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In today’s post, I will answer some stock market questions I have been asked recently. They may be basic for some but hopefully insightful and helpful for others.
First question, what does LONG and SHORT mean and how does it work? The easier of the two concepts, is long, and it simply means you own the asset (so own the stock) and therefore expect the asset to go up in value. Somewhat easy, so you are long, you own, 100 shares of Apple stock. Whereas short is basically the opposite, but a touch complicated, as it means you sell the asset (so sell the stock) and therefore expect the asset to go down in value. BUT here is the key detail…you don’t own the stock to sell…what? It means you don’t sell your 100 shares down to zero shares, that is defined as closing a long position. Going short literary means you have a negative position, so being short 100 shares of Apple stock, means you have a -100 position. How is that possible? You borrow 100 shares from someone who is long (someone who owns them) and you pay a fee to borrow them (very much like an interest rate) and you sell the position in the market. Therefore while you are short you must pay your borrow cost (the interest rate) to the stock lender and at some future date buy the shares back in the market and return them to the lender. Somewhat confusing, but no different to borrowing anything, at some point you need to return what you borrow and in this case you pay a borrow cost for the time you are borrowing it.
Second question, why is short interest so high? First, a quick definition on short interest, short interest is simply the percentage amount of shares which are currently being borrowed. What’s high short interest? High is typically a percentage of 20% or more of the shares available for trading (knowns as free float), so 30% or 40% is really high and at reasonable risk of a short squeeze so 50% and above is really extreme. That being said, another, and perhaps more important and appropriate, way to reference high short interest is a based on the number of days-to-cover. Meaning…how many days would it take for the short sellers to cover the amount of borrowed shares based on the average volume of shares traded each day. So if an event occurred causing short sellers to all want to cover their shorts, how many days, based on average trading volume, would it take? Typically anywhere above 5 days is considered squeezy (at risk of a short squeeze) and the risk rises very quickly above 5 days, so anywhere close to 10 days is very squeezy. At the lower end, even 10% short interest can be considered decent pending the size of the stock and amount traded per day. As another reference, both the average and median short interest for all the S&P500 constituents, the biggest stocks in the US, is around 2%, and at the extreme high end only three stocks in the S&P500 have short interest of 10-12%, so overall quite low by comparison. Back to the question, why is short interest so high? Short interest usually signals a strong negative, or bearish, sentiment in that stock. As being short means you expect the value of the asset to decline. So the higher the percentage the more negative the sentiment. This often means investors consider the current valuation as too high, the sector is in decline and/or a significant negative event is expected soon (for example, weak earnings, suspicion of fraud, lawsuits, regulation changes, competitor success, pivotal product failure etc. etc.). If you want to read my post or watch my video on some lesser-known reasons why investors are short, then click here.
Third question, what is a short squeeze? Simply put, if a stock starts rising then any short holders (meaning, investors that will make money if the stock goes down) will start to get squeezed (or pressured) into buying back their short position, as it is now moving away from them. Now that’s the rather simple definition, but in reality it typically only occurs in an extreme way when the stock moves significantly higher (say 20% or much more) and especially if linked to good news, thus suggesting the stock will likely continue to go higher AND there is a significant short position (by one or many investors), typically defined as short interest being above 20-30% or having 5 or more days average trading volume to cover the entire short position. So what happens is the stock is going higher, investors that are short are expecting it to go lower so they are losing money because the opposite is happening. The shorts start to buy back their losing short trade and that makes the stock go higher again so other short holders start to buy and here goes the short squeeze as it becomes like many people trying to squeeze through a small door – a panic and it can’t happen! Some of the most famous squeezes in history are Volkswagen back in 2008. Where Volkswagen went up 5-fold over two days from 200 Euros to just over 1,000 Euros, after already going up 4-fold over the preceding two years, which is why investors were short. So yes the car company then briefly became the most valuable company in the world before crashing back by almost the same amount over the following days. Obviously in recent times, by far the most famous is GameStop in 2021 during COVID where short interest had exceeded 100% of available share which is utterly absurd and GME shot up over 25 times in a month and crushed a big hedge fund Melvin Capital. Then AMC Networks immediately followed but to a lesser extent. So good to be aware of these rare but extreme events!
Potentially a better way to short a stock is to buy a put option…which is a great segway into…the fourth question, what is a put option? A put option is a financial derivative contract that provides the holder the OPTION (not the obligation) to SELL (or put) an asset (typically a stock) at a predetermined price within a specified period, or more commonly, on the expiration date. So to illustrate this with one of the main use cases for most investors, is if you own a stock and you wish to take out insurance for a period of time against the stock going down below a set price you can buy a put option. If the stock goes down during that period you have the option to exercise your option and sell your stock at the agreed price. Yay! Nice idea right. Another main use case is you can buy a put option as a way of expressing a negative view and artificially going short a stock, for a fraction of the price by just paying the option price. Thereby meaning you will have the option to sell the stock at the predetermined price, say today’s price, during the option period, say the next two months, if the stock goes below the agreed price. Then you make money when the stock goes down you buy the stock at the new lower price and then use your option to sell the stock at the previously agreed higher price. Yay! Another nice idea right. So that’s the basics of a put option.
