedge fund is simply a mutual or other type of fund that uses hedging as an investment strategy.
it is important to remember that, while hedge funds are businesses, they are ultimately owned by individuals. Some of the owners might be considered “fat cats.” However, there are many “ordinary” people who have investments in hedge funds. Some are direct owners, while others are participants in pension plans or own stocks in companies that, in turn, own the hedge funds.
Betting Against a Stock
Hedge funds, and many other investors, use tools that allow them to bet that the price of a stock will decrease. When you buy a stock, you are said to take a “long” position in it. You buy it because you think the price will go up. You want the value of your investment to increase along with it.
There are two tools that are commonly used when you want to profit from your expectation that the price of a stock will go down – short sales and put options.
In a short sale, the investor borrows shares from someone else and sells them. Retail investors, like you and me, borrow the shares through their broker from another of the broker’s clients who owns the stock of interest. For larger investors, there are other mechanisms that allow them to borrow shares. The investor pays interest to the lender to borrow the shares. At any point in the future, the investor can then buy the same number of shares. The purchase allows the investor to return the borrowed shares.
Here’s an example. An investor thinks that the GameStop stock price is going to go down from $20 a share to $10 a share some time in the future. The investor borrows the shares and sells them at $20 apiece. This transaction is the short sale. Let’s say the broker charges 2.5% a year in interest to borrow the stock. If the investor holds the short position for two years, the broker will get $1 a share (2 x 2.5% x $20) in interest over the two years.
If the GameStop stock price goes down to $10 at the end of the two years, the investor buys the shares. At that time, the investor returns the borrowed shares to their owner. The investor has made a $9 gain per share equal to the $20 it received for selling the shares minus the $1 in interest minus the $10 it paid for the shares. The only money the investor has paid out of pocket is the $1 in interest. In the interim, it has had the $20 per share in cash it received from selling the shares.
If, instead, the GameStop stock price went up and showed no sign of coming back down, the investor might have to buy the stock at $30. In this situation, the investor will lose $11 per share equal to the $30 it paid to buy the stock plus the $1 interest minus the $20 it received for selling the stock.
Margin on Short Sales
As illustrated, there is always the risk that the price of the stock will go up in a short sale which causes the investor to lose money. The broker who loans the shares doesn’t want to face the risk that the investor won’t be able to afford to buy the shares if the stock price goes up. To protect against this risk, the broker requires investors to hold money in their account at the time the short sale is made. This money, called a “margin,” acts as collateral for the broker and the person who loaned their shares to the investor. A common amount for the initial margin is 150% of the value of the stock being shorted.
I’ll continue the example from above. When the investor borrows the shares, the value of the position is equal to $20 times the number of shares. I’ll use 1,000 shares for this example, making the value of the position $20,000. The total value of the assets in the account must be at least 150% of $20,000 or $30,000, using the typical margin amount I mentioned above. Remember, though, that the investor has the $20,000 it received when it sold the shares.
When the stock price rises, the margin requirement rises accordingly. If the stock price went from $20 to $30 in our example, the investor would then have to have at least $45,000 of assets in its account. At that point and the broker required the same 150% margin, the investor has two choices if it doesn’t have that much money in the account. The investor can buy enough of the stock at $30 (an $11 loss in our example) to lower the margin requirement. Otherwise, the investor can move money from another account into this account so it meets the margin requirement. The broker’s requirement to either increase the total assets in the account (i.e., the margin) or reduce the short position is call a “margin call.”
I note that brokers have the ability to be flexible on the margin when the stock price changes, so the total amount of margin required in this example might not be as high as $45,000.
In a short squeeze, an investor is subject to a margin call. That investor can buy stocks to cover its short sales. When it buys those stocks, the stock price has always increased from the price at which the investor bought the stock. This difference causes the investor to lose money. The loss on that money further reduces the value of the assets in the investors account making it even harder for the investor to meet the margin requirements.
Perspective on Short Sales
To be clear, there is nothing inherently wrong, illegal or immoral with short-selling stocks. Short sales are a valid strategy for limiting risk. Short-selling stocks is also a valid trading tool, no less moral than talking long positions in stocks.
