21st Century Economics

In the example above, let’s say you are confident that ABC, Inc.’s announcement will increase the stock value within 90 days.

You buy an option to buy 100 shares of ABC, Inc. at $110 per share for the next 90 days, ending at the end of November. The option is a call (the holder has the right, not the obligation, to buy 100 shares of ABC, Inc. at a price of $110 between now and November). It would be written like this, “ABC, Inc. November 110 call”.

After you buy the call option, you hope the stock will increase in value. This rise might be because the product is innovative and a positive advantage to the value of ABC, Inc..

As a result, suppose the stock value goes up to $125 per share in October and you “exercise your option”. That means you now buy the 100 shares at $110 per share and immediately sell them at $125 per share. You made $15 per share or $1,500. If the cost of the option was $250, then you made $1,250.

Now suppose the stock declines from the time you buy your option and at the end of November, the stock is selling for $90 per share. You simply choose not to exercise your option. You are out the $250 that the option cost but if you had purchased the stock at $110, you’d be out $2,000.

Let’s see a slightly different example…..

Now suppose you are really confident that the price of gold is going to go up as a result of a rise in tensions or a full blown outbreak of violence in the Middle East. Such a rise in gold might also rise as a result the outbreak of a political scandal in our own congress or some market segment of the US economy - like the housing market, savings and loans, mortgage holders, Wall Street insider trading, major trade imbalance, devaluation of the dollar, or any of a number of similar and predictable events.

Suppose you bought a call option in August 2007 for 120 days for 1000 ounces of gold at the going rate in August, let’s say it is $650 per ounce. Now you wait and watch the gold price increase as the Middle East and political problems approach and there is an increasing degree of panic among investors. The option is not cheap. It might be as much as $2,500.

By the late of December 2007, the price has gone up to $875 per ounce. You decide to exercise your option. You buy 1000 ounces of gold at $650 and immediately sell it at $875. You keep the difference of $225,000 minus the cost of the option. You pocket a total of $222,500.
But you are not done yet.

It is now January 2008, and the prospect that new politicians will resolve the Middle East issues is improving. There is also the issue of “regression to the mean”. The price of gold is way above its mean of under $500 for the past 35 years. It is unlikely to be able to sustain a 200% rise in the price of gold for very much longer.

As a result, you might be confident that the Middle East/political problem and the investor panic will subside sometime after December 2007 with a corresponding decrease in the price of gold. So in early December 2007, you buy another option. This one is a “put” option.

Your option is for 120 days for 1000 ounces at $875 per ounce. This means that if you exercise your option, the broker will buy your gold at $875 per ounce. In this mythical scenario, the option cost is still $2,500.

Now you wait until the end of February or into March 2008 and see that further political primaries, the Iraq surge and other events have dampened the turmoil in the Middle East and on the home economic front and the price of gold has dropped back to $600 per ounce. You buy 1000 ounces at that price and then exercise your option to sell it at $875 per ounce. The difference of $275,000 minus the cost of the option, nets you $272,500. Combined with your call option, you cleared $495,000 in 6 months and had virtually no out of pocket expense*.

Had the price of gold not followed the expected predictions, you were at risk for the first $2,500 call option but by early December, you would see that the price of gold is not following the predicted trends and you would decide to not buy the second option.

Our position, at 21st Century Economics, is that we are not addressing the professional Wall Street investor with our service. We, therefore, do not advocate investments that require minute-by-minute attention to the rises and falls of the value of the investment. Futures trading is like that.

It is for this reason that we at 21st Century Economics do not advocate anyone get into the futures market unless you have lots of excess money, lots of time to learn and follow the market and can take the stress and risks of a very volatile market.  

The Short and Simple Explanation:

You pay a fee for the “option” to buy stock at a future price so you can sell it now. In other words, you have the option to sell some stock now at a high price and then, at some time in the future, you buy it when the stock price has dropped.

The real neat trick is that you can wait until that future time to see if the price did, in fact, rise before you elect to sell the stock at today’s price. If the stock does not rise, you simple elect not to complete the transaction and all you forfeit is the cost of the option.

Typically, you buy the option and then wait to confirm that it is going to go down. If it begins, then you can elect to exercise your option and sell now at its current price of let’s say $110. Suppose you sell 100 shares for a total income of $11,000. Now you wait for the stock price to drop. When it reaches $85 per share, you buy 100 shares for $8,500. You sold the stock for $11,000 and bought it for $8,500. You made $2,500 minus the cost of the option.

