Setting short-selling straight; or, "But who let you short that?"

You might not be aware, but I've been short-selling some cryptocurrencies. (I would have said "been making money short-selling cryptocurrencies", but ...)

Often people ask some from of, "oh wow, what broker lets you do that?" It's actually an interesting misunderstanding, in that it misses a key insight:

You can short-sell any time you have a debt denominated in that asset.

At that point, you are short the asset. You benefit from anything that makes that asset easier to obtain, and thus extinguish your debt.

In the decentralized finance world, there are platforms (in my case, Compound.finance) that let you deposit some crypto asset A, and borrow some other crypto asset B. Once you do so, and sell B, you are now short-selling B!

The concept applies more generally too: for example, if you owe your friend the favor of helping them move, then you are "short moving services" (because anything that makes moving services cheap, also makes your debt easier to service, at least because you have the option to satisfying by paying a service rather than doing it yourself).

Also, if you borrow US dollars, and spend them, you are "shorting the dollar", although it's usually not talked about in these terms. (You hold a debt denominated in dollars, after having "sold" them for something else, which we generally refer to as "buying".) Although, there was an interesting case where people would borrow USDC (a crypto dollar substitute) and then find out they could be bought back for less than a dollar during the Silicon Valley Bank collapse. Thus making them "accidental short-sellers"!

Setting professional Bitcoin traders straight

It's bothered me how a lot of the people posting criticisms of Bitcoin manage to get their facts wrong. But apparently, even people with a giant financial incentive to get them right ... still get them wrong.

At this point, I think it's only fair to post disclosures: I hold a portfolio that is long Bitcoin.

Anyway, I saw an (unintentionally) funny post on the blog at the Financial Times's Alphaville.

According to the post, a trader found out about Bitcoin and, based on technical analysis (chart-reading), he judged that Bitcoin was in a bubble and wanted to short. Okay, fair enough, we have someone entering the marketplace and tendering his judgment through the price system. So, you would think he would do his diligence and have some clue about what he was trading before trying to make a big bet on it, right?

Well ... I'll just quote him:

I've done some research, read through the concept [of Bitcoin] and quickly got to the point where I felt that the only reasonable position would be to short such a bull market. [...]

... so I tried to contact Adam at Bitcoin.org to ask if they intended to implement a possibility to short the BTC. Due to the overload in mails they must have had, I never got an answer on my inquiry.

See the rookie mistake there? (If you don't, that's okay. After all, you weren't about to bet $50,000 on your incomplete understanding.) Bitcoin is a open source project that uses protocol that implements a currency. That's all it does: make sure that the ability to use Bitcoins, per its own published protocols, works. The people at Bitcoin.org -- the development team and volunteers updating the wiki -- don't run exchanges (like Mt. Gox) where you can convert bitcoins into dollars. Those are independently run by people who use Bitcoin.

In short, MT. GOX IS NOT THE SAME AS BITCOIN!

So, this trader just did the equivalent of "trying to contact" the U.S. Mint to "ask if they intended to implement a possibility to short the US dollar", and then speculating that they must have been unable to answer his inquiry "due to the overload in mails they must have had" in this oh-so-heated market.

No, bright guy, they probably just didn't have time to talk to someone who didn't even understand the difference between a Bitcoin exchange (like Mt. Gox) and the Bitcoin project. Just like, I suppose, the U.S. Mint doesn't respond to inquiries misdirected people who ask them when they can short the dollar. (Note: it's not shorting the US dollar that's necessary misdirected, but asking the U.S. Mint about it.)

The blogger, Tracy Alloway, didn't seem to do any better. He added:

We like the currency trader’s rather more nuanced take ...

Nuanced? Yikes. I just hope traders -- and financial journalists -- have a better understanding of their normal playground than they do about Bitcoin.

So, what economic idea *is* hard to popularize?

In my last post, I ridiculed the idea that the Arrow Impossibility Theorem is somehow underappreciated. Do I have an answer to Tyler Cowen's request for a hard-to-popularize result in economics, then?

Yes, I do: the Put-Call Parity Theorem, and I gave my attempt at explaining it herea while back. It's important because it reminds us that markets can phrase the same transaction in several different ways, making it hard to ban particular ones. This forces you to think carefully about exactly what kind of transaction you want to prohibit when you say that e.g. options trading, fractional reserve banking, etc. should be illegal.

A non-conspiratorial explanation of oil's price history

As you're probably aware, oil this year surged to $147 a barrel and then fell to, as of today, about $40 -- over a 2/3 drop in less than six months. And its peak was over a 100% increase from the previous year. With a lot of the decline shortly before the election, this roller-coaster ride has prompted quite a lot of conspiracy theories.

