Formula to compare the potential earnings of buying the same stock at different prices
If I want to buy an index fund, I could buy it today at the current price, or I could setup a limit order and try to buy it at a lower price.
Obviously it's better to get it at the lower price, but how much better, exactly? Waiting introduces the risk that it won't be filled, so I'd like to know how to balance the risk vs reward.
Over a N year period, what is the formula to compare the amount I'd earn if I bought it at the current price, against the amount I'd earn if I took the risk and waited for it to potentially reach the lower point?
How is that affected if the fund offers a dividend?
(4)4 Comments
Sorted by latest first Latest Oldest Best
What is the formula to compare the amount I'd earn if I bought it at the current price, against the amount I'd earn if I took the risk and waited for it to potentially reach the lower point?
X = current price of the fund
Y = possible lower price of fund at a later date
Z = assumed higher price (than X or Y) at an even later date
If you buy now, your profit will be (Z - X)
If you wait to buy and you are fortunate enough to buy later at a lower price, your profit will be (Z - Y)
How is that affected if the fund offers a dividend?
If a security pays a dividend, share price is reduced by the exact amount of the dividend on the ex-dividend date. Someone usually shows up to rebut this statement. Should that occur, rather than argue the point, let me state in advance that FINRA rule 5330 Adjustment of Orders (USA). It applies to how open orders to buy or sell the security are handled:
(a) A member holding an open order from a customer or another broker-dealer shall, prior to executing or permitting the order to be executed, reduce, increase, or adjust the price and/or number of shares of such order by an amount equal to the dividend, payment, or distribution on the day that the security is quoted ex-dividend, ex-rights, ex-distribution, or ex-interest, except where a cash dividend or distribution is less than one cent ([CO].01), as follows:
(1) Cash Dividends: Unless marked "Do Not Reduce," open order prices shall be first reduced by the dollar amount of the dividend, and the resulting price will then be rounded down to the next lower minimum quotation variation.
What does that mean to you? If you buy XYZ at the close today and it goes ex-dividend tomorrow then in the morning before trading resumes, your stock will be worth and you will be entitled to per share on the Pay Date. Ignoring the tax inefficiency of receiving the dividend in a non sheltered account, you are effectively buying XYZ for . If you understand this then you can factor it into your "Buy" equation.
The concept you are referring to is "expected value". Expected value is a concept in probability that says if you know how likely each scenario would be, and the value of that scenario, you can create a sort of 'weighted average' value.
For example: assume I offer you a bet: you pay me , and I will flip a coin. If it is heads, I pay you . If it is tails, I pay you nothing. This is a simplistic bet, and the intuitive value of it is that, on average if you did this 100 times, then half the time you would get back nothing, half the time you would get back , and therefore over 100 times you would get back an average of 0.
In probability-speak, we could say this bet has an Expected Return of . That is - on average, performing the bet is worth , meaning I have fairly priced your options. Mathematically we can work this out as: 50% chance of [CO] + 50% chance of = .
Now let's complicate things. Assume I offer you a bet about the weather tomorrow, and you have to pay me 0 if you want to participate. If it rains, I pay you 0. If it doesn't rain, you get nothing. If it snows, I pay you a jackpot of ,000. How can you find the appropriate Expected Return? If the weather channel was accurate, you could go on, and see that there is, say, a 30% chance of rain tomorrow. So you do the math, and 30% chance of rain adds .3*500 = 0 value + 69.9% chance of no precipitation adds .699 * 0 = [CO] value + .1% chance of snow adds .001 * 10,000 = in value = total value of the bet of 0 to you. Great! It only costs you 0 to enter, but the value of the bet is 0!!
But how certain are you of those %'s? What if I have a doppler radar system and a meteorological degree, and I estimate that there's only a 5% chance of rain tomorrow? Suddenly the bet is biased towards me. This is your risk if you try to estimate these values on your own.
Look up the Random Walk theory of the stock market, as Acccumulation indicated, which basically says that the market is perfectly efficient given all publicly available information, and that movement after that point is effectively random from a perspective of being able to forecast it. Be very, very careful that you don't become overconfident in your abilities. I will kindly point out that if you are asking how to calculate an expected value of a future event, you are not sufficiently informed to be able to invest in individual stocks without getting taken advantage of. I highly recommend you consider yourself a beginner investor, and search for questions on this site for 'how to get started in investing'. The most common advice would be - invest money every paycheck into diversified index funds (equities and fixed income) with low management fees.
Based on prior market close, the S&P 500 can be bought in the current mini futures contract at 2740.25 or bought in the Dec contract at 2701.25.
The Dec contract misses 2.29% in dividends. So 2701.25 plus 2.29% in dividends equals to 2763.11 cost for the Dec contract.
Or the Dec S&P 500 commodity call-option is priced at 296, but actually times 100 total cost, for a contract size of 270000. Scale down to a contract size of 2700 and the cost of the option is 296. Add 296 to 2700 and the total cost is 2996. The price of the option certainly includes a time value but the price is not expected to be adjusted for dividends.
One note with the option example is that it represents a partial loan of the total securities purchase price. So the option price could be recalculated for different interest rates. The calculation is known as a Black-Scholes calculation.
Also, the current S&P 500 commodity call-option, and at the current prior-close price level, is scaled at 2740 + 109 or 2849. That result is for a March 20, 2020 expiration. Ten days costs 109 extra and so obviously there is a volatility risk.
Then a determination of a volatility risk, as in dollar and time amounts, may be the best answer to the question with some of the other points as possible practices within the range of the subject.
If you think that the stock is, on average, going to go up, then not buying it immediately represents a loss of expected value. If you don't think the stock is going up, then you shouldn't buy it at all. Stock prices are a random walk. Buying a stock right after its price goes down has no greater expected return than buying a stock in general.
Terms of Use Privacy policy Contact About Cancellation policy © freshhoot.com2025 All Rights reserved.