Archive for the ‘Investor Education’ Category

Short selling, who loans their share?

Tuesday, January 5th, 2010

Recently, one of our readers asked,

I can see how Naked Short Selling is fraud, but I can’t figure out who would knowingly loan shares to someone who wanted to short them? What interest do they get on the loan of shares or risk premium that they will be returned? I am assuming you have to have permission to borrow and sell someone else’s shares and they need to be compensated for the privilege. Especially when some one long company ABC wants to see the stock go up, and keeping their shares off the market helps create the lack of supply that helps that upward dynamic. So why help someone who wants to go short and what do you get from it? It would be great to see a Post about this whole issue of shorting. Especially when I want to sell something short, who have I asked to borrow the shares?

First, for the beginners, let’s explain what short-selling is. Basically, it is a way for traders to profit from falling stock prices. This is how it works:

  1. The trader borrows stocks from someone else.
  2. Then the stocks are sold on the market.
  3. Later, the trader buys back the stocks on the market.
  4. The stocks are returned that someone else.

Between step 2 and 3, if the stock prices fall, the trader will make a profit. On the other hand, if stock prices rise, the trader will make a loss.

What is naked short-selling?

No, it has nothing to do with nudity. Basically, in naked short-selling, step 1 is omitted and in step 4, the stocks are delivered to the buyer instead of to the ‘someone else.’? That is, the trader sells the stocks first without arranging to borrow it from someone else.

The next question you may ask is, how can selling stocks without having any on your hands be possible? If you are a retail investor trading through say, your Internet-based discount broker, it is not possible. This is because most brokers will not allow you to send any sell orders to the market if you don’t own the stocks in the first place. But for traders with the ‘connections’ or independent access to the market, it is possible. Usually, these are the institutional traders. To understand how it works, imagine you are a bidder for a painting in an auction market. You have no money in your bank account. But does that prevent you from placing a bid for the painting? No. The auctioneer is not going to search through all your assets to make sure you have the cash at bank. You can still bid for the painting. But should your bid be successful, you will be legally obliged to cough out the cash. In the same way, the stock exchange is basically an auction of stocks.

You can certainly come up with a short-sell arrangement with your friend. You may borrow your friend’s stocks (by filling in a securities ownership transfer form), sell the stock on the market (through your broker), buy back the stocks later (again, through your broker), and then return your friend’s stocks (by filling another securities ownership transfer form). To be fair, you will also compensate your friend any dividends foregone in the interim period that the stocks are not under his ownership.

If your friend is your bosom buddy, he may verbally agree to such an agreement for free. But in the real world of money, there are legal obligations involved. The terms of loan of stocks will be governed by law, which requires that the stock borrower provides the stock lender with collateral in the form of cash, government securities or letter of credit. Both parties will negotiate a fee for this loan arrangement. If cash is used as collateral, then the borrower is entitled to the interest earned on the cash, of which the borrower may rebate some of the interests as part of the lending fees.

The fees are where the motive for lending stocks come from. Stocks usually pay dividend once or twice a year (or maybe not at all if the business is at a growth phase). Other than that, it is an ‘idle’ asset. If you can lend stocks to short-sellers for a fee, then you will be earning additional income from your stocks. From the point of view of the lender, if he does not have the intention to sell his stocks, then this seems to be an opportunity to earn additional income for nothing- after all, the stock borrower has to compensate the stock lender for any dividends foregone. Indeed, we have seen such an arrangement packaged as financial ‘products’ to entice retail investors to permit their stocks to be lent out. Worse still, we have read newspaper reports of superannuation funds lending out their stocks to short-sellers in order to earn fees to bump up the returns of the funds.

Who are the ones lending the stocks? There is a class of institutions called the “Security Lenders” who have access to ‘lendable’ securities. They include asset managers who have many securities under management (e.g. your superannuation funds), custodian banks holding securities for third parties or third party lenders who access securities automatically via the asset holder’s custodian. These institutions include big names like Citibank, Deutsche Bank, Goldman Sachs, HSBC, etc.