Well, recently on another (private) forum, I summarized the significant reasons why oil acted like that, without reference to any conspiracy. I'll repeat it here:

1) China was buying a lot of oil and stockpiling it. Unlike the general "growth in emerging markets", this actually came as a surprise to a lot of speculators, which is why it was such a fast rise instead of a gradual one since 2000. China was doing this in order to burn less coal and make the air cleaner for the Olympics. Now that that's over, a significant source of demand is gone.

2) Because of the credit crunch, speculators were significantly less able to borrow and bid up the price of oil. Once it hit, they had to significantly unwind their positions.

(Now, I'm all for the right of people to make speculative purchases; however, what we had there was *far* from a free market. For one thing, the government's bailing out of banks that had hedge funds doing the speculating, eliminated the strong negative downside to hype-based, stupid speculation. Also, a lot of the *naked* shorts and longs were very corrupt where if one party lost money, the brokerage would act like it can't find the original contract and try to reverse the sale. Things like this artificially amplified the price premium due to hype [as opposed to rational estimations of future developments] and crowded out wiser investors.)

3) The global economic downturn significantly revised investors' estimates of future oil demand.

4) The president's, and then congress's, termination of the ban on offshore drilling also significantly changed expectations about future oil availability. These helped prod oil down.

GM outdoes itself again

Finally, mainstream investors are wising up to the completely ridiculous assumptions you have to make to justify investing in General Motors. A Deutsche Bank analyst has finally set a target price of GM stock at $0. But here's what will really refuel your ROFLcopter:

GM bonds maturing in less than 3 years now yield SEVENTY-****ING-FIVE PERCENT!!!!!!

(Scroll down to "Last Sale" at the bottom. Thanks to rluser at Marginal revolution for pointing me to a free bond price site.)

The time it takes for investors to Set Things Straight is way too long.

Yes I'm still around

And, inspired from a different context, I drew this comic about the current credit crisis corruption.

Well, I guess the crisis is over now

Warren Buffett is buying into Goldman Sachs, on very favorable terms -- 10% "perpetual preferred shares" plus the right to buy the stock cheaper than it currently is. This will signal that Goldman Sachs is sound, which will then provide a basis for trusting one party, which can then establish a basis for trusting their counterparties, until everyone can trust each other and the crisis can be averted -- for now -- long enough for me to dump the rest of my US shares on idiots -- without a massive government bailout. Hooray!

Alright, maybe a bit too optimistic.

Yeah, I know some of you are waiting for me to joke about how "Buffett has gold man-sacks" ... not gonna happen. This is a family blog. Hi Mom! :-)

Time to review the Put-Call Parity Theorem

With the SEC's recent move to ban short-selling of politically-important securities, it's time to review the beautiful Put-Call Parity Theorem to understand the futility of doing so. Here's my phrasing and elegant explanation of it:

B(t,$X) = S + P(t,$X) - C(t,$X)

B is the value of a bond maturing at time t for $X.
S is the value of some asset, it doesn't matter which.
P is the value of right to sell the above asset at time t for $X. (In financial terminology, a put option dated at t with a strike price of $X.)
C is the value of the right to buy the above asset at time for $X. (In financial terminology, a call option dated at t with a strike price of $X.)

In this sign convention, negative means the counterparty to the security, so for example, if the bond term were negative, it would refer to the value to the borrower on that loan, while the negative call option refers to the person having the obligation to sell at $X to the call owner.

So, the equation means that, for some time t and some money amount $X, a bond maturing at t for $X is equal in value to some asset, plus the right to sell the asset at time t for $X, plus the obligation to sell it at time t for $X.

Proof: the left-hand side of the equation is worth $X at time t. The right-hand side is also worth $X at time t because if S were worth less than $X, the holder of the put could sell it for $X, while if it were worth more, the holder of the call could buy it for less. Q.E.D.

Note that if you find a case where the two sides are not equal, you profit through arbitrage buy buying the cheaper side and selling the more expensive side. In a discussion a few years ago, Gene Callahan claimed this was how he made money. You also might be interested to know that this theorem -- though of course it wasn't referred to in such terms -- was historically used to circumvent financial regulations such as bans on usury, since through clever rearrangement of the equation you can recreate any financial security. Here is a neat paper on that history.

