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Money & Investing - Stocks                                                                             Mutual Funds   Options

 

 

Why should I buy (invest in) common stocks?

What is the price-earnings ratio?

Why is the price-earnings ratio important to me?

What are warrants?

What are options?

What happens if I buy a stock before the ex-dividend date, but the records of the corporation cannot be updated in time

     for proper dividend credit? 

What is the current yield on a stock?

Why do stock prices go up and down?

What is a bull market?

What is a bear market?

 

What is the total return on my stock?

What is my stock portfolio?

How do I diversify my stock portfolio?

How do I diversify by industry groups or sectors?

How do I diversify by market behavior?

How do I diversify by investment objective?

What are growth stocks?

What are income-oriented stocks?

Can I diversify by investing n foreign stocks?

What are some of the risks of investing in foreign securities?

 

Is there a possible tax consequence in owning foreign securities?
Every day I hear quotes for the Dow Jones Industrial Average and the S&P 500. What do these quotes mean to me?
What are some of the most popular indexes and averages?
How do I go about buying and selling stocks?
How do I choose stocks that meet my investment objectives?
What are the major U.S. stock exchanges?
What are some of the over-the-counter market terms I should know?
What is the bid price?
What is the asked price?
What is the spread?


If my account is coded to hold in customer name, what does this mean?
If my account is coded to hold in street name, what does this mean?
What are some of the different orders I can enter?
What is a short sale?
Are there any special rules when entering a short sale order?
What is the risk in entering into a short sale?
After I buy a stock, how do I follow my stock's progress?
How will dividend changes effect the price of my stock?
What is a stock split?
What is a stock dividend?
How do stock dividends and stock splits affect the value of my investment?
What is a reverse split?
 


Q. Why should I buy (invest in) common stocks?

A. The short answer is that you can often make more money than you can make from other savings and investment alternatives. You may make money owning  common stocks by:

  1. Receiving dividends.

  2. Through capital appreciation.

The payment of dividends is a way for a corporation to share part of its profits with its owners. Many corporations have a history of regularly increasing the dividends they pay their owners (stockholders). By increasing dividends, the corporation increases the return to owners as its profits increase. Increasing dividends serves as an inflation hedge for the corporation's stock owners.

Another way of making a profit on common stocks is through capital appreciation, an increase in the price of the stock over a period of time. If you bought a common stock at $50 a share ten years ago and it is now selling at $100,, you would have capital appreciation of $50 a share, or a 100 percent increase in the value of your invested money over ten years.

To properly compare the returns on different investments held for different periods of time, you need to know the annual return. A 100 percent increase over ten years provides an average annual return of 10 percent per year. It also provides a compound annual return of 7.18 percent per year. If the value of a stock you purchased at $50 a share increased by 7.18 percent each year, the value at the end of ten years would be $100.

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Q. What is the price-earnings ratio?

A. The price-earnings ratio, often referred to as the P/E ratio, is the price of a stock divided by the company's earnings per share.

Example: If a stock's price is $60 and the earnings per share are $4.00, the price-earnings ratio is 15 (60 divided by 4 = 15). If the price is $40, the P/E ratio is 10 (40 divided by 4 = 10).

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Q. Why is the price-earnings ratio important to me?

A. The price-earnings ratio can be a good measure of whether a stock is a bargain or overvalued.

  1. If the P/E ratio of the corporation you are reviewing is lower than that of similar corporations, you may want to investigate why it is lower. The stock may be a bargain.

  2. Conversely, if the P/E ratio of the corporation you are reviewing is higher than that of similar corporations, you may want to investigate why it is higher. The stock may be overvalued.

Illustration:      Ten-Year History of the Average Annual P/E Ratio of PepsiCo Common Stock

Year Average Annual P/E Ratio

        1. 11.8

        2. 12.6

        3. 16.3

        4. 15.5

        5. 12.6

        6. 15.7

        7. 17.8

        8. 20.4

        9. 22.8

        10. 20.0

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Q. What are warrants?

A. Warrants are rights to buy shares of a corporation's securities, usually common stock, at a specified price for a limited period of time. Warrants are primarily issued as a marketing technique to help make other types of securities of a corporation more attractive to investors. Many warrants have a market value and a trading market for buying and selling. If warrants are exercised, they are a potential source of additional shares of common stocks.

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Q. What are stock options?

