Investment objectives

Investments aren’t exactly one-size-fits-all, so asking a client about his investment objectives can be a real help. As a financial expert, you’ll likely have to help clients pin down what their goals should be. I help you find out how in the next section, but for now, here are some possible investment objectives:

• Preservation of capital: Investing in safe securities, such as U.S. government bonds, municipal bonds, high-rated corporate bonds, and so on
• Current income: Investing in securities (such as bonds, preferred stock, income funds, and so on) that’ll provide interest or cash dividends
• Capital growth: Investing in the stock of relatively new companies or ones that have a high growth potential
• Total return: Investing in a combination of stocks and bonds, looking for both growth and income
• Tax advantages: Investing in securities (such as municipal bonds, direct participation programs, retirement plans, and so on) that give tax breaks
• Liquidity: Looking to purchase securities that can be bought and sold easily
• Diversification: Investing in securities from several different companies, municipalities, and/or the U.S. government to offset the risk associated with only owning one security
• Speculation: Investing in securities with higher risk in an attempt to maximize profits if the securities move in the right direction
• Trading profits: Looking to buy and sell securities on a constant basis
• Long-term or short-term: Looking to tie up money for either a long time or a short time

When recommending securities to your customers, you need to make recommendations that are suitable and fit their investment objectives. You must have a “reasonable basis” for recommending a security to a customer. Some customers may fit into more than one category (for example, looking for diversification and liquidity), which is considered “customer-specific” suitability. And you should make recommendations based on their financial situation (income statements, balance sheets, investments, obligations, cash available for investing, and so on). This is known as “quantitative suitability.” You should not be making recommendations that are beyond your customer's financial ability or comfort level. All customers should have a diversified portfolio (meaning they own several different securities and/or types of securities). If a customer can’t afford to diversify, you ought to recommend mutual funds. (For info on mutual funds and other packaged securities, check out Chapter 10.)

Note: Even though it will likely cost you a commission, there are going to be times where you are going to make recommendations to hold securities. If you feel that one of your clients is invested in securities that you believe are the right ones for him and you believe that they are in a position to perform well, you should probably tell that client to hold his position for now.

The following question tests your ability to answer a question about investment objectives.

You will likely be opening institutional accounts as well as accounts for individual investors. However, similar rules apply. As with individual or joint accounts, recommendations to institutional investors should also fit their investment objectives. You must also make sure that the person you're dealing with who's handling the institutional account is capable of understanding the risks of particular transactions and investment strategies.

Factors that influence your customer’s investment profile

If an investor is clueless about how much risk he should be taking, your job is to help your client figure it out. Think of yourself as the Sherlock Holmes of the investing world and use the information you have available, such as your client’s age, whether he has a family, how much money he has, and so on. Additionally, feel your client out to try to get an idea of how much risk he’s comfortable taking.

Asset allocation

Asset allocation is the process of dividing an investor’s portfolio among different asset classes, such as bonds, stock, and cash. The main purpose of asset allocation is to reduce risk by diversifying the investor’s portfolio. Asset allocation differs from investor to investor depending on the investor’s risk tolerance.

Modern portfolio theory

The modern portfolio theory (MPT) or portfolio theory takes into account these risk measurements: alpha, beta, standard deviation, Sharpe ratio, and R-squared. Fortunately for you, you won't need to know all of them to pass the Series 7. However, if you should decide to become an investment adviser, you will need to know and understand them all. Decades ago, stockbrokers and the like were mainly concerned with attempting to bring in the highest returns in an investor's portfolio. However, they eventually caught on and realized that most investors are risk averse, so they had to change their thinking. The idea of the modern portfolio theory is to optimize a portfolio and maximize returns for the risk each investor is willing to take. MPT attempts to create a diversified portfolio by purchasing securities that aren't directly linked to each other. In other words, some securities may go up while others are going down. This is obviously preferable to having all the securities go down at the same time. Hopefully, over the long haul, the value of the portfolio will be up while the risk was minimized.

