I
n the world of politics, the majority wins and the minority loses. In the world of investments, it’s often the opposite, especially at major turning points in history.The many who join stock market booms can get crushed as crowds break down the exit doors in a crash. Conversely, the few who learn the secrets of crash profits can sometimes make more money in the decline than many people made during the preced- ing boom.
Linda Dedini came from a family that knew more about busi- ness and finance than most. Yet no one ever talked about crashes—
let alone about crash profits.
Crashes were things that existed strictly in an ill-defined histor- ical past and that modern society had long-ago learned to prevent.
At the very worst, a crash was an aberration that could not last, an opportunity to snatch up bargains before the market resumed its semieternal rise. The entire concept of actually making moneyin a decline was totally foreign to most people, including Linda Dedini.
The classic way to make crash profits is to sell short. However, the term “selling short” was not even something she ever thought about, except in its colloquial meaning. “Never sell yourself short,”
her mother used to say, or “always respect your family; never sell them short.” Selling short was obviously an inappropriate behavior.
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THE WINNING
116 Crash Profits: Make Money When Stocks SinkandSoar
Until recently, she had left investment decisions primarily in the hands of others, such as her broker. Now, however, devastating losses in the stock market left her no choice but to dig in and finally learn more about investing. The living room TV, which used to always drone in the background with Disney Channel, Nick- elodeon, or MTV, now droned with talking heads on CNBC. The family’s cocker spaniel, whose morning job was to mangle the Washington Post,now had to work double time—to mangle boththe Postand the Wall Street Journal.
One evening, while Linda was poring through a stack of tests on elementary mechanics, two words uttered on a CNBC talk show caught her attention: “crash” and “profits.”
She knew all about the crash. She had been through it her- self. She knew all about profits too—that’s what the broker had promised but never delivered. But crash and profits in the same sentence? It seemed totally incongruous.
She brushed it aside, stared for a moment at the still- uncorrected stack of tests, sighed, and picked up another to grade:
Physics 101. Unit 1—Mechanics. Question 1. Levers are tools that transmit and modify force applied at two points and turned about a third. Give three examples in your daily life, and explain how they fit the definition.
The question was a giveaway. Any student who didn’t get this one would likely run aground on the tougher questions requiring serious problem-solving skills. She read some of the answers.
Crowbar, car jack, catapult, spoon in cafeteria food fight, elbow of teacher smacking student for dumb test answers. “Yes!” or “Witty!” were her comments in the margins, as the chit-chat on CNBC continued in the background.
Then, suddenly, there they were again! Those same two words, coming from the same Surround Sound speakers that habitually blasted Backstreet Boys or Britney Spears: “crash” and “profits,”
plus one more word—“leverage.”
Leverage? In the stock market? In a crash? Generating profits?
Stop!she said to herself. Stop grading these tests and pay attention for a change!
As she put down the tests and listened more intently, however, instead of the clarification she sought she got a new torrent of jar- gon: “shorts” . . . “reverse index funds” . . . “puts” . . . and then, suddenly, for a third time, “crash! . . . profits”!
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Needless to say, it was the very firsttopic in her very nextcon- versation with her adviser.
“I’m absolutely amazed at what I just heard about crash prof- its,” she said during an earlier-than-usual morning phone call to his home. “It was on TV. I wasn’t even paying attention, but the words just leaped out and grabbed me while I was engrossed in school work.”
At first he seemed as perplexed as she was. “ ‘Crash profits?’
What are you talking about?”
“No, not exactly crash profits. First it was the crash-word, then they said something else, then came the profits-word. But it was practically in the same breath. I think the Dow was down some- thing like 300 points the day before yesterday, right? So at first I thought they were talking about some unique stock that had gone up in spite of the market decline. I assumed they meant profits despite the crash. Then, though, it seemed like they were talking about profits because ofthe crash itself. That’s why I called you right now. Sorry for bothering you so early.”
The adviser waved off the apology, explaining that he was an early riser and that he had indeed given her the OK to call him at home. “What particular investment were they referring to?” he asked.
“I haven’t the faintest idea. All I know is that some of them had jumped by as much five times. Can you believe that? 500 percent profit!”
“Well, no, not exactly. If an investment jumps by five times, that’s actually a 400 percent profit. For example, if it goes from, say, $100 to $500, your profit will be $400, or 400 percent of your original investment.”
“That’s it!” she said conclusively. “That’s exactly what they said, or very close. There was one they talked about that had gone from about $100 to $250. Another had surged from $150 to nearly $800.