Where it can go bad is when the short-sellers spread rumors and gossip, sometimes outright fabrications, in order to advance their positions. The same is true for people who fabricate stories to increase the price of a stock so they can profit from taking a long position. Using rumors, gossip or lies to manipulate the price of a stock in either direction is wrong and it is against the law.
Another strategy that investors use when they believe the price of a stock will go down is to buy put options. When you buy an option, you have the choice to buy or sell something, but aren’t required to do it. By comparison, when you short-sell a stock, you are required to buy it at a later date.
A put option gives the buyer the option to sell a stock at a pre-determined price, known as the strike price, by a fixed date. That is, unlike short-sales which have no deadlines, options have deadlines that limit the time frame during which the buyer can exercise the option.
If the stock price goes down before the deadline, the buyer can buy the stock at the then-current price and exercise the option to sell it to the person who bought the put option. When the stock price doesn’t fall below the strike price before the deadline, the option expires and nothing else happens.
As I write this post, the price of Boeing stock is $194.19 per share. The price or premium of a put option to sell 100 shares of Boeing stock at $195 on or before a week from today is $5.72. My broker may charge me a fee for buying the option in addition to the premium. For this example, I’ll ignore those fees.
Let’s say I buy that put and the stock price goes down to $190 at some point in the next week. I can exercise my option to sell my 100 shares stock at $195 per share or a total of $19,500. Just before I exercise my option, I will buy 100 shares at $190 per share or $19,000. My gain on this transaction is $494.28 which is equal to the $19,500 I get from selling my shares minus the $19,000 I pay for my shares minus the $5.72 I paid for the option.
If the price jumps up above $195 very early on the next trading day and never falls below $195, the transaction costs me only the $5.72 I paid in premium.
Margin Requirements on Puts
I don’t believe there are margin requirements to buy puts. I couldn’t find anything that confirms that there are no such requirements. It makes sense to me, though, because the investor can’t experience a loss once the put has been purchased.
How the Hedge Funds Got in Trouble
At first, it might have seemed counterintuitive that hedge funds could get in financial trouble when these stock prices went up. It turns out they had significant short positions in many of these stocks.
I’ll use GameStop as an example. On January 12, the stock price was about $20 per share. By January 26, the stock price closed at just under $150 per share. There are approximately 70 million shares of GameStop outstanding. Let’s say a hedge fund short-sold 10,000,000 shares of GameStop at $20 on January 12. On that date and using the typical 150% margin requirement, it needed $300 million (= $20 per share times 10,000,000 shares times 150%) in its account as margin. When the stock price went up to $150 per share, the margin requirement went up to $2.25 billion (or a lower amount if its broker was willing to lower the margin requirement)!
If the same hedge fund had only $1.125 billion in its account in total, it would need to buy enough GameStop stock to reduce its margin to $1.125 billion. Initially, it could buy 5 million shares to reduce its short position. However, two things happen when it buys those shares. First, when someone buys shares totaling more than 7% of those outstanding (5 million / 70 million total is about 7%), the price of the stock goes up even further. Second, the company has to pay $750 million to buy the 5 million shares which will likely reduce the value of the money in its account. Remember that the hedge fund has to return the shares it bought to the lender. It doesn’t get to keep them in its account. You can see what’s coming next! With less value in the account, it needs to sell more shares . . . .
How Can So Many Shares be Sold Short?
The hedge funds short-sold more shares of GameStop than are outstanding. It took me a while and some help from a friend who is a retired stock analyst to figure this out. Essentially, the hedge fund borrows the same shares more than once.
Here’s an example. Mary buys 500 shares of GameStop. She allows her broker to loan them out for short sales. Hedge Fund A borrows Mary’s shares and sells them to Joe who then sell them to John. John, in turn, allows his broker to loan his shares. Hedge Fund B borrows shares from John, but it turns out they are the same shares it borrowed from Mary! If this pattern happens often enough, investors can short-sell more shares than a company has outstanding.
