Rant About It

The Art of Making Money in the Bear Market

Posted by rantaboutit on March 27, 2007

In the bull market most of us makes money, and in the bear market most of us loses money. Wouldn’t it be nice to change that, and make money in the bear market. With the advanced investing technique called short selling, it is possible.

However the concept of short selling doesnt come easy to everyone. In general, people think of investing as buying an asset, holding it while it appreciates in value, and then eventually selling to make a profit. Shorting is the exact opposite where you make money when the asset falls in value. The return rates can be high from short selling, but its comes with the added high risk.

The Basics of Short Selling
When you sell a stock (say X number), that you do not own, but are promised to be delivered in future, it is called Short Selling. So how can you sell a stock you do not own ? Basically your broker will lend it to you. Sooner or later you must buy back the same X number of stocks (covering) and return them back to your broker. When you buy back the stock at the lower price than you sold earlier, you obviously made a profit on the difference. However if the stock price rises, you end up losing money.

Most of the time, you can hold a short for as long as you want. However, you can be forced to cover if the lender wants back the stock you borrowed. This is known as being called away. It doesn’t happen often, but is possible if many investors are selling a particular security short. If there was any dividend distributed, you need to pay it to the lender of the stock. Also because you have loaned the stock, you are buying on margin, which means you will need to pay an interest.

Two main reasons why investors short are: speculating & hedging.

Restrictions on Short Selling
There are few restrictions imposed on stock selling so that investors can’t sell short in a declining market.

  • You cannot short sell penny stocks (under $1 stock).
  • Most short sales need to be done in round lots.
  • There are rules (uptick rule) preventing the short selling to take place unless the last trade of the stock is at the same or higher price.

Techniques Used
Short sellers use an endless number of metrics and ratios to find right stocks to short. Some use a similar stock picking methodology to the longs. Others look for insider trading, scandals, options backdating, changes in accounting policy, or bubbles waiting to pop. One indicator specific to shorts that is worth mentioning is short interest. This reveals how many shares have already been sold short. It’s a dangerous sign if too much stock is sold short before you initiate a new short position.Risk Factor
Shorting is risky business. Let us look at few reasons for high risk.

  1. Over the long run, most stocks appreciate in price (inflation is one reason). This means that shorting is betting against the overall direction of the market.
  2. Downward movement of the stock is limited (max it can go to zero), whereas the upward movement does not have any limit. This means that you can lose alot more than you invested, but you can earn a max of 100% in returns.
  3. When trading on margin, if your account falls below the minimum maintenance requirement, you will be subject to a margin call and forced to either put more cash in your account or sell/cover your stocks.
  4. If a stock starts to rise and a large number of short sellers try to cover their positions at the same time, it can quickly drive up the price even further. This phenomenon is known as a short squeeze. A short squeeze is a great way to lose a lot of money extremely fast.

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Love Them, Hate Them
One cannot deny the valuable contribution short sellers make to the market. Short selling provides liquidity in the market, drives overpriced stocks down and helps balance the overall market. Short sellers are often the first line of defense against financial fraud.On the other hand, short sellers aren’t the most popular people on Wall Street. They are considered party poopers and are to be blamed for major market downturns. Some short sellers also use unethical tactics (short and distort) to make profits by taking short positions and then using a smear campaign to drive down the target stocks. Short selling abuse like this has grown with the advent of the Internet and the growing trend of small investors and online trading.

Conclusion:
With the knowledge of short selling, you have added another trading technique to your toolbox. Short selling can be great way of making money in the bear market. You make money by short selling when the stock price falls. However short selling can be very risky and you should proceed with extreme caution. Short selling is not recommended for investors beginning their journey at the stock market.

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(Source: Investopedia)

Posted in Bear Market, Educational, Investment, Short Selling | 4 Comments »

With So Many Options Where Does One Start

Posted by rantaboutit on March 24, 2007

Last time I checked, the Nasdaq had more than 3200 companies listed. Following all of them is simply impossible. So what do most investors do ? Short-list a bunch of stocks they like and stick to them. How do you short-list which ones to invest from so many options ? Where do you start ? Frankly, there is no straight answer to that. The best thing would be to break these stocks into smaller groups and then decide how to proceed. Ok so lets break them into smaller groups. But wait…what criteria to use to break them into smaller groups. I found few of the important criterias that make the selection process much more easy.
Company Size
Break up based on company size. By company size, i mean their market capital. Market capital is nothing but the total dollar value of the company’s outstanding shares. Based on market capital a stock can be a large cap, mid cap or a small cap.

