ﬁrst-time investors and the more experienced investor as well.
151
152
Winning with Stocks
Portfolio Liquidity: Available CashPortfolio management is far more difﬁcult than people think. Forsome, it refers to the ability to pick stocks well, make consistentproﬁts, and generate successful trades, meaning knowing not onlywhat and when to buy but also when to sell.The reality is far different than many perceive. It is considerablymore difﬁcult to time sales well and the tendency is to sell the wrongholdings at the wrong time. A related tendency is to hold onto stockslosing value, hoping they will rebound and fulﬁll the original beliefthat buying a particular stock was a good idea. Separating ego fromhuman error is an important ability for investors. If you wait foryour portfolio to prove that you were right in picking a losing stock,you are destined for future losses more than future proﬁts. But ifyou are able to review your own performance pragmatically andwith a view toward maintaining an expected return, you will probably see better performance in your portfolio.This tendency—to sell proﬁtable stocks to take proﬁts and keepunderperforming stocks to wait out a price decline—can be themost damaging practice to an individual portfolio. Your vulnerability is increased if, like most people, you own only three or fourstocks at any one time. When one of three stocks is sold, that isone-third of your total. Will you replace it with another diversiﬁedstock or, like so many others, put the money back into stocks thatcreate less portfolio diversiﬁcation? When people take proﬁts, it isvery difﬁcult for them to recognize the ongoing beneﬁts of a company or even of a sector. The belief is that in taking proﬁts andgetting out, it is time to move on to other areas of the market. Thisis sometimes true, but based on a tendency to sell at the wrong time(for example, when prices are starting to move upward) it is a mistake to abandon a strong sector in favor of a weak sector.The outcome is loss of portfolio liquidity. This assumes that theinvestor will continue to hold shares of underperforming stocks,and even worse, that upon taking proﬁts the cash will be movedelsewhere. Thus, over time, this practice creates an underperforming portfolio. If you establish a rule that you will not sell stock
Liquidity in the Market
153
unless or until you have a proﬁtable position, this is inevitable: Thelack of liquidity is self-imposed.Consider the problems this ﬂawed strategy creates:1. It is impossible to seize opportunities for future proﬁts. Proﬁtopportunities come up suddenly, and it is always desirable to maintain enough liquidity to take advantage of some of them. You do nothave to pursue each and every opportunity, just a few of them. Forexample, in an especially volatile market, the DJIA may fall 300points or more. When that occurs, most stocks fall as well, evenwhen their fundamental strength is unchanged. However, if a company is unfortunate enough to also have a disappointing earningsreport on the very day the market falls, its stock may fall well beyondthe level justiﬁed. That earnings report may be a slight disappointment. But remember, the market always overreacts and will take anybad news as a sign that at least for that company, the world is coming to an end. When this happens, a buying opportunity comes up.A stock that is pounded down to unreasonable levels is going torebound just as strongly over the coming few days. It is simply thetendency of the market. So if you have enough cash on hand, youcan buy shares when they fall excessively, even if that means youwill sell at a proﬁt in only a few days.This is a classic opportunity, and the opposite of proﬁt-taking.But there is another important difference. When the market surgesupward and prices rise, you take proﬁts but you then need to dosomething else with the money. The most likely action is to movethat money to another stock that is also price inﬂated. This meansthat if and when the sudden price surge reverses, you will see apaper loss. In the case of a fallen stock price, you are able to buyshares at the bargain price and are also able to sell at a proﬁt a fewdays later. So rather than being stuck with depreciated stock, youare faced with the timing issues surrounding appreciated stock.Most people would rather be in this position, of course.The point worth remembering is that when you are fully invested and you have zero liquidity, you cannot look at the marketobjectively. You don’t seek opportunities because you can’t take
154
Winning with Stocks
