Basic Shares Outstanding
Basic shares outstanding are the total shares that a company issued and are outstanding. This number is directly reported on the financial statements. Not all shares that are issued are still outstanding. For example, treasury stock reduces the number of shares outstanding. Treasury stock are shares repurchased by the company in the secondary market.

Fully Diluted Shares Outstanding
Fully diluted shares outstanding are the company’s outstanding shares, adjusted for potentially dilutive securities and stock options. Convertible debt is an example of a dilutive security. If the convertible debt is converted to equity shares that increases the total number of shares outstanding.

Calculating Fully Diluted Shares Outstanding
Fully diluted shares outstanding are calculated using the treasury stock method and or the if-converted method. The treasury stock method accounts for the share impact of options, and the if-converted method accounts for the share impact of convertible debt and or preferred stock.

Treasury Stock Method
The treasury stock method includes the impact of stock options by calculating the additional shares created when the options are exercised. Only in the money options are included because out of the money options are anti-dilutive as the options would never logically be exercised. This method also assumes that proceeds from the sale of stock when options are exercised are used to repurchase shares at the current price. This partially offsets options’ dilutive effect.

Fully diluted shares are then calculated by adding the additional shares to the basic shares. Additional shares are calculated by determining how many new shares could be purchased from the profits of exercising in the money options. The calculation is current stock price minus strike price divided by stock price all multiplied by the number of options.

A company’s most recent 10k contains information about all of the current options outstanding. Normally there are multiple options with different strike prices that need to be calculated.

If-Converted Method
The if-converted method is used to calculated the share impact of convertible securities by determining how many new shares would be issued if an in the money convertible is exercised. The end calculation in this process is to multiply the number of securities being exercised by the conversion ratio to determining the new shares.

Also, convertible debt that is converted eliminates interest expense. The after tax interest savings from the conversion is therefore added to earnings per share when calculating the diluted earnings per share.

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Work Ethic
In any profession, a strong work ethic is important for success. Work ethic is especially important in trading, an extremely competitive career. Schwartz always tries to be better prepared than his competition. His preparation involves long hours and attention to detail, and this work ethic is crucial to his outstanding trading results.

Accepting and Recognizing Wrong Decisions
Removing ego from his trading psychology, is another important factor for Schwartz’s trading success. When Schwartz was a losing trader early in his career he struggled to admit when he was wrong. He corrected this detrimental psychology to become a winning trader. A component of being a winning trader is accepting that you cannot always be correct. Sometimes the market acts in improbable ways that one trader cannot fight against. Winning traders are able to recognize when they are wrong and cut losses. “One of the most suicidal thing you can do is to keep adding to a losing position.”

Coping With Large Losses
Even the best traders have to face large losses at times. Schwartz trades around large losses by reducing the size of his trades until he regains confidence. “After a devastating loss, I always play very small and try to get black ink, black ink. It’s not how much money I make, but just getting my rhythm and confidence back.”

Risk Control
Schwartz, similar to many traders including Larry Hite, employs strong risk control to be a winning trader. By limiting downside risk and preserving capital during down markets, Schwartz is able to position his portfolio to take advantage of early bull markets.

Macro Market News
Similar to many of the traders profiled in Market Wizards, Schwartz monitors how markets or stocks react to news to gain a better macro view of the market. When the market drops after good news, that indicates market weakness. Conversely, a market rally on bad news signals strength.

Schwartz’s 6 Top trading Rules
1. He compares moving averages of a security to the price of the security. “I try not to go against the moving averages, it’s self destructive.”

2. Schwartz also looks for specific types of market divergences such as a stock not declining when the general market has been falling. This divergence example would be a bullish indicator for the individual stock.

3. Similar to after a large loss, Schwartz reduces the size of his positions after a large gain. He has a personal track record of making over confident trades after a winning streak, so reducing his positon size increaes profit.

4. He does not generally attempt to pick the bottom of falling stocks. Schwartz believes this is very difficult and needs strong justification to buy a stock that is near all time lows.

5. Always have a set downside limit that outlines how much you are wiling to lose before entering the trade. This risk control measure is outlined by many other star traders.

6. “Work, work, work.” By learning from your mistakes and researching new methods traders improve over time and become more profitable.

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The previous weeks economic data was mixed and the S&P 500 ended the week about even. On a positive note, industrial production increased 0.2%, beating the 0.0% expectation. Industrial production decreases during normal recessions, so a continued positive industrial production number suggests some economic strength. However, this industrial strength may be driven by the relative weakness of the US dollar, which attracts exports. The slightly better than expected trade balance number demonstrates the growing economic role of exports. Recently the US dollar has been strengthening, which could counteract this industrial trend.