A. Options, in a discussion of potential dilution, are rights to buy a fixed number of shares at a fixed price for a fixed period of time. Options are issued to a corporation's officers based on the company's performance or for other reasons. The options usually require that an officer remain employed for a certain period of time. Options are a potential source of additional shares of common stock.

When you see a corporation report primary earnings per share, this means earnings per share based on current shares outstanding.

When you see a corporation report fully diluted earnings per share, this means the earnings per share if all possible shares were issued. It does not mean that all the potential additional share will be issued. The warrants, convertible securities, or options are only possible sources of additional shares

Click here for further information on other types of options.

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Q.  What happens if I buy a stock before the ex-dividend date, but the records of the corporation cannot be updated in time for proper dividend credit? 

A. If the buyer is entitled to a dividend, but the ownership has not been transferred on the corporation's books in time for the dividend to be paid to the buyer, the brokerage firm executing the transaction is responsible for claiming the dividend from the seller and making certain that the payment is made to the buyer. This is referred to as a dividend claim.

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Q. What is the current yield on a stock?

A. The current yield is the anticipated annual dividend divided by the current price of the stock.

Example: If you purchase a share of PepsiCo at $40 and the anticipated annual dividend is $0.64 per share, your current yield is 1.6 percent ($0.64 divided by $40 = 1.6 percent).

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Q. Why do stock prices go up and down?

    A. The current price of a stock is the price investors will pay for that stock at that moment. The price represents the present value of the expected future cash to be received from that stock, either from dividends or through capital appreciation. When you buy a stock for its appreciation potential, you believe that expectations about the corporation will improve and investors will pay higher prices for the stock. Since the price depends on investors' expectations, the price will rise or fall as new developments occur, such as:

    • Company developments. The corporation's own operations will sometimes exceed or fall short of investors' expectations. For example, IBM's internal troubles from 1991 to 1993 caused its stock to fall even as the stocks of other computer companies continued to rise.

    • Industry/group developments. The industry of which the corporation is a part will experience better or worse prospects from time to time, such as the banking industry during the credit crisis in the 1989-1991 period.

    • Market developments. The entire stock market environment can change, pulling a stock's price along with it regardless of how well the corporation is doing. The bull market that began in 1982 elevated the price level for stocks in general, and the market crash of October 1987 pulled most down temporarily.

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Q. What is a bull market?

A. A bull market is a period during which the general level of stock prices are rising.

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Q. What is a bear market?

A. A bear market is a period during which the general level of stock prices are falling.

  • Economic/political developments. Good or bad reports on the economy and political events such as elections or new laws can affect expectations about a corporation, an industry, or the entire stock market. As a historic example, the Arab oil embargo of 1973-1974 affected not just oil stocks, but the stock market and the economy as a whole.

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Q. What is the total return on my stock?

          A. Total return is dividend yield plus appreciation.

Example: You bought a stock paying s 50 cents per share dividend one year ago for $10 a share (5 percent yield). Today, the stock is worth $12 a share ($2 per share appreciation or 20 percent). Your total return is 25 percent: the dividend yield of 5 percent plus appreciation of 20 percent. If you had owned the stock for five years, your total dividends would be $2.50 (50 cents per year for five years), or 25 percent ($2.50 dividend by 10). Add the appreciation of 20 percent and your total return is 45 percent over five years. This translates into an average annual return of 9 percent, or a compound annual return of 7.7 percent.

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Q. What is my stock portfolio?

A. Your stock portfolio is your entire holdings of stocks. As your investment strategy develops and changes, you should regularly review your portfolio to make sure it continues to meet your objectives and requirements.

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Q. How do I diversify my stock portfolio?

A. You diversify your stock portfolio by owning several different types of stocks. You should not put all your eggs in one basket by investing all your money in one security. Diversification into different types of stock will reduce risk. Often a difficult period for one type of corporation or industry will be offset by good relative performance of the rest of the portfolio. You may diversify in several different ways, including:

    • Company size

    • Industry group

    • Market behavior

    • Investment objective

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Q. How do I diversify by industry groups or sectors?

A. Companies operate in many different industries, and those industries are grouped into industry sectors. The major industry sectors and some industries within those sectors are the following:

  • Basic Industry, Chemicals, Metals, Paper.

  • Capital Goods, Machinery, Computers, Electrical Equipment, Telephone-Long Distance, Pollution Control, Aerospace / Defense.

  • Consumer Durable, Appliances, Autos, Building, Photography.

