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Mark's Market Blog

5-24-09: Market Uncertainty and Shorting

By Mark Lawrence

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I don't have much to say about the markets lately, because the markets don't have much to say about themselves. The stock market has traded flat for a couple weeks now, or perhaps has even been declining. I interpret this as a battle between opposing forces: everyone knows that we're not in a recovery, we're just taking a break on the FED's and Obama's injection of money. On the other hand, they have injected a lot of money. The banks desperately need more capital, and the FED is doing everything they can to lower the cost of money and raise the banks' profits. A side effect of this is that there's more money in the markets too. Some are forecasting that the S&P will continue up, after a brief rest, to 1000 or more. I stand by my earlier statements: this summer is not going to be pretty for people who own stocks. Time will tell.

There's a derived index called the Chicago Board Options Exchange Volatility Index, or CBOE VIX for short. This is a measure of volatility (fast price movements) in the stock markets. Below is a 19 year chart of the VIX. Normally this index is somewhere between 10 and 20. Historically when it gets to 30 or above, people think it's time to sell their stocks. For the last six months the index has been between 40 and 80, the highest the index has ever been. Last week the index briefly dropped below 30 for a few days, leading many to claim the bear market was over. I think this is like being on a six month bender then saying "Last week I was mostly sorta sober for 3 days, so I'm no longer an alcoholic."

Last week we saw there are several ways to sell stocks: you can sell at the current market price, you can sell when the price drops below a predetermined price (stop loss), or you can sell when the price has come down from the previous high a certain amount (trailing stop loss). Today we're going to see a couple more ways to sell stocks, but this time there's a big difference: we're going to sell stocks that we don't own. This is called a short sale, or shorting a stock.

The simple way to understand this is, imagine you think GM stock will go down as a result of the company declaring bankruptcy, then issuing 100 times more shares than currently exist. I know, it seems pretty far-fetched that this would effect the stock price, but work with me here. . . Suppose you knew someone more rational than you who owned a bunch of GM stock and had no particular intention of selling. You could borrow 100 shares of stock from them and agree that you would give the stock back within six months. Then you sell the borrowed shares at the current price of $1.50, getting a payment of $150 from some character. If the stock were then to drop to, say, a penny sometime in the next six months you could buy 100 shares for a dollar and give them back to your friend. You would have made $149 on the deal. If the stock went up over that six month period you would have to buy back stock at a higher price and you would lose money. So if you think a stock is going to tank, you can short the stock, meaning borrow a bunch of shares and sell them.

You can short entire indexes. There are synthetic stocks made to have the same effect as shorting an index. For example, if you think the S&P 500 is going up, you can buy the synthetic stock SPY which tracks the index. If you think the S&P 500 is going down, you can buy the synthetic stock SH. Both stocks are shown in the chart below, SPY in blue, SH in red.

If you really think the S&P 500 is going to take a high dive, you can buy SDS, which is a synthetic stock called an "ultra short." If the S&P goes down 10%, this goes up 20%. SPY and SDS are shown in the chart below, SPY in blue, SDS in red. There's an important point to notice about an ultra-short stock: SPY has gone up 5% in the last month, and SDS has gone down 12% in the same period. Due to technical (math) reasons, you lose a bit of money in an ultra short every time the stock goes down then up. So you don't want to buy an ultra-short and hold it for a long time, as your money will just evaporate. Historically when markets drop large amounts, they do it very quickly, like in a couple weeks or so, so optimally you would buy the ultra-short the day before the drop and sell it at the bottom of the drop. You only need to be psychic and it all works out. There are synthetic stocks that short most every index you can think of, and then several more synthetic stocks that ultra short the most popular indices.

Below is the same chart, except from January 2 2009 until today. Notice that at the market bottom in early March, SH or SDS would have made you a whole bunch of money. Notice also the dashed line on the graph representing 0%. SH (short, red) crossed this line about a week before SPY did, and SDS crossed it almost a month before SPY did. If you had bought SH on January 2nd and held it until today, the market is at almost the exact same price but you would have lost about 5% of your money. With SDS (ultra-short, green) you would have lost about 15% of your money. These stocks are not to be held for long times.

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