Capital Asset Pricing Model (CAPM)

Unlike the modern portfolio theory, which looks at the risk versus reward of the whole portfolio, CAPM looks at the risk versus reward of an individual security. The CAPM takes into consideration the time value of money as well as the risk. U.S. Treasury securities are considered risk-free investments believe it or not. So starting with what you'd be making on a U.S. Treasury by way of interest, you would need to compare the risk you'd be taking on a particular security by looking at its beta coefficient and how much you'd expect to make above the return on the U.S. Treasury security. In order for a security to be worth the risk, it should meet or beat the return on a risk-free treasury security plus the risk premium (the extra return you'd expect for taking the risk).

Note: Member firms may provide interactive investment analysis tools to their clients. These investment analysis tools produce simulations and analysis which will help investors see the likelihood of investment outcomes if they make certain investments. However, no member may make any statement or in any way imply that FINRA approves or endorses (“FINRA does not approve or endorse”) the use of the investment analysis tool or any recommendations made by the tool. If a member firm does offer an investment analysis tool, it must let customers know either in retail communication or if the tool provides a written report:

• The criteria and methodology used and its limitations
• That results may vary with each uses and will likely vary over time
• If applicable, the universe of securities considered in the analysis, how the tool determines which securities to select, if the tool favors certain securities and why, and so on
• The following must be displayed: “IMPORTANT: The projections or other information generated by [name of investment analysis tool] regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results.”

Strategizing with portfolio management policies

In addition to all the other investment choices, investors may have a defensive investment strategy, an aggressive investment strategy, or some combination of the two. An investor who adopts a defensive investment strategy has safety of principal and interest as a top priority. A defensive investment strategy includes investments such as

• Blue-chip stocks with low volatility (stocks of well-established, financially stable companies — see Chapter 6)
• AAA rated bonds (Chapter 7)
• U.S. government bonds (Chapter 7)

An investor who adopts an aggressive investment strategy is attempting to maximize gains by investing in securities with higher risk. An aggressive portfolio strategy includes

• Investing in securities such as highly volatile stocks (Chapter 6)
• Investing in put and/or call options (Chapter 12)
• Buying securities on margin (Chapter 9)

Although defensive and aggressive strategies are clearly defined, most investors have a balanced portfolio (aggressive/defensive), which includes securities included in both an aggressive and defensive portfolio.

Regarding risk

Investors face many risks (and hopefully many rewards) when investing in the market. You need to understand the risks because not only can this knowledge make you sound like a genius, but it can also help you score higher on the Series 7:

• Market (systematic) risk: The risk of a security declining due to negative market conditions. All securities have market risk.
• Call risk: The risk that a corporation could call its callable bonds at a time that's not advantageous to investors. Corporations will more likely call their bonds when interest rates decrease.
• Business (nonsystematic) risk: The risk of a corporation failing to perform up to expectations.
• Credit risk: The risk that the principal and interest aren’t paid on time. Moody’s, Standard & Poor’s, and Fitch are the main bond-rating companies.
• Liquidity (marketability) risk: The risk that the security is not easily traded. Long-term bonds and limited partnerships have more liquidity risk.
• Interest (money rate) risk: The risk of bond prices declining with increasing interest rates. (Use the idea behind the seesaw from Chapter 7: When interest rates increase, outstanding bond prices decrease.) All bonds (even zero-coupon bonds) are subject to interest risk.
• Reinvestment risk: The risk that interest and dividends received will have to be reinvested at a lower rate of return. Zero coupon bonds, T-bills, T-STRIPS, and so on have no reinvestment risk because they don’t receive interest payments.
• Purchasing power (inflation) risk: The risk that the return on the investment is less than the inflation rate. Long-term bonds and fixed annuities have high inflation risk. To avoid inflation risk, investors should buy stocks and variable annuities.
• Capital risk: The risk of losing all money invested (for options [Chapter 12] and warrants [Chapter 6]). Because options and warrants have expiration dates, purchasers may lose all money invested at expiration. To reduce capital risk, investors should buy investment-grade bonds.
• Regulatory (legislative) risk: The risk that law changes will affect the market.
• Currency risk: The risk that an investment’s value will be affected by a change in currency exchange rates. Investors who have international investments are the ones most affected by currency risk.
• Nonsystematic risk: A risk that is unique to a certain company or a certain industry. To avoid nonsystematic risk, investors should have a diversified portfolio.
• Political (legislative) risk: The risk that the value of a security could suffer due to instability or political changes in a country (for example, the nationalization of corporations).
• Prepayment risk: The type of risk mostly associated with real-estate investments such as CMOs (Chapter 7). CMOs and other mortgage-backed securities have an average expected life, but if mortgage interest rates decrease, more investors will refinance and the bonds will be called earlier than expected.
• Timing risk: The risk of an investor buying or selling a security at the wrong time, thus failing to maximize profits.