them anyhow. You are continually worried about loss-positionstocks in your portfolio, hoping their prices will rise, preferablysooner than later. You are like a person with very little money tryingto shop for dinner. You can’t afford the expensive cuts of meat orﬁne wine, so you end up in the frozen food section and the bargainpriced juice and soda section. You would prefer better food, but youcan’t afford it. This low liquidity applies in the stock market as well.If there is no cash available, you cannot even begin to think aboutthe best way to manage your portfolio. Your only concern is what todo here and now to manage a bad situation.2. Simple movement of a small amount of capital is increasinglydifﬁcult. The liquidity problem is not only limited to the inability totake opportunities. In such times, you cannot even afford to makerelatively minor moves because you lose sight of your broader objectives and begin to think defensively. So if you have only a smallamount of cash in your portfolio, it becomes more precious and youfail to take advantage of even small opportunities, such as a classicone-day price decline. You become overly concerned with making abad decision and augmenting your problem, and perspective aboutthe relatively small sums involved gets blown out of proportion.Rather than continuing an effective method of portfolio management, investors in this situation go into ‘‘crisis management’’mode. They stop thinking like investors. The alternative is to calmlyassess the situation and develop some sound plans. For example, ifyou are approaching the end of the calendar year, it may be a goodtime to sell some stocks that have dropped in value and create acurrent-year tax loss. This is limited for federal taxes to $3,000 peryear. You want to be sure that you don’t exceed this level, becausecreating carryover losses is not efﬁcient.The creation of a tax loss mitigates the portfolio problem andmakes the best of it in two ways. First, it reduces your tax burdenwhile discounting the severity of the loss itself. Second, it gets thoselosing stocks out of your portfolio, which you need to do as part ofthe turnaround process. Every investor in this position eventuallyneeds to ‘‘clean house’’ to get rid of the problems while changingthe overall approach to the market. The tax loss is a good start. If
Liquidity in the Market
155
you have had no capital gains this year, you can write off up to$3,000 in current-year losses. If you have previously had gains, youcan sell even more. For example, if you have accumulated capitalgains of $4,000 earlier this year, you can sell stocks and create asmuch as $7,000 in new capital losses, creating a net loss of $3,000to write off. This not only gets stock out of your portfolio and freesup capital to invest elsewhere, it also eliminates the tax on your previously created proﬁts.3. Poor performance tends to curtail future self-conﬁdence. Perhaps the most destructive consequence of low liquidity—especiallywhen it is the result of underachieving stocks—is its effect on yourself-conﬁdence. Investors need to feel conﬁdent in taking the risksthey are willing to take; when they begin questioning their ownstrategies, they lose the ability to take even acceptable risks, andinertia takes over. This destroys the person’s ability to proceed.What can you do when your portfolio value has dwindled, thereis no cash, and all of your stocks are currently lower than originalvalue? This is a troubling situation, but it can be solved. The longterm goal is to regain the initiative in developing situations in whichyou take losses in stride because you are creating proﬁts that offsetthose losses.Among the steps you can take is to consider a new evaluation ofyour strategic approach and risk level. You are either buying thewrong stocks, timing your decisions poorly, or taking too manyrisks. There is a tendency to try and offset past losses by gettingmore aggressive and taking on higher risks, but this may lead toeven higher losses. Take a look at how you pick stocks and whenyou decide to buy. You might discover that you have become distracted, and this has created liquidity problems in your portfolio.You can also reduce paper losses with an option-based strategyof portfolio management. This specialized market should never beused unless you ﬁrst understand it thoroughly. Several strategiescan be used to repair a damaged portfolio. First, you can write covered calls. In this strategy you sell a call (producing income) against100 shares of stock in your portfolio. Be sure to structure the callso that if exercised, it will generate a net proﬁt. The exercise price
156
Winning with Stocks
should be no lower than the net of your original purchase priceminus the premium you get for selling the call. A second strategy isdesigned to protect paper proﬁts. You can buy put on appreciatedstock, so that in the event the stock’s price falls, the put’s value willrise to offset the loss. Finally, you can buy calls on stock when pricesfall excessively. When the price rises, the call’s value follows andthose calls can be sold at a proﬁt. Options are best used by conservative investors to protect portfolio positions or to take advantage ofopportunities without having to (1) buy stock they don’t want tokeep, or (2) sell stock they would prefer to hold for the long term.