Of course, when it is a bull or stagnating market, lending stocks for a fee is a no-brainer way to earn additional income. After all, it is the short-sellers that bear all the risk of losing money in a rising market. The stock lender carries no risk at all as long as stock prices do not plunge.

But when it is a vicious bear market, short-sellers will be the ones making a killing while the stock lenders carry all the losses. That is what happened during the Panic of 2008. Naturally, the supply of stocks to be lent out dried up in such an environment. In a bear market, when everyone wants to sell stocks, no one will be lending them out to short-sellers. That is where naked short-selling comes in. Because short-sellers cannot find stocks to borrow (or the fees were exorbitant) in the Panic of 2008, they naked short-sell.

Naked short-selling becomes a problem when the short-seller fails to deliver the stocks to the buyer. This will result in systemic to the financial system if allowed to go out of hand. During the Panic of 2008, there were newspaper reports of hedge funds deliberately failing to deliver the stocks. By naked short-selling, those hedge funds received payment for the stocks from the buyer first. Then the payment was used to earn interest. As the penalty for failing to deliver the stock was less than earned interest, it made financial sense to drag out the non-delivery of? stocks for as long as possible. In theory, an infinite quantity of stocks can be sold through naked short-selling, overwhelming the market into panic with an avalanche of phantom stocks for sale.

Until not long ago, retail investors do not have access to short-selling. This is because short-selling is seen as too ‘risky.’ This is because in theory, the potential loss of a short-seller is infinite because the upper limit of stock prices is infinity- practically possible in money-printing nations like Zimbabwe. But nowadays, even retail investors can short-sell with their online brokers (e.g. CommSec, Macquarie Prime) either in the form of traditional short-selling or via CFDs (a financial instrument that is not available in the United States).


P.S. We will continue the story from our previous article in the next article.

Here comes the silly season for the markets

Sunday, December 20th, 2009

It’s less than one week to Christmas and we would like to wish all our loyal readers a very Merry Christmas and a Happy New Year. Enjoy your holidays and eat, drink and drive in moderation.

For us, we will be taking it easy for the next two weeks. So, you will find that we will be writing at less than our usual frequency from today till the 3rd of January. After the next two weeks of break, we will be back to our regular publication schedule. However, there will be some activities at our Twitter and Facebook page during the holidays. Of course, we wouldn’t leave you completely on the lurch- should there be any extraordinary market events, we will write about them. With that, we will leave you one little market nugget to digest…

It is the official silly season for the financial markets!

What we mean is that at this time of the year, investors should not read too much on the market movements. Traders, like everyone else, are also taking a break and taking it easy. Fund managers are squaring their books. Trading volumes are typically very low. In other words, the markets will be making strange movements that should not be over-interpreted.

Our friend, Adam at Market Club has this to say about the silly season (in the context of the gold market): It’s Official Silly Season for Gold. Adam’s bottom line is this:

I strongly recommend that if you?re not in gold [Ed’s note: to trade, not invest] to wait until we see more interest and activity coming into 2010.

If you are into trading, you may want to get 10 trading lessons FREE from Adam Hewison and MarketClub. But if you into long-term big picture invest in gold and silver, then you will want to read out book, How to buy and invest in physical gold and silver bullion.

How are bond vigilantes neutered?

Sunday, December 13th, 2009

In our previous article, Rating agencies doing the job of bond markets, we said that bond vigilantes are being neutered. It didn’t occur to us that we had skipped a few steps and some of our readers were wondering why is it so. Our apologies. Here, we will explain why…

First, you have to understand that bond yields and bond prices are inversely related. Why is this so? As we explained in Rating agencies doing the job of bond markets,

For example, if you pay $100 for a newly issued 10-year government bond that pays 6% per annum, you are sacrificing $100 of today?s consumption in order to receive $6 per year for the next 10 years. That 6% is your rate of return on your investment. Now, let?s say you decide to sell your government bond to Tom at $90. The rate of return for Tom is 6/90 = 6.67%. Let?s say Tom sells the bond to Dick at $110, the rate of return for him will be 6/110 = 5.45%. Thus, the rate of return of the bond is inverse to the price paid for it.

