Trading Strategy

In this week's post I thought I would introduce the concept of a trading strategy. Everyone who trades, whether it is stocks, commodities or currency, needs a trading strategy. A trading strategy gives you consistency and allows you to solve problems before you are even presented with them. Without a trading strategy you are just stringing together random trades, without purpose or direction. Consistently following your trading strategy should, in the long run, lead to an edge or an advantage that leads to profit. Everyone's trading strategy will be different but anyone trading in any market should know their strategy before making a trade.

The way that you view the market will lead to different ways of trading and thus different strategies. For example, if your plan is to buy low and sell high, you are saying that you can see something in that trade that the market has missed. Possibly some potential good results, or good fundamentals in the company that you believe will eventually raise the price. The other side of this view is that the market has fairly priced the stock or commodity for what it is worth. This leads you to the buy high and sell higher approach, popular with technical traders. Thus you need to think about how you view the market to develop your approach to trading and create a strategy.

However you decide to trade, the most important point is to have a complete trading strategy before you begin to put money into the market.

Payout Policy - Retained earnings

I have not had a specific question on this topic yet, but I think it may make for a series of interesting and informative blog posts. This series should go over the next few posts so that I can explain all of the concepts. Remember to send your questions to illuminatingfinance@gmail.com!

A payout policy is the way a firm chooses between the alternative ways to pay cash out to shareholders. When a firm generates a profit, the managers have a choice with what they would like to do with the excess funds. They have several options and each choice has advantages and disadvantages, which I will try and explain. The diagram shows the options available to a firm once all debts have been serviced.

 

This week we will cover the options when the firm decides to retain the profits. By retaining the excess cash flows (profit), the firm can choose whether to invest them in new projects or increase their cash reserves.

If a firm is presented with a profitable investment opportunity it can choose to reinvest the cash and increase the value of the firm. Many young, rapidly growing firms choose to reinvest all of their cash flows this way. By successfully investing the cash the firm would increase the value of the shares for the shareholders.

Choosing to retain all of the profit to increase cash reserves is not a particularly common choice. Often firms choose to retain a small percentage to 'top up' their cash reserves but distribute the rest. If firms retain cash reserves that are too high there is no benefit to shareholders. Some make the arguement that by having excessive cash reserves it can encourage managers to inefficiently allocate the funds. However, by increasing cash reserves the company can be confident that they will have sufficient funds to invest in a future project. Possibly avoiding the often costly process of raising capital in either equity or debt markets.