I Admit It – I missed the Boat on that One

During the recent turmoil in the financial sector, there were a few companies that were particularly hit hard with massive losses (we’re talking tens of billions of dollars here). As many of you probably already know, several of those companies required huge cash infusions from the federal government to stay alive and prevent the entire financial system from collapsing. A crashing stock price was a natural consequence of these problems. Investors don’t like it when their companies need bailouts from the government.

This is exactly what happened to two of the worst culprits of the financial crisis – AIG and Citigroup. I’ve mentioned both companies several times in previous posts as some of the most severely affected names in the crisis. AIG, one of the world’s biggest insurance companies, was impacted through selling insurance policies against the very mortgage backed securities that caused the crisis. When those securities began to wither in value, it was left with billions in claims obligations from banks that it could ill afford. Citi, on the other hand, became deeply involved in the selling of mortgage backed securities. The company eventually became a hugely complex and slow-to-react institution that was unable to handle the downturn in the very products it sold.

Eventually the stock of both companies fell…and they fell hard. We’re talking declines of 95%+ from their highs. At one point, Citi was trading under $1 a share! But somehow, some way, after billions of dollars of bailout money from Uncle Sam, both companies were able to survive the crisis.

Time for the Runup

So at the height of the crisis earlier this year, both Citi and AIG were down in the dumps in terms of stock price. Eventually, after seeing some stabilization in the market, they were able to crawl back a few dollars per share. Citi went from its lows of $0.90 a share to almost $3. That’s a gain of over 300%, and the brave few that chose to invest during that time made out like bandits!

It was around that time that certain family members of mine encouraged me to buy Citi stock. Their logic was that since the company wasn’t going bankrupt, how much lower could the stock go? I thought otherwise. Forever the skeptic on huge runups that companies like this had, my thoughts were the following:

1. The government had HUGE stakes in these companies now (that’s right, fellow tax payers, you own 30%+ of Citigroup right now). This creates a huge conflict of interest for the company that many of Citi’s biggest competitors didn’t have.
2. Citi had to issue massive sums of new stock to stay alive during the crisis - meaning that the stock was so diluted, $3 could very well be a fair value for it, even if $30 was fair before.
3. This one is just common sense, the stock had already gone up 300%! How much more running room could it have?

Because of these (what I thought were logical) reasons, I refused to play with fire and buy Citi stock. Low and behold, the stock has continued to skyrocket since hitting $3 a share. In fact, it has gone up almost another 100% and is hovering around $6 a share.

Why Was I so Wrong?

OK, so I made a mistake. My family was on to something, and I missed an opportunity for an easy 100% gain. But, to me, the more important thing here is to understand where I was wrong. What did I miss about Citi that has caused the stock to go up six fold in a matter of months.

Well, what I was missing was what’s known as the ‘Short Squeeze’. This highly technical and not so much fundamental concept is when traders who are shorting the stock are forced to buy the stock in order to cover their short positions, thereby bidding up the price.

I’ve talked about shorting a few times before, but I’ll do a quick refresher. Shorting is basically betting that a stock will go down. You accomplish it by borrowing the stock from your broker and selling it. You then hope the stock will go down so you can buy it back later at a lower price. However, if the stock goes up, traders often have to buy the stock anyway to pay back their brokers and cover their losses (this is called ‘covering’ a short position). Sometimes when a stock is going up rapidly, there is a large amount of short covering that occurs, thereby driving up the stock price even higher due to the buying that must be done for the short covering. This is eventually known as a ‘short squeeze’, because the shorts are being ‘squeezed’ out of the stock and the stock price is vaulting even higher.

Well, during the worst times of the market, there was HUGE amounts of short positions on both Citi and AIG. At one point, Citi’s short ratio was 18% of float. That means that 18% of Citi’s total stock was being held as a short position – an absolutely massive amount.

Well, with that much short interest being squeezed out of the market after it became apparent that Citi and AIG would survive the downturn, the stock just rocketed up. And I totally underestimated just how short the market was on these stocks. The past few months have been a massive short squeeze for both Citi and AIG. Although there are also some more fundamental reasons for the runup, they’re few and far between.

My Lesson

So, my parents were right, and I was wrong (isn’t the first time). Citi was still a good buy at $3 a share because the short squeeze was very much still in progress. Unwinding 18% of short interest just takes some time. However, another interesting aspect here is that, because the runup in the stock is to a large extent a short squeeze, it’s not driven by fundamentals. This could very much indicate that the price is now artificially inflated and will eventually have to correct. Where that will be, I’m not sure. But maybe it’s time to actually short Citi and AIG….?