What the bond vigilantes do to keep governments accountable is that whenever they perceive governments to be too foolish with their finances (e.g. printing too much money, borrowing too much, etc), they sell off their holdings of government bonds. That in turn will depress the price of government bonds, which imply increases their yields.

The free market is supposed to determine the price of the longer-term government bonds, which implies that long-term interest rates are set by the free market. Therefore, long-term government bond yields are supposed to be an indicator of the trustworthiness of government borrowings. For example, if the free market expects high inflation, then it will be reflected in high bond yields. Conversely, if the free market expects deflation, then it will be reflected in low bond yields.

However, in reality, the price of long-term government bonds are not totally free. Central banks of major nations (e.g. Federal Reserve, Bank of England and Bank of Japan) interfered in the price of long-term government bonds by creating money out of thin air to buy up those bonds. That created additional demand for government bonds, which pushes up its price, which in turn imply lower bond yields than otherwise.

Because central banks is the only authority allowed to create money out of thin air, they can conjured up infinite quantities of money to support bond prices (i.e. “do whatever it takes” to prevent bond prices from falling). Bond vigilantes as a whole do not have infinite resources to push down the yield of bonds. That’s why they are neutered by the central banks.

What happens to the bonds that the central bank purchased? It enters their balance sheet as an ‘asset.’

Reversal of trend reversal?

Thursday, September 10th, 2009

Exactly a week ago, we were wondering whether it’s time to short stocks (see Time to short stocks in the NYSE?). We wrote,

Currently, this Point-and-Figure indicator is not officially in trend reversal status yet. But it will be soon if more stocks comes under ?Sell? signal.

Today, the Point-and-Figure indicator goes like this:

NYSE Bullish Percent indicator
NYSE Bullish Percent indicator

As you can see, the indicator has gone up by more than 1%. That is, the trend reversal has not yet happened according to the indicator. Stocks are currently very overbought and therefore, very vulnerable to a correction. But that does not necessarily mean that one is imminent.

According to the Point-and-Figure indicator, now is not the time to buy stocks. More conservative traders may not want to short stocks (yet) either.

Before you short the market with options…

Sunday, September 6th, 2009

After reading our previous article (Time to short stocks in the NYSE?), one of our readers asked us a very practical question on using options to successfully trade the market. For those who are thinking of making their wealth with options, please read and understand what we wrote to this reader:

But one thing you have to bear in mind: learning about the technical aspects of options (e.g. delta, gamma, theta, delta-neutral, options strategy) is the easy part. We have quite a few good book recommendations that can teach you the technical aspects of options very well. The difficult part is to be a good trader. Even if you are an options expert, you will still make plenty of losses if you are a bad trader. On the other hand, if you are a good trader, you can still make good money with the most basic options strategies.

Options is just a tool. A bad trader who uses a powerful tool will lose money regardless of how well he/she understand about the tool. A good trader, coupled with a strong basic understanding of the tool, can make good money.

Options trading is a very vast field of study (for example, the topic of volatility in itself can cover a thick volume). Therefore, this is something that we cannot cover in just one article. For this article, we will give a little preparatory background about options before going into something more practical. For those who are totally uninitiated to options, please read Introducing options as insurance and How not to use options first before continuing.

For budding options trader, the thing to remember about options is: statistically, around 80% of options expire worthless.

  • Therefore, buying options (whether call or put) is likely to result in loss.


  • But the other 20% of options (that are not worthless when they expire) have the potential to yield fantastic profits.

Therefore, buying options allows you to profit from Black Swans. If you have not already, please read Failure to understand Black Swan leads to fallacious thinking. Put it simply, even though you are more likely to lose money buying options, you will make lots of money should you win the unlikely-to-win (based on statistical probability) bets.

  • Conversely, if you write options, they are likely to result in profits.


  • But on the other 20% of options (that are not worthless when they expire) expose you to a contingent liability that can result in substantial loss.

Therefore, writing options makes you vulnerable to Black Swans. Put it simply, even though you are likely to make a nice income writing options, you are exposing yourselves to contingent liabilities that can result in substantial losses (if you are not hedged).

