It’s a lesson in physics so basic that even schoolkids know it.
In fact, everyone knows it…
Everyone except – apparently – the world’s central bankers.
In their rush to provide liquidity to banks through experimental stimulus programs like “quantitative easing,” central banks have failed to create the usual cascade of liquidity normally associated with massive money-printing shenanigans.
Indeed, by attempting to force-flow money uphill, liquidity in the all-important bond markets essentially has been drying up. Central banks have been taking bonds out of circulation, warehousing them on their own balance sheets.
As a result of this attempt to defy the laws of financial physics, we’re now frighteningly vulnerable to a bond-market crash. And the best potential remedy – opening the sluice gates – can’t be employed because liquidity isn’t in the reservoirs where it’s needed.
Today I’m going to show you how this financial-market Disruptor came into being. I’m also going to explain how ruinous it could be to the economy, to the bond market, to the stock market and to you.
I’m also going to show you how to turn this expected “Disruption” to your advantage – to make money from it…
Upending the System
Quantitative easing (QE) is a special Disruptor.
In fact, it’s the biggest financial Disruptor ever.
In the past, when the U.S. Federal Reserve wanted to do its part to stimulate the economy, it might first announce its intention to lower interest rates – and might even announce a “target rate.” The interest rate they targeted was the “repo” rate.
Repos, short for repurchase agreements, are very-short-term interbank loans where one bank offers up U.S. Treasury bills, notes or bonds as collateral for an overnight loan from another bank – and repurchases (buys back) that collateral the next day, or a few days later, depending on the term of the repo agreement.
When that first bank buys back its collateral, it pays a little more than it borrowed – which is the “interest” the lending bank earns.
That interest, when expressed in percentage terms as a “rate,” is the overnight rate, or the “repo rate” – and serves as the base rate for all banking loans.
If banks can borrow cheaply from each other because the repo rate is low, they will borrow a lot and use that money to make loans throughout the banking system.
The Fed doesn’t directly control the repo rate by mandating what it is. The repo market is a free market where the repo rate is set by traders engaged in repurchase agreements every day. All big banks have repo desks.
If Fed central bankers want to lower the repo rate, they can announce what they want it to be. But that doesn’t always cause repo traders to adjust the rates they charge for overnight loans.
So, the Fed has its New York Bank – which conducts all the U.S. central bank’s “open-market operations” – actually go into the repo market and offer loans at cheaper rates than other banks are offering. In other words, it’s effectively trading overnight money by making it more available in order to bring down the cost of overnight borrowing by big banks.
That Old Profit Model
In theory, that cheaper base-borrowing rate for banks that I just described for you is supposed to work its way through the financial system. By that I mean it’s supposed to get translated all down the line into cheaper loans for banks’ commercial and retail customers.
During the financial crisis, big banks weren’t lending to each other. They were actually afraid that their “counterparties” – the other big banks – would go out of business… meaning the money they loaned might not be repaid.
The repo market essentially seized up.
And that left America’s central bankers with a big challenge.
The Fed, you see, needed to jump-start the system. It had to create “liquidity programs” that would flood banks with money so they could meet depositors’ withdrawal requests, meet their reserve requirements and continue to fund their outstanding loans, most of which have to be “rolled over.”
Banks have to constantly roll over the short-term loans they’ve taken – and for a very good reason. While banks actually “lend long” in their core business, they obtain the money they use to make those loans in short-term markets – like the repo market.
That makes their “cost of money” cheap. And it boosts the profits they make on those loans by widening the “spread” between what they paid on the money and what they earned by lending it out at higher rates.
That spread is known as the “net interest margin,” or NIM.
Backed Into a Corner
That brings us back to the struggles of the U.S. economy during the Great Recession.
There wasn’t any real loan demand because the economy was flat on its back. And that already precarious situation was heightened by the fact that interest rates were still relatively high because banks didn’t want to make loans, period.
The Fed had to act.
And it did.
The U.S. central bank started by flooding big banks – which were already on life support – with the liquidity needed to stay alive.
But that was just the beginning.
The Fed then started lending money to big banks – first by doing direct, longer-term repos and taking their U.S. Treasuries as collateral… and later by taking nontraditional assets like mortgage-backed securities (MBS) as collateral.
When that wasn’t enough to ensure the future of the banks and stimulate the economy, the Fed came up with quantitative easing – known colloquially as “QE.”
Quantitative easing simply means interest rates are as low as the market can push them. To achieve further progress – and lower rates more – the Fed now has to engineer “quantitative purchases” of banks’ assets.
By buying Treasuries and MBS from banks in massive quantities, the Fed was flooding banks with cash.
That central bank move achieved two objectives. First and foremost, it healed banks’ balance sheets. Second, it infused those banks with cash to make loan money available at cheap, economy-igniting interest rates.
If you think that sounds like the happy ending to an economic-crisis tale, think again.
It’s actually the beginning of an ugly story – even a horror story – that details the situation we face right now.
The Bloodbath to Come
In all, the Fed purchased more than $4 trillion worth of banks’ Treasury bills, notes, bonds and mortgage-backed securities.
While the Fed was taking Treasury inventory off the market – and warehousing it on its own balance sheet – stricter capital requirements were being levied on banks.
That brings us to the topic of bond-market liquidity – which is really all about Treasury inventory.
Banks use U.S. Treasuries as liquid instruments, which they point to when they calculate what they are holding in capital reserves. Banks have to hold reserves on everything. They even have to hold reserves against the cash they hold.
When banks need money overnight to meet their reserve requirements, they usually go into the repo market and lend their Treasuries as collateral for overnight loans.
But those banks don’t have as many Treasuries as they used to. There aren’t as many in circulation.
Those Treasuries are sitting in the vaults of the U.S. Federal Reserve.
Hedge funds, including “funds of funds,” which currently hold more than $3 trillion in assets, use Treasuries as collateral to borrow from banks and prime brokers to finance their risky bets. There aren’t enough Treasuries for them, either.
The $2.5 trillion money-market-fund industry buys Treasuries as liquid investments with the cash investors deposit with its funds. But they’re having a hard time finding enough inventory.
At the same time, America’s annual federal budget deficit is shrinking and tax receipts are picking up. That means the government won’t have to issue as many Treasuries as it’s been issuing in the past. That’s going to further reduce the inventory of Treasuries.
And this dearth of Treasuries poses a serious liquidity problem.
In a panic, asset prices plummet, and holders need to meet margin calls with Treasuries as collateral. Bond prices fall because sellers can’t put up liquid Treasuries as collateral to hold their positions. Falling prices of financial assets fall – creating buyable bargains – but speculators can’t put their hands on Treasuries to use as the collateral needed to grab those “distressed” assets.
When that happens, what’s going to save us?
The Fed can’t just sell the Treasuries they have.
It’s going to be ruinous. It’s going to make 2008 look like a day at the beach.
And massive numbers of investors will be clobbered when that scenario I’ve sketched out plays out.
Just about every investor knows about the stock-market “Flash Crash.”
Even though it happened all the way back on May 6, 2010, this historic sell-off has been all over the news lately as U.S. regulators try to extradite a small-time London-based trader they’ve identified as the cause.
That’s rubbish. Stocks don’t crash because one trader put down bunches of “sell” orders.
But today I want to tell you a story… about another Flash Crash.
It was bigger and more frightening than the 2010 Flash Crash.
It happened a lot more recently – in October 2014.
But most investors know nothing about it.
And they need to.
This “other” Flash Crash is another example of the lack of market liquidity we’ve been telling you about lately.
It’s a market Disruptor – one that can sting you badly if you don’t know about it… or make you rich if you do….
Once Every 3 Billion Years
This “other” Flash Crash hit the U.S. Treasury bond market back on Oct. 15.
Bond yields plummeted in an “unprecedented” manner, said JPMorgan Chase & Co. (NYSE: JPM) CEO Jamie Dimon – who described it as “an event that is supposed to happen only once in every 3 billion years.”
I’ll tell you what really happened, why it happened and what’s so frightening about it.
In the 2010 Flash Crash, the Dow Jones Industrial Average plunged 998 points, or about 9%, in 36 minutes. That was the biggest intraday decline in the Dow’s entire history.