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.

Yet Another OPTION To Invest! (Pun Intended)

In the spirit of exposing the Investing Decoded world to new ideas and methods of investing, today I’d like to talk about options. If learning to buy stocks was like getting a bachelor’s degree, options trading is like getting a master’s. There’s a whole new layer of complexity associated with options that change the entire risk/reward profile of the instrument. In fact, I would advise most new investors to stay away from options. But at the same time, options can contain valuable information about a stock that you may already own or are thinking about buying.

What Is an Option?

Imagine that you’re looking into buying a stock (let’s just say GE for example). You’ve read all those awesome InvestingDecoded articles and have done your homework on GE. After all that, you’ve decide that GE should be up 10% by the end of the year. But there’s one slight problem, you don’t have the money to buy a significant amount of stock. Not to worry – all you have to do is take the money you have and buy a ‘call’ option for GE. The option will allow you to take advantage of upside (or downside if you buy what’s known as a ‘put’ option).

Conceptually an option is pretty simple – it’s a contract that give you the right – but not the obligation – to buy (call option) or sell (put option) a stock at a pre-determined price (the strike price). In our GE example, since you think the stock is going to go up by 10% by the end of the year, you can buy a call option that gives you the right to buy the stock.

Here’s the catch, though. Like most contracts, options eventually expire. So the option might give you the right to buy the stock at a certain price, but you will also have to ‘exercise’ that option by a certain date.

At this point you might be thoroughly confused, so let’s go through an example. Say you want to buy the GE stock because you think it’ll go up 10% to approx $17 by the end of the year, but you only have $100 to invest (not really enough to make a big impact). Instead of buying the stock itself, you start looking into buying call options for GE stock. Just like stocks, you can pull up a quote for GE options (they’re known as option chains). This option chain will show you what the various option contracts (various strike price/expiration data combinations) are trading at.

Looking at the GE option chain you can see that the December 17 Call options (meaning options that expire in December and have a $17 strike price) are trading at $0.50 per contract. This means that you can reserve the right to buy 100 shares of the stock for $17 at the 3^rd Friday of December (options contracts generally expire on the 3^rd Friday of the month and trade at 100 share increments).

So let’s say you buy a December 17 contract for GE while the stock is trading its current price of approx $14.50. As the third Friday of December approaches, if the stock is trading below $14.50 the option will likely also be worth closer and closer to $0 – until the actual expiry date, at which point it expires worthless. If you had bought the option, you would’ve lost exactly $0.50 – nothing more.

If the stock goes up as December approaches, the option will also trade higher. If the stock trades around $19, then you could expect the stock to trade more like $0.70 – that’s a 40% jump! You can then trade out of the option (sell the contract to someone else) and run. OR, you can wait until the option expires. Assuming the stock is still trading at $19, you’ll have the right to buy the stock at $17 and can then immediately turn around and sell it.

How Options Are Useful

As you can probably see by now, options can be somewhat complicated. That’s why I suggest that if you’re not wholly comfortable with them. To be honest, I tend to stay away from them myself. There are a few serious risks you should understand about them before you try your hand at them:

1. When you buy an option, all you do is own a contract – not a real asset. The contract is merely a piece of paper with an implied value. This is different from a stock where you actually own a piece of the company (a hard asset) and the dividend and voting rights that go along with them.
2. Options are used by a leveraging mechanism – they multiply the effect of a stock’s movement. This means that you can get into real dangerous situations if the stock goes the opposite way from where you expect. If the stock goes below the strike price of the call option, the option will be worthless and you'll lose 100% of your money.

But All’s Not Lost!

Even if you don’t invest in options, you can still benefit from them. This is because options can give you really good insights as to where the stock of the option is headed. For example, if on a given day there’s heavy buying for call options for a given strike/date combination, that indicates that investors are betting the stock will be going up by that date. It might be a risky bet because if it was really going up, many of the investors would probably actually buy the stock. But as an equity investor, you can look at the options of the company as a sort of barometer for where the stock is headed.

Recently I bought Ford stock (F). Since then the following article came out about a bullish sentiment on the stock based on its option activity. This is a great example of how options trading impacts the actual stocks and you, as an individual investor who doesn’t directly invest in options, can benefit!

http://messageboards.aol.com/aol/en_us/articles.php?boardId=70219&articleId=63835&func=6&channel=Money+%26+Finance&filterRead=false&filterHidden=true&filterUnhidden=false

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.