What can investors do when stocks drop in value?
A stock dealer watches monitors as stock prices decline to record lows recently.[NEWSIS]
Have you heard of the Kospi? This is the composite price index of the shares listed on the main exchange. The index dropped significantly. It started around 1900 points this year but now it is over 1500.
There may be many reasons for the index’s decline but selling by foreign investors is a major factor. Foreign investors have been selling stocks everyday. Between June 9 and recently, foreign investors sold more stocks than they bought almost everyday. In that period, they sold nearly a net 8 trillion won ($7.9 billion) of shares.
They sold a lot of shares so they should make up a smaller portion of the local stock market. On June 9, foreign investors accounted for 30.94 percent of the total market capitalization. On July 14, they comprised 30.43 percent. Only 0.51 percent dropped. They sold a lot but why did the percentage drop so little? That’s because much of foreign investors’ selling was not of actual shares they own but short selling.
For short selling, in Korea, investors need to borrow stocks first. This is called loan transaction. Institutional and foreign investors are allowed to carry out loan transactions. Lenders and borrowers sign a contract and decide on the interest, fee, collateral and the contract’s expiration date. Individuals can borrow stocks from brokerages and can actually short sell but it is not very common.
Loan transactions suddenly increased recently. According to the Korea Securities Depository, the loan transaction balance grew from less than 1 trillion won at the end of 2002 to 16 trillion won at the end of last year. Recently, it reached 30 trillion won. Loan transaction is mostly used by foreign investors. Total loan transactions were worth 74 trillion won last year. Of that, 67.1 trillion won, or 91 percent, worth of loan transactions were done by foreign investors. This is why financial watchdog agencies recently said they would investigate whether there were unfair transactions by foreign investors.
Then, how can investors make money through short selling? Let’s assume that Samsung Electronics Corp.’s share price was 600,000 won on July 17. The share price is expected to fall. We can borrow 100 shares of Samsung Electronics for two months through loan transaction. If we short sell the shares, they would be worth 60 million won.
After short selling, the share price dropped to 500,000 won after 40 days. Since the share price is less likely to fall further and the payback is due soon, we’d better return the shares to the lender. Then, we buy 100 shares of Samsung at 500,000 won each and pay back. It costs 50 million won to buy 100 shares at 500,000 won each. A while ago, we sold the 100 shares for 60 million won but it cost us 50 million won for payback. So, there is a profit of 10 million won. Even after paying interest, it is still profitable
However, if the stock price rises, it would be a disaster. What if the share price rises to 700,000 won per share after 40 days? Then it costs 70 million won to buy 100 shares of Samsung. This would result in a loss of 10 million won.
The stock price needs to fall for short selling to be profitable. There have even been rumors that foreign investors spread rumors to push down the price of certain stocks after large short selling. If there is a likelihood that the stock price is going to rise after selling short, short sellers should buy actual stocks fast to pay back and reduce losses. Buying actual shares to pay back is called short covering. This is why some brokerages said a certain issue targeted for large loan transactions could see its value hike when short sellers buy the issue for short covering.
Usually, investors make money when the stock price rises. However, like short selling, there are ways to make money when stock prices fall. This means that there are ways that investors can make profits no matter whether stocks rise or fall.
Another way to make profits when stock prices fall is investing in the futures market. In Korea, there is a futures market for the Kospi 200 and 15 individual stocks including Samsung Electronics Corp., LG Electronics Corp. and Posco. Buying futures is different from buying stocks. For buying futures, investors only need a deposit rather than a large sum of money that can buy actual shares. In the futures market, investors can buy many shares with a relatively small amount of money. Thus they can make either huge profits or huge losses.
Although making the deposit is a little complicated, trading futures is similar to short selling. If the stock price is going to fall, investors sell futures at a current price. Then when the stock price actually falls, they can make profits as much as the fall or otherwise loses as much as the rise.
The option market is also similar. Options are the rights to purchase or sell stocks. Call options are the rights to buy while put options are the rights to sell. If the stock price is going to fall, investors sell call options and buy put options. If stock price falls, the call option price falls too. Conversely, put option price rise if stock prices fall.
Investors can also use equity linked warrant. Like put options, put ELW price rises when the stock price falls. If there is a chance that the stock price is going to fall, investors can buy put ELWs.
There are also mutual funds that can make profits when stock prices decline. A reverse index fund is a good example. When the Kospi declined this year, reverse index funds made profits. Now absolute return funds are available in the market and they can yield a certain return regardless of market conditions.
By Ko Ran JoongAng Iilbo [jbiz91@joongang.co.kr]
with the Korea JoongAng Daily
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