Typically, the usual option buyer would buy much more than 100 shares. You can see that if you bought 10,000 shares, you would have made $250,000. The advantage is that you bought the 10,000 shares with money you made from the sale of the 10,000 shares. Sounds weird but it’s done everyday on Wall Street. You also have a low risk since if the stock goes up or does not change, you can elect to NOT exercise your option. You lose the fee you paid for the option but that’s all you are out of pocket.

Where this is most useful is when you KNOW that the stock will move down. In the case of a known political, economic or Middle East crisis, we often do KNOW that some stocks will go down and some will go up and then down. Therein lies your chance for profit.

You should read this next section but you can also skip down to the section marked Cautions.

The Longer Explanation:

As you might expect, it’s a little more complicated than what is listed above. Here’s how it really works.

You tell your broker you want to short 100 shares of ABC, Inc. at $110. This means that you are entering into an agreement with the broker to temporarily borrow 100 shares of this stock at $110/share for specified period of time. Technically, you are borrowing the 100 shares from your broker in order to sell them to someone else at the current price of $110.

The broker either has the shares in inventory or he borrowed them from a client or another brokerage firm. The sale is made and the shares are now in the hands of a third party that has paid $110 per share for them. At this point, you have not paid the broker any money but you do owe him for the 100 shares.

Now you wait. If the price of ABC, Inc. goes down, to $85, you then buy 100 shares of the stock at that price. You have now spent $8,500 for the 100 shares of stock. You now return to your broker the 100 shares of ABC, Inc. stock that you borrowed. You borrowed the stock at $110 and sold it at that price for $11,000. Then, later, you bought it back at $85. You made $25 per share in profit or $2,500. You sold the borrowed stock for $11,000 and bought it back for $8,500. Technically, you sold something before you owned it and bought it back after you sold it. Sounds crazy but that is what is called Selling Short.

Under some circumstances, it is possible to return the stock to the broker before you have to pay to buy it meaning that it is a paperwork drill until he sends you your $2,500 profit.

Cautions:

As with all stock transactions, there is a down side to this activity. Suppose the price of ABC, Inc. goes up to $125. You borrowed it from the broker and sold it at $110. Now he wants his stock back but the price has gone up. You now have to go into the market and buy 100 shares of ABC, Inc. at $125 per share or $12,500. You can then return the loaned stock to the broker. In this case, you lost $1,250.

There are ways to protect yourself from too much of a rise in price by using a ‘buy stop’ order GTC (Good Till Canceled). You decide that if the price of ABC, Inc. rises $5 you want to get out of the deal. You would place a buy stop order at $115. Then, if the price of ABC, Inc. rises to $115, you are assured that you will get out at about $115.

You may also want to get out of a short trade when you have hit a certain amount of profit. In this case, you would use a buy stop at you maximum loss level and a buy stop at your profit target level. This is called an either/or order. You are placing two orders to protect you if the stock rises and to take profit if the stock declines.

For the most part, brokerage firms do not place a time limit on the shares of stock they loan. This is because they make a commission both ways. And also, they want to keep the customer happy. There are some other rules and limits on this kind of sale but it has its rewards.

As you will see, selling short is a very useful technique when you know a stock or other investment will go down. What do you think will happen to all those defense contracting companies after this Iraq crisis all dies down? What do you think will happen to those defense contracts - like with Haliburton, if an anti-war president is put into power in 2009? What do you think will happen to GOLD after the panic passes about an oil crisis or a war with Iran? You can bet money that they will go down from their Bush Era highs. Make Money!  

What makes any given stock go up or down almost defies logic and analysis. So many things can affect a stock’s value that the only successful investors are ones that totally involve themselves in every nuance of the business they are investing in. They know every aspect of the business, often better than the owners and managers of the business itself. There have been only a few such investors in all of the history of the stock market.

Peter Lynch, the portfolio manager of Fidelity Magellan Fund, was one such investor. He had a well-known reputation for knowing everything about a business before he invested in it. But what he was really doing is establishing a baseline or reference of performance on a company in order to more accurately predict what its future will be. This often took weeks or months of on-site study for each investment decision.

The attraction of most investors to put money into a single stock is the hope they will find the next Microsoft or Bell Telephone and their stock will skyrocket in value. Unfortunately, it can also lose everything. In fact, statistically speaking, the vast majority of initial price offerings (IPO’s) (what they call a new stock that is being introduced to the market for the first time) fail and the initial investors usually lose most or all of their investment. Although there are companies that can show very rapid gains, no one has figured out a way to precisely determine exactly which companies will fly high and which will fail.

