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Trading Ideas: The Stock Tip Quandary

By  Jul 21, 2011

Topics: Finance & Investing

Are “tips” worth pursuing? If you hear about a great opportunity from a friend, family member or stockbroker, you have to wonder about two major issues. First, is it a good tip? Second, why are they telling you? In a majority of cases, acting on stock tips is either illegal or ill-advised.

An action known as the “pump and dump” is behind many stock tips, especially those you see on investment chat room sites. In this action, someone buys shares in a company and then promotes the company with promises of impending big rises in value. Others hear this and also buy shares, inflating (pumping) the price. Then the original trader sells (dumps) shares at a profit. This is illegal and it can get you in trouble with the SEC. But the big danger of even listening to the hype is that if you are like most traders, you like hearing that a stock’s price is going to go up. It makes you want to buy.

Here are a few suggestions about how to deal with stock tips:

 1. Ask yourself, Why is this a good trade? What criteria should trigger an investment or trade? Most people giving you “free tips” have no idea how to answer this question. They are mostly likely repeating something they heard from someone else -- not a good enough reason for you to put money at risk.

 2. When you get a tip, ask one very important question: How many shares do you own and how long have you had the position? The answer will be revealing. If they own a lot of shares, are they trying to get you to buy to inflate the price? This pump and dump is based on the “greater fool” theory of investing (there is always a greater fool ready to invest). But what if they don’t own any shares? Why are they telling you to buy?

3. A follow-up question: Has the value gone up or down since you bought shares? If the value has gone down, by how much? What was your purchase price? If they have gone up, how high do you think it will go?

4. Also ask, When do you plan to sell? Do you have a profit or a bail-out target price? Most traders who give out “free” recommendations without much analysis have never studied the stock from a risk/reward perspective. If the tipster doesn’t know the answer (and most don’t) then how do you know whether it is a good purchase or not? Knowing when to exit is just as important as knowing when to enter.

5. Also ask your tipster, What product or service does the company sell? This seems like an obvious question, but many people, including investors, do not know the answer. Many people think they know what companies sell because the names are household words. But for example, someone might suggest you buy shares of Kraft. The cheese guys, right? Yes, but Kraft cheese accounts for only about 7% of total revenues. Kraft also owns Oreo, Nabisco, Cadbury,Trident Gum, Maxwell House Coffee, Philadelphia Cream Cheese and Oscar Mayer.  If you didn’t know all of this, you’re not alone. Many big operations are in several businesses, but traders and investors are often simply not informed.

Being informed does matter and the wisest investor or trader learns quickly that acting on tips is a poor idea. Whenever someone gives you a “hot tip,” ask these questions to find out what your source really knows … or does not know, about the company itself.

Michael C. Thomsett is an instructor with the New York Institute of Finance. He teaches five  courses: “Swing Trading with Options,” “The Amazing World of Options,” “Synthetic Options Strategies”, “Options timing and dividend income strategies,” and “Using candlestick reversal and continuation patterns to improve timing.”  He is also an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com. Thomsett’s latest FT Press book is Trading with Candlesticks. He also contributes to the CBOE blog and to the Seeking Alpha blog.