Saturday, 31 January 2015

Why Short Sellers Are Good

Finished reading Jim Rogers Street Smarts last month, and he explained why short sellers are good to the market.

Difference between Hedge and Mutual Fund

The difference between hedge and mutual fund is ability to hedge which means can sell short. Mutual fund only can buy.

What is Short Selling

You buy a stock at $10 a share, and anticipating or wanting it to rise. It then rise to $20 a share when you sell. Now you make a profit of $10 per share.

Selling short is the reverse of the process.


Now if there is a stock trading at $20 a share, and you think that it will fall to $10 – You are going to short it. What you do now is to sell the stock at $20 and then buy it back at $10.

Hmm…if I do not have shares how do I sell?

For shorting, what you do is to borrow the shares from a bank. E.g. I borrow 1,000 shares from a bank and sell the stock at $20. Now my stock account has $20,000.

Then as what I predicted, the value of the shares drop to $10. I then begin to buy back 1,000 shares at $10 which cost $10,000.

Now I return the 1,000 shares to the bank with interest. The longer you borrow, the heftier the interest pay back. Discounting the interest, I then make the difference of $10,000 (20k – 10k).

Why Short Sellers are Good

Excerpt from Jim Rogers Street Smarts:

Short sellers create liquidity and stability to the market otherwise stock price will skyrocket and also otherwise during collapse, it will collapse faster.

Market need buyers and sellers. Without sellers, price will sky rocket. Without buyers, price collapse.

E.g. during Dot com mania, everyone buy Cisco. Price went up from $20 to $80. Without Short sellers, price may go to $110, now it is $90. Without sellers, there will be no liquidity, things will go nuts!

Let us say short sellers are wrong. They cover their shorts, and summarily forced out of market. Stock will go up! But if short sellers are right, (by the way, short sellers have a better record than most Wall Street), stock price will head towards a collapse. Everyone will be in panic and wanted to sell. But now there are no buyers! Well there is actually the short sellers. This is because they have to replace the stocks they borrowed. They have to cover their shorts! So in a collapse, stock does not drop as much as it might have. Let's say it will drop to 80 instead of 30.

So short sellers are good. They save you from buying the failed stock at $110 - if you bought at the top, you bought at 90 instead. When you dump, the short sellers replace stock which you will be able to get out at 80 instead of 30.

During an interview I gave on CNBC in 2008. Jim Rogers shorted Fannie Mae. Fannie Mae was a sham and on verge of collapse. In 2008, it drop to 60 to bankrupt. It was down to 20 by then, and reporter interview me - Sharin Epperson - opinion that collapse was Jim fault.

"Listen, I told Ms Epperson, as politely as I could, "if you really think that Fannie Mae is going into the tank because of short sellers, you really should get another job!"

Short sellers are not the cause (of collapse), they are simply the messengers and as such they exposed many of the great frauds. The criminal enterprise that was Enron is one of the most famous scandals they are responsible for having identified!

Rolf’s Summary

I added this paragraph after blog mentor SMOL’s incitement that I am not a parrot in the comment. LOL

In my opinion, for every buy, there must be a sell, and vice versa. In a food chain, there exists predator/prey systems, and relationships between herbivores and their food source such that a stable equilibrium is achieved. This is called the “balance of nature” or homeostasis. Other examples are regulation of temperature and balance of acidity and alkalinity in our body internal environment in response to external conditions.

In the stock market it is no difference. We need a self-regulating process in which buyers and sellers in a dynamic equilibrium continuously change reach a balance.

So if there are no short sellers, how to achieve BALANCE during euphoria?



Related Posts:
PEG Vs PE Ratio

10 comments:

  1. Rolf,

    You have just summarised what Jim Rogers think about short-sellers.

    Drum roll.....

    What do you think? (Somehow I don't see you as a parrot)

    ReplyDelete
    Replies
    1. Hi SMOL,

      Your blog make people think. Your comments make people work.

      Thanks for the reminder. I always try to have a summary/view at the end of most of my article. This one I miss out....

      I have added a new paragraph in the above article and updated it.

      I AM NOT A PARROT. I AM MYSELF! HAHA LOL.

      Delete
    2. Hee hee.

      Was thinking this is not your usual writing style ;)



      Delete
  2. Rolf : As long as it can make you sleep at night without worrying about the trend... Just Do It! ;-)

    ReplyDelete
    Replies
    1. Hi Richard,

      I had never short sell before. I do not think I am ready and will definitely loose sleep now if I do.

      Anyway, I am already loosing sleep due to my newborn. Haha LOL.

      Delete
    2. Rolf : hahaha.. That's what I thought so..

      Congrats for being a daddy.. First time daddy?

      Delete
    3. Hi Richard,

      Thanks. I am daddy of three.. How about you?

      Delete
    4. Hi Rolf,

      Oooh! Experienced daddy then... I am married with no kid...;-)

      Delete
  3. Realized you earned twice the average salary.

    :-)

    ReplyDelete
    Replies
    1. Hehe... My wife maybe....

      Better to save and invest twice or more the average than to earn...

      Delete