  • Consumer, Nondurables / services, Foods and Beverages, Drugs / Health, Retail, Publishing, Tobacco, Household, Entertainment / Leisure.

  • Energy, Oil Service / Drilling, Oil-Domestic, Oil-International.

  • Financial, Banks, Other Finance, Insurance.

  • Transportation, Air, Rail, Truck.

  • Utilities, Electric, Gas, Telephone.

  • Miscellaneous.

Investing in a broad variety of industry groups usually allows you, the investor, representation in the different sectors of the economy. Companies in an industry sector will be affected by the same industry developments, but companies in other sectors often will be affected by different factors and circumstances. Diversifying a portfolio among industry sectors usually reduces the risk from down cycles in any one sector.

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Q. How do I diversify by market behavior?

A. Classifying stocks by their historic price behavior in various market environments is another way of seeking diversification. In addition to size and industry groupings, stocks also may be classified by how their price reacts to various cycles within the stock market and the economy. At the start of an economic upturn, for instance, cyclical stocks (those tied most closely to the economy's health, like steel or machinery stocks) will usually perform well. The reverse is also true: as the economy turns down, defensive stocks (those of companies making staple goods, such as foods and beverages) will resist the downturn better than others.

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Q. How do I diversify by investment objective?

A. Stocks may also be classified by which investment objective, such as growth or income, they most closely fulfill.

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Q. What are growth stocks?

A. Growth stocks are those of corporations, such as computer makers, that are growing rapidly and that reinvest the majority of their earnings in this growth rather than paying them out as dividends. Growth stocks have a long-term record of superior appreciation tied to growth of the company's earnings. Since the shareholder's total return and accumulation of wealth often depends on this growth, the stocks tend to be more volatile than stocks with higher dividends.

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Q. What are income-oriented stocks?

A. Income-oriented stocks generally provide a high income and often a steady growth of income, but do not hold as much promise for growth and appreciation. Examples include utility stocks or real estate investment trusts. Such stocks are usually steadier in price behavior because investors are not demanding dynamic appreciation potential. Generally, the higher the yield of a stock, the less opportunity there is for capital appreciation. In general the following is true: the prices of income stocks will decline if interest rates increase; their prices will rise if interest rates decrease.

Note of Caution: If a stock is yielding a great deal more than similar stocks, you may want to investigate whether its dividend is in jeopardy.

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Q. Can I diversify by investing in foreign stocks?

A. As the world becomes smaller and stock markets develop abroad, many investors are seeking opportunities in foreign stocks. You can invest in foreign stocks either directly or through American Depository Receipts (ADRs). Generally, an American investor will not purchase the stock of foreign corporations directly. He or she will invest in American Depository Receipts.

Shares of many of the larger foreign corporations, such as British Petroleum, Sony, and Honda, are traded in US markets via ADRs. Even though ADR certificates look like stock certificates, they actually represent shares of a foreign corporation that are held by an American bank, which issues the ADR. ADRs are a popular way for Americans to invest in foreign corporations because of the ease of transfer and sale.

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Q. What are some of the risks of investing in foreign securities?

A. If you invest in foreign stocks, your investments may be subject to currency adjustments, special taxes, or transfer difficulties. Currency adjustments mean that the dollar value of your foreign stocks may fluctuate because of a change in the value of the foreign currency relative to the US dollar rather than because of any corporate event or news. Rules and regulations and reporting requirements for foreign markets are often different from those for domestic corporations. Foreign stocks that are traded in US markets must conform to US reporting requirements.

Note of Caution: Before investing in ADRs or foreign securities, you should look into potential problems and see if you are willing to assume the additional risk.

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Q. Is there a possible tax consequence in owning foreign securities?

A. When you own ADRs or own shares of a foreign corporation directly, the country in which the foreign corporation is located will often withhold income tax from the dividends you receive. Generally, you may credit such withholdings against your US income taxes. For precise information on the taxation of the dividends or distributions from foreign corporations, you should consult your broker or tax advisor.

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Q. Every day I hear quotes for the Dow Jones Industrial Average and the S&P 500. What do these quotes mean to me?

A. Indexes reflect the general direction of the stock market or specific segments of the stock market. When news commentators want to indicate the direction of stock prices, they quote the movements of one or more stock indexes.

Indexes are published daily to give investors the general direction of stock prices. The indexes are commonly reported by the news media as part of regular coverage. When large movements occur in stock prices, the change in the indexes often makes headlines.

