Wall Street University: USD 101

Dated May 2, 2020; last modified on Thu, 02 Sep 2021

Short Selling

Say $A shares are selling at $100, but I think they’re overpriced. So I borrow 10 shares, pay my brokerage interest and post some collateral. I then sell the shares for $1,000.

Whoever buys my shares has no idea that I do not own them. In a naked short, I do not actually borrow or ensure that the security can be borrowed within the standard 3-day settlement period. As a result, I fail to deliver the securities to the buyer.

If $A dips, say to $60, then I buy 10 shares for $600 and return the shares. My profit before fees is $400.

If $A rises to $150, and I have to replace the borrowed shares, then I’d incur a loss of $1,000 - $1500 = $500. Notice the losses have no upper-bound.

Even if $A eventually falls, the intermediate highs may still bankrupt me because more collateral will be needed from me during the highs.

Reasons for short selling: to profit from expected drop, to provide liquidity after unanticipated buyer demand, to hedge the risk of a long position in the same/similar security.

Options

Options are contracts giving the owner the right to buy (call option), or sell (put option) an underlying asset, at a fixed price, on/before a specific future date.

ABC December 70 Call $2.20 entitles the buyer to buy $ABC at $70/share at any time prior to the options' expiration date in December. At the time of buying the option contract, the buyer will pay $2.20/share. Say I buy the contract, which 100 shares of the underlying stock. I pay $220 for the contract.

Say $ABC rises to $80/share before the expiration date. Because the value of the underlying stock has increased, the premium on the ABC December 70 Call has increased to $20.20, making the option contract worth $1,020. I could:

  • Sell the option now (closing my position), for a profit of $1,020 - $220 = $800.
  • Exercise the option and buy $ABC from the writer of the call for $70/share. I have therefore spent $7,220 to acquire shares currently worth $8,000.

Instead, suppose I believe $ABC will rise even further, but on the expiration date, $ABC’s price is $65. Given $65 is less than the strike-price, the call option is out-of-the-money and therefore worthless. I lose the initial $220.

Picking Up Pennies In Front of a Bulldozer, and Other Moneymaking Techniques

The riskier the investment, the more capital a bank needs to have. To reduce risk, banks buys insurance, and therefore subject to lower capital requirements. Wall Street banks paid AIMCo to cover unlimited losses in case of an extreme stock market crash. Well, the crash happened and AIMCo is out C$2.1B. The key thing is that the arrangement exists because regulation demands it so, and not that the risk will never come true - banks seldom buy superfluous protection.

Share repurchase programs. Herbalife wants to buy back shares. Merrill Lynch collects $266m from Herbalife on May 7, 2014, and commits to conclude the repurchase no later than June 2014. Herbalife gets to buy stock at a discount. Merrill makes $$$ from stock volatility: each time the stock goes up, it buys less, and vice-versa. If the stock is stable, then Merrill loses money because of the discount offered to Herbalife.

References

  1. Investor Bulletin: An Introduction to Options. https://www.sec.gov/oiea/investor-alerts-bulletins/ib_introductionoptions.html . Mar 18, 2015.
  2. It Doesn’t Pay to Be Too Ethical. Levine, Matt. https://www.bloomberg.com/opinion/articles/2020-05-01/it-doesn-t-pay-to-be-too-ethical . May 1, 2020.
  3. 'Amateurish' Trades Blew Up AIMCo’s Volatility Program, Experts Say. Leanna Orr. https://www.institutionalinvestor.com/article/b1lffwvwdh7xtq/Amateurish-Trades-Blew-Up-AIMCo-s-Volatility-Program-Experts-Say . Apr 30, 2020.
  4. Herbalife Keeps Finding Fun Ways to Buy Stock. Levine, Matt. https://www.bloomberg.com/opinion/articles/2014-05-08/herbalife-keeps-finding-fun-ways-to-buy-stock . May 8, 2014. Accessed Feb 15, 2021.