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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.

Recommended Books:

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(Source: Investopedia)

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

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.

Recommended Books:

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(Source: Investopedia, Wikipedia)

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Money Markets: Reduce Your Risks – Part 1

Posted by rantaboutit on March 21, 2007

Most investors are hypocrites when it comes to the stock market. In the bull market they are raving about the stock market, where as in the bear market, they cannot stop cursing it. In the bear market alot of investors get out of the stock market and park their money in the money market, that offers an alternative to high risk investments.

Introduction to Money Market
Money market is one of the significant type of fixed income market. Money market securities are issued by governments, financial institutions and large corporations. These instruments are very liquid and considered safe. They are better known as a place for large institutions and government to manage their short-term cash needs. Because they are extremely conservative, money market securities offer significantly lower returns than most other securities.

How is Money Market different from Bond Market ?
The difference between the money market and the bond market is that the money market specializes in very short-term debt securities.

How is Money Market different from Stock Market ?
One of the main differences between the money market and the stock market is that most money market securities trade in very high amount which limits access for the individual investor. Also in case of money market, firms buy and sell securities in their own accounts, at their own risk, whereas in the stock market, a broker acts as an agent to buy and sell. Add to that, there is no central trading exchange in case of money market, but just transactions over the phone or electronic systems.

How to Get Access to Money Market ?
The easiest way to gain access to the money market is through a money market mutual fund or through a money market bank account. Some money market types, like Treasury bills, may be purchased directly. They can also be acquired through other large financial institutions with direct access to these markets.

Types of Money Market
There are different instruments in the money market, offering different returns and different risks. Let us take a look at the major money market instruments.

Treasury Bills (T-bills)
Treasury Bills are short-term securities (say 3-month, 6-month or 1-year maturity). T-bills are purchased at less than their face value. On maturity the full face value is returned. For example, if you bought a 90-day T-bill at $9,800 and held it until maturity, you would be returned $10,000.

To buy a T-bill, a bid has to be submitted either non-competitively or competitively. In non-competitive bidding, the full amount determined at the auction will be returned. With competitive bidding, based on the desired returns, the bid maybe a success or a failure.

Advantage

  • Their popularity is mainly due to their simplicity and affordability.
  • One of the safest investments in the world, since it is backed by U.S. government.
  • They are exempt from state and local taxes.
  • They are short-term investments instead of being locked for a longer time frame.
Disadvantage
  • The returns from this investment are not great compared to bonds, certificates of deposit and money market funds.
  • The investment cannot be liquidated before maturity date.
Certificate of Deposit (CD)
Certificate of deposit is a fixed term deposit, also known as time deposit. CDs are issued by commercial banks but can be bought through a brokerage firm. They have a maturity period ranging from 3-months to 5-years with a specified interest rate. Interest rates depend on various factors like current interest rate in the market, money invested, maturity period. A fundamental concept to understand when buying a CD is the difference between annual percentage yield (APY) and annual percentage rate (APR).

Advantage

  • CDs have a higher yield compared to T-Bills due to their slightly higher risk factor. (ie. What is the bank goes out of business)
  • Almost every bank offers CDs, which means they are easily accesible. This also means you have multiple options to get the best rates.
  • CDs are relatively safe and will earn more than in a savings account.
Disadvantage
  • CDs cannot be withdrawn instantly as desired similar to a checking account. A huge fine can be levied if the funds are withdrawn prior to maturity.
  • The returns from this investment are not very exciting compared to many other investments.
Commercial Paper
Borrowing money from banks for a short-term can be sometimes frustrating process. In response to that, commercial paper gained popularity among corporations. Commercial paper is an unsecured, discounted, short term loan issued by a corporation. Maturity period is no more than 9 months.

Advantage

  • Safe investment because the financial situation of a company can easily be predicted over a few months.
  • Only companies with high credit ratings issue commercial paper.
  • Higher returns than T-bills.

Disadvantage

  • They are not afforable to everyone, since commercial papers are issued in the range of $100,000 or more.
  • Small-time investors can only invest in commercial paper indirectly through money market funds.
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. There are a few more instruments i did not cover in this post, which would be covered in Part-2. Hope this post opened your eye to money market securities. To be continued…

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(Source: Investopedia)

Posted in Educational, Investment, Money Market | 1 Comment »