In options trading lingo, buying options gives you positive gamma while writing options gives you negative gamma. If you have no idea what “gamma” is, forget about it because it is a specialised jargon used in the options universe. If your options position have positive gamma, you will benefit in sudden increase in volatility. On the other hand, negative gamma positions will benefit from little volatility in the market.

When options traders construct an options position, they are using a combination of buying and writing options to adjust between the positive and negative gamma according to their tolerance for risk and their conviction of the market.

In the current market, if you believe that there’s a likelihood of sudden unexpected increase in volatility, your options position should have positive gamma (e.g. from simple buying of put options to the more complex put ratio backspread). Positions with negative gamma are vulnerable (e.g. writing put options in the belief that a nice gradual up-trend will continue) to sudden increase in volatility. To explain this in more detail, let us give you a few examples:

  1. If you buy out-of-money put options, you are likely to lose 100% of your money, based on statistical probability. But if the market suddenly crashes, you will make many times the return on your capital.
  2. If you write out-of-money call options, you are likely to make a little money most of the time. If the market crashes or rises a little, you will profit a little. But if the market rises significantly (e.g. a stock that receives a takeover bid), you will likely to suffer heavy losses.
  3. If you buy out-of-money call options, you will suffer limited loss should the market crashes. But if the market sky-rocket suddenly (e.g. if the Fed announces that they will drop freshly printed US$100 trillion from the sky via helicopters), you will make big money.
  4. If you write out-of-money put options, you will make a little money if the market rises or falls a little. But if the market crashes, you can lose a lot of money.

That’s all for today on options. If you do not understand what we are talking about, don’t worry. Options traders live in a different planet from the rest of the world.

One final note: in a recent interview, Marc Faber said that he believes that the market will make a big move in the next 10 to 14 days.

Time to short stocks in the NYSE?

Thursday, September 3rd, 2009

In our last article, we mentioned about that gold prices are in the cusps of renewed volatility. The question is, will the volatility break gold prices out to a new record high or will it break it down to a low?

Yesterday, gold price surged US$20 with high volume of trading. Gold prices had not jumped so much for quite a while already and in the minds of many trend following traders (in the context of gold prices forming a technical pennant) this is indeed a buy signal. In the days to come, if this upward momentum is sustained, this will attract the attention of the mainstream media.

But is this the time to short stocks? Let’s take a look at this Point-and-Figure indicator:

NYSE Bullish Percent Index

This indicator tells us the percentage of stocks in the NYSE that are currently under “Buy” signals. Unlike the other index (e.g. Dow Jones & S&P), this is a very ‘democratic’ indicator in the sense that each stock is given an equal share of one ‘vote.’ It is used as a contrarian indicator to tell us when the market is in extreme bullish position or not. As the chart shows, it is current down to 77.23%, from a high of 80%. As you can see from the chart, 80% is an unprecedented high since 2001. The market is at a very high risk territory for a reversal.

Currently, this Point-and-Figure indicator is not officially in trend reversal status yet. But it will be soon if more stocks comes under “Sell” signal.

Reader’s question on Warren Buffett

Tuesday, August 18th, 2009

Recently, one of our readers asked this question at the forum:

So why is Warren Buffett’s net worth so much higher than Charlie Munger’s? And why Ben Graham, the founder of the idea, never really make it? It seems like value investing only works extraordinarily well with Buffett. I was hoping someone like Ed could give some insight.

We see that this is an excellent discussion topic. So, what do you think? Join in the forum discussion now!

Answer to reader quiz: likelihood of takeover

Tuesday, August 18th, 2009

In our previous article, we gave our readers a short quiz to assess the likelihood of a takeover. The purpose of this quiz was not to be a lesson on takeover analysis- the takeover discussion was a red herring to distract you from the core of the issue. As Pete, one of our readers said,

Whilst looking at these takeover targets from a “what has happened in the past” perspective seems intelligent, takeovers rely on much more than is mentioned in those points.

Instead, the purpose of this quiz is to show you a very common mental pitfall that will deceive the minds of many unsuspecting investors.

