The Money Machine We Are All Safer

March 18, 2002

# Stocks Ahoy

Let us start with a story, a story that is pure fiction. It is a story of Jerry and his love of money and food. Jerry decides to put the two together and start a restaurant. So he rents a room with a kitchen for \$100 a month. Like the story, the sums of money involved are fiction too.

Jerry buys chairs, tables, plates, cutlery, pots and pans. All that costs him \$100. He manages to convince his good-for-nothing friend, Joe to be the cook and finds some attractive ladies to be waitresses. Soon, the restaurant is open for business; with a sign up front that reads “Merry Jerry’s”.

After a year, Jerry tallies up his accounts. Thanks to some good deals on almost rotten meats and vegetables, and the watered down wine, Merry Jerry’s has spent \$1,000 on food, fuel and advertising, \$1,000 on salaries and \$1,200 on rent, bringing the total spending to \$2,700. His sales have been not great, and his restaurant made only \$2,000. So he lost \$700 that year.

The next year is much better. The customer base is up, Merry Jerry’s receives a good review in the local newspaper (thanks to the bribe paid to the reviewer). Many more people ate, and the materials cost \$5,000 but the earnings were \$6,000, which gives Merry Jerry’s a profit of  \$1,000. Deducting last year’s loss, Jerry is ahead by \$300.

Over the years the business stabilizes and is running a profit of \$1,000 a year. Jerry gets tired of running this scam, and wants to start a Flight Training School, or a Computer Software Academy. So he decides to sell Merry Jerry’s. What is the price he should ask for?

Since Merry Jerry’s makes a net profit of \$1,000 a year, about \$10,000 is a good price (10% return on investment). But Jerry can find no one who has \$10,000. So he sells shares of the business. He creates 1,000 units of stock, called MJ, and sells each share (or stock) for \$10. Soon 1,000 people are joint owners of Merry Jerry’s and the party continues. Every year, the profits are divided equally and each holder of each share of MJ gets \$1, called the dividend.

Some of Merry Jerry’s new owners decide they do not want the dividend, and they try to sell their shares. Since Merry Jerry’s by now is quite well-known, they find that there are people willing to buy MJ stock for \$15. So the stockholders of MJ who sell out, make a profit and those who do not, hold on, getting dividends and expecting the stock to rise even further.

Let us take another look at the situation. If we stopped Merry Jerry’s operation, it would be worth nothing, but the price of the used tables, chair, pots and pans, at most \$50. This works out to \$0.05 per share and is called the “book value”. As a business in operation, MJ is worth \$15,000 (1,000 shares at \$15 each). For most businesses, the book value is meaningless the real value is in the stock price. MJ’s value may even go higher, if people decide to pay \$20 for its stock. Its value may go lower if the too many people start getting upset stomachs after eating there.

How do people owning MJ find people to sell stock to? They go to the local stock exchange. The stock exchange is a fun place full of people yelling and running and buying and selling. They buy stocks of businesses they like and sell businesses they don’t. To facilitate this operation, instead of actual people doing the buying and selling there are people called stockbrokers who facilitate the transactions and keep records and even hold on to the stocks for their clients. The stock exchange is the focal point of the trading activity and anyone interested in stocks go there to deal with the stockbrokers. The price of the stocks is determined by the stockbrokers (also called market-makers) based on what the clients are willing to pay for each share of stock.

The stock market is a great enabler of capital-raising, a place where people congregate to buy and sell stock. Companies come there too to sell additional shares. A company can issue more shares of stock (called dilution) that what there were originally and sell them at the prevailing price. As the stock rises, the company can get more money with less dilution. This helps it to raise capital for growth.

The above is a classic example of how companies are created and stock trading is done, albeit over-simplified. However, the story does not end here. Due to the crooked side of human ingenuity, the whole business of stock trading can be (and routinely, is) convoluted much further to everyone’s delight and dismay.

One day, a nefarious character called Marty the Shorty is having lunch at Merry Jerry’s notices some cockroaches scurrying around. He rushes to the stock exchange and wants to sell 100 shares of MJ at the going price of \$15. But there is a slight problem; Marty does not possess any shares of MJ. So he contacts a stockbroker and strikes a deal. The stockbroker takes 100 shares of MJ belonging to some of his clients and sells them. Marty collects \$1,500, deposits it with the stockbroker (since he did not have any stock to start with) and goes home.