Anyway, the point to remember is, let's say I want to take a short position in a stock. That would be represented by "-S" in the above equation. But let's say you found out that was banned! No problem. Just rearrange the equation! With the function arguments suppressed:

-S = -B + P - C

So, borrow money, buy a put, and write (sell) a call. Problem solved! (Except for the cost of fending off the SEC guy giving you an intimidating stare, of course.)

Arnold Kling asks for crisis joke, Silas delivers

In a great post on the current financial market issues, Arnold Kling says:

The guys who got it right on low-down-payment mortgage are the Freddie Mac folks that [ousted Freddie Mac CEO Richard] Syron ignored. (There has got to be a siren-Syron pun in their somewhere, but I'm missing it.)

Oh, that's easy: "In America, it's dangerous for you to ignore a siren. In Soviet Amerika, it's dangerous for Syron to ignore YOU."

I can't post it in his comments section for obvious reasons. If one of you would point him here, that would be rockin'.

Play-money arbitrage opportunity

Now this is weird: there's a play money contract on Intrade on whether Fannie Mae common stock will be under $1 per share on Jan 20, 2009. The market there is placing about a 14% chance of it happening.

But then when we look over at financial markets, we see puts on Fannie (the right to sell Fannie shares) trading at $1.60 for a stike price of $2.50 dated right near that. Do the math. To make a profit on the right to sell Fannie at $2.50 when you pay $1.60 for it, the shares must be under $1 at that time, so the financial markets are placing -- at least if my understanding of options is in order -- over a 100% chance on that same event.

If there were a real-money contract on this, it would be a nice arbitrage opportunity. I'll let you figure out what the trades would have to be.

As for me, I snagged 325 contracts, average price $1.21 (payoff is $10/contract if the event happens). All in play money, keep in mind.

UPDATE: Okay, my understanding of options isn't in order. But the point stands: the market places a "very high" chance of Fannie shares being under a dollar by innauguration day, while the play money prediction markets place a "pretty low" chance.

How to get Silas interested in Barbie dolls

Because of that whole heterosexuality[1] thing, I've never been interested in Barbie dolls. But I have been interested in the path of American industry and innovation, and where that intersects with Barbie dolls, you've got me hooked.

The big story today is that Mattel, the maker of Barbie, won a smaller-than-expected judgment against MGA, maker of the rival Bratz dolls.

It's a sad story, MGA having to pay damages, but becoming all too common. As the author of the story, Charles Payne, puts it:

I write about the deteriorating competitive nature of American businesses... Mattel makes for a great case study in corporate compliancy and hubris. ... At some point, a bell has got to ring. Our largest businesses have to be willing to truly innovate, to find genuinely new ways to get things done. Wall Street was greedy and complacent, and couldn't back away from the trough of easy money.

What happened in this particular case was that a designer at Mattel came up with an idea for a new kind of doll. Mattel didn't like it, so he went to work for another company that was actually competent enough to see the merit therein, MGA. So then Mattel, seeing their stupidity play out in the Bratz dolls' success, sued on the grounds that well, since the designer developed it under them, some contract gives Mattel rights in it. Except that -- oops -- they couldn't substantiate a case against the designer, and dropped it.

So Mattel's attitude basically comes down to: we deserve all of the reward and none of the risk, and we'll sue you rather than produce innovative products. (For what it's worth, I volunteer at an intermediate school [4th-6th grade, 9-13 year olds], and I've only seen Bratz-themed products, never Barbie.) And keep in mind, it takes quite a bit of innovation and guts to compete with Barbie in the doll market, one in which the buyers want to have what all the other buyers already have. Let alone compete well!

Payne is right: more and more often we see such clowns in charge of big corporations. At American car companies who lose boatloads of money and are valued at a sliver of their foreign competition. ("Honda is an engineering company, GM is a marketing company.") At financial companies that made billions in bad loans based on questionable models. The list goes on and on. When will America get its competitive edge back?

I don't know, but in the mean time, I'll make sure my money with those who deserve it. Today, I finally took the plunge and cast my vote of no confidence in the future of American business (and inability to pay back debts) by shifting my S&P 500 investments to an international stock mutual fund.

[1] Not that the opposite would constitute a valid basis for criticism.

So why aren't you shorting GM, liar?

With all my doomsaying about GM, all my warnings about the emptiness of their warranties, shouldn't I be taking action based on this certainty? Well, good point. In strategizing about the implications of my pessimism for my next portfolio decisions, I forgot to include GM, mainly because I associate "short-selling" with "risking being screwed by a dead cat bounce.

