Archive for September, 2007

How to implement an asymmetric payoff strategy: Part 3- Using margin lending, GSL & CFD

Sunday, September 30th, 2007
In our previous article, How to implement an asymmetric payoff strategy: Part 2- Using options, we mentioned about using options to profit from a possible stock market crash. Today, we will introduce to you another technique. It may sound complicated because of the 3-letter acronyms, but once you understand it, it is far more easily conceptually than using options. First, let us explain some of the elements used in this strategy:

  1. Margin lending – We assume that you know what margin lending is all about. Basically, you borrow money to buy stocks. At any point in time, the amount you borrowed must remain at or above a certain ratio relative to the total valuation of your stock.
  2. CFD – This is a leveraged derivative instrument called Contracts for Difference. It is an agreement between two parties to settle, at the close of the contract, the difference between the opening and closing prices of the contract, multiplied by the number of underlying shares specified in the contract. The usefulness of CFDs is that you can use it to bet on a falling stock price as well as on a rising stock price.
  3. GSL – This stands for Guaranteed Stop Loss. This is different from the ordinary stop-loss (see How to implement an asymmetric payoff strategy: Part 1- stop loss, the wrong way for the pitfalls of using stop-loss). The difference is that in the GSL you are guaranteed a selling price (or buying price when you go short) even if the prices gap down.

So, how do you implement this strategy? Below are the steps to do so (assuming that the everything is ideal in a perfect world):

  1. Long (or buy) the stock at a particular price, using margin lending for leverage.
  2. Use a GSL that will activate when the stock fall by a certain percentage.
  3. Use CFD to short the same stock at the same price that you go long.

When the stock market is behaving normally, profit (loss) from the long leg will offset the loss (profit) of the short leg, resulting in net profit/loss of zero. When an extraordinary event (i.e. a crash) occurs, falling market price will activate the GSL, thus terminating the long leg. The short leg is then allowed to run free, resulting in runaway profits.

This is the theory anyway. What are the possible pitfalls to watch out for this technique? They are:

  1. Interest charges – When you use margin lending to borrow money, you have to pay interests. When you use CFDs to go short, you are paid interests. However, the interest rates on these two legs are different and most likely against your favour.
  2. Percentage activation of GSL – When you set a GSL level, you have to specify the percentage of the fall in stock price before your GSL will activate. This is the tricky bit.
  3. GSL fees – Guaranteeing a stop-loss comes with a price to the stock broker who provide you with this service. The charges varies depending on the market volatility, the percentage level for which the GSL will activate, the length of time this GSL facility is active.

The concept of this technique is simple, but the devil is always in the detail.

Recommend web sites

Sunday, September 30th, 2007

As of today, we are starting to maintain a list of recommended web sites that we like and visit frequently here.

Should you hold gold or cash in times of deflation?

Thursday, September 27th, 2007

In our earlier article, What should be your fundamental reason for accumulating gold?, we said that:

If you cannot remember anything else, please remember this: gold is a hedge against loss of confidence in fiat paper currencies.

Such loss of confidence manifest itself in the form of hyper-inflation, which is what is happening in Zimbabwe right now.

Now, what about in the situation of deflation (the bad kind of deflation due to economic malaise, not increase in productivity)? If you can recall, in The mechanics of deflation- increase in demand for holding cash, we elaborated on deflation:

Deflation happens when liquidity dries up. This can happen in a period of severe economic pessimism when the apprehension of the future drives people to increase their holdings of cash for the sake of peace of mind. When that happens, the quantity of money in circulation decreases, which means there are fewer money chasing after a given amount of goods and services. Consequently, prices have to decrease to accommodate for the decreased supply of money in circulation.

Thus, as we said before in Warning: gold price can still fall significantly

When the inevitable liquidity contraction occurs, gold price will fall as well. On that day, we will be ready to swoop in with cash to buy even more gold.

So, a good question to ask is this: in times of deflation, wouldn’t it be better to hold cash instead of gold?

The short answer is this: In theory, yes. In reality, no. If you want to know the long answer, read on.

Yes, in deflationary times, the purchasing power of cash increases. But when deflation occurs in times of severe economic pessimism, there will be asset price deflation, high unemployment, collapsing businesses, bankruptcies, bank runs and so on. In such an environment, is your ‘cash’ really safe? Remember, for the vast majority of us, most of our ‘cash’ does not exist in the form of cold hard physical paper. Most of them exists in the form of bank deposits. As you may recall in 363 tons of US dollars to Iraq?how much money will eventually be multiplied into the economy?, because of the fractional banking reserve system, every physical dollar deposited into a bank account will eventually result in multiple times the value of bank deposits into the financial system.

That is where the trouble starts.