As you can imagine, this investment decision process is very complex and requires the consideration of hundreds of parameters about the investment candidate. As a non-professional investor, you do not have the skills, time or access to do this kind of analysis and neither do most other investors.

As an alternative, they rely on investments in a broad range of stocks called mutual funds. These are groupings of individual stocks into a large collection of similar kinds of investments. For instance, they might all be from the same or related industries, such as automotive or health care; or, they may all have the same kind of investment strategy such as growth or income stocks or government bonds.

The objective is to average out the fluctuations and effects of any one stock in order to gain a more modest gain across a much larger group of stocks. It must work because that is where the vast majority of investors are now putting their money.

Peter Lynch studied and analyzed each stock that he invested in to establish a baseline or reference of past performance that he used to make investment decisions. So, too, must there be a reference for the groups of stocks that make up mutual funds. To meet this demand, Wall Street has created numerous “indexes” that plot the averages for dozens or hundreds of stocks. The most famous of these indexes is the Dow Jones Industrial Average (DJIA) which reflects the averages of only 30 industrial stocks that are suppose to be indicators of what the entire economy is doing. Another well known index is the Standard and Poor’s Stock Price Industrial Index or the S&P 500. This averages a dynamic list of the top 500 stocks on the New York Stock Exchange.

There are many others but they all have a common purpose - to supply the needed baseline or reference of performance on a group of stocks in order to more accurately predict what the investment potentials will be.
As we go from the performance of a single stock, to the performance of indexed stocks like the S&P 500 and to the mixtures contained in mutual funds, we get two characteristics:

As the number of stocks grouped together increase, the fluctuations of any one stock have less and less effect on the total value of the group. This is for two reasons:

(a) each individual stock makes up less and less of the total as the group gets larger and

(b) as one stock goes down, others in the group may go up, resulting in a more consistent and steady response to the changing economy.

As the number of stocks grouped together increases, the gains and losses tend to move into much more modest swings so that the average gains or losses are smaller than the gains and losses that you might get with a smaller group.

The swings of gains and losses is called volatility and is directly related to the risk you have of sharp and frequent changes in the value of the investment. In general, mutual funds are less volatile than an individual stock will be. The larger the mutual fund, the more likely it is to be stable and non-volatile.

As the average investor, you need a reference of performance that you can easily understand and easy to follow. Ideally, you would want to find a “megatrend” that you can invest in and be reasonably confident that it will result in profit. Use of indexes like the DJIA or the S&P 500 are a step in the right direction but if you look at a long term graphic chart of these indexes, you will see lots of fluctuations. It’s hard to base your investment decisions on a performance index that has an inconsistent trend. What we need is some other index that let’s us KNOW we will make money.

One impact of the two characteristics listed above is that although the high highs and the low lows are averaged out across the entire group of stocks, the end result is that your losses will always be less and your gains will be less than for a single stock. The larger the group you average together, the more they will tend toward a single average of gain or loss.

For instance, if you looked at investments in all of the various stocks related to railroads over the last 50 years, they would have an overall trend downward. A similar examination of all the various stocks related to the insurance business would show a general trend upward.

This kind of trend discovery also develops as you average a longer and longer period of time. For instance, if you average across one year, the S&P 500 was down by 1.54% in 1994 but up by 34.11% in 1995; however, it has shown an average gain of 11.54% over the last 15 years. These trends begin to emerge only when you average over a long enough period of time.

If we combine the idea of averaging across a large number of stocks and across a long period of time, we can discover if there are some megatrends that are inherent in the entire stock market.

Someone has done exactly that for the largest possible group of stocks and for the longest period of time possible. The result is the ultimate performance reference for the stock market investor.

Professor Jeremy J. Siegel has created an index for the entire stock market called the “real-total-return” trend. It considers all the stocks, not just the groups that make up various indexes or mutual funds. It also adjusts for inflation and considers the capital gains and dividends of the stocks. The period of time he considers is from 1801 through 1998.
That is as long as there are records to support an analysis. The resulting graphic overlooks the year-to-year fluctuations and economic turbulence and displays a remarkably stable long term total return on equities of 6.8% per year over and above inflation.

This is a remarkable discovery. It means that the overall basic trend of the stock market is increasing by that much every year for the past 197 years. The effect of that would be that if you invested just $1.00 in the market in 1801, you would have $561,264 dollars today (equal to more than $1,000,000 in 1801 adjusted dollars).

This is a useful performance index that you can use to make shorter term investment decisions, as you will see if you read the section about Regression to the Mean investment strategies.