All in one day! I urgently need to know more about these invest- ments. Please, can you tell me what they are?”
The adviser thought for a moment before responding. “There’s only one investment I know of that could go from $150 to $800 on a crash day. They’re among the most powerfully leveraged invest- ments in the world. In other words, like a big lever, they provide potentially very large gains with a very small investment. They’re
118 Crash Profits: Make Money When Stocks SinkandSoar
usually cheap. They’re volatile and speculative, but they can be fun, provided you don’t overplay them. But before I tell you more, I need to know: What are you trying to accomplish? What’s your goal?”
She sighed. “I really don’t know. All I know is, we’re scared. We should never have sold our mountain retreat. We should never have put that money in the stock market. We took a huge beating.
Then every time we tried to make up for it, we got killed even more. We have to recoup those losses quickly, but how?”
She hesitated for a moment and bit her lip. “Plus, now, I have more bad news. Remember my grandfather and his portfolio?”
“Uh-huh.”
“We never sold it. It wasn’t Grandpa so much as it was my brothers. They’re both doctors. They don’t know any more about the market than I do, but they thinkthey know more. In their mind, selling after the market has already gone down is like closing the barn door after the horse has escaped. If anything, they said, we shouldbuy more.”
“What about the list I gave you?”
“List? Oh, you mean the most vulnerable stocks? Sure, we looked through that very carefully, but he’s got stocks like Exxon, General Motors, Phillip Morris, IBM, and a whole bunch of blue chips he bought decades ago. Only a couple of the stocks in his portfolio were on your list.”
“Then why didn’t you check the stocks with one of the inde- pendent rating agencies I told you about?” the adviser asked.
“Huh? Hmm, I don’t remember. I guess no one volunteered to do the work. Besides, I didn’t want to fight them on it, and they didn’t want to fight me on it. So we dropped it, and the whole thing fell through the cracks. My concern is that maybe now it’s too late.”
“No, no, it’s not too late. Not at all. Most of the blue chips are still vulnerable in many ways. The portfolio is overinvested in common stocks. Better late than never.”
“The other bad news,” she said sorrowfully, “is that the doctors say Grandpa has only weeks to live.”
“So what does the family want to do?”
“They—we—don’t know. If we sold the shares now, the capital gains taxes would be huge. But it’s a moot point. Although we have some influence, we don’t have control over the portfolio. I figure it’ll be months before it’s out of probate. My mother tells me the
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portfolio’s down over 10 percent just in the past few weeks. What are we going to do? Just sit there and watch it go down the tubes like our telecoms?”
The adviser responded reassuringly. “You’ve already liquidated all the stocks in your personal portfolio, right? You’ve already put that money into Treasury bills or something equivalent, right? Yes?
Very good. That takes a lot of pressure off you right there. You’ve stopped the bloodletting. Now, you and your family have two remaining goals.”
Crash Protection
“We do?”
“Yes. First goal—to recoup losses. Second goal—for you and the other heirs—to protect the stocks in your expected inheritance against the next market crash. The protection is your first priority.
What do you know about selling short?”
“Nothing!” she said firmly, conveying a distaste for the concept.
“Don’t get me wrong. I’m not going to recommend that you sell stocks short, but you need to understand how it works. Essentially, instead of buying low and selling high, you just reverse the order of the transaction. First you sell the shares high; then you buy the shares low.”
“How in the world can you sell shares that you don’t own?”
“You borrow them. Let’s say Exxon is selling for $35 per share.
You go to your broker, you borrow 1,000 shares, and you promptly sell them. That gives you a $35,000 credit in your account. Got that so far?”
“Sure. $35,000 cash in my account.”
“No, not cash—credit!”
“Oh, OK. I have a $35,000 credit in my account. Go on.”
“Then, Exxon falls to $15. You buy the 1,000 shares for $15 each to return them to the broker. How much do you to deduct from your $35,000 credit to pay for those shares?”
“One thousand at $15 per share? $15,000, I guess, but”
“Just bear with me. So how much does that leave in your account?”
“$20,000?”
120 Crash Profits: Make Money When Stocks SinkandSoar
“Exactly. That’s your net proceeds—$20,000. Naturally, if the stock goes up, you incur a loss.”
“Interesting,” she said unenthusiastically.
“Now, let me explain the reasons I do notrecommend short sell- ing to most investors. If the stock goes up and you hold on indefi- nitely, there’s a danger that you could eventually suffer losses greater than the amount you invested. I assume”
“No, thank you! I can’t expose myself to that kind of risk. I have a family to care for. I have two kids that deserve to go to a decent college someday. In any case, I don’t want to sell short the market.
