Easy Street Investing

FAQs

What does “or better” mean when you give instructions to buy or sell a stock?

When buying, it means purchasing the investment at the stated price or lower, if possible. When selling, it means at the stated sale price or higher.
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What does a “protective stop” mean?

A protective stop is used to help mitigate the risk of loss in a particular investment. For example, when you own a security, you could place an order with your broker to sell if the security falls below a certain point. In other words, you would use a protective stop to sell the security when its price falls to a point where the expected uptrend is no longer valid. In a short sale, a protective stop is an order to purchase the security when its price rises to a point where the expected downtrend is no longer valid. Note: Placing a protective stop does not guarantee that your order will be filled at the “stop price.” Depending on market conditions, the price your stop order is filled at may vary, either better or worse for you. Still, a protective stop can go a long way in helping you reduce overall risk.
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What is leverage?

In investments, this is the control of a large amount of money by a smaller amount of money. In finance, this is the relationship of debt to equity on a company’s balance sheet. The higher the debt in relation to equity, the more leverage exists.
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What is the difference between debt and equity financing?

Companies must raise money to finance their ongoing operations. The two basic methods are debt and equity. With debt, money is borrowed under an agreement to repay over a specific time at a specific interest rate. Equity financing is the selling of an ownership stake in the company.
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Are all option contracts based on 100 shares?

All options that trade on listed exchanges in the United States are based on 100 shares of stock. Occasionally, there are some exceptions, chiefly when two companies with listed options merge. When this happens and you own an option on one of the companies’ shares, it’s best to check with your broker to see if there are any changes in the option.
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What are futures contracts?

A commodity exchange agreement to sell or buy a specific amount of a commodity or security at a specific price and time.
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What is a derivative security?

A derivative is a financial instrument whose value is based on and determined by another security or benchmark. This includes options, futures, interest-rate swaps, and floating-rate notes.
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What exactly are derivatives?

Some derivatives are speculations or side bets on other investments. Example: Someone could bet you $1,000 that the euro will rise faster than the Japanese yen between now and June. Other derivatives are investments that have been artificially constructed by splitting up bonds into segments, such as the interest portion vs. the principal portion. Some portions or “tranches” are safe; some are risky.
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What is the difference between a Treasury Bill, a Treasury Note, and a Treasury Bond?

T-bills are short-term government debt instruments with maturities of 3, 6, or 12 months. T-notes are longer term government debt instruments with maturities from one to 10 years. T-bonds are government debt instruments with maturities over 10 years.
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Treasury-only funds invest in derivatives, right? That makes them risky.

No. They do invest in repurchase agreements or “repos” (very short-term loans that are at least 100% collateralized by Treasury securities). And, technically speaking, repos are classified as “derivatives.” But that doesn’t make them risky. Quite to the contrary, the repos bought by Treasury-only funds are in the same safety category as Treasury bills themselves.
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Most of my retirement is in a Treasury-only money market fund and a “prime” or general purpose money market fund. Since these are not insured, are they absolutely safe?

These are money market funds that maintain a $1-per-share value and are similar to a savings deposit at your bank. The Treasury-only money market fund invests strictly in short-term Treasury securities, which are 100% guaranteed by the Treasury Department. However, the same cannot be said for a prime or general purpose money market fund. It holds only a portion of its portfolio in U.S. Treasuries, with the rest of the money in other obligations such as prime commercial paper and foreign bank obligations that are not guaranteed against default.
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My banker says a CD is better than a short-term Treasury security because it’s insured. How do you respond to that?

Either he’s poorly informed or deliberately trying to mislead. It is widely agreed — by banking and Treasury officials alike — that U.S. Treasury securities are clearly higher on the ladder of relative safety than bank CDs. With a CD, your guarantee is by the FDIC. With Treasuries, it’s by the U.S. Treasury Department — stronger than the FDIC in terms of borrowing power and credit rating. With a CD, your guarantee is limited to $250,000 and wouldn’t even cover accrued interest above that limit. With Treasuries, your guaranteed amount is unlimited. Furthermore, CDs involve a penalty for early withdrawal; Treasuries can be sold at any time with no penalty. Income on CDs is subject to local and state income taxes; income on Treasuries is not. Best of all, despite all these advantages, yields are very similar.
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Can U.S. government securities be used as a substitute for Treasury securities? What does it mean to be backed by the “full faith and credit of the U.S. government”?