Then, last Oct. 15, some not-so-good economic news came out in the morning. Retail sales for September fell 0.3%. The producer price index (PPI) declined 0.1%. And the Empire State Manufacturing Survey showed “the pace of growth slowed significantly from last month.”
Because bad economic news means the U.S. Federal Reserve likely won’t dare raise interest rates, we were in a “bad-news-is-good-news” period for bonds. (We’re still there today.)
When the bad news came out, bond prices rallied. Prices for the Treasury’s 10-year maturity bonds didn’t crash, they shot up. What crashed was bond yields, not bond prices.
Let me show you with a simple lesson you’ll never forget.
Bonds, as you know, pay interest. And for bonds, price and yield are inversely correlated. That’s important to understand.
Let’s say you bought a 10-year bond with a 2% “coupon” (that’s the interest) and paid $100 ($100 is “par”) for it.
Sometime later, the issuer of your bond sells the same 10-year bond with attached interest of 3% and a price of $100.
That means the price of your bond will change.
Here’s why. Someone who comes along and wants to buy a 10-year bond now has a choice: to buy your bond or to buy the new 10-year with the higher coupon.
Obviously, he’d buy the new bond for $100 to get more interest. So, in order for you to be able to sell your bond, you will have to lower the price to some level where the amount someone pays is so much less than $100 (in other words, a discount from par) that the amount he pays (invests) turns the 2% yield into a 3% yield.
To give you some perspective, the price we’re talking about here is around $66.67.
Bonding With Bonds
Now the bonds are essentially the same to any buyer. The discount is a mathematical formula. That’s why bond prices go down when interest rates go up. Similarly, if interest rates go down, the price of your bond would go up, because it pays more interest than new bonds coming out. And because it pays more, the price someone will pay you is higher than par. That’s the same mathematical formula.
Now that you understand that when bond prices rise, bond yields fall, we can talk about the Treasury Flash Crash. Because what actually happened was a huge price rally – meaning the crash was in yields.
From 9:33 a.m. to 9:45 a.m. the morning of Oct. 15 – a scant 12 minutes – the yield on the 10-year plunged from 2.15% to 1.86%.
Thanks to the “bad-news-in-the-economy-is-good-news-for-bonds” backdrop, the disappointing economic reports meant the Fed wasn’t going to lift rates, which meant it made sense for investors to buy existing bonds.
At the same time, the 10-year yield was at “support,” meaning the yield had come down enough that traders were betting it wouldn’t go any lower. In fact, traders were expecting better economic news and yields to start rising.
Treasury bonds are traded by every big bank in the world: The market is gigantic – about $12.5 trillion, according to a recent Bloomberganalysis.
The job of traders is to make money. Because a lot of them expected yields to rise and prices to fall, there were a lot of “short” positions. Shorting bonds is the same as shorting stocks: You short them expecting the price to go down, so you can buy them back cheaper for a nice profit.
Just at the moment when traders – most of them watch the same metrics and use the same support and resistance and trend lines by way of technical analysis – were short at the 2.25% yield level, the bad economic news caused buyers to come into the market. As prices rose quickly (and yields fell), shorts had to start covering quickly in order to not lose massive amounts of money on their short positions.
That’s what caused bond prices to spike – causing the Flash Crash in bond yields.
That’s what happened.
But it’s not the story.
Less Liquidity Than the Atacama?
The U.S. Treasury bond market is considered, by far, the most “liquid” market in the world.
What’s frightening is that bond prices could move so much, so fast, in that market.
It’s never happened before.
Mathematically, it was close to an eight-standard-deviation (eight sigma) move.
While it’s an exaggeration to say it’s a “one-in-3-billion-year event” (the bond market hasn’t been around that long, nor have traders), it’s not crazy to say the move was… well… crazy.
In fact, it’s actually crazy-frightening: If it can happen on a “rally” in prices, meaning yields fell, it can just as easily happen in reverse.
Why is that crazy-frightening? Because banks and institutions and hedge funds and governments own trillions of dollars of bonds.
If prices fall instead of rise – as quickly as we now know they can – they all lose money on a mark-to-market basis (meaning on-paper, if they don’t actually sell). They could all lose hundreds of billions of dollars.
What the bond-market Flash Crash showed us is there isn’t the same old liquidity in the bond markets that there used to be. Like the stock market now, bonds can crash.
We’re hearing a lot of worried voices about bonds being vulnerable these days – both from some of the biggest players in the bond market and from Fed Chair Janet Yellen.
(In that recent Bloomberg analysis we referenced, big traders said the U.S. government debt market has lost a significant amount of its “depth,” or ability to handle big trades without having prices move. A year ago, traders said they could move about $280 million worth of Treasuries without causing prices to move. Now it’s only $80 million, JPMorgan Chase says.)
The risk is actually even higher than most people know.
Between computerized trading machines now wreaking havoc on the bond market and the global – yes, I said global – lack of liquidity in bond markets, something will happen.
We’ve been talking a great deal lately about market Disruptors – including, of late, market liquidity.
When it comes to Disruptors, there are lots of them. And when it comes to markets, there’s one giant disruptor, liquidity, specifically the lack of it and how bad that is for markets.
If the lack of market liquidity was a Disruptor category, it would be the biggest of them all.
I’ll tell you the full extent of the liquidity crisis in the bond markets next time. I’ll also tell you what to look for to know when the bottom is about to fall out – and how you can make a ton of money if you play it right.
[Editor’s Note: In today’s Wall Street Insights & Indictments, Shah warns that liquidity has reached dangerously low levels. Read his analysis with care. On April 15, 2010, Shah publicly issued a similar warning. Three weeks later, the markets experienced the “Flash Crash” – the biggest intraday market decline in U.S. history.]
Liquidity, the grease that allows the world’s capital markets to function, has been murdered.
It bled to death in the stock market from a thousand nicks and cuts and was suffocated violently in the bond market by the gloved hands of its erstwhile babysitter.
We should be afraid. The murdering henchmen are the regulators and guardians of the stock and bond markets. That they don’t understand what they’ve done is scary enough.
What’s more frightening is how the wheels of both the stock and bond markets could seize and come to a shredding halt at any time.
Investors who don’t want to be murder victims need to examine the evidence.
Here it is, in black and white with red all over.
And in our talks here about market “Disruptors” – the catalysts that change the fortunes of companies, markets and our own financial futures – the lack of liquidity is one of the biggest, and most troublesome, change agents we’re watching for you…
Liquidity – the victim in our financial-markets murder mystery – is the ability to buy and, more importantly, sell the stocks, bonds, derivatives and other financial assets that define the capital markets.
And you want to be able to make these transactions without moving prices too much.
If you have to pay up for a stock or bond because there are more buyers than sellers, while the additional cost isn’t desirable, it’s not the end of the world. At the end of that trade, you actually own the asset.
But if you want to sell that same asset at a time when there are more sellers than buyers – and the price is falling – if the buyers you thought would always be there disappear, you’re dead.
And in the absence of liquidity – meaning the absence of buyers – prices can fall precipitously.
Liquidity is critical for smooth functioning markets. Abundant liquidity has been the hallmark of U.S. capital markets. While there have been corrections and crashes in those markets, most of them were caused by massive selling that overwhelmed normal liquidity.
That’s not the case anymore.
There is only normal liquidity on sunny up-market days.
But on down days – for stocks and for bonds – liquidity dries up quickly. Indeed, it can disappear altogether – literally – in a matter of seconds.
Disappear as in none… no buyers to be found – at any price.
We saw this exact scenario play out on May 6, 2010, in the infamous “Flash Crash.” All stock-market indexes plunged that day. The Dow Jones Industrial Average plunged 998 points, about 9%, in 36 minutes. That was the biggest intraday decline in Dow’s entire history.
Lots of mini-flash crashes – mostly in single stocks – have happened since.
More are on the way.
The Masked Vandal
Don’t even – for a New York second – believe some trader in London, whom U.S. regulators want to hang for causing the Flash Crash, is the unmasked villain in this capital-markets “whodunit.”
