The Secret Broker: Shorting. Puts. CFDs. It’s all Greek to me!
The Secret Broker
The Secret Broker
After 35 years of stockbroking for some of the biggest houses and investors in Australia and the UK, the Secret Broker is regaling Stockhead readers with his colourful war stories — from the trading floor to the dealer’s desk.
So, I was asked the other day to explain how ‘this shorting stock business thing’ worked and this was from a wealthy man, who made all his money from commercial property and owning a communication business.
He has shares in his self managed super fund but they are mainly lithium stocks, so he understands the market but he must have seen something on Sky News, as that is all he watches and talks about.
I presumed they must have mentioned the closing down of a hedge fund by Jim Chanos out of the USA.
After 40 years of specialising in going short in companies his fund speculated would fall in value, he was hanging up his dealing pad and returning capital to his fellow investors.
He said he would keep going for himself and a few other mates in his short side investment thesis and that data centres were in his sights.
Apparently, he had run a short on Elon’s Tesla company for five years and in those five years, the stock had risen by over 4,800%. As I have explained before, a shorter can only make 100%. They can, however, be liable for losses of more than 100%, if their bet sours.
That is, if you are short of a share at A$5.00 and it falls to A$0.00, then that is all you can ever make. However if they go to A$15.00, then you are down 200%.
So, it is a specialist game and going into a short ‘naked’ is something I never liked doing. Going ‘naked’ just meant that you had not hedged against it in any way, you were just all in and stood to potentially lose more than just your shirt, hence the term.
If you were short ANZ and bought CBA as your hedge, then you are not naked.
There are various ways that you can short a company. There’s the old fashioned way of just selling them into the market, or there are a couple of synthetic options.
The old fashioned way would require you to find someone to lend you some of their stock, so you are able to settle your short by delivering your borrowed stock into the market.
You then have to, at some point, repay the loan by returning those shares. This you can do by physically buying them back or by borrowing them off someone else.
Over the term of the loan, you are liable for any dividends paid, including any franking credits attached, with which you then settle both components in cash.
In the example above, if during your period of being short ANZ and they pay a dividend, then you are liable to pay their fully rounded up dividend in cash. A A$1.00 dividend payment could cost you an extra 30% or more on top.
Remember though, ANZ would have gone ex dividend on the market and fallen in value. Also note, that the buyer of your short would have received their dividend directly from the company, so everything balances out.
A synthetic way of going short is to buy a put option.
Now, I must admit, when I was first introduced to the option market in 1982, it took me three weeks to get my head around how a put option actually worked.
A call option I could understand, as it meant you could ‘call’ the shares at a fixed price in the future. But a put option defies all human logic.
How could you ‘put’ shares onto someone else, if you didn’t own them?
At this time I of course didn’t have a share portfolio, so it didn’t compute in my head that if you held them, then you could just deliver them and collect the proceeds.
This was something they never taught us at school, though if I had bothered to listen to our Greek teacher, then certain Greek terms may have remained familiar.
In the option world of calls and puts, certain calculations have Greek names like delta, gamma, vega, and theta.
Sit back and get yourself a glass of Retsina as we delve into those words and their meanings.
Delta is the measurement in the change of an option’s quoted price resulting from an up or down movement in the underlying share price.
Gamma measures both the delta’s rate of change over time, as well as the rate of change in the underlying share price and is used to forecast price moves in the underlying share price.
Vega measures the risk of changes in implied volatility or the forward-looking expected volatility of the underlying share price.
Theta measures the time decay in the value of your option as it heads to expiry.
There you go, it’s as plain as mud to everyone. And it is all calculated automatically by algorithms, so you really don’t have to worry too much about them.
Before calculators came along, it was pretty much a guessing game in how to price options, though some of us were trained in using a Curta.
Then came along a couple of intellects, who published a paper on the best way to calculate an option’s price.
Their names were Fisher Black and Myron Scholes and their methodology became the way to price options. It became known, somewhat unimaginatively, as “Black and Scholes”.
Later on it was proved they had an error in the assumptions. In fact Warren Buffett noted the model didn’t work in the long term and when you go from months to years and another intellect blamed the tinkering of their formula by bank traders for the GFC in 2008.
Regardless, a put option is therefore calculated using the Black-Scholes method, so historic share price movements (volatility) and time (how long before they are due to expire) are the quickest way to mentally calculate a price.
The other synthetic way is to open a CFD account, put in some margin capital and sell a CFD, though you can’t net the two out and your position is in the hands of your CFD market maker platform.
Your CFD provider can end up long or short at the end of the day and to hedge their book, they may have to borrow shares and physically sell them in the market.
When the GFC did hit us all in 2008, most exchanges made it illegal to short bank shares after pressure from politicians, so the way around that was to short the futures and hedge by buying an underlying basket of shares which matches the index you shorted.
Ie, the FTSE 100 is based on 100 UK listed companies, so what the sharp traders did was to buy everything in the FTSE 100 bar any of the banks, like Barclays.
So to sum it up a short seller has to borrow shares to settle their trades, or they could buy options, or they could sell CFDs to a market maker, like CMC.
The other way that I now look at it, being a bit wiser and older, is that if you don’t own any shares that you think are heading for a fall, then you are short of them, whilst you wait for them to fall.
If you don’t own them and they fall, then you can now buy them at a lower price and you haven’t had to mess around in borrowing shares or buying puts.
But I will leave you with this thought.
If you do buy a call option, then the person who sells you that option wants the underlying shares to fall in value, so in a way they could become a shorter (to you).
And now this is where it gets really curly – if you buy a put option, the seller wants the underlying shares to go up, whereas you want them to go down.
Now, take all of this information and put it into the hands of a big trading room. If there are 10 trading banks all doing the same thing, then they are creating the volatility which is required to make all of this happen.
If they banned trading in derivatives, then we would all be able to live in a much more quiet way.
It happens at the weekend and maybe it should be extended?
I shall now turn off my phone and go and hide in a bunker as this last bit will majorly irk all of the grown-up bankers who think they contribute to society.
As I’ve learnt, there is much more to life than fat boy lunches and cut-throat dealing rooms.
Oh and Retsina. It tastes like s..t.
Feel free to contact him with your best stock tips and ideas.