Thursday, August 10, 2006

Stories of a Student Trader

By: Michael Cavallaro
The Stillman Exchange - Seton Hall's Business Newspaper
Managing Editor

The first time I ever thought about trading stocks was in the fourth grade. My school had formed a stock trading club in which the students were entered into a nation wide competition where teams of two were given an account of $100,000 of pretend money. The only source of information we had at the time was the newspaper; primarily the Wall Street Journal. The computer and the internet had not yet been integrated into my school or most grammar schools across the nation at the time. Each day the Wall Street Journal would arrive at the school and I would look through the listings for companies that might be a good investment. I had not charts, financial reports, financial ratios, and zero experience. All I traded on was the closing price from the day before. Each day I would place my trades by giving the teacher a special form with my trades and that was sent to the company that tracked all the teams’ money.
During this time I developed my own way to track the daily changes in certain company’s prices. I was able to turn my $100,000 into almost $300,000 by making trades based on the trends I saw in Exxon, Mobil, and Xerox. I simply bought low and sold high and waited for the stock to drop and buy low and sell high. Further, I noticed a constant fluctuation of about $5 in Xerox. I would then buy Xerox low and let it rise $5 and sell it, then sell Xerox short expecting the price to drop $5 and make money on the downside. I made so much money that I knew I was ready for the real thing so I asked my father to mortgage the house and give me the money to invest it all in Exxon. Unfortunately, my father could not mortgage the house just so I could trade. I told him I would settle for ten or twenty thousand dollars but in a gentle, fatherly way he had to explain to me that was just not feasible. We always chuckle now because had he given me the money back when I was in fourth grade we would have made quite a bit of money in Exxon (do the math).
So what can we learn about my fourth grade trading experiences? Well, it is important to follow the trends of a company price. Knowing when to buy and sell is the art of investing. BUY LOW, SELL HIGH. Before you invest any money create an exit and entry strategy and have a reason for buying the company such as good financial statements, a revolutionary product, high return on equity, etc. Figure out what percent you would like to make on a certain trade. For example, I want to invest $1000 in company X and make an 8.00% return or $80 and I am willing to loose 4.00% or $40.00 on my investment. Don’t be afraid to sell when you make money or loose money. Getting attached to a company is the wrong thing to do. When you are ready execute your trade! You may want to consider setting up a stop loss order. A stop loss order sells your stock at a certain price. For example, if your original investment of $1000 drops to $960 your investment will automatically sell and protect you from further losses. On the flip side, when you make your 8.00% do not automatically sell but let your investment ride with a stop loss order set at $1080. If you investment keeps growing raise your stop loss order to help ensure even more profits. That’s it! Sounds easy, right? Yes, it does get more complicated than what I just outlined but those are the basics and until you master the basics you will not be able to master advanced techniques.
We have access to a lot more resources than I did in fourth grade here at the school such as the computer, the internet, and the Trading Room. The Trading Room is equipped with some of the best tools available for trading. With a little practice you can follow not only the daily trends in a company but use the analytical tools in the Trading Room and theories learned in class to know when to buy, sell, and make successful trades!

SEC Bullish on the Bear

By: Michael Cavallaro
The Stillman Exchange - Seton Hall's Business Newspaper
Managing Editor