So what if this trader “manipulated” markets by putting down thousands of sell orders to create the appearance of a Mongol horde coming to burn stocks down, and then canceled them after profiting when the futures he shorted fell on the market’s reaction to his “spoofing” and “layering” games. That’s done every day by the high frequency trading (HFT) desks cloaked within big banks, investment banks and hedge funds – and by Virtu Financial Inc. (Nasdaq: VIRT), a company recently listed on the Nasdaq, as well as at trading desks all over the world.
Stock-market regulators want you to believe that there are “bad guys” out there who are going to be rounded up for “crimes against the market.” But the regulators are telling us this because they can’t ever tell us the truth.
The Flash Crash happened, can happen again and will happen again because regulators – unwittingly at first, then by aiding and abetting HFT market-gamers – oversaw the gradual, then wholesale, destruction of liquidity in the U.S. stock market.
There’s only one reason stocks can free-fall: There’s no liquidity. If there are no buyers waiting to catch falling assets at even bargain prices, there is no “bottom” to the market. If there’s no liquidity – and no bottom other than zero – investors caught in the next free-fall may not be so lucky… if markets don’t rebound like they did in May 2010.
Disrupting the Disruptor
That brings us to an important question: Where have all the bidders gone?
Just what has caused this capital Disruptor – this lack of liquidity we’re experiencing today?
The answer isn’t a secret. And it’s not hard to understand.
So-called “modernization” – which unfolded one step at a time – changed how the markets function. The net result of all those changes is the lack of liquidity that we’re seeing today.
Would-be buyers of stocks used to line up to buy shares of the stocks they wanted. In the old days, they sent orders to their brokers, who then sent those orders down to the floor of the New York Stock Exchange (and, later, to other physical exchanges).
Upon arrival, “specialists” wrote the orders down in their leather books. Both buyers and sellers put down orders.
Lots of prospective buyers wanted to have orders down to snap up shares if prices dropped to levels these traders believed to be good purchase points. On any given day – for years and years, in every well-known stock – there were hundreds of thousands, then millions of shares to be bought on specialists’ books on the NYSE, the American Stock Exchange (AMEX) and, later, on the electronic books of market-makers on the Nasdaq (National Association of Securities Dealers Automated Quotations).
The first big hit to liquidity resulted from increased exchange competition. The advent of computers on trading desks, and then personal computers, yielded Instinet (the first private electronic trading network for institutions). This was followed by a bevy of electronic communications networks (ECNs). ECNs fought and won the right to list, on their trading platforms, the same stocks that once only traded on the NYSE, the AMEX or the Nasdaq.
With many different venues available to traders and investors, the orders that once stacked up on the books of a handful of specialists got spread around everywhere.
Then came decimalization. The U.S. Securities and Exchange Commission(SEC) decided that, from April 9, 2001, on, stocks could trade in increments of one penny – in decimals, because there happen to be 100 pennies in a dollar. Prior to decimalization, stocks mostly traded in eighths of a dollar (which harks back to the days of Spanish“pieces of eight”), meaning increments of 12.5 cents each.
While it was noble to think that smaller increments would tighten bid-ask spreads, lower transaction costs and increase market liquidity, there were unintended consequences.
And liquidity was one of the victims.
Anatomy of a Scam
In a nutshell, so-called market “insiders” – meaning specialists and market-makers who get customers’ orders to execute and therefore know what prices they are willing to buy and sell at and for how many shares – instantly discovered they had a cheaper way to make money. That’s because specialists and market-makers also trade for themselves.
Let’s go back, before decimalization, and pretend I was a specialist or market-maker in XYZ stock. Let’s say you sent me an order to buy you 100,000 shares of XYZ at $25. I see there are not a lot of buyers below your order who are willing to buy at the next level down, which would have been $24.875. And I see there are a lot of “sell” orders coming in at $25.125. I would sell you the shares you want myself.
That means I’d be short 100,000 shares, because I am a specialist or market-maker and can do that. I do that because I see there are a lot of “sell” orders – and not a lot of “buy” orders – so I believe I’ll benefit by being short if the stock goes down.
But if I’m wrong and more buyers come in, or out of the blue a big buyer comes in and buys the stock being offered at $25.125, I’m in trouble. I’m short at $25, and the stock is already higher trading at $25.125. Because I’m at risk for at least 12.5 cents a share if I personally sell you the stock you want, maybe I won’t make that trade or will trade against you.
But after decimalization, I’m only risking a penny if the next highest offer to sell is $25.01. I’ll be far more inclined to hit your bid and sell short stock to you if I know I’m only risking one penny, if I can cover my short at $25 by buying shares back at $25.01.
What happened after decimalization was that specialists, market-makers and traders of all stripes actually had less risk when they speculated because the minimum increments were cut from 12.5 cents to a penny. On the other hand, mostly buyers – who wanted to buy stocks for a longer-term investment and who wanted good prices – kept getting picked off by traders trying to then knock down prices. In the final analysis, fewer and fewer buyers were willing to just put down orders and leave them. Buyers now stay on the sidelines waiting until they see favorable prices to put down orders.
The net effect of all the changes I’ve described to you: There’s no real liquidity anymore, most importantly on the downside, because orders are spread around now and because buyers don’t like getting picked off – meaning they stick to the sidelines until they’re ready to put down orders.
Then came the high-frequency traders.
The exchanges and regulators let the HFT crowd infiltrate the wires transmitting “buy” and “sell” orders to and from exchanges and trading venues, so they could read “order flow” like specialists and market-makers – but without providing the services that are supposed to be part of their duties.
In other words, they are just “pick-off artists” reading our orders and trying to influence those specialists and market-makers to trade on us, around us and against us.
So what if it’s a penny, says the HFT gang and the regulators under their breath?
HFT gangs are not liquidity providers – despite their claims. They turned off their computers during the Flash Crash.
There were no buyers in the Flash Crash because there is no real liquidity in the stock markets anymore.
That’s a problem that’s going to one day crash the markets. We have the regulators to thank for that.
And the bond market?
It’s bleeding liquidity at an alarming rate. In fact, it’s the bond market – not the stock market – that’s going to crash first. And that bond-market stumble will tank the stock market.
You didn’t know that?
If not, stop back next time and see what’s in store for the global bond market. It’s the next big Disruptor story you need to know.
Over the last several weeks, I’ve been telling you about “Disruptors,” the economic catalysts that are serving as agents of change in every geographic market, business sector and asset class you can think of.
These Disruptors create winners in some situations, and dislocations in others. And every change brings with it identifiable profit plays.
And if there’s one Disruptor story that has dominated the headlines – and the global financial markets – over the past two decades… it’s China.
With its low wages and economic emergence, China disrupted the manufacturing markets for technology products, the pricing for rare earths, and shifts in demand for energy, food and capital.
The upshot: China, the Disruptor, became China, the wealth creator.
If this talk of wealth seems out of place after I’ve spent the last several weeks talking about making money when markets go down, think again…
Nothing, you see, goes up forever.
Not even China.
Sure, China’s economic growth has been astronomical, and the Shanghai Stock Exchange Composite Index has skyrocketed.
But the laws of gravity haven’t been repealed.
China’s gross-domestic-product (GDP) growth has already cooled off, and stocks took an 8% hit early last week.
While this may not be the beginning of the end for the Chinese economic miracle – and its pumped-up stock market – it could be.
Then again, a lot of analysts and famous short-selling hedge-fund honchos have been calling for a hard landing in China, which hasn’t happened. Still, that doesn’t mean they’re wrong. It just might mean their timing is off.
Here’s what’s scary about what’s going on in China…
The “Fast” Slowdown
China just posted first-quarter GDP growth of 7%. While that’s super-strong by anybody else’s standard, it’s a marked slowdown for China.
For all of 2015, China’s been telling the world its economy will grow at 7%. With three fiscal quarters to go – and 7% the slowest growth since 2009, and the lowest projection for GDP growth in 25 years – there’s a good chance the rest of the year will see more of a slowdown than economists have been predicting.
Meanwhile, as the economy’s been slowing, the SSE Composite has been soaring.
At its recent high of 4,572, that benchmark index is up an astounding 130% in just a year. Since the beginning of 2015, stocks are up 41%. That’s in the face of a slowing economy.
Stocks are being propelled higher by the same “front-running” that occurred in the United States and Europe when speculators flooded into markets ahead of central-bank stimulus moves. Those moves hosed financial assets with catalyzing cheap money, causing a rush higher.