However, CPI increased 0.8%, greater than the 0.4% market expectation. I think growing inflation continues to be an economic question mark. Recent drops in values of commodities combined with a rising US dollar have placed downward pressure on inflation, but significant inflation still has a negative impact and handcuffs the Fed.

Next Weeks Economic Data (August 19 - August 21)

The housing starts and building permits numbers will provided insight into the strength of the weak housing sector. If these indicators are in line or above expectations, the data may support the idea that the falling housing market is beginning to stabilize.

Another important economic indicator is PPI, a measure of inflation. In addition to the CPI, the PPI will provide important data about the impact of changing commodity prices and a slowing economy on inflation.

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In the footer of the theme are both a tag cloud and a most viewed section. The tag cloud visually illustrates topics that are most blogged about. The most viewed list is part of a plugin that will track which posts are clicked on the most. I hope you enjoy the new theme.

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• Damn, it Feels Good to Be a Banker: Book Review

Damn, it Feels Good to Be a Banker is an antithesis to other insider accounts of banking such as Monkey Business that deglamorize the investment banking industry. Damn, it Feels Good to Be a Banker reglamorizes the “baller” investment banking world. The elitist content parental advisory on the cover really summarizes this book.

Underneath the heavy satire, the book outlines all general aspects of the job and life of investment banking analysts. Damn, it Feels Good to Be a Banker is split into four main sections: business, people, culture, and entertainment.

Business
The business section outlines the general structure of investment banks and the roles of all members of a banking deal team. For people who have not been exposed to banking, I think this section provides a solid general overview of the industry and the roles of different groups within an investment bank. For example, Leveraged Sell-Out differentiates between bulge bracket investment banks and boutique banks like Rothschild. The book’s continuous elitist satire is present throughout this section. When discussing the 100 plus hour work weeks that investment banking analysts typically work, Leveraged Sell-Out states, “If I wanted to sleep, I’d have been a surgeon.”

People
Covering schools, the interview process, girls, race, and back office support staff, the people section paints a comedic picture of the employees that drive investment banks. Surprisingly, the race section is quite politically correct, but the girls section does not portray female bankers in the best light. I especially enjoyed the recruiting chapter where Leveraged Sell-Out prepares a friend for interviews. Incase the interviewer asks for a joke, Leveraged Sell-Out provides the following. “What is the best part of the Playboy Enterprises (PLA)’s IPO? The pitch book.”

Culture
The culture section of Damn, it Feels Good to Be a Banker centers on fashion, compensation, and geography. In the fashion section there is a great picture depicting fashion progression from an intern wearing a hand-me-down tie, to the managing director wearing a $6,000 Hermes tie. The geography section provides numerous reasons why New York is the superior investment banking city.

Entertainment
The entertainment section covers all aspects of the glamorized “baller” investment banking lifestyle, including clubbing, dancing, and music. The dance chapter contains critical moves that all bankers should know including the excel modeler, raise the capital, on a call, the and the private chopper.

Conclusion
If you want a quick overview of life as an investment banking analyst, this book is a good source. The elitist satire is very funny, and if you strip out this satire the book is somewhat informative. Life as a banking analyst is not this glamours though, and I think Damn, it Feels Good to Be a Banker also stands as a contrarian indicator marking a peak of the recent financial “bubble.”

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Higher than expected growth in personal income and personal spending provides positive support of the US economy. The US economy is highly impacted by consumer spending, so income and spending strength is also important. However, the question of how much the $110 billion stimulus package has influenced these numbers remains.  Walmart for example, provided caution in guidance suggesting weaker future sales because most shoppers have already received stimulus checks. In addition, continued productivity growth is a positive indicator. Productivity increases help drive GDP and keep cost-push inflation under control.

The FOMC also met last week. The fed left the key lending rate at 2%. In addition, the FOMC stated that inflation is of increasing concern and the risks to growth still remain.

Thus, I think economic indicators still paint a skeptical picture of the economy. The ability of the economy to grow in the face of dropping housing prices, rising unemployment, increasing inflation, and a deleveraging banking system paint a negative picture. However, I believe recent decreases in commodity prices the resilence of productivty and consumer spending are positive indicators. Also the rally in the stock markets driven by some positive earnings announcements, lower oil prices, and a rise in the value of the dollar relative to other currencies is encouraging.

For the general stock markets, this quote by the late Sir John Templeton is important: “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.”

Next Weeks Economic Data (August 12 - August 15)

The economic indicators I will be especially interested in monitoring are trade balance, retail sales, CPI, and industrial production.

