Yesterday, we discussed the types of basic transactions and how to read a stock chart. We also discussed the most cost-effective manner of purchasing stocks. Yesterday’s blog was about rational responsibility. Today, we will be taking a walk into the dark side… Today, we will be discussing the riskier forms of investment. It is my hope you will stay away from doing so unless you know what you are doing, but short selling is a reality of the investment game. And as a long-term, stable, calm investor you need to understand shorting, because often times the ones yelling at you to SELL SELL SELL are only doing so to drive the stock down in price because it benefits them.
We quickly discussed short selling in our vocabulary section, but I will go over what ‘shorting’ is one more time. When you invest in a stock directly, you can actually bet on one of two outcomes. Either the stock is going to go up, or the stock is going to go down. If you think the stock is going to increase in value, you BUY shares and take what is known as a LONG POSITION. If, however, you think the stock is going to tank, you BORROW shares and initiate a SHORT POSITION.
Borrow you say? Yes. You borrow them. You go to your brokerage (online, on the phone, over Dixie cups and string, etc.) and SELL SHORT 100 shares of General Motors at $5.00 a share. The brokerage will lend you the shares to sell to them, and they will deposit the $500.00 from that sale in your brokerage account.
Two very important things have just occurred… First, you have taken a loan of $500.00 on margin at whatever the margin interest rate is. Second, you have entered into an obligation to give 100 shares of General Motors stock back to the brokerage.
What is margin? It is nothing more than a loan against your existing shares of stock. Let’s say your portfolio is worth $10,000 and you apply for margin privileges at your brokerage, they will give you $10,000 (actually less, more on why later) in credit at a variable rate tied to prime in order for you to have a little more to play with. I’m serious. It is a dangerous thing to fiddle with ladies and gentlemen; remember one of our rules from earlier… DON’T PLAY WITH WHAT YOU DON’T HAVE.
Shorting is the one of the few exception to the rule above, and honestly, I don’t recommend short selling to the inexperienced, we will see why in a bit. I have tried to keep a positive tone, in spite of myself, throughout this series! Let’s keep that up and discuss the bright side first.
In our example above, we got the $500.00 in our account and the obligation to pay back 100 shares of GM. Let’s just say… oh I don’t know… that GM went bankrupt. We could then walk up (in the virtual world) to our brokerage and hand them 100 shares of $0.10 a share GM stock and the obligation would be met leaving us with the $490 as profit. Actually, it would be a little less to a lot less depending on brokerage fees and how long we had to wait for that to occur, remember, we are paying interest on that $500.00 margin loan! (The good news is that the interest is tax deductable!) I hope this gives you a small idea of why shorting might be a bit on the risky side… If it didn’t, let’s take a look at the “2012 Mayan Prophecy Apocalypse Scenario”.
We are sitting pretty with our $500.00 cash money. We have converted it into one dollar bills so that we can go to the strip club and “Make it Rain” like Pac Man Jones. We go out, party, drink, live it up and tell all of our friends and family how we’re going to ‘make a killing on this GM thing.’ The stock does begin to fall a little, but one day, Saudi Prince Bandar, touched by youthful memories of dessert quickies in his Corvette, decides that GM is too important to die (especially given some of their EPA ratings). He gives, free of charge, enough money to free General Motors from all of its debt! The stock market goes apeshit with this news! All of a sudden, GM stock rises like the great Peter North himself and ends the day at $25.00 a share. Guess what mon ami… You still owe the brokerage 100 shares of GM stock, which is now valued at $2,500.00.
Miamians… Americans, of both the Northern and Southern Hemisphere, I know exactly what you are thinking. “So what! I’ll just leave it there… you never said I had to pay them back in any given amount of time, besides, 6% interest isn’t that bad, my credit cards are easily double that!” Au contraire mon frère!
You see, using Margin is a dangerous thing for several reasons… There are two words that every fund manager, investor, or trader never wants to hear. MARGIN CAAAALL! A Margin Call occurs when the percentage owed falls out of whack with your actual equity. As we know from earlier, Margin is borrowing against the value of your investment portfolio… If your stocks go DOWN in value, or a short position goes out of control, your ‘collateral’ will all of a sudden no longer be sufficient. A Margin Call, is a loan shark coming to collect what he is owed. Look at it that way, because that is what it is… except that instead of breaking your legs, they can go in and SELL all of your stocks to cover what you owe them… And if you’re in a down market, when many of those stocks are at historic lows (like last year) you can turn what seemed to be a silly $500.00 bet on GM into a several thousand dollar debt spiral ordeal. It happens all the time believe it or not.
Shorting does have its legitimate uses in the world of investment; sometimes shorting can be used to hedge (offset) a long investment. This is part of the concept behind options and futures trading, which we will not discuss in this series, as it has no part in the life of your average American (Unless you are a farmer or are in a commodity based industry). But the truth is that you should not try to short stocks haphazardly, because you have more than everything to lose. With a stock, even if the company goes bankrupt, the most you lose is your initial investment. With a short position, as in our example above, you could end up losing more than your initial investment.
So why am I try to scare you with the scenario above? Because I don’t want you to think you are Gordon Gecko or “a hot-shot home-game wall street-wannabe-asshole”. I want you to do what our grandparents did. I want you to believe. I want you to buy smart, and I want you to buy loyally. What do I mean by that? If you want to invest, if you choose to put your backing behind a company don’t just buy a couple of shares, then go buy another company next month, and so on and so forth. You must increase your position, reinvest your dividends and keep acquiring more shares. Have the discipline to add a little to the pile, even if it’s a share at a time. Sometimes, you will come out ahead (when the market is down) other times you will pay more (when the market is up). Over time, you will learn to love those down days, because of how much more you are getting for your dollar. This is counterintuitive, but true. Don’t give up, don’t give in, keep at it. Be a diligent investor. Trading and investing, are two completely different things which people often confuse. An investor does not constantly buy and sell, a trader does, there is a fundamental difference. That being said… sometimes, it makes sense to sell! But there is one more thing you must do, that is done by both traders and investors (at least the smart ones)
You must do your research and attend the company conference calls (or the replays). You must read the annual report, and you must do so much more. To a point, to be good at picking winning companies you must look at the world around you! Are there any socio-political, economic, legal, or environmental factors that may affect this company? How does a drought in a place where they grow a lot of wheat affect Pillsbury? If you hadn’t guessed, increased flour prices due to lower availability of wheat, perhaps the increased gas costs last year caused profits to drop. Each and every company out there is affected by a number of factors, from within, from its industry, from its state, from its country, from the world! You must know your company and know it well, and yes, I mean YOUR company, because by owning shares you own a piece of it.
I know I sound like a broken record. I do so, because this is important stuff. Many a person has lost their ass or worse, the ass of others in the investment game. The only way to truly win at it, is to be patient, be persistent, be unafraid! Because the truth is, you haven’t lost a penny, until you sell the stock! That’s the big secret. If you learn anything from this series, let it be that you should not be afraid of something as silly as money.
Tomorrow, we summarize (for you lazy sons of bitches) and wrap it up.
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