Developments

After-Hours Trading: Understanding the Risks

The highest volume market centers today have traditionally been open for business from 9:30 AM to 4:00 PM EST. Although trading outside that window-or “after-hours” trading-has occurred for some time, it has been mostly limited to high net worth investors and institutional investors.

But this is changing. Some smaller exchanges have recently extended their hours. And, with the rise of electronic communications networks, or ECNs, everyday individual investors can now trade in the after-hours markets.

Be aware that after-hours trading for the individual investor is in its infancy and changes are taking place rapidly. Before you decide to trade after-hours, you need to educate yourself about the differences between regular and extended trading hours, especially the risks. You should consult your broker and read any disclosure documents on this new and developing area. Check your broker’s Website for available information on trading after-hours. As with trading during regular hours, the services offered by brokers during extended hours vary. You should therefore shop around to find the firm that best suits your trading needs.

Information About Trading in Fast-Moving Markets

The price of some commodities, especially recent “hot” IPOs and high tech stocks can soar and drop suddenly. In these fast markets when many investors want to trade at the same time and prices change quickly, delays can develop across the board. Executions and confirmation slow down, while reports of prices lag behind actual prices. In these markets, investors can suffer unexpected losses very quickly.

Investors trading over the Internet or online, who are used to instant access to their accounts and near instantaneous executions of their trades, especially need to understand how they can protect themselves in fast-moving markets.

You can limit your losses in fast-moving markets if you:

  • know what you are buying and the risks of your investment; and
  • know how trading changes during fast markets and take additional steps to guard against the typical problems investors face in these markets.

With a click of your mouse, you can buy and sell stocks from more than 100 online brokers offering executions as low as $5 per transaction. Although online trading saves investors time and money, it does not take the homework out of making investment decisions. You may be able to make a trade in a nanosecond, but making wise investment decisions takes time. Before you trade, know why you are buying or selling, and the risk of your investment.

To avoid buying or selling a stock at a price higher or lower than you wanted, you need to place a limit order rather than a market order. A limit order is an order to buy or sell a security at a specific price. A buy limit order can only be executed at the limit price or lower, and a sell limit order can only be executed at the limit price or higher. When you place a market order, you can’t control the price at which your order will be filled.

Information About Convertible Securities

A convertible security is a security – usually a bond or a preferred stock – that can be converted into a different security – typically shares of the company’s common stock. In most cases, the holder of the convertible determines whether and when a conversion occurs. In other cases, the company may retain the right to determine when the conversion occurs.

Companies generally issue convertible securities to raise money. Companies that have access to conventional means of raising capital (such as public offerings and bank financings) might offer convertible securities for particular business reasons. Companies that may be unable to tap conventional sources of funding sometimes offer convertible securities as a way to raise money more quickly. In a conventional convertible security financing, the conversion formula is generally fixed – meaning that the convertible security converts into common stock based on a fixed price. The convertible security financing arrangements might also include caps or other provisions to limit dilution (the reduction in earnings per share and proportional ownership that occurs when, for example, holders of convertible securities convert those securities into common stock).

By contrast, in less conventional convertible security financings, the conversion ratio may be based on fluctuating market prices to determine the number of shares of common stock to be issued on conversion. A market price based conversion formula protects the holders of the convertibles against price declines, while subjecting both the company and the holders of its common stock to certain risks. Because a market price based conversion formula can lead to dramatic stock price reductions and corresponding negative effects on both the company and its shareholders, convertible security financings with market price based conversion ratios have colloquially been called “floorless”, “toxic,” “death spiral,” and “ratchet” convertibles.

Both investors and companies should understand that market price based convertible security deals can affect the company and possibly lower the value of its securities. Here’s how these deals tend to work and the risks they pose:

  • The company issues convertible securities that allow the holders to convert their securities to common stock at a discount to the market price at the time of conversion. That means that the lower the stock price, the more shares the company must issue on conversion.
  • The more shares the company issues on conversion, the greater the dilution to the company’s shareholders will be. The company will have more shares outstanding after the conversion, revenues per share will be lower, and individual investors will own proportionally less of the company. While dilution can occur with either fixed or market price based conversion formulas, the risk of potential adverse effects increases with a market price based conversion formula.
  • The greater the dilution, the greater the potential that the stock price per share will fall. The more the stock price falls, the greater the number of shares the company may have to issue in future conversions and the harder it might be for the company to obtain other financing.
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