Monday, August 27, 2012

Living On The Margin (1)


When a person gets a loan from a stock broker, it is called margin.  Short sellers borrow stock instead of money, but it is still the same thing, margin.  The amount of margin an individual can borrow is limited by the amount of equity, i.e., the combined value of all of the securities in the person's stock account with the broker.  In the US, the percentage of margin available to the account owner is set by the Federal Reserve Bank (FRB).  Stock exchanges and individual brokerage firms have their own rules as well, but they take the lead from the FRB.  The margin percentage has changed over the years depending on whether the FRB wants to depress or stimulate stock market action.  The lower the margin rate, the more people can borrow; the higher the rate, the less they can borrow.  The minimum margin requirement rate today is 50%.

In addition to margin requirements, only certain securities are "marginable."  Only the securities which qualify can be used in the individual's brokerage account as collateral for the margin loan.  These securities can be liquidated (sold) to cover the margin loan if their values decline to the point that the percentage of margin exceeds the required amount.  If the stocks decline in price, the broker contacts the customer and demands additional collateral (cash) be deposited in the account, a margin call.  If the customer does not respond on a timely basis, the broker sells enough securities in the account to pay down the loan.  It is said that one of the primary causes of the 1929 Wall Street crash was a vicious circle of unmet margin calls which triggered stock sales by brokers resulting in reduced stock prices, which led to another round of unmet margin calls, stock sales and price declines, over and over.

What is the attraction of margin?  It may be nothing more than the old philosophy, "More Is Better."  If you were to ask those folks wiped out during the Dotcom bust of 2000, they may ruefully tell you that more is just more.  In any event, using margin holds the promise of large gains with little invested equity.  Here is a simple example.  Assume that you have $10,000 to invest in a stock trading at $50 per share.  Ignoring fees, commissions and interest charges (this is just an example, remember), you can buy 200 shares.  If the stock is qualified for margin loans, you buy 400 shares with your $10,000, half of which is on margin lent to you by your broker.  One year later, the stock is trading at $75 per share and you sell at a profit.  If you had not used a margin loan and purchased only 200 shares with your $10,000, you would have a profit of $5,000 ($15,000 - $10,000).  With the sale of your 400 margin shares, your profit  is $20,000 ($30,000 - $10,000).  A $5,000 profit on a $10,000 investment is a 50% annual return on your investment.  A $20,000 profit on a $10,000 investment (remember, we're ignoring fees, commissions and interest) is a 200% annual return.

Sounds too good to be true, right?  Well, if the stock had dropped to $25 per share at the end of that year, the losses are magnified as well.  If you had just purchased the 200 shares, you would still own stock worth $5,000 in your account.  Assuming the broker issued a margin call on your account which you did not meet, the broker would have sold enough stock to cover the price decline (400 shares @ $25 = $10,000) and you would have nothing left.  You would have lost your entire initial investment of $10,000.  In reality, you would have lost more since the broker would still be looking for those fees, commissions and interest charges to be paid as well.

A very good explanation of margin loans is provided by Interactive Brokers at their website.  Here is a link.  We will continue our look at margin loans in the next blog.

Comments are always welcome.

Monday, August 20, 2012

Short Selling (2)


We began exploring short sales in the last blog.  The short seller borrows stock which he or she expects to decline from a broker and sells them.  The short seller's brokerage account now has the proceeds from the sale.  Assume you sell 1,000 shares of a stock at $50 per share.  You now have a credit balance in your account of $50,000 (we'll ignore the fees, interest charges and commissions).  If, as you believe, the price of the stock drops to $30 per share, you buy the 1,000 shares in the market for $30,000 and return them to the broker.  Your account still has $20,000 in it.  That is your profit.  If the stock goes up to $60 and you decide to close out the transaction, you have to buy the shares you owe the broker at a cost of $60,000.  You have to add $10,000 to the $50,000 in your account to complete the purchase.  The additional $10,000 deposit is your loss.  

One of the most famous traders, Jesse Lauriston Livermore, wrote a book about his trading experiences and methods in 1940, How To Trade in Stocks.   Livermore explained in his book why he engaged in short selling as follows:

There is no good direction to trade, short or long, there is only the "money making" way to trade.  But the stock market moves up roughly a third of the time, sideways a third of the time, and downward a third of the time.  If you only played the bull-side of the market, you were out of the action, and a chance to make money two thirds of the time.