China’s central planners and its central bank, the People’s Bank of China (PBOC), have been making rule changes and cutting bank-reserve requirements and lowering interest rates – to spur lending and ease tight conditions in the slowing economy.
Desperate times, you see, require desperate measures.
While things don’t appear desperate on the surface, the story bubbling under is different – thanks to a mountain of expensive debt that is humbling the borrow-at-any-cost country’s growth model.
Consulting firm McKinsey & Co. estimates the cumulative debt of China’s government, corporations and households in mid-2014 hit $28 trillion. According to analysts at Standard Chartered Bank, financial credit surged to 251% of GDP in mid-2014, up from 147% at the end of 2008.
Local government spending to meet Beijing’s demanding growth rate targets saddled municipal borrowers with more than $3.64 trillion in debt.
As the economy slows, exports taper, construction grinds down and property prices keep falling, the worry is that China will see “rolling defaults.”
The PBOC has been doing its part to spur lending by lowering interest rates and reducing reserve requirements.
While those central-bank moves are to be expected, they’re not enough, according to central planners. In what looks like a desperate move to flood banks with more money to lend to stressed borrowers, securitization rules have been ripped open.
Just recently, the PBOC – with a nod from central planners – announced that regulatory approval of securitization issues of asset-backed securities was no longer required. Now issuers only have to register their deals.
Holy financial crisis redux!
Ostensibly, the idea here is to let banks – which currently hold $28 trillion in “assets” (assets are loans) – package them into asset-backed securities (ABS), which will mean they’ll be “structured… Wall Street speak for leveraged, traunched and chock-full of trouble. Those structured securities will be sold to investors – which, I promise you, will include all the same banks selling loans, to get whole loans off bank balance sheets, selling them for cash to spur lending… to already indebted debtors.
It’s like déjà vu all over again. Only this time it’s China playing the “derivatives of mass destruction” game.
Why will exploding ABS issuance be a problem? How about the lack of regulatory oversight? How about the fact that banks will want to offload bad loans and bury them in structured products? How about the inside-the-ropes, bare-knuckle truth that it was originally a Basel I rule change that lowered the reserve requirements global banks had to maintain against mortgage-backed securities?
That led banks to package all their whole-loan mortgages – and hold them as securities rather than whole loans – which allowed them to massively leverage themselves up with riskier securitized loans believing they could sell them in a market rout.
We know how well that worked.
China is blowing itself into its own bubble. The problem is that it’s eventual bursting is that the contagion will be global and the fallout nuclear.
Will this Disruptor hit soon? It’s possible, but not probable. There’s lots of pumping about to start happening. Watching ABS issuance rates will be a good measure of the pace of leverage building in the system.
It could take years to blow.
Remember Alan Greenspan’s comment in December 1996 that the markets were exhibiting “irrational exuberance”? That bubble inflated another four years before causing the tech-wreck.
Remember Citigroup CEO Chuck Prince’s July 2007 comment to the Financial Times: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”
It took another 15 months before that bubble almost imploded the global financial system.
Timing is always tough when ascertaining a bubble’s expansion. We’re not there yet.
[Editor’s Note: We encourage you all to “like” and “follow” Shah on Facebook and Twitter. Once you’re there, we’ll work together to uncover Wall Street’s latest debaucheries – and then bank some sky-high profits.]
I’ve been telling you about market “Disruptors” for several weeks now, and showing how these “agent-of-change” catalysts are the trigger points for some of the greatest profit opportunities you’ll find.
But that’s only part of the message I’ve been emphasizing to you in our get-togethers here.
I’ve also urged you to keep your eyes open for all profit opportunities – on both the “long” side of the market… as well as on the “short” side.
Using all the opportunities that come your way is a belief I’ve held my entire career, and it’s why my personal mantra is “There’s always a place to make money – always.”
One of those places is on the short side.
And one of the tools to use is the “put” option.
Used correctly, put options can make you a bundle.
And today we’re going to add that tool to your arsenal…
Put options are another component of an investor’s short-side toolbox.
There are two types of options that investors and traders use all the time. Of course, there are all kinds of exotic, derivative and customized options investors can dabble in, but we’re sticking here with basic exchange-traded calls and puts.
If you purchase a call option, you’ve bought the right to buy a predetermined number of shares of a stock at a predetermined price, by a predetermined date. As the term “option” implies, it gives the investor the right to make the purchase, but doesn’t require them to do so.
An easy way to remember how call options work is to think of the word “call.” If you own a call option, you have the right to call the stock to you – to purchase the shares.
Put options are the opposite of calls. If you buy a put, you’ve purchased the right to sell a set number of shares of a certain stock at a predetermined price, by a predetermined date.
Again, an easy way to remember how puts work is to think of the word “put.” If you own a put option, you have the right to put stock onto someone – or sell it to them.
Standard exchange-traded options are traded in “contracts.” One contract controls 100 shares of stock. If you buy one put contract, you are buying the right to sell someone 100 shares of a stock or ETF.
Options have “strike” prices and “expiration” dates.
Strike prices (usually whole numbers) are price levels of the underlying stock where there are contracts that can be traded. For example, if XYZ Inc. stock is trading at $50, there will probably be options contracts with strike prices of $30, $35, $40, $45 $50, $55, $60, $65. There will probably even be higher and lower strike prices.
All option contracts have an expiration date. You can buy an option that expires this month, maybe tomorrow, maybe in a few days (they usually, but not always, expire on a Friday – and it’s typically the third Friday in a month). Or you can buy an option that expires next month, or the month after that, or six months from now – and sometimes much further in the future.
We’re talking today about put options.So from here on, we’ll leave call options out of our discussion.
I’m going to show you how puts work – including some detailed examples.
Disruptors are catalysts that interrupt the status quo. And they’re not just technology focused – you know, like the latest piece of software, new Web device or newest drug.
Disruptors can be economic, financial, governmental and even personal. They change the rules of the game. They change the playing field. They change where the money is flowing.
Here in the United States, the fracking boom – which is pointing us toward energy independence – is an example of an economic “Disruptor.”
Think about the way the U.S. Federal Reserve intervened in the financial crisis – slashing interest rates to zero and instituting the whole “quantitative easing” deal. That’s been a financial Disruptor.
And the U.S. Food and Drug Administration (FDA) decision to create a “Breakthrough Therapy” designation that “fast tracks” new drugs to market is an example of a governmental Disruptor.
In China, the massive migration of people from the distant agrarian provinces and into the big cities – the biggest mass migration in human history, in fact – is an example of a personal Disruptor.
When the rules, playing fields and money flows change, so does the “pecking order” of players involved in the affected sector.
In other words, winners become losers, losers become winners and new players emerge to profit.
Most investors focus on the winners – and look for ways to profit on the long side – by purchasing and owning those shares.
But you can also profit – dramatically, in fact – in cases where formerly dominant winners are leapfrogged by new players… and become losers.
Those are stocks you want to “short.”
And put options are one very good way to do that.
Let me show you how put options work.
Putting It to the Test
Let’s say you’ve been watching XYZ stock, or maybe you own XYZ stock. It’s gone up from $30 to $50 to $70 and is now going back down and is trading at $52.
Let’s say you’ve done your homework, and you believe XYZ’s slide is going to continue – the stock might even collapse.
Of course, you want to protect the profit you have if you bought it lower, or prevent any further loss if you bought it at a higher price. Or maybe you just want to put on a trade that will make money if XYZ goes down – because you know the company is about to get “leapfrogged” by a landscape-changing Disruptor.
No matter reason – to protect profits or to make money – you can capitalize on your belief that a stock is going lower.
You can buy puts.
The four things you will have to consider are:
How many contracts do you want to own?
What strike price do you want to use?
What expiration date do you want to consider?
How much should you pay for a contract?
Let’s say you own 100 shares of XYZ and want to sell that many shares in the future. You would want to buy one put contract, because one contract allows you to control and sell 100 shares. If you have 200 shares, you would want to buy two put contracts, and so on.
If you are speculating, you have to consider how many put contracts you want to buy based on how much each contract will cost you and how much money you are risking.
The price of an option, which controls 100 shares, is expressed in what seems like a small amount. Maybe the option is 25 cents, or $2.50, or $10.