Soon, other people start seeing cockroaches and stops eating at Merry Jerry’s. The business falls and so does it stock price. When the stock reaches \$5, Marty shows up and buys 100 shares and gives these stocks to the stockbroker who hands him back the \$1,500 Marty had deposited earlier. Since Marty paid \$500 for the stock, he goes home, with \$1,000 laughing all the way.

What is wrong with this situation? Did Marty do anything wrong or illegal? No, Marty played a routine game that is played with alarming regularity on stock exchanges the world over, called “short selling” stock. Shorting is the risky act of borrowing stock and selling them, with the hopes you can buy it back (and return it) later at a lower price. It is risky since, if the stock goes up in value instead of down, the short seller would have to shell out real money to repay the stock.

While Marty was making money shorting the stock, Shelly was eating at Merry Jerry’s. She noticed that the place was cleaner than before and the ubiquitous cockroaches were on vacation. Shelly had a hunch that Merry Jerry’s was becoming a nice place again. So she runs to the stock exchange and tells her stockbroker that she is willing to pay \$6 for 100 shares of MJ (which is selling for \$5), but she would rather buy it 2 months from now.

The stockbroker is a little taken aback. He tells Shelly she can have the stock right now for \$5, why wait 2 months and pay more? “Never mind” says Shelly “Here is \$100 for your trouble, you can keep it, as long as you promise to sell me 100 shares of MJ at \$6 two months from now.”

The stockbroker agrees, pockets the \$100 and buys 100 shares of MJ out of his own money and holds them for Shelly. In two months, Merry Jerry’s has seen a turnaround, and the stock is back up to \$10. Shelly, of course come running back, buys 100 shares from the broker for \$6 each and immediately sells them on the market for \$10 each.

Let us do the arithmetic. Shelly paid \$100 initially—it is called a premium. Then she paid \$600 for the stock and received \$1,000 as she sold them all. In total, she profited \$300 in two months, for an initial investment of \$100. Pretty good! The stockbroker made \$200 too, so they are both happy.

What Shelly did was to buy a “call option”—an option to purchase stock at a future date for a fixed price. Such an option trade can be very lucrative if the stock goes up. Shelly could have purchased a “put option”—an option to sell stock at a fixed price at a later date. That option is valuable if the stock goes down.

If this is not confusing enough, Shelly could buy a call and put option on the same stock at two different strike prices for the same (or different) periods. Doing so is a convoluted scheme called “hedging”. Hedging places limits on how much money you can make as well as limits on the amount of losses in case things do not turn out as you expected.

From a simple method of creating multiple participation in ownership and profit sharing of a business, via the creation of stock we landed up with shorting, put/call options and hedging. These stunts of course have little to do with the core business, they are financial gimmicks created by investors to make and lose large quantities of money rather fast. This creativity of course does not end here.

Instead of trading in MJ we can trade in meta-stocks, stocks created by merging together a basket of stocks from many different companies. For example, the two best known indices in the US Stock market are the DJIA and S&P500. DJIA (Dow Jones Industrial Average) is a basket of 30 stocks and S&P500 (Standard and Poor’s 500) is a collection of 500 stocks. It is possible to buy shares in DJIA (called Diamonds) or shares in S&P500 (called Spyders). It is also possible to buy options on Diamonds or Syders. What is even more exciting is that the options themselves are stock-like things, that is, even though an option can be exercised when it matures, it can be bought or sold prior to maturity.

In case you are wondering where this madness ends, it does not. A stock can be split into derivatives, that is, we can subdivide a stock such that one part of it gets the dividends and the other part gets the gain (or loss) of value. Then these parts can be traded as separate entities, along with its own set of options. How about derivatives of options? Yes, that is possible too. All this is so scary; it makes one think that UTM (under the mattress) is the best place to put the money.

Partha Dasgupta is on the faculty of the Computer Science and Engineering Department at Arizona State University in Tempe. His specializations are in the areas of Operating Systems, Cryptography and Networking. His homepage is at http://cactus.eas.asu.edu/partha