As if the Enron, Worldcom, and Adelphi scandals were not enough, Bear Stearns has arguably entered their ranks. Bear Stearns has neither admitted nor denied allegations of illegal mutual fund trading, but have agreed to pay a $250,000,000 fine. The Securities and Exchange Commission and New York Stock Exchange Regulation, Inc. are making efforts to prevent Bear Stearns from committing violations of federal securities laws. The fine sounds expensive but one must wonder whether or not these fines deter corporations from wrongdoing or are considered just another cost of doing business?
On March 16, 2006, The Securities and Exchange Commission settled an enforcement action against Bear, Stearns & Co., Inc. and Bear, Stearns Securities Corp (collectively, Bear Stearns) according to SEC press release 2006-38. The enforcement action was an order instituting administrative and cease-and-desist proceedings, making findings, and imposing remedial sanctions and a cease-and-desist order pursuant to section 8A of the Securities Act of 1933, Sections 15(b) and 21C of the Securities Exchange Act of 1934, and sections 9(b) and 9(f) of the Investment Company Act of 1940 (SEC Admin. Proc. File No. 3-12238). Bear Stearns was charged with two types of illegal mutual fund trading practices between 1999-2003: Late trading and deceptive market timing (SEC Admin. Proc. File No. 3-12238).
The Bear Stearns Companies Inc. is a holding company that through its broker-dealer and international bank subsidiaries, principally Bear, Stearns & Co. Inc., Bear, Stearns Securities Corp., Bear, Stearns International Limited and Bear Stearns Bank plc is an investment banking, securities and derivatives trading, clearance and brokerage firm serving corporations, governments, institutional and individual investors worldwide. (Reuters BridgeStation Plus Business Description). The company is primarily engaged in business as a securities broker and dealer operating in three principal segments: Capital Markets, Global Clearing Services and Wealth Management. (Reuters BridgeStation Plus Business Description).
“‘Market timing’ includes: (i) frequent buying and selling of shares of the same mutual fund or (ii) buying or selling mutual fund shares in order to exploit inefficiencies in mutual fund pricing. Market timing can harm other mutual fund shareholders because it can dilute the value of their shares. Market timing, while not illegal per se, can also disrupt the management of the mutual fund’s investment portfolio and cause the targeted mutual fund to incur considerable extra costs associated with excessive trading and, as a result, cause damage to other shareholders in the funds. Market timing may be illegal, for example, if deception is used to induct a mutual fund to accept trades that it otherwise would not accept under its own market timing policies.” (Admin. Proc. File No. 3-12238 pg. 4 ¶ 8).
“‘Late trading’ is the practice of placing orders to buy, redeem, or exchange mutual fund shares after the time as of which mutual funds calculate their net asset value (“NAV”), typically 4 p.m., but receiving the price based on the prior NAV already determined as of 4:00 p.m. Rule 22c-1(a) under the Investment Company Act (the “forward pricing rule”) prohibits late trading. Late trading enables the trader improperly to obtain profits from market events that occur after 4 p.m., such as earnings announcements and futures trading, that are not reflected in that day’s NAV. By being able to late trade, customers of Respondents and correspondent firms obtained trading advantages over the other shareholders of the targeted mutual funds.” (Admin. Proc. File No. 3-12238 pg. 4 ¶ 9).
Late trading and market timing give advantages to certain investors that are plain unfair. The illegitimate mutual fund trading practices of Bear Stearns reminds one of the movie Back to the Future II. In Back to the Future II, Old Biff steals the time machine to go back to the future to give young Biff a sports almanac. The result is young Biff is able to exploit the fact he knows the outcome of certain sporting events in advance for financial gain by gambling on guaranteed winning teams.
According to SEC press release 2006-38, orders which were actually received after 4:00 p.m. were processed as if they were actually received before 4:00 p.m. The Bear Stearns Mutual Fund Operations Department (“MFOD”) use an electronic mutual fund order entry platform called the Mutual Fund Routing System (“MFRS”). (Admin. Proc. File No. 3-12238 pg. 4 ¶ 10). “Because MFRS accepted orders until 5:45 p.m. and processed those trades as if they had been received before 4:00 pm. without regard to when they were actually received, prime brokerage customers had the ability to lat trade unchecked.” (Admin. Proc. File No. 3-12238 pg. 4 ¶ 11). A Bear Stearns Mutual Fund Operations Department supervisor stated in a recorded telephone call to a Bear Stearns broker:
“Because you’re sending trades down some days after what’s considered a legitimate time, 4 o’clock New York time, we want, we want to make sure that you know that we need to populate a time prior to 4:00 p.m. New York time. What I’d like for you to do, we’re going to populate either 4:00 p.m. or 3:59. [Y]ou know obviously, you should have them before 4… Obviously, we aren’t going to receive it most of the time before 4:00 p.m. New York time, so that if the auditors come to us, and, you know, they want to see something, we have that you took, you took the trade before 4:00 p.m.” (Admin. Proc. File No. 3-12238 pg. 10 ¶ 48).
In addition to late trading, Bear Stearns facilitated deceptive market timing for customers. Bear Stearns helped to hide the identities of certain customers that used market timing from mutual funds that wanted to avoid market timing business. Bear Stearns “facilitated deceptive market timing by offering timers a number of devices that helped hide their identity from mutual funds, including: (1) opening new account numbers for blocked customer accounts and, in some cases, journaling funds from a blocked account to another account so the timer could continue timing the same mutual fund with the same money in a new account; (2) creating new RR numbers to disguise timers from mutual funds; (3) assigning new branch codes to timers’ accounts; and (4) suggesting that timers trade in smaller amounts in order to avoid being detected as timers by mutual funds.” (Admin. Proc. File No. 3-12238 pg. 15-16 ¶ 81).
Bear Stearns was ordered to pay a disgorgement totaling $160,000,000 and civil money penalties totaling $90,000,000, for a total payment of $250,000,000. (Admin. Proc. File No. 3-12238 pg. 39). The SEC press release stated “the New York Stock Exchange Regulation, Inc. censured and fined Bear Stearns, and imposed compliance with these undertakings.” Further, the press release stated “[t]he fine imposed by the NYSE will be deemed satisfied by the payment of the $250 million pursuant to the Commission’s order.”
In torts, you learn about Judge Learned Hand’s famous “Hand Formula” which was used to decide United States v. Carroll Towing Co., 159 F.2d 169 (2d Cir. 1947). Using the Hand rule, liability depends upon whether the “Burden” is less than the “Injury” multiplied by the “Probability”; B < I x P . (Carroll, 159 F.2d at 173). The economic idea behind the Hand rule is that a company will want to maximize profit. If the burden of preventing an injury is greater than the injury multiplied by the probability, a company will most likely not take steps to prevent the injury because it will decrease profit. When analyzing whether or not a fine will deter a large financial company from wrongdoing we can apply the Hand formula with a little tweaking. For example, if we change burden to economic gain and change injury to fine, we have a formula that states if Economic gain < Fine x Probability of getting caught, then a company may be deterred from using illegal or deceptive practices for financial gain. However, a company may be tempted to use illegal or deceptive practices for financial gain if a company can produce a higher economic gain than the fine multiplied by the probability of the fine.
In other words, implementing fines that are so large that no company will face economic gain or will face economic loss may deter companies from illegal practices. However, the problem with instituting a monetary value that is applicable for all companies is imbalanced since not all companies are of equal value. A fine of $250 million may put some companies out of business, whereas, the same fine will have little or not effect on another company. Rather, percentages should be used when implementing fines in order to fix the imbalance of company values. For example, a fine could be a certain percentage of net revenues or net income for the year. If a company is fined a 25 percent deduction in net income they may think twice before using illegal tactics.
In addition to settling the enforcement action on March 16, 2006, Bear Stearns also reported record quarterly results with the highest ever net revenues, net income and earnings per share. Net revenues rose 19 percent to $2.2 billion. Net income increased 35 percent to $514 million. Earnings per share went up 34 percent to $3.54. Do you think the fine even fazed Bear Stearns?