Travel down the "Imaginary
River"
Never row a boat where the oars are fixed in place and one them is missing.
You are now about to travel down the Imaginary River and you will
need to select a boat for use on your journey. There are only two
boats available, each for the same price for the same amount of time.
You carefully look them over and discover that both boats have their
oars bolted in place so that one cannot pick up the oar on the port
(left) side and move it to the starboard (right). On closer
inspection, you discover the first boat has both oars bolted down and
intact. The second boat, however, is missing one oar. There are no
replacement oars available and the boat is for rent "as is".
Which boat would you rent? Can you imagine trying to row down the
Imaginary River in a boat with fixed oars and only one available for
rowing? How long would it take you to run ashore on the nearest shoal
of land?
It rains a lot in Seattle. On days when it does not rain, it is often
cloudy. Let's assume for the sake of a hypothetical that the sun
shines in Seattle on 182 days of every year, that no sun is to be
seen on 182 days per year and that 1 day of each year is a mystery.
Can I can interest you in a little game. The game is this. You are to
make a $1000 bet as to what the weather will be like in Seattle
tomorrow. You must make this same bet every day for the next 365
days. There is only one rule to this game. You must always bet
that tomorrow will bring sunshine. Would this be a fun game to play?
How much money would you win where the statistics were 182/182/1? Who
would want to play this game every day for the next 365 days?
Don't buy boats with only one oar. Don't be forced to bet that the
sun will shine every day in Seattle.
Let's suppose that you buy 100 shares of stock in a company called
"The Imaginary River" corporation. You buy your shares at
$10 each and you bet the price will rise. Somewhat later, you buy
more shares at $100 each and still you bet that the price will rise.
Eventually you buy more shares at $1,000 each, betting again on
higher prices. Finally, at $10,000 a share, you make your final
purchase betting on still higher prices. What are you doing? Are you
always betting that prices will continue to advance? Isn't this like
buying a boat with one oar or every day betting on sunshine in
Seattle? Do you really want to find yourself in such a situation?
Rule Number 3. To succeed in stocks, bonds, futures or options,
you need to be able to bet once in a while that prices will go down.
If you can only bet that prices will go up, you are like an investor
in a boat with only one oar and that oar being fixed in place.
If you own stocks or mutual funds or equities (you can be said to be "long")
you can simply sell your ownership when you feel prices will decline
and no longer be long. This is what most people do most of the time
when they do not wish to weather a price decline.
When trading futures contracts, however, one does not have to be
always "long" a market. One can actually be "short".
The opportunity to be "short" a market applies to stocks
and equities too but it is not as commonly used in those markets as
it is in futures. In the futures market everyone is either
"long" or "short". And this means everyone.
Let's suppose that it is now January of 2000 and the price of wheat
for delivery in December of 2000 is $3 a bushel. Now assume that you
are interested in making some money in the wheat market and here are
your alternatives as to how to proceed,
-
The only bet you can make is that wheat prices will rise - you are
like the investor with the one oar boat or the person who is betting
on sunshine in Seattle tomorrow.
-
You can bet that wheat prices will rise - or you can bet that wheat
prices will decline.
Which alternative would you select? Maybe when wheat is priced at $3
a bushel, you don't mind selecting the first choice. But what if
wheat was $10 a bushel, or $20 a bushel, or $100 a bushel. Would you
want to be so restricted that you could only bet that wheat prices
would continue to rise, or would you want to be able to bet that
maybe wheat price might fall. Would you like to be in a boat with two
oars or a boat with only one?
In the futures and options markets, (and even in stocks, though it
is less commonly done), you are always allowed to bet that prices
will decline. This is the concept known as "being short" a market.
Isn't this exciting. To know that there is a market where you can bet
prices might decline? Isn't it nice to have two oars in your boat so
you can row to either shore or perhaps simply stay in the middle of
the stream? How does the concept of going "short" work?
Let's start with a futures contract. In the futures market, not only
can you bet that prices will go up or down, but there is no futures
contract unless one entity is betting that prices will go up (said
to be long) and another entity is betting that prices will go
down (said to be short). In futures, not only can anyone bet
either side of the market, go "long" or "short",
but there is no futures contract unless both sides of the market are
bet by someone.
You want to buy crude oil futures and bet that prices will rise. You
simply open a futures account with appropriate margin, talk to your
futures broker, decide upon a time period when you think that this
will happen, and tell your broker to "buy you one contract of
crude oil at $25 a barrel for delivery at the month you have
selected". If you are able to buy crude oil at the price you
have bid, you will said to be "long" crude oil at $25
a barrel.
But suppose you think crude oil at $25 a barrel is too high and you
want to bet that prices will decline. You do everything the same as
you did above, you open a futures account, talk to your broker,
select a time period during which you feel prices will decline except
that now you tell your broker to "sell one contract of
crude oil at $25 a barrel for delivery at the month you have
selected". If you are able to sell crude oil at the price you
have offered it, you will be said to be 'short' crude oil at
$25 a barrel.
How do you make money if you are "long crude oil" and how
do you make money if you are "short crude oil", which can
be translated into the question of how do you make money if you are
long wheat or gold or stocks and how do you make money if you are
short wheat or gold or stocks? I could answer this for you, but I am
going to show you by example online. That should make it easier to
understand. In general terms, you make money when you are
"long" by buying at a lower level than you sell at. You
also make money when you are "short" by buying at a lower
level than you sell at. The only difference is that when you are
long, you buy first and sell second. When you are short, you sell
first and buy second. But you still make money the same way in both
cases no matter whether you are "long" or "short".
You make money by buying at a lower level than you sell at. That is
how it is done. To see how this works with crude oil, click on this
hyperlink and I will show you how exactly.
The important thing to remember from Lesson Number 3 is this.
If you restrict yourself to always having to bet that prices will
rise, eventually you are going to be wrong. If you always have to bet
that the stock you bought at $20 or $200 or $2,000 will advance in
price, one day you will find that for at least part of your shares,
perhaps the stock you bought at $2,000 a share, you will have made
the wrong bet. If you are trading only in stocks, mutual funds, or
equities, you can always sell your ownership and get out. But if you
are trading in futures contracts or options, (and even stocks, if you
want to try it one day), you have the alternative of actually making
a profit from declining prices.
Never handicap yourself so that you always have to bet that prices
will rise. All prices come down from their peaks. One who bets that
prices will never come down has made a fool's bet.
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