You see, the ‘cash’ that you had deposited in a bank is an asset to you but a liability to the bank. In times of severe economic conditions (e.g. during the Great Depression), can your bank honour its liabilities? If it can’t, then your ‘cash’ is in grave danger (if it can due to the government guaranteeing deposits via printing money, then we have inflation problem)!

If you hold physical gold (in bullion form, not jewelery), it is a different story. It is your asset and nobody’s liability. In times of deflation, even though gold prices may fall in nominal terms, its physical presence gives you the assurance that abstract ‘cash’ cannot provide. For this reason, you may still want to hold gold even in times of deflation.

Counter-productive way of dealing with inflation?price control

Tuesday, September 25th, 2007

As we all know, price inflation in China is getting more and more serious as the days go by. In the year to August, the official price inflation rate hit 6.5%. Our long time readers should be clear on why this is happening?see Why is China printing so much money? and Cause of inflation: Shanghai bubble case study. But recently, China is trying something very foolish in an attempt to control price inflation.

Price controls!

As this article, Inflation in China builds up steam says,

THERE is not an economist in China who thinks Premier Wen Jiabao can stop inflation by telling power utilities, petrol stations and even salt vendors to freeze their prices until next year.

How can you possible control price inflation by imposing price controls when you are, at the same time, printing money like there’s no tomorrow? We believe such folly will end up doing more harm than good.

To help you see why, imagine you are making a living by making and selling cakes. As price inflation roars ahead, you find that your input costs (e.g. eggs and flour) rise. Therefore, the only way for you to remain in business is to raise the selling price of your cakes. Now, what happens if the government decreed that you are not allowed to raise the price of your cakes? Initially, you may be able to remain in business by reducing your costs through degrading the quality or size of your cakes. But eventually, if this decree is not revoked, you will go out of business.

Now, extend this scenario to the rest of the economy and what will you get? Widespread layoffs and business failures! This will then result in lower aggregate production, unemployment, lower profits and so on. In the end, the economy will suffer.

In an economy, prices tells us how to allocate limited resources to satisfy unlimited wants. Once you meddle with prices, the economy loses this vital piece of information. For example, if the price of petrol is rising, it tells producers that there’s money to be made by digging out more oil. It also tells consumers they should curtail their demand for oil by being more frugal in their use of petrol. Once you impose price controls on petrol, producers will not produce more and consumers will continue to consume more. What will happen then? Shortages! In this example, thanks to government intervention, the market fails!

It does not take a genius to work out that price controls AND printing money is a great recipe for stuffing up the economy.

Collateral Debt Obligation?turning rotten meat into delicious beef steak

Monday, September 24th, 2007

Back in February this year, in How to dump risk to consumers: securitisation, we mentioned that

With the recent financial ?innovation? of debt securitisation, lenders can now aggregate their loans, and through dicing, slicing, splicing and divesting, repackage it into an ?investment? product.

Back in the old days, the nexus between lenders and borrowers was strong. Before the bank lends you money, it has to know your financial health intimately and ensure that you are credit-worthy enough for a loan. You had to dress in a suit to impress the bank managers enough to convince him or her to give you credit. Indeed, in the old days, accumulating bad debt was bad business.

Today, through the financial ?innovation? of securitisation, the link between lenders and borrowers were broken. It has developed to the point whereby the one who is lending you the money is not the one who has to bear the loss or clean up the mess when you default on the loan. As the loan travels down the chain from the lender to the ultimate owner, intermediaries along the way collect fees and charges. Thus, lenders make profits the moment they make a loan. After that, they pass the risk of bad debt down the chain like a hot potato.

Alas, human avarice knows no bounds. The greed for profits drives lenders to make as much loan as possible, to the point of recklessness. It has come to the point that lending money becomes a sales job?this time round, the lender dress in a suit to ?sell? you home loan ?products.?

After you ?buy? the home loan ?product,? your regular loan repayments are aggregated together with other borrowers? repayments into a tap of cash flow. This cash flow is then sliced into pieces of ?investment? products. The first piece in the queue to receive the cash flow will receive AAA credit rating, while the next in queue will receive lower credit rating (e.g. BBB, CCC, etc). This is stage one of the securitisation process.

Next, comes another bright spark of financial ?innovation.? Since such a securitised ?investment? product is a cash flow, why not aggregate them together and securitise them again? This time, why not aggregate the various BBB-rated (or lower) cash flows from stage one of the securitisation process and then slice them further into many pieces. Again, the first piece in the queue to receive this cash flow will receive AAA credit rating. This securitisation of securitised ?investment? products is called Collateral Debt Obligation (CDO). Somehow, through the magic of financial ?innovation? and ?sophisticated? mathematics, bad credit-rated loans ended up with AAA rating.

This is how rotten meat gets converted into delicious beef steak. Add in appetizing sauces and you may get a delicious meal. But be prepared to have a bad stomach should you eat such poison.