Trade balance is a key indicator in the increasingly export driven United States economy. As the US dollar has decreased in relative value, exports have substantially increased. Continued export strength will boost the weak US economy. 

Retail sales are critical for a consumer driven US economy. Retail sales have remain resilient in the face of rising commodity prices, lower home values, and slowing employment. The continued strength of retail sales is important especially because of the $110 billion stimulus package provided to citizens.

CPI, a measure of inflation, is also an important economic indicator. There is continued debate about the US economy is moving into a stagflation period, similar to the 1980s. In addition, rising inflation combined with a slowing economy places the Fed in a difficult position because cutting rates to boost the economy will increase inflation. While Core CPI has remained contained with a slowing economy, total CPI has been increase driven primarily by rising commodity prices. Recent decreases in commodity prices should help contain inflation, evidenced by decreases in the 5 and 10 year break even levels.

Industrial production has yet to substantially decrease on a year over year basis. In recessions, industrial production normally falls well below previous year levels. The continued resilience of this indicator is important.

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Below are the top 10 Sharpe Investing posts, in order of page views. A new list will be posted every year highlighting the top content for that year. Thanks for visiting Sharpe Investing this Year. I look forward to learning more with you next year.

1. Roth 401k Overview
The most popular Sharpe Investing post of the past year provides an overview of the Roth 401k. The Roth 401k allows participants to contribute after-tax dollars while investing for retirement but then withdrawal tax-free dollars during retirement.

2. GSTrUE: Goldman Sachs’s Tradable Unregistered Equity OTC Market
GSTrUE provides a way for companies to raise capital with limited disclosure.

3. Finance, Investing, and Economics Reading List
I am happy to learn that the Recommended Reading list was one of the most popular posts for year one. In the finance and investing industry, reading about the field is very important and key to learning more.

4. VISA IPO - Goldman Sachs Financial Institutions Group
The VISA IPO was one of the largest IPOs in history. This post provides a comprehensive overview of the IPO.

5. Hedge Fund of Funds
This post provides a detailed explanation of hedge fund of funds and identifies problematic characteristics of the hedge fund of funds industry.

6. Sharpe Ratio
I am glad that the Sharpe Ratio post, the ratio that this blog is named after, is on the top content list. This post outlines the Sharpe ratio.

7. Retirement Calculators Review
Retirement calculators are a good tool for financial planning. This post reviews basic and advanced retirement calculators.

8. LIBOR – London Interbank Offered Rate
This post focuses on LIBOR, the rate at which banks borrow funds from other banks in the London interbank market.

9. Theory of Reflexivity
The theory of reflexivity, developed by famed hedge fund manager George Soros, is explained in this post.

10. Yankee Bonds
Yankee bonds are dollar-denominated bonds issued in the United States by foreign corporations, banks, and governments.

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1. Improbable Market Events
First, there is normally an improbable market event that effects the specific central investment or trading strategy of the hedge fund. For example, the 1997 Asian Financial Crisis contributed to the failure of Long Term Capital as widening spreads caused relative value trades to fail. Hedge funds frequently engage in this type of relative value trade or other forms of arbitrage, such as capital structure arbitrage, that center on profiting as spreads return to theoretically normal levels. The failure of these types of relative value trades also contributed to the blow up of Sowood Capital Management.

2. Leverage
The second factor that causes hedge fund failures is leverage. To enhance returns, hedge funds frequently employ leverage. Hedge funds acquire leverage by borrowing money from counterparties, frequently investment bank prime brokers. Hedge funds post a small amount of margin to purchase securities, using the investment as collateral.

During a hedge fund blow up this use of leverage has two negative effects. First, if margin terms between the broker and hedge fund are not locked, brokers can modify the hedge fund’s margin requirements. This is problematic, because during a hedge fund implosion and chaotic market, brokers may reevaluate the riskiness of the hedge fund’s assets and thus demand a higher margin haircut. Second, as the hedge fund’s portfolio falls quickly in value, margin calls occur. The broker demands additional collateral to reduce the broker’s risk to the falling asset value.

When a hedge fund’s portfolio quickly falls in value the results of the negative impact of leverage cripple the hedge fund. To meet margin calls and higher collateral requirements, hedge funds normally first burn through excess cash. As the investments fall further, the hedge fund normally sells the most liquid investments. However, by selling liquid investments, the portfolio becomes more illiquid, and thus more risky from the broker’s viewpoint. This causes the broker to demand even more collateral, and the downward spiral to the ultimate collapse continues.

3. Investor Redemptions
Investor redemptions  contribute to hedge fund blow ups. If investors withdraw money from a hedge fund that has little cash, the hedge fund is forced to liquidate positions, causing a downward spiral similar to events resulting from margin calls. However, many hedge funds have long lock ups that prohibit investors from withdrawing money. Also hedge funds normally have significant early redemption penalties.