Livermore emphasized the fact that a trader, whether short or long, had to pay constant attention to the trend of a stock, not its price.  He explained his strategy as follows:

One should never sell a stock (he means going short), because it seems high-priced.  You may watch the stock go from 10 to 50 and decide that it is selling at too high a level.  That is the time to determine what is to prevent it from starting at 50 and going to 150 under favorable earning conditions and good corporate management.

Conversely, never buy a stock because it has had a big decline from its previous high.  The likelihood is that the decline is based on a very good reason.  That stock may still be selling at an extremely high price relative to its value -- even if the current level seems low.

He followed the stock's price trend, not its price level.

Although not legally correct, the old lines of Wall Street doggerel succinctly sum up the lesson to be learned by short sellers:

                                         He that sells what isn't hisn
                                         Must buy it back or go to prisn.

I think that short selling is best left to market professionals speculating throughout the day in the market.  It is not a game for amateurs trading on a part time basis.

Excerpts from How to Trade in Stocks, Jesse Livermore, copyright 1940, published by McGraw Hill in 2001 with updates and commentary by Richard Smitten, pages 12 & 144

Comments are always welcome.

Monday, August 13, 2012

Short Selling (1)


As pointed out in earlier blogs, most investors and traders are optimistic (or at least hopeful) that the price of the stocks they purchase will rise.  They make their money when the price increases ("bulls").  A minority of individuals, however, are equally convinced that prices of some stocks are destined to decline.  They invest with the goal of making money on price declines ("bears").  They are called "short sellers."  They do not own (they are "short") the shares they sell in the market.

A short sale is a speculation for a trader, not a long term investor.  The trader believes that the price of a particular stock is going to decline.  The trader borrows stock shares and sells them in the market.  The buyer of the stock does not know that the shares he or she purchases are borrowed.  Usually the shares are borrowed from a stock broker, and the trader agrees to return the shares on demand.  If the stock price drops after the transaction, the short seller then purchases the stock on the open market at a lower price and returns them to the broker.  The difference between the price at which the stock was sold and the lower price paid by the trader to replace them is the short seller's profit.  If, however, the price rises, the short seller must purchase the shares at the higher price and suffers a loss.

The shares that are lent by the broker come out of the accounts of the broker's other customers who actually own the shares being shorted.  If you have an account with a broker and your shares are held by the broker in your account, in "street name", the fine print in your brokerage account agreement, which you signed when opening the account, provides that the broker may do this.  You never know this is happening because any dividends paid by the company during the time the stock has been lent out are still credited to your account.  If you sell the shares during the period the shares have been lent out, the broker will supply them from other accounts to cover your sale.  The broker charges the short seller interest for what is, essentially, a loan, albeit, a loan of shares of stock, not money.  The short seller deposits a percentage of the value of the loan with the broker to provide security that he or she will complete the transaction and replace the stock when required, just like a person who borrows money from the broker (margin) to buy additional stock.

A majority of people have a dim view of short sellers.  The practice strikes an emotional chord in people.  It seems predatory to try to profit from price declines, which represent losses to those who actually own the stock.  Fred Schwed, Jr. gleefully describes this animosity toward short sellers in his 1940 book, Where Are the Customers' Yachts? as follows:

I recall reading a novel about a rich man who was in everything vicious and hateful.  Among his evil attributes the author described how he had made his first fortune.  He had "sold stocks short during a great panic and had thus enriched himself fabulously while hundreds of thousands were being plunged into poverty and ruin."

This quotation expresses well enough the vague, universal indignation at the short seller. (This indignation only exists during and after panics -- during prosperous times he receives about as much attention as do people who practice barratry.  Before October, 1929, no one objected to short sellers except their own families.  The families objected to going bankrupt.)

Vague as the general feeling is, two of its implications are quite clear.  One is that being a bear raider is something like being a usurer or a jewel thief -- that it is an easy way to pick up a fortune provided you are willing to be immoral.  The second is that it is socially harmful.

Before examining these two claims, I must touch on the ancient human tendency to personify general misfortune in some human shape.  While "hundreds of thousands are being plunged into poverty" only the thoughtful ask, "What is happening to us?"  The popular cry is "Who is doing this to us?" and its satisfying sequel --"Just let me get my hands on him!"