I’ve read that the shares are supposed to be tagged once they have been loaned. The tags ensure that no shares are loaned more than once. I don’t know why these tags didn’t work the way they were intended.
How and Why Brokers Responded the Way They Did
Some brokers, Robinhood most notably, restricted their clients’ ability to trade in some stocks and, in some cases, sold clients’ shares without their knowledge or agreement. Initially, I saw rumors that these restrictions were to protect the clients from too much risk or to help bail out the hedge funds. The reality is that some brokers were having their own version of a short squeeze, though it wasn’t a short squeeze and isn’t called one either.
Most individual investors are unaware of the process of settling stock trades. From our perspective, it appears that we can instantaneously buy or sell a stock. What actually happens is that the order goes to a clearinghouse. It takes two days from the time you place your order until the clearinghouse settles the trade. In the meantime, brokers are required to have cash as collateral until the trade settles. I have not found exactly how much cash is needed, but it bears some relationship to the market value of the trades that have not settled and the clearinghouse’s perception of the volatility of the stocks being traded.
As investors made more and more trades at higher and higher prices, the dollar value of unsettled trades skyrocketed. Some brokerage firms didn’t have enough cash to meet the collateral requirements, with Robinhood being one of them. When that happened, Robinhood couldn’t accept more trade orders until one or both of its cash requirements were lowered as trades started settling or it acquired more cash.
The information in this post is based on my understanding of what happened. I have no first-hand knowledge. I have done my best to provide a fair and balanced explanation. It is not clear that everything that has happened is completely legal. I will leave it to the Securities and Exchange Commission, among other, to sort out those details.
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Protection against loss is critical for everything you do, including running your own business or earning money from a side hustle. The primary tool for mitigating business risks is property-casualty insurance. There are many insurance policies within the realm of property-casualty insurance, each with its own vocabulary. Understanding the different types of property-casualty insurance can help you limit the amount of many catastrophic financial losses. In particular, you will want to know which ones apply to your business or side hustle.
In this post, I’ll talk about the most important types of property-casualty insurance for small businesses and side hustles. These coverages include businessowners (with key components – auto, liability, and property), professional liability, workers’ compensation, and fidelity and surety bonds. I’ll highlight the coverage provided by each type of business insurance. In addition, I’ll touch on some factors to consider as you decide whether to buy them.
Some small businesses buy a package policy, called a businessowners policy (BOP), to cover their vehicle, liability, and property exposures. It is similar to the combination of personal auto and homeowners insurance policies. Businesses that don’t need all three types of insurance coverage can buy insurance policies separately. The separate policies are commercial auto (covers all types of vehicles), general liability, and property. The package policy is usually less expensive than the three separate policies, as long as you need all three coverages.
The limit of liability determines the maximum amount the insurer will pay for a covered liability claim. Also, one or more deductibles determine the amount the insured pays before the insurer starts paying for physical damage claims. Separate deductibles can apply to each of the comprehensive and collision portions of vehicle coverage and to physical damage claims related to any buildings and/or contents covered by the policy.
The vehicle coverage is the same whether bought using a BOP or a separate commercial auto policy. It protects against anything for which the business owner becomes legally liable related to the operation of vehicles covered on the policy. That is, if an insured driver is in an accident, liability insurance will usually cover the costs to third parties. These costs can include injuries or damage to their property. The insured has the option to also purchase physical damage coverage. This insurance can cover damage to the insured’s vehicles either from an accident (collision coverage) or other perils, such as theft and fire (comprehensive coverage). The vehicle coverages for commercial vehicles are very similar to those in a personal auto policy which I cover in detail here.
If you use your personal vehicle for your side hustle or business, it is critical that you buy commercial auto coverage. Personal auto policies generally exclude coverage for:
- Employees during the course of employment.
- Ownership or operation of a vehicle while it is being used as a public or livery conveyance, such as Uber or Lyft.
- The insured when employed or otherwise engaged in any business.
Almost all claims made against your personal auto insurance will be denied if your vehicle was being used for a side hustle or business.
