Lesson 3: 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,

 

1. 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.

2. 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.