Different indexes are formulated to measure different sectors of the market. The Dow Industrials includes only 30 large-capitalization stocks, whereas the S&P 500 measures the broader market, covering 500 stocks.

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Q. What are some of the most popular indexes and averages?

    A. Some of the most popular indexes and averages include:

    • The Dow Jones Industrial Average.

    • The Dow Jones Transportation Average.

    • The Dow Jones Utility Average.

    • The Standard & Poor's 500 Index.

    • The NASDAQ Composite Index.

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Q. How do I go about buying and selling stocks?

A. Your first step is to establish your general investment objectives and the role stocks should play in your strategy to achieve those objectives. For assistance in establishing your investment objectives, you may turn to a professional at a brokerage house, bank, or other advisory firm.

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Q. How do I choose stocks that meet my investment objectives?

    A. The process of searching for appropriate stocks is called investment research. Some investors conduct their own first hand research, which may be of two major types:

    • Fundamental analysis.

    • Technical analysis.

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Q. What are the major US stock exchanges?

A. The major US stock exchanges include:

  • New York Stock Exchange.

  • American Stock Exchange.

  • Pacific Stock Exchange.

  • Philadelphia Stock Exchange.

  • Midwest Stock Exchange.

There are also stock exchanges in many foreign countries.

When you buy or sell a stock that trades over-the-counter (OTC), your order is not sent to New York or Philadelphia or any other exchange location. Your broker's own trading desk makes direct contact with another firm's traders. They negotiate price and execute the transaction themselves, reporting the trade to you and to the networks of OTC trading firms around the country. The major OTC reporting network is called the National Association of Securities Dealers Automated Quotations (NASDAQ) system. Another OTC reporting service called the "Pink Sheets" is published by the National Quotation Bureau Inc. and reports trading in smaller stocks. Daily trading in many OTC stocks is reported in major newspapers. The format is the same as that used for exchange listed stocks.

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Q. What are some of the over-the-counter market terms I should know?

A. Some over-the-counter market terms you should understand are:

    • Bid price.

    • Asked price.

    • Spread.

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Q. What is the bid price?

A. The bid price is the price a dealer would pay a seller for shares.

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Q. What is the asked price?

A. The asked price is the price a dealer would charge a buyer for shares.

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Q. What is the spread?

A. The spread is the difference between the bid and asked prices, which the dealer keeps as compensation for the trader who executed the transaction. Your broker may also charge you a commission.

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Q. If my account is coded to hold in customer name, what does this mean?

A. If your account is coded to hold in customer name, a certificate will be registered in your name but held at the brokerage firm for safekeeping. All dividends and corporate information will be mailed directly to you at your address of record.

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Q. If my account is coded to hold in street name, what does this mean?

A. If your account is coded to hold in street name, securities are registered in the name of the broker/dealer for the benefit of you, the owner. This method facilitates transfer, collection of dividends, identification, and notification of major corporate events. All dividends and corporate information are mailed to the broker/dealer and forwarded to the investor. The investor may instruct the broker to hold dividends for future investment.

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Q. What are some of the different orders I can enter?

A. Once the account is open, you may enter an order to purchase or sell stock. Again, you may state your preference on a number of factors, including price and time.

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Q. What is a short sale?

A. Sometimes investors sell a stock that they do not own with the intention of repurchasing it at a lower price. This transaction is known as a short sale. If the short sale is successful, the difference between the sale price and the purchase price is the investor's profit.

Example: An investor decides that IBM common stock is overvalued at $100 per share and sells the stock which she does not own. Six months later, IBM is selling for $50 a share, and the investor purchases stock to close the position. Her profit is $50 per share.

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Q. Are there any special rules when entering a short sale order?

A. Yes. You must disclose to your broker that you are selling short (selling stock you do not own), because the broker must make arrangements to borrow  the number of shares you are selling to make delivery. The buyer of the stock you are selling must receive the shares for the stock he or she is buying.

Short sales must be executed in a short account. In order to execute a short sale, you must also have a margin account. On most major exchanges, short sales can only be executed when the price of the order is higher than the last trade. This is referred to as the uptick rule.

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Q. What is the risk in entering into a short sale?

A. When you invest in a stock, you are risking only the money you invested. In a short sale, in theory, your risk is unlimited-that is, the price of the stock you short could continue to rise indefinitely.