“U.S. government securities” is a broader category than “Treasury securities.” It includes not only securities issued by the U.S. Treasury but also those issued by government agencies, such as Ginnie Mae. Yes, these agencies are implicitly backed by a moral and legal commitment by Congress. But that’s not quite as good as being supported by the Treasury Department itself. A similar distinction holds for money funds. A “government-only” fund invests in Treasury securities plus government agency issues. A “Treasury-only” money fund invests 100% in Treasuries. Assuming there are no derivatives in either one, the differences in safety are hairsplitting right now. But if we have a serious fiscal crisis, we believe the Treasuries are ultimately safer.
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My broker has assured me that my Treasuries, which are held in my broker’s name, are safe, even if the firm should fail. That’s because of SIPC insurance, which insures accounts up to $500,000, the SIPC is a branch of the government similar to the FDIC.

The Securities Investor Protection Corporation, or SIPC, is not a government agency. It is a nonprofit, membership corporation, funded by its member securities broker-dealers. If a brokerage firm fails, SIPC oversees the transition as it is sold off to another firm. In a massive industry-wide crisis, however, assets in “street name,” including Treasuries, could be frozen and you could be denied immediate access to your funds. If your Treasuries are short term, there would be no loss. But if they are long-term Treasuries and the market goes down during the freeze period, SIPC would not cover the loss.
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I’ve heard that the Federal Deposit Insurance Corporation (FDIC) only insures the bank holding company, and not individual depositors. Is that true?

Quite the contrary, the FDIC insures depositors, not banks. So you are protected up to $250,000.
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Are zero-coupon bonds backed by the full faith and credit of the U.S. government?

Zeros are created by private firms, but are fully based on U.S. government securities. Since the principal and interest of the underlying securities are backed by the full faith and credit of the U.S. government, that guarantee flows through to the owner of the zeros.
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What is the difference in risk between “street name” and “book entry” accounts at a brokerage firm?

It’s hairsplitting. In street name accounts, the broker holds the certificates; in book entry, the ownership is just recorded in the customers’ account records. But in both situations, if the broker fails and the authorities can’t find a buyer for the firm right away, your securities could be temporarily frozen. There are two ways to avoid this risk: The first is to take possession of the securities yourself, which entails extra costs and exposes you to a different kind of risk — theft, accidental loss, and low liquidity. The second and better solution is to stick with a strong brokerage firm.
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Can you evaluate my portfolio and tell me which investments I should keep and which to sell?

I’m sorry, but we cannot give individualized advice. My staff and I are constrained by law and the SEC in giving any advice about an individual’s portfolio or financial holdings. We cannot, by law, make recommendations about your specific holdings.
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What does it mean to exercise an option?

When you buy an option, you have the right to either purchase or sell a stock at a predetermined price. When — and if — you choose to purchase (in the case of call options) or sell stock (in the case of put options) at the predetermined price, you are said to be “exercising your right.”
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Since options depreciate in value over time, is it better to buy a nearby option or a longer dated option?

The closer an option is to expiration, the less time you will have to be right about the direction and magnitude of a stock’s move and the more rapid the price decay. The decision about what expiration month to use will vary according to your expectations for the stock. Generally, the more time you buy, the more room for error. The flip side of that is that you generally get less leverage, since the longer term option costs more than a shorter term option.
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What events would cause options to make a big move?

The same unexpected events that would cause the underlying stock to make a big move — any number of reasons, such as a surprise earnings announcement, a general news event, or even a big move in the broad market.
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What is the “bid” and “ask”?

The bid is the highest price a buyer is willing to pay. The ask is the lowest price a seller is willing to sell at. The difference between bid and ask prices is called the “spread” and is the way market makers earn their living.
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What is more accurate — the last sale or the closing price?

The ask price is a closer measure of how much you will need to pay to buy an option. That’s because the last sale when the option was bought could have been several days earlier and not a reflection of the current position of the underlying stock. Always check the ask price.
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What is an option’s “open interest”?

