Tuesday, March 18, 2008

A lesson in short selling stocks & more fun with Bear Stearns...


If I was a bit more active and a lot more forward thinking, there would've been a bundle of money to be made shorting Bear Stearns on Friday. At any point during the day.

(A quick intro on shorting: Shorting or "short selling" a stock is what empowers speculators to make money on a downward moving stock. Essentially, you borrow a share at the current market price and sell it to a buyer. You then promise to produce the share at a later time, ideally once the price has lowered. You're contractually obligated, however, to produce the share whether the price goes up or down.

Example: I sell you a share of Bear Stearns for $50. I don't actually own the share; I'm just "borrowing it" for the moment at that price to sell it. I'm contractually obligated now to pay for the share at some point or another, to cover the short. So, if the price drops to, say, $35, I can cover the short (fulfill my obligation to provide the actual share I already sold you) for $15 less than I sold it for. I sold you a share for $50 that I paid $35 for, but I had to wait for its price to go down to make any money on it.

There are plenty of issues with selling short. Least of all is that, instead of a typical long position in the market, in which you can ONLY lose what you put into it (excepting purchases on margin, where you borrow broker money) and your potential earnings are unlimited—the stock can continue to go up forever. In a short, I can sell you a share at $10. If the price of the stock rises to $100, I still need to cover that sale, except that I have to do so at the market price of $100. I'm out $90. Worse still, I can only earn a MAXIMUM of 100% of the stock's value, and that's only if it bottoms out completely to 0. I can't earn any more than that.

So I have exactly the opposite risk profile: potentially unlimited risk with limited earnings. (In actuality, the broker would issue a margin call once the price raised past a certain point to ensure that you covered the short before it reached a point you could no longer cover.)

That being said, I could've made a bundle selling short BSC. There was chatter of it bouncing back to life on Monday, with BSC moving their earnings call forward, but then the news broke that JPMorgan Chase was buying them for $2/share. From $30, the deal forced an open at $2/share.

So why did it end up closer to $4? People covering shorts, but only a small portion. A lot of people are viewing it as a cheap lottery ticket at this point. There's talk of another suitor coming along with a better offer. Consider: If you buy a 1,000 shares at $3, and another firm offers $10/share instead of the $2/share not yet approved by shareholders, you've made $7,000 effectively. Brilliant.

Why would shareholders or even the corporate governance of BSC reject the deal? The bailout facility set up on Friday covers them for 28 days. It's backed by the Fed. The 43 story building that they occupy on Madison Avenue in Manhattan is worth more than the $250M JPM offered to pay for the entire company AND all their assets. Effectively, this makes bankruptcy/complete liquidation a more attractive option for the shareholders. (If you can get more than $250M for the building alone, mark-to-market, then liquidating can provide more value for your shareholders if debt obligations are met properly.)

Either way, the market is taking a nasty hit. Hopefully things correct a bit tomorrow and hopefully the Fed let's failure fail when it's due.

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