In the IBM example, if the price of IBM stock rose to $300 and the investor decided to repurchase at that price, her loss would be $200 a share ($300, the price at which she purchased the stock, less $100, the price at which she sold the stock).

Note of Caution: If the price of a stock you shorted increases, you may receive a margin call for a portion of the rise in value. In some instances, you may not be able to enter a short sale because your broker cannot borrow a certificate to make delivery.

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Q. After I buy a stock, how do I follow my stock's progress?

A. It is important that you keep current on your stock's activity, the underlying company, and general market conditions. By checking your stock regularly, you can determine if there is an upward or downward trend in its price movement and if its trading volume is above or below average. Volume trends can reinforce or contradict the trend you see in price movement.

For instance, if your stock's price is rising and its trading volume is heavier than usual, this may indicate not only that investors are willing to pay higher prices, but also that there is increased demand at the higher price levels. On the other hand, if the price has been falling, but the volume is getting very light, there may not be many more sellers willing to accept the lower prices, and the price decline may be ending.

News on corporate developments will affect the price of your stock. By reviewing the company's quarterly and annual reports on sales and earnings, and any news releases the company may issue, you will notice the effect good or bad news can have on your stock's price. You should also watch general news, since broader developments in the market and the economy can also affect your stock, regardless of how well the particular corporation is doing. One-time events may not have a major effect on your long-term investment. But if such events become a trend in the corporation's operations, the nature of your investment will change, and you might want to decide whether to hold, buy more, or sell your stock.

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Q. How will dividend changes effect the price of my stock?

A. Dividend payments are one of the most direct contributors to your investment return. Once you know the quarterly dividend payment dates and the amount of the dividend the stock has been paying, you can record the upcoming dates in your calendar and anticipate these payments. From time to time, corporations will increase or decrease the dividend. One indication that a stock is a good investment is a record of steady increases in its dividend.

If you own a stock and the corporation announces a dividend increase, you may see the stock price appreciate as investors react to the good news. A dividend increase is a message that the board of directors has a positive expectation for the corporation's future.

The reverse is also true. If your corporation is having difficulties and announces a reduction or elimination of its dividend, this is generally a negative signal on the corporation's outlook.

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Q. What is a stock split?

A. A stock split is a proportional division of a corporation's outstanding shares. A shareholder will receive a proportional number of additional shares, and the par value and market price of the stock will decrease proportionately.

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Q. What is a stock dividend?

A. A stock dividend is a distribution of additional shares to current shareholders in addition to or in lieu of a cash dividend. As in a stock split, your shares will increase in number, but your overall ownership and value remain the same.

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Q. How do stock dividends and stock splits affect the value of my investment?

A. In theory, stock splits and stock dividends do not affect the value of your investment. In both cases, the corporation issues more shares and the stock's market price is automatically adjusted proportionately so that the value of your total investment stays the same. For instance, if you own 100 shares of a stock priced at $60 (a $6,000 value) that splits or declares a stock dividend, the math will change, but the value will not:

Pre-split 100 at $60 = $6,000 value

2-for-1 split 200 at $30 = $6,000 value

100% stock dividend 200 at $30 = $6,000 value

3-for-2 split 150 at $40 = $6,000 value

50% stock dividend 150 at $40 = $6,000 value

Like cash dividends, stock splits and stock dividends will have a declaration date, a record date, and a payment date. If the payment date has passed and you have not received your new shares, you may follow the same procedures outlined for cash dividend payment problems-

Note: Par value is a nominal dollar value per share set by the corporation's charter when the stock was originally issued. Currently, par value has little significance except for bookkeeping purposes within the corporation.

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Q. What is a reverse split?

A. Corporations whose stocks have very low prices, say under $1 per share, may declare a reverse split to adjust the price upward to what investors may perceive as a more mainstream price level. For example, a holder of 1,000 shares of a $0.75 stock declaring a 1-for-10 reverse split would receive a replacement certificate for 100 shares, and the price would adjust to $7.50.

Note of Caution: A reverse split will substantially reduce the number of shares you own. If you own a stock selling at under $1.00 per share and you suddenly see the price quoted several times higher, you should inquire whether an event such as a reverse split has affected your holdings. If you sell stock that you do not own, you may be obligated to purchase additional shares to make delivery, even if the result is a loss.

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Source: Money & Investing Victor L. Harper., Arthur S. Brinkley.,with Sarah E. Dale


 

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