Sunday, October 09, 2005



In last week’s Thursday post, the Author reported that all of the stock market indicators he follows were in negative territory. The post also shared the Author’s defensive portfolio which included two inverse funds, funds that move inversely, or the opposite direction, to a defined benchmark.

The two funds the Author employs operate inverse to the S&P 500 and to the NASDAQ 100. The two funds are:

Rydex Tempest S&P 500 Inverse Fund. (RYTPX). This particular fund seeks to return 200% inverse to the S&P 500, so if the S&P falls 2%, the RYDEX fund will increase by 4%. Year-to-date, this fund has returned 3.16% versus the S%P 500 falling 1.32%. Note this is not a perfect inverse correlation. Rydex Venture NASDAQ 100 Inverse Fund.(RYVNX). This particular fund seeks to return 200% inverse to the NASDAQ, so if the NASDAQ falls 3%, the fund will increase by 6%. Year-to-date, this fund has returned 9.18%, against a 4.02% fall in the NASDAQ index. Note this is not a perfect inverse correlation

There are other ways to “short” the market. The most common method is to simply sell ‘short” a stock or an ETF. Shorting a stock is a technique where a short seller enters a “short” order for a stock. The short seller will be required to buy the stock back later, hopefully at a lower price. Let’s say that a person believes that IDISALIE Inc. will fall from its current price of $75 per share. She contacts her broker and enters a short sale order. If IDISALIE falls to $65 per share, the short seller can buy IDISALIE at $65 and then she can sell it back on the short order at $75, netting a profit of $10 per share. (minus transaction costs.)

Sounds simple, right? Well, not quite that simple. Here are the risks and examples of the transaction costs:

1. Market Risk. This is the obvious one. If the short seller is wrong on the direction of the price and the stock goes up, the short seller will have to buy back (“cover”) her short sale and sell it at a loss. If IDISALIE rises to $85 per share and the short seller must sell at $75, the short seller loses $10 per share.

2. Lost Dividends. The short seller does not own the shares that she is short. The brokerage company puts up the shares and the owner of the shares still havs the rights to any dividends. So if IDISALIE issues any dividends while the seller is short, the short seller will not receive the dividends.

3. Margin Requirements. Short selllers must open margin accounts. Margin accounts are accounts where the brokerage company permits the account owner to buy shares on margin, or loan. The margin amount for a loan is inititally 50%, and if the value of stocks in an account fall below a stated % of the loan, the margin account holder will receive a “margin call” and will be required to deposit additional cash or the brokerage firm will sell shares in the account to cover the margin shortfall.

Not so simple after all. But short selling is an effective technique in the hands of a skilled investor. The Author does not currently sell short. However, there are other techniques to short a market. One is the inverse funds discussed above. Another is the purchase of puts, which will be discussed in an upcoming post or newlstter.


IMPORANT DISCLAIMER: This newsletter is offered for informational purposes only. Sources of information provided are believed to be reliable, but are not guaranteed to be complete or without error. Opinions and suggestions are provided with the understanding that readers acting on information contained herein assume all risks involved. The author may or may not buy or sell securities discussed in this newsletter.


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