That isn’t the whole price. It is the price you pay per share. Don’t forget: One contract is for 100 shares.
So, if the option price is 25 cents, you have to multiply 25 cents times 100 shares to get the cost of one contract. In this case, one option contract would cost you $25.
If I tell you I paid $2.50 for my put options, you would have to quickly multiply $2.50 times 100 shares to know that I actually paid a total of $250 for one contract. An option contract at $25 (per share) would cost you $2,500.
Time to Buy
When I decide I want to buy a put option, my first consideration is always the time element: When do I think the stock will fall?
There’s no point in buying a put option that expires in June if I think the stock won’t fall hard until we get closer to the end of summer, or after the election or some other long-term time frame. So, I’ll first look at the expiration month I want.
It’s May now, but maybe I’ll choose a September-expiration put option because I think XYZ stock will start falling as the summer comes to a close (because my made-up stock XYZ makes pool cleaning equipment and sells its services in early-fall New England).
While you may guess right that XYZ, which is now at $52, is going to $40, if you buy a $40 strike price put contract that expires in June but XYZ doesn’t fall below $40 until September, your contract would expire and be worthless.
The thing to remember about expiration months is that the further out you go the more the option will cost you. That’s because you are paying for more time – and time costs money.
Besides, there’s a person on the other end of the sale to you of those XYZ put options, and that person is selling you the right to put stock (sell stock) to them, not for a few weeks, but for the next four months. The more time you buy for the stock to do what you think it will do, the more you are going to pay.
Here’s the next thing I ask myself: What strike price do I want to buy?
Because XYZ is now at $52 and I think it will go lower, I have to determine which strike price based on how low I think XYZ might go by the September expiration date. And what’s the best price to pay, since different strike price put options cost different amounts to buy?
The final consideration: How much will have to pay for the put options I want to buy?
Let’s go back to XYZ stock. It’s trading at $52 now, and I think it’s going to $40 by early September. I have lots of options.
If I look at the September works $60 puts, they might be priced at $10. The September $50 puts might be priced at $5, and maybe the $45 puts are priced at $2, and maybe the $40 puts are prices at 25 cents.
That’s a big difference in cost.
September $60 puts allow me, until the contract expires on the third Friday in September, to sell 100 shares (for one contract) of XYZ to the person who sold me the option contract at $60 a share, any time between now and then.
If I pay $10 to have the right to sell XYZ at $60, it doesn’t do me any good today, because even though I could sell stock at $60 today (it’s actually trading at $52 today), that put option cost me $10. That means I could sell stock today for $60 and collect $60 a share, but it cost me $10 a share. So I’d net $50 a share if I “exercised” my September $60 strike price put option today.
Exercised means you exercise your right under the contract. Your right is to sell stock at $60 a share to someone. When you exercise your option, you’re selling 100 shares for $60 per share. In other words, you’d collect $6,000 for selling 100 shares.
The Whys Have It
Why would you ever sell stock at a net price of $50 today (you sold stock at $60 a share based on the strike price you owned, but you paid $10 a share for the option contract, so you actually netted $50 per share) if the actual price in the market you can sell stock at is $52 a share?
To calculate your breakeven price for the put option, you take the strike price and subtract the cost of the option. The strike is $60, and it cost you $10, so your breakeven is $50. The stock has to fall to $50 by expiration for you to be able to sell the option you bought and break even.
Did you catch that? You can sell your option at any time before expiration.
You see, to make money, you don’t actually have to exercise your option and sell stock. If you owned shares and exercised your put option and sold stock, you’d be out of the stock you owned, because when you sell stock you have to deliver shares to the buyer. Your broker would take the shares out of your account and deliver them to the person who you forced to buy them from you at $60.
If you exercise your put option to sell shares to someone and you don’t actually own any shares, that’s fine, too. You just end up being “short” the shares you sold. At some point, you’re going to have to buy back those short shares.
I talked about covering shorts in a previous article. You can refresh yourself here.
Your third option is the most common option that option buyers choose. You can simply take the put option you bought and sell it to someone else.
Whether you make money when you sell the option depends on the price of the option at the time you sell it, and that depends on what the price of the underlying stock is and how much time there is left on your option contract for the person who buys it from you.
That brings us back to our stock XYZ.
If the stock is at $52 now and I think it will be at $40 by September, I could buy the $60 puts, but they’re expensive. If I buy them and XYZ looks like it will close at $40 on expiration day, I’d probably sell them the day before to lock in my profit.
They would be worth $20 a share (or $2,000 a contract) because I could sell someone stock at $60 and buy it back for $40 and make $20 a share. Or I could sell the option to someone, which would be worth about $20.
But, I paid $10, remember?
So I actually make $10 a share. I paid $10, made that $10 back and made an additional $10. So, by selling my option for $20, I made a 100% return on my trade.
But I might not want to pay $10 a share for the $60 strike-price put options. There are cheaper options.
I’d probably buy the $45 strike or the $40 strike put options if I was confident XYZ would fall there by September expiration. They’re a lot cheaper, I can buy more of them for the same amount of money (that’s leverage) and I’d have much bigger gains if I buy those strike-price options.
The $45 strike put options are going for $2 now. If XYZ is at $40 on – or before – expiration, those options will be worth at least $5, because $45 (the strike price) minus the price of the stock when it gets to $40 is $5. That’s the minimum price someone else will pay me for my options before they expire.
If I made $5 and paid $2, my profit is $3 per share, or a 150% return.
The best I could have done would have been to buy the $40 strike put options and bet the farm. If I had $1,000 to invest, remember I could have paid $10 a share for the $60 strike put options, which would have cost me $1,000. But instead, I spent $1,000 buying $40 strike put options for 25 cents a share (25 cents times 100 shares = $25 per contract); for my $1,000, I could have bought 40 contracts!
Before expiration, my $40 strike put options would rise in price as the stock falls toward $40. If it’s two months, or a month, or a few weeks before expiration – and XYZ is getting close to $40 – people will want to buy my $40 put options. The reason: They’re still cheaper than the higher strike-priced put options, but worth paying up for.
Based on this hypothetical situation and my extensive experience trading options on the floor of the Chicago Board Options Exchange (CBOE), I’d guess I could sell my $40 strike puts for at least a dollar sometime before expiration – and probably for a lot more than a dollar.
But at a dollar each, after paying 25 cents each, I’d make $4,000. That’s because for a $1,000 investment at only 25-cents a share ($25 per contract) I could buy 40 contracts. Because 40 contracts control 4,000 shares (40 × 100), I’d be selling 4,000 shares worth of stock at $1, which would be a 400% gain on the trade.
That’s what you can do with put options.
Sure, there’s more to how they’re priced, which is complicated and has to do with volatility, interest rates and time to expiration. And sure, you can lose everything you pay for a put option if it expires worthless.
But, now you know something important about puts. You can make them work for you in down markets. And you can use them to profit when economic Disruptors transform once-powerful market leaders into sector also-rans.
This is some complex stuff, so feel free to post questions below. I’ll be sure to answer them in a future report.
[Editor’s Note: We encourage you all to “like” and “follow” Shah on Facebook and Twitter. Once you’re there, we’ll work together to uncover Wall Street’s latest debaucheries – and then bank some sky-high profits.]
It’s easy to make money when stock prices are rising.
Just invest in one of the 5,000 stocks listed on major exchanges or one of the hundreds of exchange-traded funds (ETFs) that are already available – with more being added almost every day.
But if you want to make money when the stock market goes down, it’s just as easy.
Maybe even easier.
Just buy shares in one or all of the four “investments” I’m going to tell you about today…
More Pain Means More Gain
In last week’s report “How to Make Money in Any Kind of Market,” I introduced you to the “short” side of the market – and explained how shorting strategies would allow you to cash in when stocks, bonds or other assets fall in price.
Indeed, there are lots of ways to make money when things go down. But just knowing about the three most popular strategies to play price or market declines is enough for you to cash in on the next stock that plunges on disappointing earnings – or on the next bear market in blue chips.
As I told you, those three key “short-side strategies” are:
Selling short, more commonly known as shorting.
Buying inverse ETFs.
And buying put options.
I gave you the overview on “shorting” the last time we talked. And I promised that I’d return with an inside look at inverse ETFs.