Now, let’s take a look at this paragraph in the quoted Eureka Report article:

Of the six [takeover likelihood criteria], I find that the presence of strategic shareholdings is the strongest predictor of corporate activity; in fact, since 2000 about 60% of listed Australian companies receiving takeover bids had such strategic shareholders already on their register, even though only about 20% of total companies in the ASX 300 index fulfil this condition.

Upon reading that paragraph, it is easy to conclude that if a company fulfils all the six criteria, then its likelihood of takeover (based on statistical probability and assuming that all takeover bids are successful) is at least 60%.

Unfortunately, even if you believe that statistical probability is an accurate gauge of takeover probability (those who believe in that must read Failure to understand Black Swan leads to fallacious thinking), that number is wrong. The reason why 60% is the wrong number is because it is skewed by survivorship bias.

As we quoted an article in Mental pitfall: Survivorship Bias, the

… tendency for failed companies to be excluded from performance studies because they no longer exist. It often causes the results of studies to skew higher because only companies which were successful enough to survive until the end of the period are included.

That 60% is based on companies who were taken over. It does not include companies who fulfil those criteria and were not taken over. If we take the entire sample of all companies that fulfil those criteria, the proportion of those who was taken over could well be far below 60%.

Today’s lesson on survivorship bias is very instructive on how statistics can be misused to lie and deceive.

Reader quiz: likelihood of takeover

Monday, August 17th, 2009

Today, we will give our readers a simple quiz.

Last month, Eureka Report released an article titled “Top Ten Takeover Target.” The article goes like this:

PORTFOLIO POINT: What are the most likely takeover targets for the year ahead? Here?s my list.

Will BHP come back for Rio? Will Kerry Stokes go the whole way and make an audacious bid for the
Packer family’s Consolidated Media.

It’s never easy picking takeover targets in advance, but neither it is impossible. Over the years I have devised certain criteria that I hope you’ll find useful. There are some obvious factors, such as a wave of pending consolidation; and others that might not be too obvious to the untrained eye, such as ?lazy? balance sheets.

The six main criteria I use to select takeover targets are:

  • The presence of a strategic shareholding on its register.
  • Industry consolidation taking place.
  • Substantial changes to the legislative or regulatory environment.
  • The occurrence of a previous (and unsuccessful) bid for the company in question.
  • Monopolistic and/or duopolistic industry structures.
  • Underutilised balance sheets and strong cash flows.

Of the six, I find that the presence of strategic shareholdings is the strongest predictor of corporate activity; in fact, since 2000 about 60% of listed Australian companies receiving takeover bids had such strategic shareholders already on their register, even though only about 20% of total companies in the ASX 300 index fulfil this condition.

So putting these criteria together and overlaying them on Australian stockmarket, what do you get?

Here then are my top 10 takeover targets (in no particular order) for the year ahead:

Let’s say you searched high and low for a company in the stock market. Finally, you found company XYZ that fulfils each one of the six criteria.

Our question to you is: how likely (expressed as a percentage) is company XYZ going to be taken over?

Why do some black box strategies that ‘worked,’ stop working when you use it?

Thursday, May 14th, 2009

Let’s imagine you come across an online advertisement that tries to sell you a ‘secret’ trading technique that brought investors untold returns over the past, say 20 (or 30 or 40 or whatever) years. That technique is based on complex black-box algorithm that involves processing huge amount of data. The underlying message from the advertisement is that since this technique is successful over so many years, it is one that ‘works.’ That advertisement may show you past trading records and perhaps even back-tests of that technique.

Impressive isn’t it?

How was the ‘secret’ trading technique derived? Such advertisements will usually claim that the ‘soundness’ of the techniques are based on studying the market over a long time and ‘proven’ by the ‘stellar’ performance of the technique. But in reality, such ‘proofs’ are an illusion. Let’s turn to the Chapter 1 commentary of Benjamin Graham’s The Intelligent Investor:

?If you look at a large quantity of data long enough, a huge number of patterns will emerge?if only by chance. By random luck alone, the companies that produce above-average stock returns will have plenty of things in common. But unless those factors cause the stocks to outperform, they can?t be used to predict future returns.

This is the basic thesis of Nassim Nicholas Taleb’s book, Fooled by Randomness. Therefore, buyers beware!