But you don't have to do it that way. Instead, I can just buy some long-term, far-out-of-the-money puts. Check out this list for GM options expiring in January '08. My eyes are on the $2.50. Bonus: I can dump the options if some news temporarily makes the value surge.

Another bonus from using this method: No ill will from my brother :-P

Profit opportunities for Silas: oil and GM

Back to the two most frequently discussed topics on this blog.

First, let's talk about oil. Though by the end of the day, this may change, the spot price temporarily went below $120. Time to strike when the iron is hot? If I bought the double-oil-return ETF discussed last week (DXO), and it were to return to its previous high, that would be a nice 46% return. (Btw, y'all oil options traders are accurately factoring oil's massive volatility into the implied volatility term in your options pricing, right? Okay, just checking.)

Second, let's talk about GM. I have been claiming, since studying GM's history back in '05, that a bankruptcy was near, and so my brother and I have been discussing an even odds bet that would pay off if bankruptcy happened, or some other even of equivalent lameness, such as: defaulting on any bond, PBGC takeover of legacy obligations, refusal to pay legacy obligations, or government bailout. I'm not sure if we ever agreed to a bet value and a time frame, but a few weeks ago I emailed my brother some news about GM, and he reiterated his position that there would be no bankruptcy, so if we haven't agreed to something, I could still get an even odds bet in.

While I did post some news about GM's lameness last Friday, I have some more. Here's a Reuter's article detailing GM's rising defaulting insurance premiums and falling bond prices. Right now, you must pay 47% of the amount insured, so $47 to insure $100 of debt. And you know what? Most people, facing that much to insure something, just don't buy it, and bear the risk themselves. Heck, that's what hospitals do for their liability insurance, which can get that high.

It also lists the prices of GM bonds, but strangely, Reuters prefers to list the cents on the dollar (click on "first vlog post") price, and never the yields, neither the current yield, nor the yield to maturiy. But my own calculations give about 12% current yields for short term bonds and 18% for long term bonds based on the numbers there

But strangely, the prices of GM bonds that I found on my Scottrade account gave a different story. (I can't seem to find a free no-hassle source for bond prices I can link.) I don't remember the current yield, but it listed GM bonds maturing in December of this year as trading with 9.3% yield-to-maturity, and bonds maturing in 2011 -- 3 years from now! -- as paying, and make sure you're sitting down, 29% YtM. Twenty-nine percent!!! There are banana republics right now that pay lower interest on their debt! There are reckless shoppers right now with lower credit card interest rates!

I just don't get no respect -- about prediction markets

You've heard of prediction markets like InTrade, right? Basically, like gambling, but on real-world non-sporting events, so as to aggregate the market's knowledge about the future, and reward those who know and "share" their knowledge. GMU professor Robin Hanson did a lot of the work in formulating them and encouraging their development.

Now, if only he could recognize the insights of others.

Back in January, his blog posted Peter McCluskey's idea to use prediction markets to unveil another kind of information: how a presidential candidate impacts prices in financial markets, such as oil futures, government bond yields, etc. And how does he propose to do it? The prediction market would host a bet on a measure of their correlation. Which measure? The (modified) ratio of how much the candidate's contract price (i.e. market's estimate of chances of winning) changes to how much the financial security's price changes ... on election day. ( a so-called "shock response future")

Great idea, I thought -- but wrong measure. Election day by itself is unreliable. After all, more than just the election will influence the financial security's price that day. Plus, the market has already largely incorporated the influence of whoever's expected to win except in very close races. Worse, it's way too easy to manipulate: want to "prove" Democrats make interest rates low? Eat a loss by buying treasuries at an absurd price at a critical time, just like that gentleman who ate a loss on oil just to be the first to buy oil at $100/barrel.

So, I told them exactly that and suggested a better measure: don't just look at election day: measure the correlation all the way up through election season. Find how often e.g. oil's price goes up as a Democrat's chances of winning go up, and look at how closely they track each other, each day or week. That's far more robust against manipulation, and extracts much more relevant information. Yet arguing the point with McCluskey and Hanson was like talking to a wall: they were responding to distortions of my idea that seemed to have only a partial understanding of it. For example, Hanson argued that no, no, no, silly: we need a metric available before the election ... which mine is. No no no, Hanson really meant something completely different from what he actually said.

Well, McCluskey went ahead and launched his inferior futures market on the InTrade site. And, just two days ago, Hal Finney launched a celebration of those futures markets' "success" with a blog post that developed the implications of the prices those contracts traded at. Major posters gave McCluskey a good pat on the back.

(Re-)Enter Silas.