At the very moment when we were buying that stock, hopefully  and constructively, looking forward and upward toward better things, those fellows, men without bowels, were selling it and they didn't even have it to sell!  They were looking downward and for worse things.  They thought it would go down and they helped it to go down.  How unnatural!  How perverse!  How cynical!  Why should society tolerate such men any more than those who burn down houses for insurance?

(Author's emphasis in bold)

We will continue our look at short sales in the next blog.
Excerpts from Where Are the Customer's Yachts? or A Good Hard Look At Wall Street, Fred Schwed, Jr., copyright © 1940, republished by John Wiley & Sons, Inc, pages 112 - 115

Comments are always welcome.

Monday, August 6, 2012

Options, Futures And Fantasy Football (3)


Another popular form of derivative is the futures contract.  With an option, the purchaser has the right to fulfill the call or put contract.  With a futures contract, the purchaser has the obligation to fulfill  the purchase or sale contract.  A futures contract is a form of what is called a forward contract.  A forward contract is one in which a person can enter into an agreement for the purchase or sale of a commodity or a financial asset at a set price now, but need not pay for the asset until a later date, the settlement or expiration date.  This would be your basic agreement between a farmer and a grain processor.  Unlike an option, in which the processor would have the right to buy but not the obligation, a futures contract is a legal obligation with the price, the amount of the commodity and the date for payment agreed to by the parties.  The time of payment is delayed.

A futures contract is much like a forward contract but one important difference is that any gains or losses that might accrue as the current market price varies from the futures price are realized daily, not at the settlement date.  This daily accounting is referred to as the "mark to market" accounting principle.  Another difference is that both parties to a futures contract have to post a bond or make a deposit with the broker acting as the intermediary in the contract to ensure their performance at the end of the contract.  This deposit or bond is called the initial margin and it generally ranges between 2% and 10% of the contract value, depending on the volatility of the asset.  Since each party has to "mark to market" at the end of every day, a person with a losing position may be called upon by the broker to deposit more money in his or her margin account.  The futures contracts have standard provisions relating to the settlement date and the size of the contract which allows them to be freely traded on exchanges.  The majority of traded contracts are futures contracts.  Forward contracts tend to be much more customized to the needs of the parties.  They are not normally traded on exchanges, but rather they are established through forward contract brokers who act as intermediaries.

Although it is too complicated for me, both futures contracts and options are used by professional traders to reduce or "hedge" the risk inherent in holding a stock.  As a simple example, let's assume you own 100 shares of a stock which is trading today at $100 per share.  You purchased the stock several months ago for $75 a share, so you have a gain of $2,500 now.  Assume also that, for tax reasons, you do not want to sell the stock today.  Maybe you want to put off the gain until next year in order to postpone the taxes on your profit.  Although you have to wait, you are concerned that the price may fall before your target sale date.  How do you capture the gain?  If there is a futures contract available for your stock which fits your circumstances, you could enter into one which will require you to sell and the other party to buy your stock at some point in the future for $100 per share.  You have locked in your $25 per share gain and postponed the date of sale.  You could accomplish the same thing on an options exchange by buying a put option for your stock at $100 per share at the settlement date.  When the life of the put option expires, you can, but need not, sell the stock at the agreed upon $100 per share.  The added benefit of using a put option is that you are not obligated to sell the stock if it has continued to increase in price.  I assume there is a difference in the transaction costs between using a futures contract versus a put option, but I do not know for sure.

Although derivatives like futures contracts  and options would seem to be modern financial tools, such is not the case.  Aristotle told a story about one of the first Greek philosophers, Thales of Miletus (circa 624 BC - 546 BC).  Unlike most of his contemporaries, Thales believed weather was a natural phenomenon;  not a message sent by the gods to show their pleasure or displeasure with the people.  He supposedly had a knack for predicting the weather.  As Aristotle's story goes, one year most folks believed the gods were angry and that the weather would result in a bad olive crop.  Suspecting that the weather and the crop would be fine, Thales went to every olive press owner in the area in the spring and purchased the exclusive rights to use their presses at harvest time.  Since the owners believed their presses would sit idle at harvest, they gladly took his money.  As Thales predicted, the weather that year was fine and there was a bumper olive crop.  Thales had the right to charge the olive growers whatever he wanted for the use of the presses.  It is said that he made a lot of money.  Aristotle went on to point out that Thales thought of himself as a philosopher, not a trader, and did this to demonstrate the usefulness of weather prediction, not to cash in on his insight.  I suspect that all those drachmas played some part in Thales' derivative play.

Comments are always welcome.