I’m keeping that promise today.
When I talk to investors, one of my main messages is that “there’s always a place to make money” – with any kind of asset… and in any kind of market.
And short-selling is a core piece of that belief.
In fact, investors who aren’t at least considering short-side trades are missing major profit opportunities – in essence, leaving lots of money on the table.
ETFs are packaged products that trade all day like stocks.
You can buy them… sell them… and short them.
And there are hundreds to choose from.
Inverse ETFs are a category of exchange-traded funds that do the opposite of what an underlying portfolio or index does.
When markets fall, inverse ETFs rise in value. And the steeper the market drop, the bigger your profit.
Here’s what I mean.
Outperforming “Mr. Market”
The “stock market” is a generic term for all stocks that trade on a specific market or exchange, in an index or across all exchanges.
Here in the United States, there are different measures – or representations – of what we think of as the “stock market.” The most popular measures for “the market” are indices that track 30 stocks, or 100 stocks, or 500 stocks or 2,000 stocks.
If you think the stock market, as measured by the Dow, is going higher – and you want to make money on the anticipated rise in share prices – you can buy all 30 stocks in the Industrial Average. You can do the same thing with the Nasdaq 100, the S&P 500, or the Russell 2000.
But there’s also a way to cash in on the surge in one of those indices – get the exact same performance, in fact – and do so without buying any shares in the actual companies that make up the index.
That’s because there are ETFs that track each of those four major indexes. You can buy shares in an ETF that tracks any of those benchmark indexes and make money if “the stock market” – as measured by the index you choose – goes up.
As we all know, however, stocks don’t only rise in price.
They also fall.
If you owned an ETF that tracked the market, and you began to believe that the market was going to fall, you could easily sell your ETF shares.
That’s a “defensive” move – one that would let you keep the profits you’d already booked and avoid the losses that accompany a market decline.
But what if you believed the market was going to go down a lot – and wanted to be opportunistic?
If you thought the market was headed for a substantial decline, you might start by selling the ETF shares you hold “long.”
And you’d follow that move by shorting the ETF – selling it short.
Let’s face it: A move like this isn’t for everyone.
Some people just don’t like to short. And some investors can’t short because their money is held in an IRA or some other type of account through which they can only buy stocks.
But I see the “short side” as a slice of any complete investing game plan.
And that’s where inverse ETFs come into play.
There are all kinds of inverse ETFs, including inverse plays on the Dow Jones, the Nasdaq 100, the S&P 500 and the Russell 2000.
As we’ve already demonstrated, an ETF that tracks the Dow or S&P 500 goes up in price if the underlying index goes up. And if the underlying index goes down, so does the ETF that tracks it.
As the term implies, an inverse ETF works in the opposite manner. If the Dow, or the Nasdaq 100, or the S&P 500 or the Russell 2000 rises in value, the share price of the inverse ETF drops.
But when the market goes down, an inverse ETF goes up in price. So if the Dow or S&P 500 sells off – and you’re holding shares of the associated inverse ETF – you’re going to cash in.
That’s how you can make easy money when the stock market drops.
Let’s take a look at some key examples.
If you’re expecting a decline in the Dow Jones, you can buy shares of the DowProShares Short Dow30 (NYSE: DOG), the ETF that rises in price when the widely followed 30-stock blue-chip index stumbles.
Retail investors follow the Dow. But when looking at broad-market topics, institutional investors tend to focus on the S&P 500. And the ProShares Short S&P 500 (NYSE: SH), is an inverse ETF that goes up in price if the S&P 500 does down.
Let’s say you’re concerned about tech stocks, which have experienced quite a run. The Nasdaq Composite Index set a new all-time high late last month and has zoomed to a 20.5% gain over the past 12 months – close to double the 11.5% advance posted by the S&P 500.
To pull down profits if tech stocks nosedive, you can buy shares of the ProShares Short QQQ ETF (NYSE: PSQ), an inverse ETF that goes up in price if the Nasdaq 100 goes down.
There’s also the small-cap sector, represented by the Russell 2000, an index whose 7.6% return over the last 12 months has lagged both the Nasdaq and the S&P.
If you’re projecting a sell-off there, you can buy shares of the ProShares Short Russell2000 (NYSE: RWM), an inverse ETF that goes up in price if the Russell 2000 goes down.
Each of these inverse ETFs is designed to move about as much, on a percentage basis, as the underlying index it tracks – only in the opposite direction.
Besides regular inverse ETFs, there are “leveraged inverse ETFs” that move two times and three times as much as the underlying indexes they track.
These leveraged inverse ETFs are not as straightforward as the conventional “1X inverse ETFs” that we’ve talked about here today. Indeed, they can be quite tricky, so I’ll get into them another time.
But the lessons we’ve talked about today are straightforward.
Making money when the markets go down can be easy – especially when you use inverse ETFs to make your trades.
We’ll be looking at more pieces of short-side trading – and other profit strategies – in reports to come.
In the meantime, feel free to post comments or questions below: I always like hearing from you.
[Editor’s Note: We encourage you all to “like” and “follow” Shah on Facebook and Twitter. Once you’re there, we’ll work together to uncover Wall Street’s latest debaucheries – and then bank some sky-high profits.]
Just the other day, a friend came to me with a serious and specific question.
He’s been watching the markets, and the headlines, and wanted to know if he should “sell everything and go to cash.”
I laughed and asked: “Do you know something I don’t? Do you know, for sure, that the sky is falling?”
He doesn’t, of course. But I could tell from his comments that he was worried about several things – that China was about to implode, or could in the near future – and that he wanted to protect his investments.
Without missing a beat, I suggested he just “short” China and make a ton if it crashes.
This wasn’t an off-the-cuff quip. Investors who’ve followed me for a long time know that one of my core beliefs – a mantra, really – is that there’s always a place and a way to make money.
I believe you can find ways to make money in any kind of market – bull, bear or trendless. And I believe that because you can make money on both “sides” of the market – the long side and the short side.
That’s why I love trading and investing. It’s possible to make money when something… anything… everything… goes up.
And it’s also possible to make money when something… anything… everything… goes down.
That understanding is a big part of the reason I’ve been so successful through the years.
Today I want to share that insight with you…
Three Keys to the Market’s “Other Side”
Unfortunately, most people don’t know how to make money on both sides of the market.
Everybody knows that if you own stocks, bonds, commodities, gold or real estate – or any asset in any asset-class for that matter – you make money as long as prices are rising.
But asset prices don’t rise forever.
Sometimes prices dip down. Sometimes they crash. Sometimes they recover quickly, sometimes they recover slowly and sometimes they never recover.
You can make money in any market if you know that nothing goes up forever. With that understanding, you’ll not only avoid big losses when prices drop – but can actually make a ton of money when that happens.
It’s not hard. There are lots of ways to make money when things go down. And you don’t even need to know them all.
In fact, you just need to understand the three most popular ways to play price or market declines. Those three key strategies are:
Selling short, more commonly known as “shorting.”
Buying “put” options.
And buying “inverse” exchange-traded funds (ETFs).
Today I’m going to tell you about shorting. In some upcoming columns, I’ll explain put options and the inverse ETFs.
On Wall Street, the term for owning something is “being long.” If you own shares of International Business Machines Corp. (NYSE: IBM), then you are “long” Big Blue.
If you own gold (it doesn’t matter if you own gold bars or a gold stock) and I come to you and ask, “Do you like gold?”… then you could say, “Yes, in fact, I’m long gold.”
That tells me you own some gold.
The opposite of long is short. The opposite of being long something is being short on that same asset.
That’s where the terms “short selling,”“selling short” and “shorting” all come from. They all convey the same thing – the opposite of “going long,” or “being long.”
Instead of buying and going long on an asset – in essence, betting the price will go higher – you can short that asset and bet the price will go lower.
It’s really simple. You either tell your broker you want to short XYZ stock or look on your trading platform (online broker) and find the button or link for shorting.
The process, for the most part, is as simple as buying a stock.
A Step-by-Step Look
Here’s what happens behind the scenes.
When you sell a stock short, you are selling that stock to someone who is buying it from you.
However, you don’t actually “own” the stock that you’re selling.