Creating Adequate Liquidity In Your PortfolioIn repairing a damaged portfolio, your goal is to mitigate the damage as much as possible and get out of poorly selected positions.When you have stock you no longer want, you are probably betteroff taking the loss and starting over with better-selected stocks.However, the creation of adequate liquidity should start with a critical examination of how things went wrong.Examine your portfolio practices with these three questions:1. Do I pick stocks based on a short list of predetermined criteria? Some investors create a sensible set of indicators by which tobuy and sell stocks, only to forget to follow that list. In a highlyvolatile market with rumors of proﬁt and fast-moving price changes,it is all too easy to become distracted by momentary speculativeideas, and end up taking risks beyond established and predetermined risk tolerance levels. It is crucial to (1) identify sensible stockselection indicators, (2) decide which indicators to rely upon to buyor sell, and most importantly, (3) ensure that you follow your ownrules and resist the temptation to make decisions without analysis.If you have wandered from this course, the ﬁrst step is to evaluate the stocks you are holding and immediately sell any that violateyour own risk tolerance standards. Taking a loss now is a bettercourse than taking no action or hoping for the best. The ﬁrst step increating adequate liquidity is to get rid of underperforming stocks,
Liquidity in the Market
157
starting with those that do not meet your previously establishedstandards.2. Are these criteria effective in making good choices? If youhave been following your list of indicators but your portfolio underperforms anyhow, you have to ﬁgure out why. Is the market simplymoving south at the moment and if so, do you think it will turnaround in the near future? If the market is not in a decidedly downward spin, then what is wrong here? If your portfolio is not performing on a par with the market as a whole, you have to wonderwhether your indicators are effective. Reevaluate your criteria withas much honesty as possible, and consider replacing any indicatorsthat have not helped you to pick proﬁtable stocks.3. Is my timing ﬂawed? If so, how can I improve on this aspect?You might be picking worthwhile companies to buy, but with poortiming. Do stocks come to your attention only when their price isrising? Do you consider buying after a price run-up while ignoringstocks that remain low or are even falling? It could be that this kindof selection process violates your otherwise well-picked indicators.When you only buy stocks whose prices have already risen, you maybe buying at the price top of a short-term cycle. This invariablymeans that the price is going to drop after you buy shares, which isthe opposite effect you hope to achieve.In using your indicators effectively, you need to put price considerations at the bottom of the list. Prioritize your criteria to ensurethat you pick companies that yield the desirable dividend, producea long-term trend of growing revenues and proﬁts, and are competitive within their industry. Then consider technical indicators likeprice volatility. The last criterion for picking a stock should be recent price action. In fact, if a stock’s price has risen considerablyover the last year and is now at or near its 52-week high, that couldact as an indication that the opportunity was missed. Rather thantaking the chance, you might be better off looking elsewhere. Evenwhen all of your indicators work, the price history can disclose poortiming choices when you have mistakenly come to believe that thehistory of rising prices was a positive sign. By putting this test at thebottom of the list instead of at the top, you improve your timing.
158
Winning with Stocks
A complete evaluation of the methods you use to decide whetherto buy stock and then when to sell deﬁnes your effectiveness. Youwill need to set up liquidity practices in order to take control. Forexample, if you budget additional capital to put into your investmentaccount each month, perform some personal asset allocation. Put aportion of that into a money market fund or a short-term CD (threemonths, for example, with staggered maturities). This creates immediate liquidity and allows you to grow more liquidity over time.If you believe that the degree of liquidity can be best deﬁned interms of a percentage of your portfolio value, you should be puttingthat percentage of all new funds into a highly liquid account, andnot using it all to immediately buy new shares of stock. You can alsoaugment liquidity by moving dividend income from the investmentaccount into a money market account. It is more desirable, ofcourse, to reinvest dividends so that you get a compound rate ofreturn, but that is not always possible. It is more important to create,build, and maintain liquidity as a ﬁrst step. Only in this way can youregain the control needed within your portfolio.