Fifth question, what is a call option? A call option is a financial derivative contract that provides the holder the OPTION (not the obligation) to BUY (or call) an asset (typically a stock) at a predetermined price within a specified period, or more commonly, on the expiration date. So to illustrate this with one of the main use cases for most investors, you wish to own a stock because you think it will go up in value. Sadly you do not have sufficient capital available to buy 100 shares so instead you buy a call option. This will give you the same exposure for a fraction of the price. If the stock goes up as expected, you can exercise your option and buy the stock at the previously agreed lower price BUT the key issue being you can only buy during the predetermined period. Therefore, if you timing is off and the stock goes up after your option expires then you lose the cost of the option. Another common use case for call options is income enhancement. What does this mean? This means if you own a stock, say 100 shares in Apple. At the moment many people are suggesting Apple is overvalued, the likes of Warren Buffett has sold a large amount of his stake, so maybe you want to hold your stock but are worried it won’t go up much over the coming months. You can sell a call option and receive that option premium as income immediately. Then as long as the stock does not go up above the agreed option price during the option period then there is nothing further for you to do and you have just enhanced your income in a sideways moving stock. You can then sell an option again each week or month you have the same view. It is generally a good idea to avoid doing this in months where significant news may be revealed, like the months where earnings will be announced of other big event months. So that’s the basics of a call option.
Sixth question for today, is the good news priced in? And why making a lot of profit doesn’t necessarily mean much? This is quite a fun question that many new investors do not quite understand. Logically we all know stocks are companies. Companies are supposed to make a profit and ideally build better products and services to their competitors. So then we have amazing companies that tick all these boxes yet the stock still goes sideways or worse goes down. Why is that? Well sometimes all that great future story, rockstar products, market domination, etc. is already factored into the current price of the stock. Meaning it is rarely the news we know about that moves a stock, as once the news is known then the market has a chance to include that news into the current stock price. So typically only new news moves a stock. This also coincides with expectations. Meaning if expectations are for profit to go up by 20% and profit instead goes up by 15% then in isolation it sounds amazing. The company has grown profits by 15% but the market was expecting 20% so it’s actually a disappointment. So as investors we need to know whether the news we are thinking about is already factored into the stock price and also how does the news compare to expectations of that news. This is sometimes hard to do but a real fundamental key to understanding stock values and stock moves.
Seventh question, why does everyone quote PE multiples and use this other language for stocks? Well, everything in the stock market is a relative comparison. Meaning how can we easily compare an auto company like Ford against a beverage company like Coca-Cola? We do this by creating standardised valuation metrics, because investors need a way to be able to decide between investing in which stock. So we need to compare them as fairly as possible and the PE multiple and other metrics like that help investors compare stocks to each other. Otherwise it might seem as simple as buying Apple which makes about $100 billion profit each year so clearly that’s an insane amount of profit each year but it’s currently valued at $3.7 trillion so therefore 37 years of future earnings is currently priced into the stock’s value.
Eighth question, why do State Street, Blackrock, Vanguard, JPMorgan have such large ownership percentages in so many stocks? This is another fun question, big asset managers and banks often have positions in stocks for many different reasons and it is rarely simply because they simply think that stock will go up in value. So for any new investor looking at current holders (meaning owners) list they can kind of be misled to think all these big, potentially smart, asset managers think that stock will go up in value. In reality, it is typically simply because the asset manager is providing a product which includes that stock and many investors own that product. So the asset manager may have no view at all positive or negative and you can think of it as they are simply a manufacturer of products and the stocks are the components which make up those products. These can be ETFs or other derivatives. In the past 10-20 years or so the biggest reason for this is the proliferation and acceptance of ETFs and index trackers. There are trillions of dollars invested in these products today and there are just a few major players providing the majority of ETFs, that is Blackrock, Vanguard and State Street. That’s why these three are typically always listed on any holders list. And in a similar way for many of the big banks, they offer custodian services to smaller firms (meaning they hold stocks on behalf of others) and therefore show up as a large holder of a stock but may not have a position themselves. So knowing this helps you discount various holders as having expressed a view in a particular stock. Either adding to it or reducing it may not be a choice of that asset manager. So you are often better off referring to the insider holdings (CEO, CFO, etc.) but even then they may simply be wanting to buy a new house or pay for something else which is why they are selling some shares. Many CEOs make official statements upfront about when they will sell stock so investors know in advance and do not assume it is because they think the stock will be going down soon.
Ninth and final question for today, why do I say share price is largely irrelevant? This is another concept many new investors do not quite understand. Share price is totally irrelevant in that it is simply the price derived by slicing the company into a random number of pieces, the number of shares. So for example, if the company was sliced into one million shares and was priced at $100 it’s total value is $100M. Whereas if it was sliced into two million pieces the price is halved to $50 but the total value is still $100M and therefore the company value is identical. So the true value is actually defined as the market capitalization – the stock market word for company value… So stock price is simply market capitalization (total company value) divided by the number of shares issued, which is a totally arbitrary and kind of made-up number. As…over time, the number of shares issued changes with events like stock splits or reverse stock splits; rights issues – meaning the company sells more stock; …stock options paid to company directors and also stock buybacks by the company. All of these various events change the total number of outstanding shares. All of these events must be publicly disclosed in the company’s financial statements, typically ahead of time so investors are aware of them. So when you hear a stock is priced at $5,000 and another stock is priced at $50, just know the $50 stock could be a much bigger and more valuable company as what actually matters is the number of shares multiplied by the stock price and therefore company value – referred to as market capitalization. …Stock price is therefore irrelevant and can be changed by the company and often is substantially changed every 5-10 years by doing a stock split, as so many investors do not understand this concept that price is irrelevant and they get intimidated by stocks with high individual share prices $1,000 or more and then management do a stock split to bring the price back closer to $100, which is often seen as the sweet spot for investor participation. So they simply say if you own 10 shares today at $1,000 boom instantly now you own 100 shares at $100. Literally no difference except this arbitrary made up number called share price.
That is all for today, a bit of a Q&A session, hopefully interesting. So which question was most interesting for you? And which question would you like answered in a future post/video? Please drop them in the comments below.
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