On the Series 7 exam, to determine the best investment for a customer, pay close attention to the investor's risk tolerance, financial considerations, non-financial considerations, risk(s) mentioned, and so on. If the question isn’t specific about the type of risk, use strategic asset allocation to determine the best answer (see the earlier “Asset allocation” section for more information).

Mitigation of risk with diversification

Certainly, all investments have a certain degree of risk. Younger investors, sophisticated investors, and wealthy investors can all afford to take more risk than the average investor. However, when you are talking to your clients, you should examine their portfolio and help them make decisions that will help them mitigate their risk. You should help them invest in securities that aren't too volatile for their situation and make them aware of the potential tax ramifications of certain investments.

You’ve probably heard the expression, “Don’t put all your eggs in one basket.” Well, the same holds true for investing. Suppose for instance that one of your customers has everything invested in DIMP Corporation common stock. All of a sudden, DIMP Corporation loses a big contract or is being investigated. Your customer could be wiped out. However, if your customer had a diversified portfolio, DIMP Corporation would likely only be a small part of her investments and she wouldn’t be ruined. This is the reason that having a diversified portfolio is so important.

You are responsible for making sure that your clients understand the importance of having a diversified portfolio to minimize risk. Investors with securities concentration are at risk of major losses due to having a large portion of their holdings in a particular market segment (for example, automotive stocks) or investment class.

There are many ways to diversify:

• Geographical: Investing in securities in different parts of the country or world.
• Buying bonds with different maturity dates: Buying a mixture of short-term, intermediate-term, and long-term debt securities.
• Buying bonds with different credit ratings: You may purchase high-yield bonds (ones with a low credit rating) with highly rated bonds with lower returns so that you get a mixture of high returns with the safety of the highly rated bonds.
• Investing in stocks from different sectors: Often, certain sectors of the market perform better than others. By spreading your investments out among these different sectors, you can minimize your risk and hopefully make a profit if one or more sector happens to be performing well. The sectors include financials, utilities, energy, healthcare, industrials, technology, and so on.
• Type of investment: Investing in a mixture of different types of stocks, bonds, DPPs, real estate, options, and so on.

There are certainly many more ways to diversify a portfolio than the ones listed previously — use your imagination. In addition, they aren’t mutually exclusive. Remember that mutual funds (packaged securities) provide a certain amount of diversification within an individual stock. This is why smaller investors who may not be able to afford to diversify their portfolio are ideal candidates for mutual funds.

Fundamental analysis

Although most analysts use some combination of fundamental analysis and technical analysis to make their securities recommendations, for Series 7 exam purposes, you need to be able to differentiate between the two types. This section discusses fundamental analysis; I cover technical analysis later in the section “Technical analysis.”

Fundamental analysts perform an in-depth analysis of companies. They look at the management of a company and its financial condition (balance sheets, income statements, the industry, management, earnings, and so on) and compare it to other companies in the same industry. In addition, fundamental analysts even look at the overall economy and industry conditions to determine whether an investment is good to buy.

In simplest terms, fundamental analysts decide what to buy.

A fundamental analyst’s goal is to determine the value of a particular security and decide whether it’s underpriced or overpriced. If the security is underpriced, a fundamental analyst recommends buying the security; if the security is overpriced, he recommends selling or selling the security short.