I remarked that I had suggested a better metric on the earlier thread, and asked if the people there would be more interested in a futures market for my idea. A few were, and one major poster reluctantly admitted that I had a better metric and deserved acknowledgement.

A major implication of my criticism, let's not forget, was that too many other forces impact a financial security's price on any given day (including election day) and the market has already incorporated most of the impact of whose expected to win (or, of course, Senate/House elections could impact as well...). This means we should expect the market McCluskey made to be rather useless -- traders will view the correlation on just election day, as effectively random -- a 50/50 chance either way. And what do we see? Yep: "49.9-50.1" -- or an implied 50/50 chance.

As Finney sheepishly avers: "These values are so close to the 50% mark that it appears that the markets do not expect any significant movement in oil prices or interest rates on election day, that can be attributed to developing information about which party will win. As critics have noted, this could be because they don't see much effect of political parties on these values, or else because they expect that the election day results will be a foregone conclusion and there will be no surprises in that regard."

Or, reading between the lines, despite all the kudos we're giving McCluskey, he created a market that provides completely useless information, even though I told him long before how to make it useful.

Hanson tried to save face by replying again, so I had to gently correct his misguided attempt to trivialize my insights. Okay, not so gentle -- but when you're so wrong, and for such wrong reasons, why do you expect a huge amount of respect right back? Especially when you're the one always complaining about how stupid it is that you have to gain social status just to get people to listent to your good ideas!

What's especially interesting is when Hanson alleges that, duh, of course he had considered my idea. It's just an obvious variation! And yeah, in a way it kind of is. But judge his attempts at response for yourself -- are those the remarks of someone who has considered the idea and rejected it? Would he constantly respond to misunderstandings of the idea? Make so many misstatements about it? Not notice his true complaints applying to his own idea?

Furthermore, even if he does think the election day correlation is so much more important, why didn't he suggest the further "obvious" variation of simply increasing election day's weighting in the correlation, which would still retain the measure's robustness against noise and manipulation?

His latest response to my damaging criticisms? Silence. A wise, wise choice.

Will they go ahead and belatedly implement my idea before I go ahead myself with it? It will be very, very funny when they do.

And to *double* the stakes on oil ...

Well, a little googling got me a blog post from Pacific Park Financial that lists leveraged oil ETFs, which they warn as being "not meant for buying-n-holding; rather, they are meant for making a calculated bet and exiting when you've reached your profit target or stop-loss." (emphasis mine)

A calculated bet? Oh, we can do that.

The one I'd be interested in here is DXO, which makes a leveraged long bet on oil, attempting to replicate 2x the gain/loss of oil. Unfortunately, it hasn't been around long (just over a month), but this chart, which I hope you can see okay, shows it neatly getting double the return on the security OIL.

If oil (no caps) merely returns to what it was three weeks ago, that's a nice 30% return for me. But of course, the whole point of the bet was that fate doesn't work like that, and my bad luck will thus drop oil's price even more forcefully.

Perhaps with a li'l work, I can find a different oil ETF that amplifies the return, but has a longer history. Or, switch gears entirely and try to use my luck to bring down an entire commodity index, rather than just oil.

Stay tuned. (archaic expression from they days of radio when they wanted you not to tune to a different station)

How to invest in expensive oil?

While most of you still don't think it's a good idea, or will work as intended, for me to go long on oil in the hopes that my luck will bring prices down ... I still want to know the best way to do it in the case that I later decide that I want to.

First, the constraints:

I have a Scottrade (brokerage) account, which lets me buy stocks (including ETFs) and bonds. It is not, however, authorized to trade in options (or futures or forwards or shortselling), which would take a few weeks to authorize (I have to send in signed paperwork). So the first, question is, should I go ahead and authorize that, just to be ready?

As for money, the account has about $3200 in an ETF (ticker PRFZ) and under $100 in cash currently. I can add to it from cash reserves or liquidating other investments (including the PRFZ). You can safely assume I can buy $10,000 worth of securities.

Next, I would like to keep this simple, so I only want to invest in only one security -- so nothing like "buy this one and short this other ...". (It is of course acceptable to suggest a single security that *itself* employs such a strategy.) I want the best one stock whose returns track the standard quoted price of a barrel of oil, and yes, that means include any dividends, which makes it that harder to look up with the free investment tools available.

So, the question: which security to buy? An energy sector equity ETF? A natural resources sector equity ETF? A commodities index ETF? An ETF that employs some leveraged strategy that amplifies size of oil price movements? The bonds of an oil-rich developing country? Or, take the plunge and authorize buying calls on oil?

Suggestions are welcome!