I’d feel like a vulture—profiting from everyone else’s pain and suf- fering. I can’t do that. It’s unpatriotic, morally wrong.”
The adviser, who until now had been very jovial, responded sternly. “That’s pure hogwash!”
The response reminded her of her father’s reaction whenever she offended him. “Why’s that?” she asked apologetically.
“Let me explain. Investors who sell short—the short sellers—can be godsend in the market. They squirrel away buying power.
Then, when the market is down and out, they’re the first to buy.
They’re like the starter engine in your car that revs things back up again. Without them, the market could languish at low levels for months. Remember: Short sellers have all those credit balances in their accounts. Plus, they owe all those shares. At some point, they are going to haveto buy the shares back, right? When the bear mar- ket is ending, who do you think is going to get us out of the hole?
Who’s going to get us started on the road to a real recovery? The short sellers!”
Reverse Index Mutual Funds
“Fascinating, but I still can’t afford to take the unlimited risk,”
Linda said.
“You won’t and you shouldn’t. Instead, you should buy only investments in which your risk is strictly limited to the amount you put up.”
“Give me an example.”
“You can buy a specialized mutual fund to profit from a decline.
When you own shares in one of these funds, you can never lose
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more than you invest—just like any other kind of mutual fund. You will never get a margin call. In other words, they will never ask you to put up more money. And the more the market falls, the more your fund shares will be worth. Just visualize blue-chip stocks going down on one side and your mutual fund shares going up on the other side.”
She thought about it for a moment, and the image of a seesaw came to mind. On the one side of the seesaw were her grandfa- ther’s stocks, going down with the market. On the other side was this special mutual fund, going up, to offset the losses. “What do they call that kind of fund?”
“It’s called a ‘reverse index mutual fund.’ ”
“Why are they called that?”
“Because they’re the reverse of index funds. Are you familiar with index funds?”
She responded affirmatively but hesitantly.
“Let me explain them to you anyway. Index funds are matched to a major market index like the Dow 30 Industrials or the S&P 500. If you wanted to invest in a rising stock market, you’d have a hard time buying all 30 Dow stocks or all 500 S&P stocks, right?
So, you could just buy shares in one of those index funds and they’d do it for you. Or, they’d use other instruments—but always seeking to keep the value of their shares in lock step with the mar- ket index. The index goes up 20 percent; the mutual fund goes up 20 percent.”
He paused for a moment in case she had questions; then he pro- ceeded. “The funds I’m talking about do the same thing, in reverse.
They buy various investments for you that effectively sell short all of the S&P 500 or all of the Nasdaq 100 stocks, or whatever.”
“How do they do that?”
“I’ll give you more info on the mechanics later. For now, let’s talk about the results. Consider a fund that tracks the S&P 500 in reverse, for example. If the S&P goes down 10 percent, your fund shares are designed to go up10 percent. If the S&P goes down 20 percent, you should make 20 percent. The more the market falls, the more money you make.”
“Any others?”
“Yes. There’s also another one that does essentially the same thing for the Nasdaq 100 Index. If the Nasdaq 100 goes down 10 percent, your shares in the fund are designed to go up 10 percent.”
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“Sounds too good to be true.”
“It’s true all right but not always so good. If the market goes up, you lose. If the S&P rallies 20 percent and you have a fund that’s the reverse of the S&P, then your fund goes down 20 percent.
Meanwhile, though, at that point your grandfather’s shares would probably be going up. Maybe not dollar for dollar, but close.”
“I know what you mean,” she said with complete understand- ing. “It won’t be a perfectly balanced seesaw. The fulcrum may be off-center.”
She felt very content, and the adviser promised to give her the name and phone number of some of the reverse index funds, plus a set of instructions on exactly how much, where, and when to buy.
Linda breathed more easily. Until now, she had felt naked with- out some kind of protection. Now that she knew how to cover her- self, she could sleep nights. She vowed to act on it as soon as she got home.
“I’ll send you the details in a file attached to an e-mail,” he said.
“I’ll call it ‘Crash Protection.’ Check it out, and if you have any ques- tions, let me know. Gotta run now. I have a dentist appointment—”
“But wait!” she exclaimed before he hung up. “What about the investment that can turn $150 into $800? What about helping us recoup our losses quickly?”
“First, take care of your defense—crash protection. Then, as soon as you’ve got that licked, call me back in a couple of days.
Depending on your finances, you can go on the offense and aim for crash profits.”