The following sections explain some of the fundamental analyst’s tools of the trade and how to use them.

Balance sheet components

The balance sheet provides an image of a company’s financial position at a given point in time. The Series 7 exam tests your ability to understand the components (see Figure 13-1) and how financial moves that the company makes (buying equipment, issuing stock, issuing bonds, paying off bonds, and so on) affect the balance sheet. In general, understanding how a balance sheet works is more important than being able to name all the components.

People call this statement a balance sheet because the assets must always balance out the liabilities plus the stockholders’ equity.

Assets are items that a company owns. They include

• Current assets: Owned items that are easily converted into cash within the next 12 months; included in current assets are cash, securities, accounts receivable, inventory, and any prepaid expenses (like rent or advertising).

  Note: Fundamental analysts also look at methods of inventory valuation, such as LIFO (last in first out) or FIFO (first in first out). In addition, they look at the methods of depreciation, which are either straight line (depreciating an equal amount each year) or accelerated (depreciating more in earlier years and less in later years).

• Fixed assets: Owned items that aren’t easily converted into cash; included are property, plant(s), and equipment. Because fixed assets wear down over time, they can be depreciated.
• Intangible assets: Owned items that don’t have any physical properties; included are items such as trademarks, patents, formulas, goodwill (a value based on the reputation of a company — for example, the name McDonald’s is probably worth more than Fred’s Sloppy Burgers), and so on.

Liabilities are what a company owes. They may be current or long-term:

• Current liabilities: Debt obligations that are due to be paid within the next 12 months; included in current liabilities are accounts payable (what a company owes in bills), wages, debt securities due to mature, notes payable (the balance due on money borrowed), declared cash dividends, and taxes.
• Long-term liabilities: Debt obligation due to be paid after 12 months; included in long-term liabilities are mortgages and outstanding corporate bonds.

Stockholders’ equity (net worth) is the difference between the assets and the liabilities (basically, what the company is worth). This value includes

• Par value of the common stock: The arbitrary amount that the company uses for bookkeeping purposes. If a company issues 1 million shares of common stock with a par value of $1, the par value on the stockholders’ equity portion of the balance sheet is $1 million.
• Par value of the preferred stock: The value that the company uses for bookkeeping purposes (usually $100 per share). If the company issues 10,000 shares of preferred stock, the par value on the stockholders’ equity portion of the balance sheet is $1 million.
• Paid in capital: The amount over par value that the company receives for issuing stock. For example, if the par value of the common stock is $1 but the company receives $7 per share, the paid in capital is $6 per share. The same theory holds true for the preferred stock.
• Treasury stock: Stock that was outstanding in the market but was repurchased by the company.
• Retained earnings: The percentage of net earnings the company holds after paying out dividends (if any) to its shareholders.

Balance sheet calculations

If I were to give you all the calculations that fundamental analysts derive from the balance sheet, you’d likely be cursing under your breath (or possibly out loud). The good news is that the likelihood of your having to perform these calculations on the Series 7 is remote. The most important thing for you to know is what happens to components of the balance sheet when the company makes certain transactions (sells stock or bonds, redeems bonds, and so on).

There are many tools that fundamental analysts can use to measure the financial health of a company. Fundamental analysts will compare companies based on liquidity, risk of bankruptcy, efficiency, profitability, earnings per share, competitiveness, and so on. The following balance sheet formulas help fundamental analysts measure the liquidity of a company:

Net worth of a company is pretty self explanatory. It is determined the same way you would determine your net worth: by subtracting everything you owe from everything you own.

Working capital is the amount of money a company has to work with right now. The company brings in cash by issuing the bonds, which is a current asset, but doesn’t have to pay off the bonds for several years, so the current liabilities remain the same. If the current assets increase and the current liabilities remain the same, the working capital increases:

Current ratio is determining how many times your current assets (assets convertible into cash in a one-year period) covers your current liabilities (liabilities owed in a one-year period). Current ratios vary from industry to industry and from company to company but certainly the higher the current ratio, the healthier the company.