Another Kind of Liquidity: The MarketPortfolio liquidity is essential and if you lack it, you need to takeimmediate steps to rebuild. You also need to evaluate how you makedecisions and perhaps change some of your basic assumptions.Meanwhile, a different version of liquidity is always at work in thelarger market, and it has a direct effect on the market’s overallhealth.Market liquidity is an economic indicator that determines howeasily money is moved around. The market relies on adequate creditto pursue merger and acquisition (M&A) activity for institutional investors (mutual funds, pension plans, insurance companies) to buyand sell large blocks of shares, and for many sectors to operate effectively. For example, the home building sector—as everyone saw beginning in 2006—is as much affected by limited credit as by housingvalues. Financial stocks including banks, lenders, and secondary market organizations all rely on a healthy degree of liquidity (cash andcredit), and when liquidity falls the market follows.
Liquidity in the Market
159
The simple ability to buy and sell stock, whether large investoror small, is a relative indicator of market strength or weakness. Bydeﬁnition, stocks are ‘‘liquid’’ because they can be bought or sold atcurrent market for little cost; the transaction is completed swiftlyand execution can be done at any time during open market hours.However, exceptions apply. For example, on days when trading ishighly active you may experience difﬁculty getting through to yourbroker, so if you trade by telephone, high-volume days may createa disadvantage. High-volume days also create backlogs, so even ifyou execute trades online your execution could be delayed due toheavy volume.Exchanges at times place trading curbs. For example, if theindex prices move very rapidly in either direction, restrictions maybe put in place to prevent runaway price movement. This rule wasmade after the very large market price drop on a single day in October 1987. Trading may also be halted for speciﬁc stocks in somecases. For example, if a merger is announced or some other news isreleased that is likely to create a lot of interest in a stock outside ofthe normal channels, trading can be halted for the remainder of atrading day.Finally, market liquidity is subject to temporary changes dueto exceptional events. For example, the New York Stock Exchange(NYSE) was closed for several days following the 9/11 attacks dueto location as well as communications problems and priorities, notto mention the difﬁculty workers would have experienced getting towork in the Wall Street section of New York.These exceptions aside, a liquid market is deﬁned as one inwhich ‘‘ready and willing’’ buyers and sellers come together andagree on price levels for stocks. When prices fall, more buyers areavailable, and when prices rise, sellers tend to take proﬁts. Pricemovement itself is a means for keeping up a level of interest, and itsadjustment reﬂects ever-changing levels of supply and demand.Some markets are facilitated to ensure ongoing liquidity. For example, in the options market, there are times when buyers outnumbersellers (and vice versa). At those times, the Options Clearing Corporation (OCC) guarantees liquidity. It continuously acts as seller toall buyers, and as buyer to all sellers. As long as both sides matchup, there is no need for facilitation. But in practice the OCC creates
160
Winning with Stocks