Let’s say XYZ just ran from $50 to $100 a share. And you want to short it because you believe some developing news about the company – for instance, bad earnings or a nagging legal case that won’t go away – will spur profit-taking and cause the stock to fall back to $50.
When you short-sell the stock, you are actually selling it to someone. The person who buys the stock from you pays you $100 each for all the shares you sell them. He doesn’t know you don’t own the stock you’re selling – and he doesn’t care. All he knows is that he has to pay for the stock he bought and he wants the shares to go into his account.
Behind the scenes, to get you the XYZ shares that you’re selling, your brokerage “borrows” them from another person’s account. Your brokerage delivers those shares to the buyer, and now you’re done with her.
You end up with the cash – the $100 a share – in your account.
Now you are “short XYZ” at $100 a share.
If you’re right and XYZ falls to $50 – and you want to get out of the short position to lock in your profit – you would buy shares of XYZ. When you buy back shares you’ve shorted, it’s called “covering” or “buying to cover.”
So, you “cover” your short by paying $50 for XYZ stock. You pay $50 out of your account, and the seller has to deliver XYZ shares to your account. Now you have XYZ shares in your account.
But you owe someone shares of XYZ that your brokerage borrowed on your behalf.
You don’t have to do anything. Your brokerage knows whom it borrowed those shares from. The broker simply take the shares you just bought out of your account and places them back into the person’s account the shares were first borrowed from.
This behind-the-scenes maneuvering is completely permissible.
Your brokerage agreement – everyone’s brokerage agreement, in fact – allows your broker to borrow shares from your account any time it wants. It never has to tell you. You’ll never know. And it doesn’t matter to you.
The only thing that matters to you – or anyone else – is that when you go to sell the shares in your account they are there. If you sell shares from your account that your brokerage already lent out to someone, it doesn’t matter: The broker will simply borrow them from someone else’s account so you can deliver them to whoever buys them from you.
But here’s the complete picture of what happened financially – for you.
You started by selling stock for $100. You got that cash in your account. You’re up $100, out of thin air. But once the stock drops, as you predicted it would, you had to use $50 to buy back the shares you borrowed to start this all off.
So you received $100 a share at the outset – when you shorted the stock. And you paid $50 a share when you “covered.” So you ended up with a net total of $50 a share in your account.
You just made $50 a share – from a stock that went down.
A Look Ahead
There is one big difference between going long and going short.
I’m talking about the risk.
When you’re short a stock, you are expecting it to fall in price.
But what if, instead, it goes up? If that happens, you have to buy the stock back – cover it – at a price higher than what you sold it for.
If XYZ didn’t go down – but jumped up to $150 – to get out of the position (cover), you would have to pay $150 a share.
Here’s how the math would work in this situation.
When you shorted XYZ at $100 a share, you initially received $100 in your account. But with the stock now at $150 a share, you’d now have to come up with $150 to “cover” – to buy it back.
So you lose $50 a share.
When you go long on a stock – buy it – your potential loss is limited to the amount you invested… what you paid for the stock. In other words, when you buy a stock and it goes down, your loss is said to be “limited” because the stock can only go to zero – and no lower. That’s comforting.
Theoretically, selling short leaves you with unlimited risk. That’s because a stock can keep going higher and higher. As with any risk, however, there are ways to manage this.
That’s your quick lesson on shorting.
It’s a quick lesson because I’m not going into “margin” – using borrowed money for “leverage” – and how you need a margin account and what brokerages charge you for margin. If you have any questions on that topic, ask your broker. You can ask him or her how that works and what the firm’s charges are. Or you can read the account agreement the brokerage made you sign.
And if you have any questions about the topic of shorting, send them in right here. I’ll answer them.
I’ll also tell you what’s going on with China and why my friend is worried that the Chinese stock market could tank and knock down U.S. and global stock markets.
And I’ll tell you how to use put options and inverse ETFs to make money when things go down.
The financial markets bring us lots of opportunities for profit – and not all of them are on the long side.
I look at everything.
And that’s why I believe there’s always a place to make money.
[Editor’s Note: As Shah said here today, he looks forward to your comments and questions. The process is simple – you can just post the below.]
Remember the May 2010 “FlashCrash,” when the Dow Jones Industrial Average dropped more than 1,000 points in one day? Now, the British high-frequency trader who stands accused of contributing to the crash, NavinderSinghSarao, is fighting the U.S. extradition.
Should this sort of trading be illegal – or is the system the real problem? In his most recent Fox Business appearance, Shah revealed some of the bigger truths about high-frequency trading and answered even more of your biggest questions.
Someone I love very much – in fact, a family member I idolize – was recently diagnosed with Parkinson’s disease. We are all in shock, and some members of my family are very frightened.
But I made a decision. Instead of being frightened, I’m going on the attack. As transformational thinking lecturer (and “Est” founder) Werner Hans Erhard advocates, I’m going to be “cause in the matter.”
So I’ve given myself a mission… to do my part to help find a cure.
And it’s an opportune time…
Major diseases like Parkinson’s, Alzheimer’s and diabetes have a new enemy: research initiatives that attack them from fantastic new angles – yielding new protocols and medicines that can stop these maladies in their tracks or even reverse their chilling effects.
I’m not talking about “old school” drug protocols or research. I’m referring to the new healthcare and research Disruptors that I’ve been watching – and that are everywhere.
A powerful confluence of catalysts is making this possible, including new science, new technologies and even new policies at the U.S. Food and Drug Administration (FDA) – such as a groundbreaking “Fast Track” designation that slashes the time it takes to get new drugs into the hands of the patients who need them.
My resolve to help fight Parkinson’s – as well as the other terrible diseases I mentioned – has already gained me access to some rarefied circles. I’ve been asked to join the board of an extraordinary company whose partnering doctors head up the research units in their respective medical specialties at the top hospitals in the United States.
I’m also helping raise money for research – which includes making contributions myself.
The doctors I’m backing are leaning into the future in a big way. The head of the research-and-development company I’m involved with previously ran a giant pharmaceutical company. He’s now attacking the diseases his old pharma company treated with drugs by developing completely new protocols to stop diseases from spreading and eventually reverse the damage that they do.
I’m not permitted to reveal the name of the company I’m working with just yet.
But I will make this promise: Over time – as we crusade toward our goals of arresting the spread of the diseases we’re attacking and advance development of reversal protocols – I will be able to share some of what we’re learning, how trials are going and how our success will benefit everyone.
Eventually, there may even be ways for you or your loved ones to get into trials (we’re not there yet, but getting closer) by participating directly through new healthcare Disruptor tools like iPads and iPhones.
Meanwhile, we can invest in the Disruptor players, a move that will have dual benefits. It will not only aid the eventual defeat of these dreaded diseases, but it will allow us to profit from the full-frontal assault on them.
And that’s what we’re going to start looking at today…
A True “Game-Changer”
As you probably gleaned from my reference to iPhones and iPads, Apple Inc. (Nasdaq: AAPL) is a focus of interest for me – a true Disruptor company whose muscle is changing an array of sectors, markets and disciplines.
The Cupertino, Calif.-based company and its stock obviously benefits from heavy analyst and media coverage – some might even say over-coverage.
Even so, because of the way I’m looking at this, you’re in for a beautiful awakening.
Tim Cook, Apple’s brilliant and visionary chief executive officer, recently appeared on Jim Cramer’sCNBCMad Money‘s 10th anniversary show, where he discussed the impact of the soon-to-ship Apple Watch on medical research through the company’s ResearchKit open-source software framework. He told Cramer that the effect “has been so strong that, within the first 24 hours of announcing the ResearchKit, some 11,000 people signed up for a study in cardiovascular disease through Stanford University.”
In fact, Cook told Cramer “it would typically have taken 50 medical centers an entire year to sign up that many people.”
Here’s an example.
In a ResearchKit case study, Kathryn H. Schmitz, professor of epidemiology in biostatistics at the University of Pennsylvania’s Perelman School of Medicine, recounted how they mailed printed fliers to 60,000 women and got only 305 to reply and sign up for a research project. She calls ResearchKit and Apple’s related HealthKit a “game-changer.”
And the disruptions don’t stop there.