Quick or acid-test ratio is similar to the formula for current ratio but looks at how a company could handle its debt in a 3-5 month period instead of a one-year period.

Note: Quick assets include all current assets except for inventory.

If, for instance, ABC Corp. issues 10,000 bonds at par value, you can use these formulas to figure out what’ll happen to the net worth and working capital. You may not even have to plug in numbers. As far as the net worth goes, you can see that it remains unchanged. The company brings in $10 million by issuing 10,000 bonds at $1,000 par. However, because ABC has to pay off the $10 million at maturity, the liabilities go up by the same amount:

When a company issues bonds, assume that they’re a long-term liability, not short-term, unless the question specifically states that the company is issuing short-term bonds.

The following question tests your ability to answer a balance-sheet-equation question.

DEF Corp. is in the process of buying a new $50,000 computer system. If it is paying for the computer system with available cash, what is the effect on the balance sheet?

(A) The net worth decreases and the working capital remains the same.

(B) The net worth remains the same and the working capital remains the same.

(C) The net worth decreases and the working capital decreases.

(D) The net worth remains the same and the working capital decreases.

The right answer is Choice (D). The company is exchanging one asset for another, and the overall liabilities remain the same, so the net worth of the company doesn’t change. However, the company is using a current asset (cash) to purchase a fixed asset (the computer system), so the working capital (the amount of money that the company has to work with) decreases:

Take a look at the following scenarios and see whether you can determine how the balance sheet is affected. Here’s what happens when a company

• Declares a cash dividend: When a company declares a cash dividend, that cost becomes a current liability to the company. Because current liabilities are part of the overall liabilities owed in the net worth equation, both the net worth and the working capital decrease.
• Pays a cash dividend: When the company initially declares the cash dividend, the current liabilities increase, but when the company pays that dividend, the current liabilities fall. However, the current assets also decrease because the company has to use cash to pay the dividend. If the current assets (and overall assets) decrease and the current liabilities (and overall liabilities) decrease by the same amount, the working capital and net worth both remain the same.
• Issues stock: When a company issues stock, it receives cash, which is a current asset (and part of the overall assets). The company doesn’t owe anything to investors, so the overall liabilities (and current liabilities) remain the same. Therefore, the net worth and working capital both increase.

When you’re dealing with balance sheet equations on the Series 7 exam, write down the equations and think about the questions logically. Some possible scenarios include the following:

• What happens if a company buys machinery for cash?
• What happens if a company issues new debt securities?
• What happens if a company calls its bonds?
• What happens if a company repurchases stock?

If something is increasing, use an up arrow, and if something is decreasing, use a down arrow. Hopefully, this notation can help you solve a majority of the balance sheet problems.

Income statement components

An income statement tells you how profitable a company is right now. Income statements list a corporation’s expenses and revenues for a specific period of time (quarterly, year-to-date, or yearly). When comparing revenues to expenses, you should be able to see the efficiency of the company and how profitable it is. I don’t think you need to actually see a detailed balance sheet from a company, but knowing the components of an income statement is important. Take a look at Figure 13-2 to see the way an income statement is laid out. Most of the items are self-explanatory.

Income statement calculations

Here are calculations you need to know for the Series 7 that you can derive from the income statement:

The following two formulas help fundamental analysts determine a company's risk of bankruptcy:

The bond ratio measures the amount of company indebtedness. Highly leveraged companies issue a take on a lot of debt in comparison to other companies.

The following two formulas help fundamental analysts determine how efficiently a company uses its assets:

The following formulas help fundamental analysts determine a company's profitability:

As part of a company's profitability, there are a few formulas that help fundamental analysts determine the asset coverage and safety of income:

One of the major factors that could affect the market price of a stock is its earnings per share (EPS). In other words, if broken down on a per share basis, how much did the company make for each outstanding share. Obviously, the higher the better:

Note: If a company has convertible bonds, convertible stock, warrants, and/or rights outstanding, the potential for the common stock to be diluted (that is, with more shares outstanding is high). A calculation can also be done for fully diluted earnings per share, which takes into consideration the companies earnings per share if all convertible securities have been converted into common stock.