Large Cap = Market cap of anything more than $10 billion
Mid Cap = Market cap valued between $1 billion and $ 10 billion
Small Cap = Market cap of anything less than $1 billion

The larger the market cap, the more established the company, which means more stable stock prices. Small cap and mid cap companies usually have a higher potential for future growth than large cap companies, but their stock tends to fluctuate more. In short, volatility factor goes down as the market capital goes up. Large caps are less volatile as compared to small caps. For an aggressive portfolio trade in small/mid cap. For conservative portfolio trade in large cap. Exxon Mobil Corp XOM has the largest market cap at $427 billion.

Sector
Break up based on company business. 12 known sectors are basic materials, capital goods, conglomerates, consumer cyclical, consumer non-cyclical, energy, financial, health care, services, technology, transportation and utility. This definitely takes you one step closer to your potential candidates. Again you can break the sectors into subsectors to make it that much easier to find the right match. (For example, you can break a Technology sector into subsectors like Computer Networks, Computer Hardware, Semiconductors, Computer Software…etc etc). Which sector to invest in, basically depends on your overall understanding of the sector. Say you understand the Technology and Energy sector better than the others, and think that most tech & energy companies will perform better compared to others. That means you have potentially narrowed down your search. However always remember that each of these sectors go through boom and a bust (For example, technology sector saw a boom before the dotcom bubble burst, energy sector saw a boom in recent years with oil prices climbing to record highs), so never put all your eggs in the same basket (do not buy all tech sectors).

Cyclical Stocks
Break up based on business cycles. Certain companies are like rollercoasters. When the economy is good, the profits are up and the stock price rises. When the economy is bad, the profits are down and the stock price falls (For example, the auto industry makes a profit when the economy is doing good, since consumers have more money to spend on new cars. Another cyclical industry is the housing industry). Investing in cyclical stocks can possibly give good returns if you can correlate an industry (say auto-industry or tech industry) with the current economy.

Non-cyclical Stocks
Non-cyclical stocks are the opposite of cyclical stocks. If you think you do not have sufficient resources to find out possible correlations between the industry and the economy, stick to non-cyclical stocks. Non-cyclical stocks would be in industries such as healthcare, food and utilities where the demand for goods and services is constant, since people always need health, food and electricity, no matter how is the economy performing. Non-cyclical stocks tend to do well during economic downturn, but actually sag behind cyclical stocks when the economy is booming.

Dividend Stocks
Break up based on dividend returns. Dividend is a good diversification for the portfolio. Even though the stock prices fall, the high dividend can offset the loss. High dividend can assure a steady income.

Technical Analysis
Break up based on technical analysis. There are alot of analyst/traders who buy/sell/short stocks based only on technical analysis. Technical analysis helps one understand the direction of the stock. Stock movement is predicted based on past performance. Also future estimated growth of the company is used a factor to look for long term stocks. You can group stocks based on P/E ratio, EPS and PEG. P/E ratio should generally be low, indicating cheaper stock price compared to earnings. EPS should be as high as possible, indicating high earnings per share. PEG should be as low as possible, indicating higher future growth. Technical Analysis is an excellent tool to pick potential candidates.

Conclusion: With so many options in the stock market it can be difficult to decide where to invest. By breaking these stocks into smaller groups using certain criterias can make the decision process that much easier. Company size, Sector, Cyclical stocks, Non-cyclical stocks, Dividend stocks and Technical analysis are some of the important criterias to use to find potential match.

Recommendation: Using these criteria you can short-list potential candidates. Infact ideally you can combine all these criteria to come up with the perfect list that matches your style of investing. Once you have short-listed them, preferably stick to them. Trade in and out of them as per the economic conditions. I assure you, you will find success !! I am sure i missed out few more important criterias and would love to hear from the audience.