Premiums for auto insurance vary based on the number and types of vehicles insured; the coverages, limits, and deductibles purchased; characteristics of the drivers; where the vehicle is driven; and the distances driven, among other factors.
Businesses usually face one or more of four types of liability – vehicle (discussed above), premises and operations, products, and professional. Premises and operations and products liability are parts of both general liability policies and BOPs. Professional liability is a separate policy, so I’ve covered it below.
Premises and Operations
Premises and operations coverage (which I’ll call Prem/Ops) provides insurance for things related to your business location or operations. It covers injuries to third parties (not employees) or damage to their property.
Slips and falls by customers at business locations are the most common types of Prem/Ops claims. For example, if someone is injured at your business location, in your parking lot or as the result of your operations, your business may be liable for their medical expenses and/or lost wages.
If your customers come to your place of business, you’ll want to consider Prems/Ops coverage. Most homeowners policies exclude coverage for claims related to a business. As such, it is important to check your homeowners policy if you do business out of your home to avoid gaps in coverage.
The premium for Prem/Ops coverage depends on the nature of your business, the number of types of locations, and the limit of liability you purchase, among other factors.
Products liability coverage provides insurance for damages related to your products. These damages include third parties (not employees) who are injured or their property when it is damaged. For example, the products liability insurance of a medical device manufacturer protects the company against claims that its products are defective and cause injury or illness to patients. On a much smaller scale, burns from McDonald’s coffee that was allegedly too hot are also insured under products liability coverage. If you make a product that could injure someone or damage their property, you’ll want to consider products liability coverage.
Premiums for products liability coverage depend on the type of products sold, the amount of sales, and the limit of liability you purchase, among other factors.
Property insurance protects your property, including buildings and their contents. You can also purchase insurance for just the contents if you don’t own the building. Property coverage protects against a long list of perils, generally including fire, hurricane, tornado, vandalism, and theft. In many places, you must purchase earthquake or flood coverage separately. Any intentional damage or damage from acts of war, arson, and sometimes riot is usually not covered. Read your policy to make sure you understand what is covered and what isn’t.
When you buy property coverage, you estimate the values of your buildings and contents. Insurers can often reduce the amount of any claim recovery, even for partial damage, if you underestimate the value of your property. As such, it is important to determine the value of your buildings and contents fairly.
Property insurance for businesses always includes business interruption coverage. Under this coverage, the insurer pays for lost profits and some overhead expenses when your property has been damaged by a covered peril. The insurer also covers expenses related to a temporary location at which you operate your business while your building is being replaced or repaired. Business interruption insurance applies only when your business is interrupted due to a peril covered under the buildings and contents coverage. For example, pandemic is almost never a covered peril for buildings and contents because it doesn’t damage either one. In that case, there is no insurance coverage if your business is shut down due to a pandemic.
Premiums for property coverage depend on the values, types and ages of insured buildings, the value and types of insured contents, where the property is located, and the deductible you have selected, among other factors.
An umbrella policy allows you to increase the limit of liability on all your liability policies at once. That is, an umbrella policy can provide coverage for vehicle, Prem/Ops, and products liability. The limits on the underlying policies must meet certain minimum requirements. An umbrella policy usually also protects you against some liability claims not covered by the underlying policies, such as libel and slander. The concepts underlying umbrella policies that protect businesses are similar to the concepts that underlie personal umbrella policies.
Umbrella premiums depend on all the characteristics of the underlying policies, along with the limit and deductible on the umbrella policy.
Professional liability insurance protects you against claims that you have caused someone an economic loss by making a mistake when providing professional services. For example, if you are providing bookkeeping services, a client might sue you if you prepared tax returns incorrectly that led to a financial loss by the client. Or, if you are providing legal services, errors could include everything from missing a court deadline to providing incorrect advice. A professional liability policy usually covers these errors, unless intentionally made.
If your business provides advice or professional services to clients, you will usually want to purchase a professional liability policy. Professional liability covers services just as products liability insurance covers things your business manufactures.