Open interest is the number of outstanding contracts on a particular option class or series. Open interest increases when an investor initiates a new position. For example, if a trader buys a new call, open interest on that particular option will increase by the number of contracts the trader purchased. Conversely, when an option contract is offset or liquidated, open interest will decline.
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Do dividends influence option prices?

Investors often rush to purchase a stock just before it is scheduled to pay dividends. So, following a dividend payout, the value of the stock may fall due to a drop-off in buyers. This can hurt the holder of a call option, but help a put option holder. That’s because the general effect of a dividend payment is to lower the value of a call option and increase the value of a put option on that stock.
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What is a “triple-witching” day?

Four times a year — on the third Friday of every third month just before the quarter comes to an end — you will hear comments in the media about triple-witching day. On these days, expiration for options, index options, and options on futures contracts all occur simultaneously. Usually, this results in some wild price swings.
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What is the VIX Index?

It’s the volatility of the stock market as measured by the S&P 100 (OEX) options. This measurement has been the benchmark of market volatility for more than 15 years. With the emergence of Nasdaq stocks over the last few years, a separate volatility measurement index was needed for those stocks — the VXN, a volatility measurement of the Nasdaq-100 (NDX) options using the same methodology as the VIX. Historical data on both indices is available on the CBOE website at: www.cboe.com. When these indices are rising, it’s a sign that investors are nervous. When they are declining, it tends to indicate complacency.
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What is an American-style option?

“American style” is an option contract that can be exercised at any time between the date of purchase and the expiration date. Most exchange-traded options are American style.
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What is a European-style option?

“European style” is an option contract that can only be exercised on the expiration date.
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Do I need a full-service broker when I use your services?

It’s your choice, but we typically recommend using discount brokers.
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What does market capitalization mean?

Market capitalization refers to the market value of a company’s outstanding shares. To calculate this figure, take the stock price and multiply it by the number of shares outstanding.
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Explain support and resistance levels.

Support is the price level at which demand is presumed to be strong enough to stop the price from decreasing. Resistance is the price level at which selling is presumed to be strong enough to stop the price from increasing.
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What is technical analysis?

Technical analysis attempts to determine what trend will continue in the future via the examination of supply and demand in a market.
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What should I do with my stock dividends?

This largely depends on your goals, but investors who don’t need the income are typically best served by reinvestment of their dividends.
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What happens when a stock splits?

All the stock’s attributes, including its dividend, simply get divided by the split factor. For example, a stock that paid a $1-a-share annual dividend would pay $0.50 after a 2-for-1 split. The only immediate benefit of a stock split is that the shares become more affordable for the average investor to buy in round lots (i.e., 100 shares at a time). Effectively, of course, they’re getting the same earnings power and the same dividends for the money they invest.
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What is a stock’s “ex-dividend” date?

When a company declares a cash dividend — known as the declaration date — it says something like, “This payment will go to shareholders of record as of January 5, 2007.” In other words, to be eligible for the dividend, you must own the stock by that record date. To make record keeping easier, and so that investors are clear on just what they’re getting, the stock exchanges (or the National Association of Securities Dealers, Inc.) set an ex-dividend date for each stock that will be paying an upcoming dividend. This date is generally two or three business days before the record date. If you buy the stock before the ex-dividend date, you’ll get the payment; if you buy it on or after the ex-dividend date, you won’t. By the way, when a stock begins trading ex-dividend, it will be marked with an “x” in the stock listings of your local newspaper.
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What do you think about share buybacks?

When companies aren’t using cash to repay debt or reinvest in their businesses, they have two other popular options — repurchasing shares or paying dividends. Share buybacks usually result in a lower number of shares outstanding, which means your existing stake in the company gets bigger with zero tax implications. I say “usually” because companies can offset buybacks by issuing new stock to take care of employee stock options. Buybacks can also make some of the stock’s fundamentals look better. For example, per-share earnings would rise (less shares divided by the same amount of profits). But who does this really benefit most? If a company’s management has its bonus plans and other incentives tied to the stock price, the waters start to get cloudy. One other important note: While companies often announce that large buybacks have been authorized, they don’t always follow through. In short, dividends represent non-refundable payments … so we typically like them better than buybacks.
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