Wednesday, June 1, 2011

What happens when we buy stock

All too often the newcomer to the markets will take an action with their money before they know what they are doing. I'm not talking about what they are doing in the sense of picking the "right" stock. I'm talking about what happens when they turn their money over to their broker and tell them to go to the stock exchange and buy them some shares...

EDIT: At the time this blog entry was posted I had a Youtube video here. That has been removed but I want the rest of my content to be remain. Nothing hidden no past mistakes ignored. All out in the open.

In the video I say that there is risk when you initiate an order before the price moves. I touched on it with slippage and the spread a bit but I want to expand clarify that a bit. For this video and blog entry I am purposefully leaving out the words "bid" and "ask".

The spread can widen on volatility which is how fast a stock or option or whatever financial instrument's price is moving. The stock exchange knows that when something is moving fast it will attract more buyers and they want to get in on something moving fast. So they widen the spread to get more money out of those more willing to pay the higher price.

So continuing my example from the video of a stock we can buy for $10 and sell for $9.50. Let's say we have been following it and want to buy it. We place our market order. As we do it the price moves faster then we thought. Some news came out. Perhaps it's a drug company that cured cancer or is being bought out by another company or one of those "just because" fast moves. For whatever reason it's moving higher. You get filled at $10.25 because of slippage and you check the current price. The price is $10.50 to buy and the sell price only rises to $9.75. Why did the buy price go up more then the sell? The exchange knows that people are going to want to buy when stock moves up fast and buyers are more willing to pay extra for it. Sellers are less inclined to sell because maybe they can hold out a little bit longer and get a better deal so the exchange has less reason to give them more.

The stock continues to rise to $11 to buy and $10.50 to sell. The spread narrows because things are slowing down and it goes back to its normal $0.50 spread. So even though it was at $10 when you entered your order to get in and now it's valued at $11 to buy, slippage took $0.25 and the spread took an extra $0.25 then you planned on. To sell now at $10.50 when your entry point was $10.25? That $1 rise only leaves you with $0.25 actual profit.

The move ends and starts dropping, fast. Others are freaking out and selling so you decide to also. Just like before the spread widens. Though the buy price drops just $0.25 to $10.75 the reverse is happening with the spread. The stock exchange knows that people want to get out and sell. The spread widens against the seller and the price to sell your stock is $10. Slippage of $0.25 once again occurs and you sell at $9.75. The price levels off and the spread narrows back to a $0.50 range.... $10.50 to buy and $10 to sell.

So while the buy and sell price of the stock have both moved up $0.50 you ended up losing $0.50 a share! Bought at $10.25 and sold at $9.75

Oh yeah... and you also paid a commission twice, once to buy and once to sell, for the privilege of losing money even though you were right.  That's a very important thing to never forget... you can be right in guessing the move of a stock. You can be right in the timing of getting in. You can be right in the timing of getting out. With all that you can end up losing money.

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