Professional liability premiums depend on the type of services provided, annual revenue, and the limit of liability selected.
Workers’ compensation insurance (often called workers comp) protects you against the cost of injuries and illnesses to employees that occur during the course of their employment. Almost every US state requires you to provide workers comp for employees, as long as you have at least the minimum number of employees. That minimum number of employees is usually around four. Some states, such as California and Colorado, require you to provide coverage even if you have only one employee.
Workers comp reimburses employees for a state-mandated portion of lost wages and for medical costs. Employees covered by workers’ comp cannot sue for covered injuries and illnesses except in very limited situations.
Premiums for workers comp depend on the number of employees and their wages, the state in which they work, and the type of work performed by each employee.
Surety & Fidelity Bonds
Some businesses need to buy surety or fidelity bonds as part of their operations. Most surety bonds provide guarantees to third parties (the obligees) that you (the principal) will perform certain actions. By comparison, fidelity bonds protect an employer against the fraudulent or dishonest actions of its employees.
One of the most common surety bonds is a construction bond. If your business is a construction company, it might promise to build a structure for a buyer. The buyer will likely pay your business for some of its services in advance. In that case, the buyer wants a guarantee that you will complete the structure. You can buy a construction bond from an insurer for the benefit of the buyer (the obligee). If you fail to complete the structure, the insurer will either pay the obligee the cost of completing the structure or hire a contractor directly to complete it.
Other types of commercial surety bonds cover signature guarantees for notaries and remediation costs for mining or drilling operations. Surety bond requirements vary widely by state. I found the “What Bond Do I Need?” section of this website quite interesting.
Most fidelity bonds insure property, money, or securities owned by customers to which employees have access. For example, a fidelity bond usually covers the embezzlement of deposits by an employee for services or products not yet provided. Similarly, a fidelity bond can insure against misappropriation of pension assets or real estate escrow funds. Also, a fidelity bond can provide protection if an employee takes something while at a client’s business or home.
Most side hustles and very small businesses don’t require fidelity or surety bonds. Nonetheless, they are very important components of a company’s risk management plan if it has any of these types of exposures. The face amount of the bond, the type of coverage provided, and the history and financial condition of the insured determine the cost of surety and fidelity bonds.
Other Types of Property-Casualty Insurance
There are several other types of property-casualty insurance that a small business might need.
- Crime Insurance – Property insurance and fidelity bonds don’t cover all theft losses. If you sell a product, you might need to look into purchasing crime insurance.
- Cyber Insurance – Cyber insurance can cover your operations if they are disrupted by a cyber-attack. It also can protect you if your confidential business and/or your customers’ or employees’ personal information is stolen electronically. If your business has any of these exposures, you will want to investigate the various types of cyber coverage.
- Directors’ and Officers’ Liability (D&O) Insurance – D&O insurance covers economic losses incurred by third parties that result from significant decisions made by directors or officers. Publicly-traded companies or companies with more than one owner often buy D&O insurance. If you are not the sole owner of your business, you might want to evaluate the need for D&O insurance.
Where to Buy Property-Casualty Insurance
Buying property-casualty insurance for a business is similar to buying it for your personal exposures.
- Some insurers, such as Progressive (just an example – in no way do I intend to endorse Progressive as I know nothing about its premium, coverage, or service), allow you to purchase insurance for your business online.
- Other insurers, such as Liberty Mutual (again, just an example), are direct writers. You talk directly to an employee of a direct writer when buying insurance.
- Insurance brokers and agents provide access to all other insurers. They usually have access to a wide range of insurers. Small businesses, especially those without unique exposures, can work with an agent to acquire insurance. You may need to work with a broker if you have a large business or need unique expertise.
If you are new to buying insurance for your business or your business has unique exposures, I suggest a direct writer, insurance broker, or insurance agent. Purchasing insurance online, especially if you are an informed buyer, can often, but not always, save you money. The lower premium reflects insurers’ lower expenses as it doesn’t have to pay commissions or sales force expenses.
This article originally appeared on Your Money Geek and has been republished with permission.
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