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(Source: Investorguide)

Posted in Uncategorized | Leave a Comment »

Money Markets: Reduce Your Risks – Part 2

Posted by rantaboutit on March 23, 2007

As part of the money market post, let us have a look at few more worthy money market instruments. Just before doing that let me do a quick recap from the previous post.


The money market specializes in debt securities that mature in less than a year. Money market securities are liquid and considered very safe resulting in lower returns than other securities. Money market mutual fund is the easiest way to gain access to money markets. T-bills are short-term government securities that mature in one year or less. Certificate of deposit (CD) is a time deposit with a bank, which are safe investments with not so great returns. Commercial paper is an unsecured, short-term loan issued by a corporation with higher returns than T-bills because of the risk factor.

Bankers Acceptance (BA)
A bankers acceptance is a short-term discount instrument that usually arises in the course of international trade. Bankers Acceptance starts as an order to a bank by importer X to pay an amount to exporter Y at the future date (something like a postdated check). Once customer X and the bank completes the acceptance agreement, the bank keeps the acceptance (draft) in return for cash which is an amount less than the face value of the draft. The bank keeps that difference (like interest). The importer X will use that amount to pay to exporter Y.

The bank may hold the acceptance in its portfolio or it may sell, or rediscount, it in the secondary market. Also depending on the bank’s reputation, importer X may be able to sell the bankers acceptance, that is, sell the time draft accepted by the bank. It will sell for the discounted value of the future payment. In this manner, the bankers acceptance becomes a discount instrument traded in the money market.

Advantage

  • Bankers acceptances are considered very safe assets which can be traded at discounts from face value.
  • They are used widely in foreign trade.
  • If the bank is well known and enjoys a good reputation, the accepted draft may be readily sold in an active market.
  • Does not need to be held until maturity, and can be sold off in the secondary markets.
  • Maturities are generally between 1-6 months.

Disadvantage

  • The only way for individuals to invest in this market is indirectly through a money market fund.
Eurodollars
Eurodollars have very little to do with the euro or European countries. Eurodollars are U.S. dollars deposited at banks outside United States. Eurodollars are not under the jurisdiction of the Federal Reserve, which means less regulation, allowing for higher margins.

A variation on the eurodollar time deposit is the eurodollar CD. A eurodollar CD is basically the same as a domestic CD, except that it’s the liability of a non-U.S. bank. Again the returns are generally higher than domestic CD due to slightly higher risk factor.

Advantage

  • Margins are higher since eurodollar market is relatively free of regulation compared to their counterparts in the United States.
  • Maturity period is less than 6 months.
Disadvantage
  • The average eurodollar deposit is very large (say few millions). This makes it out of reach for individual investors. The only way for individuals to invest in this market is indirectly through a money market fund.
Repurchase Agreement (Repo)
Repurchase Agreement is an agreement where the holder (repo seller) of a government security sells the security to a lender (repo buyer) and can repurchase it back at an agreed future date and price. Normally for short-term (30-days) borrowing a repo seller sells securities to the repo buyer in return of cash and agrees to repurchase those securities from the repo buyer for a greater sum of cash at some later date.

There are also variations on standard repos:

  • Reverse Repo – Complete opposite of a repo. In this case, a dealer buys government securities from an investor and then sells them back at a later date for a higher price
  • Term Repo – Same as a repo except the term of the loan is greater than 30 days.
Advantage
  • They are usually very short-term, from overnight to 30 days or more. This short-term maturity and government backing means repos provide lenders with extremely low risk.
  • Repos are popular because they can eliminate credit problems.
  • Any security (be it T-Bills, Bonds, Stocks) can be used in a repo.
Disadvantage
  • Bad credit check by the lender can be lead to fraud activity.
Conclusion: When the stock market looks volatile and too risky, money markets can provide an excellent alternative. Their short-term maturity make them more attractive. Obviously the returns are not very thrilling, but there are times when even the most ambitious investor puts some cash on the sidelines. I intend to write a post in future to compare the actual rates for different money markets.

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(Source: Investopedia, Wikipedia)

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