Just on April 13, International Business Machines Corp. (NYSE: IBM) announced a far-reaching new partnership with Apple. IBM is linking its HIPAA-enabled Watson Health Cloud up with Apple’s HealthKit and ResearchKit. In conjunction with additional partners Johnson & Johnson (NYSE: JNJ) and Medtronic PLC (NYSE: MDT), IBM and Apple will develop “enterprise wellness apps” made possible by the merged medical and health data gleaned from Apple devices. Watson’s job will be to facilitate data-mining and provide predictive analytics.
The University of Rochester and Seattle nonprofit Sage Bionetworks are also working together to create the Parkinson’s research app, mPower, using Apple’s ResearchKit.
According to Sage, “mPower aims to make it easier for people to sign up for studies and providing consent to do so. The app can detect symptoms in Parkinson’s patients just by having them say ‘ahhhh’ into the phone. It also includes a finger-tapping feature that can detect symptoms, too. Finally, the app can analyze the user’s gait and balance by having them walk 20 steps then turn around and take 20 steps back.”
(If you want to check this out, this link will take you to Sage – where you can find out more about mPower and possibly get into its research program.)
The Next Sector to Be Upended
As far as making money as you help with the assault on these terrible diseases, one way is owning Apple stock. Because of the “ecosystem” it is creating, Apple’s long-term financial health is, by design, tethered to the future health of the world.
That’s big, and it’s going to make Apple one of the world’s most critical companies. In turn, the company will become even more profitable and a fantastic long-term investment for decades to come.
While Apple is the first investment idea I love because it is a healthcare Disruptor in every sense of the word, I’m following others, too.
You’ll be reading about them here for some time to come.
But I’m not done with explaining how Apple’s products are “cause-in-the-matter” Disruptors.
I know of at least one other industry – not healthcare, but related – the new Apple Watch is going to disrupt. It’s an industry you never imagined would ever change. And there’s going to be money to be made there, too.
I’ll tell you what that industry is later this week.
In the interim, however, I will give you a hint – so see if you can guess what it is.
The hint: This industry is both hated and loved. It’s hated, because it costs us a lot of money. It’s loved, by some, because it saves us a fortune.
[Editor’s Note: Shah welcomes your questions and comments. Feel free to post them below.]
We’ve been talking here for the past two weeks about peer-to-peer lending – or P2P lending, as it is known – and have given you several ways to cash in on these new Lending Disruptors.
And if you’ve acted on our recommendations, you’re already making money.
In myApril 6 report on the New Lenders, I recommendedGoldman Sachs BDC Inc. (NYSE: GSBD) and Apollo Management Corp. (Nasdaq: AINV).
GSBD, which yields more than 8%, popped at the open of trading Monday. At its high price Monday morning, you were up almost 10% from where I recommended it only six trading days ago (an annualized gain of nearly 2,600%). And just two days after we told you about it, the widely read Investor’s Business Daily highlighted the Goldman business-development entity as one of two recent initial-public-offering (IPO) stocks “notable for their eye-catching earnings and sales growth in recent quarters.”
Triple-digit sales and profit gains is part of what caught my eye.
As for Apollo Management – it’s roughly flat from where I recommended it. But the stock has a juicy yield approaching 11%, which means you’re ahead of the game even before it delivers the gains I’m predicting.
The bottom line: Stick with these two investments. They’ll rise nicely in due course. In the meantime, you’re getting a better risk-adjusted yield than you’ll find in most other places.
That brings me to the market intelligence I want to share with you today.
Most of our talks here focus on opportunities – places and ways to make money.
But successful investing also involves managing risk – minimizing the losses you incur… or avoiding them altogether.
Thanks to Disruptors like Goldmanand Apollo, the new lending market is one of the sexiest profit opportunities in the finance arena.
But what you don’t know can hurt you.
So today I’m going to show you how to avoid losing money in the shifting lending market…
They’re increasingly “investing” on (that’s “on,” not “in“) P2P lending sites like the one operated by LendingClub Corp. (NYSE: LC), a publicly traded firm, and Prosper, a privately owned Disruptor site.
On both the LendingClub and Prosper sites, investors fund borrowers looking for loans. You can see on the sites what borrowers want money for. They are all personal loans, mostly for such things as consolidating high-interest-rate credit-card debt.
The interest rates that the “lenders” (investors) earn are based on each borrower’s creditworthiness, as measured by new Disruptor credit calculation metrics and algorithms meant to be predictive of a borrower’s likelihood to repay their debts, as well as on the term (length) of the loan. Terms vary, but most are three-year (36-month) and five-year (60-month) loans.
If you’re considering funding a stranger’s loan request – because the interest rate being dangled is attractive to you – here’s what you need to know…
About Those Enticing “Interest Rates”
I said earlier that what you don’t know can hurt you.
Here’s where that warning comes home to roost.
You see, the posted rates aren’t really what you get.
And you’re funding someone’s personal loan – someone who can default and not pay you back.
About those rates.
First of all, you’ve got to pay a “service fee” to the site operator. Typically platform operators charge lenders 1% of every payment they collect from the borrower and pass the money through to the lending investor. So right away, knock off one percentage point from the posted rate the borrower is paying and that you think you’re getting.
Second – and more important – the borrower can default, meaning he or she stops making payments.
Because you’ve made a loan to that person, you’re screwed – as in, you’re not netting the interest you expected to earn on your money. And because these loans are unsecured, you may not get back the money you lent – as in never.
Here’s a good way to look at defaults and how to figure your real risk.
LendingClub and Prosper have to declare all their transactions in U.S. Securities and Exchange Commission (SEC) filings. So the data is there.
LendingClub’s 2007-2014 average interest rate paid by borrowers was 12.533%. The average default rate per year for the same period was 6.9%. Default rates plummeted from 14.81% in 2007 to 2.38% in 2014. And although the return on investment (ROI) was (3.44%) – a loss – in 2007 and rose handsomely to 9.61% in 2014, the average ROI over the period was just 4.587%.
The average interest rate borrowers paid on Prosper from 2009 through 2014 was a whopping 17.945%. The default rate over the same period averaged 7.18%. And the average ROI for the period was 9.68%.
But there’s more to numbers than digits on a page. For one thing, both platforms changed their borrower credit requirements – mostly easing them as the economic cycle moved away from the Great Recession and as unemployment, a key factor in their repayment metrics, dropped.
Interest charges over the respective periods changed, too.
To better understand the available numbers, or the ones you calculate yourself (as I did), you have to further “look through” them to better understand what they’re telling you.
There’s a lot more to the statistics.
And, on some levels, there’s also less.
These stats are for three-year term loans over the period we’re talking about.
That means the 2007 vintage loans were closed out by 2010. Most of the 2012 loans are winding down (depending on the month they began). That means some of the 2012 loans – and their successors from 2013 and 2014 – are technically not “completed.”
The takeaway: The final default rate tally isn’t available and won’t be for years to come on some of the loans.
And that changes the real numbers.
If you use the data of completed loans for three-year and five-year loans (for which there is a lot less data), the average default rate for three-year loans might be about 5% and for five-year loans about 10%.
Matt Burton, CEO of Orchard Platform, a New York firm that works with mostly institutional lenders on P2P sites, says that “performance can vary significantly, though returns have typically ranged from 6% to 7.5% over the past three years across all LendingClub and Prosper loans, net of fees and defaults.”
Burton’s right. And that’s just what I’m talking about.
The returns sound good, but because the more recent loans are largely not completed, the whole game has yet to be played. A downturn in the economy and a jump in unemployment could cause the default rates to balloon, blowing the results apart.
This is the definition of real risk. Unless you’re going to be really, really diversified -meaning you fund lots of loans in equal increments – or devise your own diversification modeling program, you’re more exposed to risk than you realize.
It only takes one default on the one loan you fund to wipe out your entire investment, net of any interest you may have received.
So be careful – very careful. If you like the nice fat yields you see on the lending sites, remember you need to engage in some risk-adjusting calculations to see if the return you hope to get is worth the risk of not getting your whole investment returned or “Not Completed.”
That’s why I recommended you invest in some of the players – instead of becoming one yourself.
[Editor’s Note: Shah appreciates the big response he’s received for his recent reports on “Disruptor” investments and will be addressing some of your questions. Keep the comments and queries coming. Just post them in the comment box below.]