4. Forced Liquidation or Portfolio Sale
Ultimately, a failing hedge fund normally faces one of two options. First, the portfolio may be liquidated by brokers to cover margin requirements. Second, hedge funds frequently sell the entire portfolio to other large hedge funds or investment firms. For example, Sowood sold the portfolio to Citadel to avoid a forced liquidation by brokers. Citadel, a large liquid hedge fund, was able to absorb the risk of Sowood’s portfolio and ultimately profit as spreads on relative value trades and capital structure arbitrage began to return to equilibrium.

Hedge fund collapses begin when an unusual market event causes the portfolio to quickly fall in value. As margin calls and investor redemptions increase, the hedge fund is forced to either liquidate the portfolio or be acquired by another firm.

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The Consumer Confidence Index increased slightly to 51.9 from 51.0 in June, beating the expectations of 50.0. While there is a debate about the effectiveness of the CCI to forecast economic strength, the economic indicator does have some correlation to the performance of the major stock market indices. The United States is a very consumer driven economy. This low CCI number continues to indicate a very pessimistic consumer outlook, but as the graph indicates the CCI increase is a positive change relative to the sharp decline in previous months.

GDP increased 1.9% in the second quarter. Again this number is both positive and negative. The fact that GDP is still increasing during what many consider to be a recession is a positive indicator. However, the GDP number was below the 2.3% market expectation. The main catalysts for GDP growth were exports and generally international business. Domestic business was generally a central drag on the economy which is not encouraging. Also, GDP was influenced by the stimulus checks spent by consumers, cash flow that will not impact GDP in future quarters. In addition, 2007 fourth quarter GDP was revised downward 0.8% to negative 0.2% indicating the economy may have entered recession at the end of last year.

Initial Claims increased to 448,000 from the previous 406,000, adding to the bearish economic evidence. The average workweek decreased to 33.6 from 33.7, indicating that employers are cutting back further and more people are working part time. The jobless rate increased to 5.7% from 5.5%, reaching the highest level in over four years. In addition non farm payrolls were negative 51,000, which were better than market expectations of 71,000 but still not encouraging. Combined, these numbers point to a weakening work force and provide more bearish economic evidence.

However, the S&P finish at 1,260.31 up 0.21%, and the NASDAQ increased 0.02% to 2,310.96, so these generally bearish economic indicators did not completely drag down the major market indicies last week.

Next Weeks Economic Data (August 4 - August 8 )

Related Sites:
Correlation of CCI to Stock Market
GDP Press Release

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This first post focuses on a section about Larry Hite titled Respecting Risk. Managing risk is the key focus of Hite’s investment strategy. “We approach markets backwards. The first thing we ask is not what can we make, but how much can we lose. We play a defensive game.” His goal was to achieve the best returns within rigorous risk control limits. This could be analogous to having a volatility limit on a portfolio, where traders are forced to unwind positions if volatility exceeds a threshold for a given period.

Hite is considered one of the top 100 traders of the 20th century, and one of the fathers of systems trading. He established Mint Investment Management Company, and achieved an annual return of over 30% before fees for 13 years. Hite retired from active management in 1994 and currently is a managing director at Hite Capital Management LLC.

In Market Wizards, Hite, like many great traders, compares trading to poker. Profitable long term investing is really based on betting the odds, and if you can estimate the odds of a specific trade or investment, then you can know if the price is high or low. Similar to poker, favorable odds do not guarantee a favorable outcome in the short run, but in the long run trading based on favorable odds can be profitable.

Hite stresses three central trading rules. First, he advocates never risking more than one percent of total capital on one trade. This is an important element of risk control, and many talented traders stress not risking a larger percentage of capital on single trades.

His second rule is to always follow trends and never deviate from your methods or systems. This links back to the relationship between trading and poker. Losing money in the short run on a trade that will be profitable in the long run is still a good trade. You need to have the conviction though to trust your system or theory amidst short term losses.

Hite’s last rule is to diversify. He traded in multiple markets across the globe, diversifying his portfolio and reducing risk. Investing in multiple assets that are not correlated helps to reduce risk.

The star trader also provided insight about analyzing the effects of news on stocks. He suggested that if a stock responds to positive news with only a small increase in value, that may indicate the stock is nearing a top. In addition, when stocks reach new highs, investors should realize that there is a reason for this break out and follow the trend.

“There are two basic rules about winning in trading and life. One, if you don’t bet you can’t win. Two, if you lose all of your chips you can’t bet.”

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