the other side of every transaction, and assigns trades based on timing of placement and the need for its participation.Concerns over market liquidity dominate the minds of bankers,Federal Reserve members, economists, and analysts whenevercredit is tight. In 2007, for example, ﬁnancial markets were greatlyweakened by tight credit. The problems in the housing market wereonly part of the problem, affecting not only home builders but thebanks and brokerage ﬁrms that funded mortgages, often aggressively. The weakened U.S. currency against other currencies, notably the Euro, only made the perception worse.From a ﬁnancial market point of view, ‘‘liquidity’’ may includea subtle variation on meaning. For example, for a company that hasﬁnanced billions of dollars in mortgages, market liquidity refers tothe ability to transfer an asset into a different form without losingvalue. If a lender wants to transfer itself out of the debt it is carryingon its books in the form of mortgage loans, the ideal situation ofliquidity enables the ﬁrm to sell off those assets near 100 percentvalue. But once perception—true or false—comes into the issueabout unknown or hidden future foreclosures, that asset begins tolose value. At ﬁrst, it can be sold only at discount. When the discount gets deeper, it might become impossible to transfer thosemortgages. The unknown factor makes liquidity impossible. Thisproblem, which often is far less severe than people think, carries aserious implication when it begins to affect investors. As one federalgovernor noted in a speech in 2007:Consider liquidity, then, in terms of investor conﬁdence. Liquidity existswhen investors are conﬁdent in their ability to transact and where risksare quantiﬁable. Moreover, liquidity exists when investors are creditworthy. When considered in terms of conﬁdence, liquidity conditions canbe assessed through the risk premiums on ﬁnancial assets and themagnitude of capital ﬂows. In general, high liquidity is generally accompanied by low risk premiums. Investors’ conﬁdence in risk measures isgreater when the perceived quantity and variance of risks are low.1
So, for example, if investors are deeply concerned about a ﬁnancial company’s ability to maintain its own proﬁtability, the price
Liquidity in the Market
161
of stock may slip. Even more to the point, when investors’ perception is that there may be trouble ahead that the ﬁnancial institutionhas not yet disclosed, the situation is made worse, even if the concerns are not true. Conﬁdence is directly connected to risk, andmarket liquidity is a central theme you will hear again and againin terms of the ﬁnancial and housing markets, interest rates, andconsumer (investor) conﬁdence measurements.As the same federal governor observed in his speech, ‘‘liquidityis conﬁdence.’’ Investors, like most consumers, want ﬁnancial certainty, or at least signs that future liquidity is going to be abundant.
Corporate Liquidity: A Fundamental TestMost investors who study fundamental analysis know all aboutworking capital tests like the current ratio. But what does this ratioactually reveal about corporate liquidity?From the point of view of the corporation, ‘‘liquidity’’ is a measure of working capital. As a reality of business, companies musthave enough cash on hand to (1) pay current expenses, (2) servicedebt, including interest as well as repayment, (3) expand the business as opportunities present themselves, (4) invest in essential capital assets, and (5) pay dividends. An examination of these primaryliquidity demands demonstrates why management of working capital is essential:1. Pay current expenses. The ﬁrst and most basic demand onworking capital is payment of current expenses. This includes payroll, rent, utilities, insurance, and all other necessary and immediatedemands. A company that is chronically late in paying its bills facessome very real problems, and recovering from them gets more difﬁcult as the problem worsens.2. Service debt, including interest as well as repayment. It is tooeasy for corporations to slip into a spiral of debt. When liquidity ispoor the temptation to borrow money is there, but this leads tohigher future demands on liquidity.