For the average person on the street, when he or she is served a mouth-watering beef steak from the waiter in a high-class restaurant, how can he or she tell that it had been prepared from rotten meat?

There will be more people with bad stomach soon.

Degradation of Australia’s fiat paper money

Saturday, September 22nd, 2007
In our previous article, Fiat paper money on the way to worthlessness, we mentioned ?we will provide you with the chart on how one of the central bankers is debasing the nation?s currency.? Today, we will pick on Australia’s central bank, the Reserve Bank of Australia (RBA) as an example of fiat money debasement that has occurred over the decades.

Please note that Australia is not the only guilty nation. Every nation in the world is engaging in such practices too. In the US, it had come to the point that they are no longer provider vital statistical data on the money supply figures (the M3 figures to be specific). What has the US Federal Reserve got to hide by suspending the publication of such an important number?

Below is the graph of Australia’s money supply figure from July 1959 to July 2007 (click on the link to see the full size image of the graph):

Money supply in Australia

In the chart we were comparing two measures of money supply?currency in circulation and M3. The former, which is sometimes called money base or M0, is basically the actual physical currency issue plus bank?s deposits in the RBA. M3 is a broader measurement of money, which includes currency held by the non-bank private sector plus non-bank private sector deposits with the bank.

Why is the money base so much smaller than M3? Recall that in our previous article, 363 tons of US dollars to Iraq?how much money will eventually be multiplied into the economy?, we showed you how money can be ?created? through the fractional reserve banking system. As you can see, the M3 figures are growing at an increasing rate relative to the money base. In July 1959, M3 was just over 8 times of the money base. In July 2007, M3 was more than 23 times of the money base.

These figures do not include the data for August 2007, when RBA injected additional liquidity into the financial system to ease the logjam in credit. We wonder what the numbers will be.

Scathing attack on Macquarie Bank

Thursday, September 20th, 2007

Today, we caught this news article, Fortune magazine ravages ‘rapacious’ and ‘complex’ Macquarie Bank:

FORTUNE magazine has hit out at Macquarie Bank’s “rapacious” fees, high debt levels and its “too complex” structure.

The long-awaited article, to be published in its latest edition, is written by award-winning author Bethany McLean, one of the first reporters to pen a serious critique of the once high-flying energy trader Enron, prior to its collapse.

A little background on Bethany McLean, author of The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron. She’s the journalist who wrote a highly critical article on Enron just about a year before Enron?s collapse.

We are not predicting that Macquarie will fall like Enron. Rather, this is a heads up on Macquarie.

Temporary workaround for RSS & email subscription problem

Thursday, September 20th, 2007

Good news! We have found a workaround for this RSS & email subscription problem. For your end, subscription is working correctly.

Fiat paper money on the way to worthlessness

Wednesday, September 19th, 2007

Yesterday, the Federal Reserve officially cut interest rate to 4.75% (and the discount rate to 5.25%). Stock prices reacted by soaring. Whatever words central bankers use to describe their action (e.g. ?cut interest rates,? ?provide monetary stimulus,? etc), it all boils down to printing money (see How does a central bank ?set? interest rates?).

Take for example the Bank of England. Yesterday, they said that they will ?guarantee all deposits? in the failed Northern Rock bank (see Inflating out of trouble- unprecedented move by the Bank of England). From where do they get the money from in order to achieve this? A couple of centuries ago, under the classical gold standard (see A brief history of money and its breakdown- Part 2), every piece of paper money had an underlying gold backing. Today’s money is fiat. That is, each piece of paper money is backed by nothing! Consequently, it is easy for central bankers to create money out of thin air by printing them (or in today’s electronic age, just flick an entry in a computer database). So, that’s where the Bank of England get its money from!

But what are the consequences? As we said before in Cause of inflation: Shanghai bubble case study, the end result will be price inflation. Do it long enough and you will get hyper-inflation, which is what is happening in Zimbabwe right now. Common sense tells us that as you print more and more money, the value of each unit of money will fall relative to goods and services (i.e. prices will rise). If this folly is not arrested, people will eventually completely lose confidence in fiat paper money. For example, during the great German hyper-inflation in the 1920s, it is cheaper to burn German Marks than firewood for warmth!

And not only that, it’s not just the United States who is doing the printing. Australia, UK, China and Russia (just about every major nation in the world) is also doing the same. That is why asset prices all over the world are sky-rocketing (see Epic, unprecedented inflation). So, when you see stock prices surging in response to intrest rate cuts, do not take it as sign of economic optimism. The Zimbabwean stock market is ‘booming’ right now, but the economy is facing total collapse (see Zimbabwe: Best Performing Stock Market in 2007?).

In the next article, we will provide you with the chart on how one of the central bankers is debasing the nation’s currency.

Web address of CIJ moved

Tuesday, September 18th, 2007

Please note that Contrarian Investors’ Journal has moved to a new address: Please update your bookmark.