Once you've determined the EPS, you can calculate the price/earnings ratio, which compares the market price of the security to the earnings per share. In this case, the lower the P/E ratio, the better.

The dividend payout ratio tells analysts how much the corporation is paying out in dividends per share as compared to how much it’s earning per share.

The current yield, which is covered in Chapter 6, tells analysts how much the company is paying out in dividends in comparison to the market price.

The following formula helps fundamental analysts determine the competitiveness (comparative performance) of a company:

The following question tests your ability to answer a question on earnings per share.

Zazzoo Corp. has 1 million common shares outstanding. If Zazzoo’s net income is $14 million, what are the earnings per share?

(A) $0.07

(B) $0.70

(C) $14.00

(D) Cannot be determined without knowing the preferred dividends

The answer you want is Choice (C). “Cannot be determined” is almost never the answer on the Series 7. Remember that a corporation doesn’t need to issue preferred stock, only common stock. Because the question doesn’t mention anything about Zazzoo having preferred stock, you can’t assume that it does; the preferred dividends are equal to zero. Therefore, solving this problem is as easy as dividing the net income by the number of common shares outstanding:

You could possibly get a bunch of formulas relating to income statements and balance sheets on the Series 7 exam. However, the most you’ll probably get is two. Understanding how income statements and balance sheets work is more important than remembering a bunch of formulas. If you feel that you have a handle on everything else that you need for the Series 7 exam and want to get the extra point or two by memorizing all the formulas, go for it.

Technical analysis

Technical analysts look at the market to determine whether the market is bullish or bearish. They look at:

• Trendlines: Technical analysts can plot individual stocks, the market, or certain segments to see if there is an upward trendline or downward trendline. Even though securities may be up or down over a short period of time, when looking at a long-term trendline, technical analysts should be able to determine if they are bullish or bearish on a security, segment, or the market in general.
• Trading volume: When the market trading volume is much greater than normal, a technical analyst will typically look at that as being the beginning of a bullish or bearish trend.
• Market sentiment: When investors are generally feeling good about the market and the economy, that means that more people will be investing and therefore a bullish sign. However, if people are not feeling good about the market or economy, more people will be selling their securities and it would be a bearish sign.
• Market indices: Market indices such as the S&P 500, Wilshire, Russell 2000, Lipper, Dow Jones, and so on are covered in detail in the Securities Industry Essentials book. Basically, technical analysts look at different indices to help determine a pattern.
• Available funds: Certainly when people have more funds available to spend, businesses do well and the market does well.
• Index futures: Analysts can get an idea of how investors feel about the future of the market based on the buying or selling of index futures.
• New highs and lows: When the market hits a new high, some analysts might look at that as a bearish sign and others a bullish sign depending on whether they feel theirs a good reason for the market to hit a new high or not.
• Advance-decline ratio: The advance decline ratio looks at the number of stocks advancing versus the number declining. Certainly, in most instances, the more stocks advancing would be a bullish sign.
• Odd lot volume: Remember, the most common unit of stock trading is 100 shares. When trades are completed for less than the normal unit of trading, it is called an odd lot. So when an investor trades 30 shares of a particular company, it is an odd lot trade. Odd lot trades are typically done by smaller, less-sophisticated investors. Smaller investors usually jump on the bandwagon a little late, so when odd lot volume is high, it is usually a bearish sign.
• Short interest: Short interest looks at the number of short sellers. Remember, short sellers eventually have to purchase the security they sold short. So when there are a lot of investors selling short, it may be a good time to buy.
• Put/call ratio: The put/call ratio looks at the amount of investors purchasing puts as compared to purchasing calls. If more investors are purchasing calls, it's a bullish sign.

Technical analysts believe that history tends to repeat itself and that past performance of securities and the market indicate its future performance.

Fundamental analysts decide what to buy, and technical analysts decide when to buy (timing).