162
Winning with Stocks
3. Expand the business as opportunities present themselves.Expansion in business, as in nature, is essential to survival. Cashis the lifeblood of expansion, so companies like to move into newterritories, expand product lines, and acquire smaller competitors.All of these activities require liquidity.4. Invest in essential capital assets. Most big companies need tobuy machinery and equipment, autos and trucks, and real estate.Few businesses can survive without investing in capital assets; manycannot grow and expand without those assets. It is not merely cashliquidity that is required to buy capital assets, but debt service liquidity as well. Many companies rely heavily on capital investment,and they need to plan ahead effectively to ensure that adequate cashwill be on hand to repay borrowed money.5. Pay dividends. Investors expect a return on their investmentand there is natural competition between equity interests (stockholders) and debt interests (bondholders and other lenders). Thehigher the interest is on debt, the more difﬁcult it is for the companyto increase its dividend, or even to continue its current level of dividends declared. Annual increases in dividends declared is one important signal of growth in the business and its proﬁtability. If acompany acquires too much debt, it is very difﬁcult to maintainlong-term liquidity.An evaluation of corporate liquidity should be performed onseveral levels. In Chapter 5, the important working capital tests ofcurrent ratio combined with debt ratio were examined. The pointmade there was that these two key ratios must be studied together.The example given was Eastman Kodak, whose current ratio remained steady over many years while the debt ratio exploded. Thisis a highly negative trend because the company acquired ever-higherdebt levels. The appearance of healthy liquidity was deceptive.Another way in which liquidity tests can be deceiving and evenmisleading is when companies carry large levels of inventory. Thismay cause the current ratio to decline over many years, even whenconditions are actually very healthy. The need for increasing levelsof inventory can distort the current ratio and as a result, exaggerate
163
Liquidity in the Market
the condition of liquidity. Likewise, companies that do not carryinventory—those providing services rather than products, for example—should not be held to the same standards as dissimilarproduct-based companies.For these reasons, two liquidity-speciﬁc variations of analysisshould be applied. All liquidity tests are best performed in conjunction with a study of the debt ratio. In a well-managed company, thelevel of debt may rise, but the ratio of debt to total capitalizationshould remain approximately the same or decline over time. Slightrises in this ratio are acceptable when borrowed funds are used forexpansion of markets, of course, but when debt levels rise over adecade from the mid-teens to 60 or 70 percent, it is clear that thehealth of the company and its liquidity are in jeopardy.The ﬁrst variation excludes inventory from the liquidity test. Incompanies with growing revenues and outlets, inventory levels mayneed to expand beyond the rate of growth in revenue and proﬁts. Aslong as long-term debt levels remain under control, this is acceptable. Inventory growth may result in the current ratio’s decline. Analternative is the quick assets ratio, also called the acid test. To compute a quick assets ratio, subtract inventory from current assets anddivide the net by current liabilities. This formula is shown in Figure8-1.The standard for the quick assets ratio against which a speciﬁccase should be measured is ‘‘1 or better.’’ The current ratio, you willrecall, has the standard of ‘‘2 or better.’’ An example: A company’scurrent assets are $942,800 and inventory is $215,000. Currentliabilities are $696,400. The current ratio and quick assets ratio are:
F I G U R E 8 . 1 . Q U I C K A S S E T S R AT I O
current assets – inventory= ratiocurrent liabilities
164
Winning with Stocks
Current ratio:Quick assets ratio:
$942,800$696,4001.4($942,800  $215,000)$696,400
1.0
Assuming that other fundamental tests, especially debt ratio, are inline with a long-term trend, the quick assets ratio is more meaningful as a test of liquidity in this instance. One of the problems ofusing this ratio, however, is the tendency for inventory to changeseasonally. You can get a distorted view of liquidity if you apply thetest at the wrong time of year. Some sectors, such as retail, have anunusually high-volume season. Retail companies often experienceone-fourth of their total annual revenues and earnings in the lasttwo months of the year. In applying the quick assets ratio, the samerule applies as with all liquidity tests. The ratio must be analyzed atthe same time of the year and studied as part of a multiyear trend.In applying liquidity tests to draw conclusions about the futuregrowth of a company, it is also important to draw proﬁtability intothe test. In the ideal situation, a highly proﬁtable and well-managedcompany will report annual growth in both revenue and earnings(especially as expressed via EPS), annual increases in dividends,steady ratios in working capital tests (either current or quick assetsratio), and steady or declining debt ratio.Liquidity may, in fact, be as critical a test of corporate value asis proﬁtability. You need both. But without liquidity today, proﬁtstomorrow will decline or disappear, and that is the lesson. If yousee debt levels rising, even proﬁtable income statements cannot becontinued indeﬁnitely. Accompanying the fundamental tests of liquidity and proﬁts, you cannot ignore volatility. Most people thinkof this in terms of stock price, which is clearly a valuable comparative technical test of risk. However, volatility is also a valuable fundamental test when applied to yearly ﬁnancial trends. The nextchapter takes a look at the many variations of volatility, and showshow you can use it to test a company’s long-term value and safety.
