While the market collapsed in ’08, and fell off a ledge in ’11, the professionals made millions. How? By using leverage. Margin is an extremely powerful tool. What is margin? To put it very simply, its like having a giant credit card hooked up to your portfolio. Out of cash to make a trade? Don’t worry, you have margin. Now, margin accounts aren’t for everyone. Typically, margin accounts have an extremely high interest rate when they are used. Not only could you lose all of your money, but you could actually end up owing money.
So how do professionals make money while you’re losing every dime in ’08 and ’11? They use those margin accounts to short stocks. You buy a stock when you think it will go up, and you short a stock when you think it will go down. Its that simple. Under normal circumstances, you can short $1 for every $3 you have. With a margin account though, you obviously have more funds to use. That means you can short even more stocks. As an example, AIG went from a $45 stock and plummeted to sub $3 a share in ’08. That is an astronomical rate of return. Meanwhile, most individuals weren’t able to short stocks. Not to mention that 401k’s don’t allow people to short stocks. So while you were losing everything in ’08, professionals were shorting stocks from $45 a share all the way down to $3 a share.
Now, let’s make the pain even worse. The professionals used options trading to exponentially increase their gains. Using that same margin account, which your 401k doesn’t let you have, and the same trading philosophy of buy a stock if its going up and shorting a stock if its going down, it was quite simple. With options, you buy a call option if the stock is going to head up. Conversely, you buy a put option if the stock is going to head down. Only this time instead of paying the full stock price, you only pay a small fee associated with buying a block of 100 shares per option.
So if you would have shorted 100 shares of AIG, although most couldn’t, it would have cost $4,500 to do so. Then when the stock hit $3 a share, you would have “bought to cover” those 100 shares you sold by shorting the stock for the low price of $300. You just made yourself a smooth $4,200. Not bad, right?
Well look at this. If you would have bought 10 put options on AIG for say a fee of $4.50, at the strike price (stock price) of $45, that would have cost you the same $4,500. Ah, but the kicker is that you have an option to sell 10 contracts at $45. Each contract is 100 shares. So you have the option to sell 1,000 shares at $45, instead of the 100 when you shorted the stock. Not only that, but you have the option to sell them at $45. That means that you don’t have to sell them at $45. So the most you could possibly lose on this trade is the fee ($4,500) that you paid for the options. I digress. So now we have these 10 put options (1,000 shares) and you exercise those options at $3 just like you did when you shorted the stock. How much did you make? Well, you sold 1,000 shares for $45 each, and you bought them back for $3 each. That means, using that same $4,500 up front, you would have made $42,000!
Wall Street did that with many different companies. You could have done the same thing which was even more extreme with Fannie Mae and Freddie Mac. Wall Street makes you jump through hoops to get margin accounts. Then they decide whether or not you are worthy of having one. One small misstep, and they deny you. So while your contra funds, high growth funds, and dividend funds were losing your money on Fannie Mae, Freddie Mac, AIG, Goldman Sachs, Citigroup, Bear Stearns, and Bank of America, we professionals were banking away fortunes betting against your 401k’s. The sad thing is, your 401k doesn’t even allow you the option to bet against those companies like we can. It’s disgusting.