Not only do technical analysts chart the market, but they also chart individual securities. Technical analysts try to identify market patterns and patterns of particular stocks in an attempt to determine the best time to purchase or sell. Even though a stock’s price may vary a lot from one day to another, when plotting out stock prices over a long period of time, the prices tend to head in a particular direction (up, down, or sideways) and create a trendline.

Moving averages measure the movement of stock indexes and individual stocks over a certain period of time (5 days, 10, days, 30 days, 6 months, and so on). By charting the security or index over a period of time, it helps technical analysts focus more on long-term trends rather than short-term price fluctuations.

Consolidation is occurring when a stock stays within a narrow trading range or trading channel. When plotted out on a graph, the trendline is moving horizontally (neither up nor down). If a stock stays within a narrow trading range for a long period of time (months or even years), it creates a support (bottom of the trading range) and resistance level (top of the trading range). For example, say that XYZ common stock has been trading between $40 and $42 per share for several months; the lower number ($40) is the support, and the higher number ($42) is the resistance.

When a stock declines below its support level or increases above its resistance level, a breakout is occurring. When a stock has been trading horizontally (sideways) for a long period of time, a breakout is considered significant. Breakouts are usually a sign that the stock is beginning a new downward or upward trend.

If a stock price is gradually moving down over a period of time, the stock’s in a downtrend. Conversely, if the stock price is gradually moving upward over a period of time, you’re looking at an uptrend. Here are a couple patterns technical analysts recognize as reversals of such trends:

• Saucer and inverted saucer: In a saucer pattern, when the stock prices are plotted for a period of time, they make a saucer shape (gradually decreasing and then gradually increasing). A saucer pattern is a bullish sign or, to be more precise, the reversal of a bearish trend. Conversely, an inverted saucer is exactly the opposite; it’s a bearish sign because it’s the reversal of a bullish trend.

  

  © John Wiley & Sons, Inc.

• Head and shoulders and inverted head and shoulders: A head and shoulders pattern is formed when the price of a stock has been increasing, hits a high, and then starts decreasing. It involves three peaks, with the center peak as the highest. The two bumps in the road (one on the way up and one on the way down) are the shoulders, and the high point is the head. A head and shoulders top formation is a bearish sign because it’s the reversal of a bullish trend. I also illustrate an inverted head and shoulders (also known as a head and shoulders bottom formation), which is a bullish sign because it’s the reversal of a bearish trend.

  

  © John Wiley & Sons, Inc.

The key thing to remember about these patterns is that the saucer pattern and the inverted head and shoulders pattern are bullish signs, whereas the head and shoulders and inverted saucer patterns are bearish signs.

The market is said to be oversold if a market index such as the DJIA or the S&P 500 is declining but fewer stocks are declining than advancing. If the market is oversold, it’s likely a good time to buy. On the other hand, the market’s overbought if a market index such as the DJIA or the S&P 500 is increasing but fewer stocks are advancing than declining. If the market is overbought, it’s likely a good time to sell or sell short (borrow securities to sell on margin).

Showing the work: Research reports

Typically, brokerage firms send out research reports to their customers (and potential customers) with certain recommendations. Research reports are documents prepared by an analyst who is part of a brokerage or investment banking firm. As with pretty much everything on the Series 7, research reports are subject to several rules:

• Quiet periods: Member firms are restricted from publishing or distributing research reports on a particular investment until at least 10 days after the initial public offering (IPO).
• Information barriers: All firms must establish information barriers (firewalls) to protect analysts from any pressure they may feel from investment bankers or any other persons who may be biased in their judgment.
• Third-party disclosures: Depending on the size of your firm, you may or may not have access to your own research analyst to prepare reports. A third-party research report is one in which the third party has no affiliation or contractual relationship with the distributing firm. All third-party research reports must include a disclosure unless the member firm makes nonaffiliated research available to its customers either upon request or through a website maintained by the member firm.

Although not in the Series 7 outline, money supply is also something that analysts take into consideration when making investment recommendations. Money supply and how the Federal Reserve Board influences the money supply is tested on the Securities Industry Essentials exam.