Note1 Kevin Warsh, member, Federal Reserve Board of Governors, speech at theInstitute of International Bankers Annual Washington Conference, March 5,2007.
C
H
A
P
T
E
R
9
VOL ATILITY ANDLEVERAGE
T
wo aspects of investing—volatility as a test of risk and leverage asthe use of capital—are important tests of portfolio health and risktolerance levels. This chapter explores these two aspects in depth.Price history serves as the basis for many forms of market analysis, most notably charting. This chapter brieﬂy describes the chartist’s theories and ideas, and identiﬁes the value of establishingsupport and resistance based on a stock’s price history.Volatility, which is one aspect of price history, is most oftenviewed only in one way—the volatility of the stock’s market price.However, there are several problems with the most popular formsof volatility analysis. Spikes may be caused by many factors that willdistort the typical analysis. Therefore, such exceptions should beremoved from the analysis. The raw material for volatility analysisoften distorts the picture. Studies of volatility are intended to provide investors with valid comparisons; this chapter shows how toadjust that raw material to make comparisons valid. The study ofvolatility helps to further differentiate companies whose fundamen-
165
166
Winning with Stocks
tals are otherwise similar or the same. Studies of volatility help tofurther deﬁne risk and opportunity.Volatility tests risk, while leverage deﬁnes risk and proﬁt opportunity in a different way. Most investors know the two most popularways to invest: in stocks (equity) and in bonds (debt). A third wayto invest is to leverage capital through borrowing money. Leverageis used when investors borrow through margin accounts, or whenthey use lines of credit secured by their homes.The risk associated with leverage is signiﬁcant because leveragerequires higher rates of return. Because interest must be paid toborrow money, leverage requires special consideration. It usuallydoes not belong in the typical portfolio.All that being said, there is another way to leverage in the market. Investors may buy or sell options and by doing so, controlshares of stock with minimal capital. This is also a form of leverage.In addition to comparing risk levels associated with options, theinvestor needs to select issues for option participation based on thefundamental trends of those companies. Thus, leverage cannot beviewed in isolation, but as an application of the ideas presented inthe preceding chapters.
Analyzing Price in Terms of Market RiskInvestors tend to compartmentalize their analysis of stocks. As aresult, the price at which they buy stocks is treated as a startingpoint, or a ‘‘zero value’’ price. The expectation is that from thisstarting point the price will rise. While such optimism is admirable,experience has shown that there is also a chance the price will fall.A more enlightened view of price is that it is part of an ongoingstruggle between buyers and sellers. This struggle, the essence ofthe supply and demand trend, deﬁnes how and why prices move.There are potentially inﬁnite reasons for prices to change but forthe combinations of all of those reasons, justiﬁed or not, the supplyand demand feature in the stock market continues to deﬁne prices.And the more rapidly and broadly prices move, the greater the volatility for a particular stock. In its most basic action, the degree of
Volatility and Leverage
167
volatility deﬁnes market risk. High-volatility stocks are less predictable than the average, and as a result have greater market risk.When you consider how supply and demand work, it makes alot of sense. When many buyers want to buy stock, it drives up theprice. As the price rises, it becomes increasingly likely that previousbuyers will become sellers. As shareholders take their proﬁts andsell, the demand ultimately weakens and falls away. This causesprices to fall. The further prices fall, the more attractive the price,bringing more buyers in to purchase shares at bargain prices. Thisaction–reaction continues endlessly. The greater the change in pricefrom day to day, the greater the volatility and market risk.Another factor affecting volatility is short selling and short covering. Short sellers sell stock as an opening transaction with theintent of