The big short: How to bet on a share price fall
When three explosive devices rocked the team bus of German football giants Borussia Dortmund ahead of a crunch Champions League match, authorities assumed it was the latest in a string of jihadist attacks to shake Europe.
But in fact, it appears the attack was motivated not by the desire to sow terror but by the desire to make a quick buck on financial markets.
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German police say the suspected attacker, identified only as 28-year-old Sergej W., was hoping to profit from a drop in the football team’s share price by taking out 15,000 put options — with handsome winnings coming his way once Dortmund’s stock tanked.
How is this possible?
In fact, there are many ways to profit from a stock, or any financial asset, falling, some legal, others not.
– Profiting from a bomb –
If the police are right, the attacker engaged in a rather extreme form of “insider trading”, the use of privileged information not available to the public, to make a quick buck.
Normally, a textbook example of illegal insider trading would be board members selling, or shorting, stock in their company in the knowledge it is about to announce an unexpected loss.
The Dortmund attacker, police believe, went one step further by actually creating the event he hoped would send the German club’s shares plunging.
He took out 15,000 so-called put options on Dortmund’s listed shares, giving him the right to sell the stock later at a pre-determined level.
Throughout the whole process, he would not ever have actually owned any shares in Dortmund BVB shares.
Instead, he would simply sell the options, whose value would have sky-rocketed as a result of the shares plunging.
He hoped to pocket as much as 3.9 million euros ($4.2 million), Germany’s Bild newspaper reported.
It is not known how much the suspect paid for the 15,000 options.
But he allegedly took out a loan of tens of thousands of euros to buy them, making him — as analysts would put it — “highly leveraged.”
– Is this ‘short-selling’? –
Yes and no. Strictly speaking, short-selling is the sale of an asset, like a company share, you do not actually own in the hope of buying it back at a lower price later and pocketing the difference between the old price and the new one.
A traditional short sale would involve Investor A borrowing a stock from Investor B, for a fee, and selling it on the open market.
Investor A hopes that by the agreed time he needs to return the original stock to its owner, the market price will have fallen and the profit – minus the fee – is his.
If, however, Investor A gets it wrong and the market rises, he will still have to buy the stock back to give it back to Investor B, losing money in the process.
In that case, investor A got caught in a “short-squeeze” as he “covered his shorts”, in market parlance.
Famous short squeezes in financial history include the one which caught British “rogue trader” Nick Leeson, whose bad bets brought down Barings Bank in the 1990s.
Since then, “shorting” an asset or market has become a generic term describing the use of any financial instrument to place a wager on a price fall.
Futures, options, warrants and swaps are such instruments, but there are possible combinations between them, such as options on futures, or swaps on warrants.
It can get so complicated that even financial professionals lose the plot. Confused investors and regulators helped trigger the global financial crisis in 2007.
– Why bet on a share price falling? –
In fact, financial operators and companies do this all the time, usually to protect themselves against any fall in value of assets they own or need to buy, such as oil for energy needs, steel for construction or wheat for a food company.
In such cases, financial instruments known as derivatives act like an insurance policy — or hedge — against losses on the assets.
For example, a company owning large oil stocks stands to lose money if the world oil price falls. If the company takes out put options, giving it the right to sell oil at a pre-agreed price, it can cover the loss on its physical assets by cashing in on the options.
The cost of this protection is the price of the options themselves, just like the price of protecting the value of your home in the case of fire is the cost of the home insurance premium.
Among financial specialists, taking out such an insurance is called a “hedge”.
If the aim is not to protect the value of a real asset, but simply to place a bet on future price moves, it’s called “speculation”, but definitions are fluid.