The purpose is to determine if a specific strategy for buying or selling stock in the stock market might be profitable over a period of time.
What's the secret to making money in the stock market? It's simple: buy low, sell high. That's it! Everything else is just "noise." Buy a stock when its price is low and sell it at a later date when the price has appreciated. Of course, the hard part is picking a stock whose price will appreciate.
Most successful investors buy stock in a company they have thoroughly researched and they believe the company has great potential for increasing its earnings in the future. When a company has increasing earnings, the price of its stock usually increases. Buying stock in a good company and holding onto it for many years is a great way to build a nice nest egg.
But, some people try to get a much quicker return on their money. They attempt to buy and sell stocks in a very short period of time, perhaps over a period of several weeks or months. Some even buy and sell within the same day; they are known as day traders.
Short-term investing can be very risky, however, and, many times, an investor will lose money or miss out on really big gains because a stock was sold prematurely. Patience usually gives investors an edge.
Nevertheless, the fearless investor is lured to a quick profit by short-term trading, just as a gambler is drawn to the chance for a big win with the pull of a slot-machine handle.
Stock market trading, however, is not quite the same gamble as pulling the handle on a slot machine. Naturally, some luck is involved and some uncontrollable factors are at play. But the odds are more in your favor in the stock market, where you can do your homework researching a company and its products, and developing strategies based on the past performance of a stock.
Stock market gurus are everywhere, selling newsletters and services, each one making recommendations as to which stock to buy, based on their "unique" strategies. How accurate are the predictions by these gurus? Their theories must be tested over time with a large sample of stocks.
Let's propose a strategy of our own, and then, over a period of two months, test our theory with a large sample size. Our strategy will be a short-term play. We will attempt to buy low and sell high within a few weeks or months to make a small profit.
Our strategy is to buy a stock if it takes a slight "dip" within the first three weeks of doing a stock split, and then selling the stock several weeks after that as the stock begins to climb.
What is a stock split? A stock split is when a company divides its total number of shares of stock to make more shares available. For example, suppose a stock is selling for $100 a share and you own 20 shares. If the company does a 2-for-1 split, you will get two shares of stock for every one share you have, but the price per share will be cut in half. After the stock split, then, you will own 40 shares of stock valued at $50 per share. Think of a 2-for-1 stock split as somebody giving you two five-dollar bills and you giving them a ten-dollar bill. You end up with two bills, but the total dollar value of the money you have has not changed. You got two $5s for a $10.
Companies may chose other ratios for splitting, for example, 3-for-1 or 3-for-2.
Why do companies split their stock? Splitting makes the price of their stock cheaper, so it is more affordable. They hope people will then buy more of it, which will cause the stock's value to increase.
Why would a stock make a temporary dip in price following a split? Once a stock split is announced, traders often start buying shares, which drives the price up a few weeks before the stock is scheduled to split. Once the split takes place, traders begin to sell their shares to lock in profits from the presplit price run-up. Historically, stock splits were a nonevent. A split is nothing more than two $5s for a $10. But, in recent years, a split has been perceived as a positive move, because stocks that announce splits have usually been very good stocks. So, the stock often goes up when a split is announced because people buy into what they think is a positive move. Once the stock splits, some traders sell their stock to capture a small profit from the stock price rising between the time of the announcement and the actual split date. That selling may cause the stock price to take a slight drop. This often happens within the first three weeks following the split. After the dip hits a bottom, the stock price may begin to rise again. There is a tendency for the stock to regain lost ground and head up toward its previous high (which may take a year or two) if it is a good company, which is why the stock went up so high in the first place.
Buying a stock on the slight dip after a split is an opportunity to buy low, and when the stock begins to climb shortly after that, to sell high.
Hypothesize that you will make a profit the majority of the time by buying stocks that take a slight price dip within the first few days or weeks following the split, and then selling the stock within a month or two as the price moves upward. We will only buy stocks that take a dip within the first three weeks following a split. We will sell the stock within two months following the split. Stocks will be bought and sold on paper (not using real money). After several months, our wins and losses will be tallied. Our hypothesis is that we will make an overall profit, even though there will occasionally be some losing stock plays.
- Computer with a modem and an Internet connection
- Computer printer
- Financial daily newspaper
- Two to three months of time
- Calculator or computer spreadsheet program (optional)
Research to compile a list of stocks that have announced they are going to split. Companies that announce stock splits are listed in daily financial newspapers (The Wall Street Journal, Investors Business Daily, and so forth) and announced on financial news programs on TV and on financial channels (CNBC). Many stock market sites on the Internet also list upcoming stock splits. Some sites include:
You need not wait for splits to take place. You can find out when stocks have split in the past by looking at their stock charts (which indicate when a stock split) or by checking these Internet sites:
This project requires viewing a lot of stock charts to observe the price behavior patterns following stock splits. The Internet has hundreds of free financial sites where you can get stock charts. Some of the best include:
Stock charts are displayed by entering a company's ticker symbol, the symbol used by the stock exchanges to represent each company. For example, Disney is DIS, Coca-Cola is KO, Ford Motor Company is F. If you do not know a company's ticker symbol, you can usually obtain it from the Internet site where you are getting your stock charts. The daily financial papers also list all companies alphabetically, along with their ticker symbol.
The Internet is a fast-changing medium, and the sites we have just listed for research and charting may or may not still offer these free services. If that happens, use an Internet search engine to search for stock market quotes or stock splits.
Once you compile a list of stocks that are due to split (at least a dozen stocks split every month), write down the name of each company, the ticker symbols, and the date the stock is due to split. Once a day, check a financial Internet site or a financial newspaper and write down the price of your stock. You may want to do this every morning or evening.
After a stock splits, watch for a drop in price. When you find a stock that is in a downward trend for several days, watch it until it appears to level off or head back up. At that time, do a paper trade, that is, pretend to buy 100 shares of the stock. Write down the cost per share and how much money you spent. Timing the market is very difficult. You may think you are buying the stock at the lowest part of the dip, only to later discover that the stock dips even more. Nevertheless, hold on to your stock, even if you think you didn't buy it at its lowest point.
Once you purchase a stock, continue to write down its closing price each day. Watch it for one or two months. If the stock rises to a point where you feel you would make a nice profit if you sold it, sell your shares. To arrive at your profit, subtract your cost from the money you made selling your shares. Determine the percent return on your money by dividing the profit by the cost, and then multiplying the answer by 100 to show percent. For example, suppose you bought 100 shares of Kmart stock at $12 per share, for a cost of $1,200. You sold the stock at $13½, or $1,350. The profit is $150. $150 divided by $1,200 equals 0.125, times 100 to show percent is 12½ percent. That's a very good return over two months!
Our rule is to only buy stocks that show a dip pattern within three weeks of a stock split. If a stock does not take a dip, do not use it in the project.
Another rule is to sell any stock you buy on dip that continues dropping more than 20 percent. We will take the loss, but we will preserve our money, so we don't lose too much. Not all stocks do well after a stock split, as evidenced by Disney (DIS) in 1999.
After several months of tracking stocks, buying, and selling, declare a stop to your project. Total your wins and losses. Did you make more money than you lost? Do you think this is a strategy that could be profitable if real money were used to do the trades?
Write down the results of your experiment. Document all observations and data collected.
Come to a conclusion as to whether or not your hypothesis was correct.
- Continue to follow the stocks for an additional two months. Would more profit be made by holding the stocks longer?
- Research news on any stock that drops after a split and continues to drop for a long time. Is there a reason why the stock price is being beaten down?