From time to time, I have expressed concern about the state of the investment markets due to the general uncertainties existing all around us, legally, economically and financially.
From time to time, I have expressed concern about the state of the investment markets due to the general uncertainties existing all around us, legally, economically and financially. At this time of year, we also face a seasonal, summer slump caused more by a lack of investment activity due to the vacation habits of the rich, whether famous or not. But what can one do about it even if you know it is quite likely.
You can make money by betting that the stock market, bond market or parts thereof, will fall in price. This is called short selling. Recently I read in Niall Ferguson’s book “The Ascent of Money” that short selling has been around for centuries.
Until recently, however, it was a tool used primarily by the broker/dealers trading for their own accounts. Today we will discuss some of the ways that we can also participate in using them to protect all of the positions you do not want to sell even if they fall in value.
These vehicles are known by various names today and they come in either open-end mutual funds or exchange traded funds or you can still short an individual stock in most cases, depending upon your investment account. Let’s start in reverse order to explain the concept first.
Imagine that a certain oil company, perhaps BP, has risen from its early 2009 low of $33.70 a share to $62.38 by January 2010 and it reaches a lower high point in April of $61. The next thing you know, there is a calamity involving a drilling rig and the near-term outlook becomes bleak. With a regular brokerage account, you can put in a trade to sell BP short. How does that work?
In essence, you will arrange to borrow shares from someone else through your account and sell them now, pocketing the value of the sale in your account. At a later time, you must repay the shares you borrowed. In our strictly hypothetical example, suppose you sold 100 shares short at $57 on April 27.
Yesterday suppose you decided to buy to cover and purchased 100 at $27. You are giving back the shares you borrowed and you have made a gross profit of $30 per share. Your net is $3,000 less trading charges and some interest for the two months you had an outstanding loan of 100 shares.
This strategy obviously requires some knowledge, research and care for success. Hypothetically, BP might not have been so completely lame and clueless. It might have been able to shut off the oil well in early June and the share price rebounded to $50 about as quickly as it had fallen. In that event you would be scrambling to close out your trade to keep it profitable. Your broker might have borrowed your BP shares from your account and done that transaction for its own profit.
Today however, you have the two other alternatives mentioned above. You can buy long a fund that produces this result itself by what the fund manager does inside the fund. For example, the Rydex Inverse S&P 500 fund is an open-end mutual fund like almost all funds you would buy. It dates back to 1994, and its goal is to provide results as nearly inverse to the S&P 500 index as possible.
Next week I will finish the story of shorting by examining the ETF choices and the proliferation of available short funds over the past several years.