Every day, the stock market seems to continue its precipitous drop towards worthlessness, crushing hopes, dreams, and investors in a flurry of dizzying price movements. Yet there is an answer; a light in the darkness, used by the masters of investment to generate excess returns even ” no, scratch that, – especially in falling markets like this one.
Shorting stock. The phrase sends a blood-curdling chill down many a buy-and-hold investors spine, frightening them into a shock-induced state of confusion. Yet for masters of this easier-then-it-sounds technique, its an extremely profitable oasis within the uncompromising desert that is this bear. Confused? Its like this… the vast majority of investors only buy stocks. When you buy a stock, there are two ways to make money. Stock price appreciation (buy low, sell high), and dividends. Which is all well and good when the market is going up, but for markets such as the one were currently embroiled in, we need a whole different animal.
Shorting a stock is actually a fairly simple process. When you buy a stock, you hope to buy low, and sell high. When your shorting a stock, your goal is to sell high, and then buy low. When you short a stock, you borrow it from your broker, and then sell it. You keep the money from this sale. Then, after the stock has dropped, you buy it back for less, pocketing the difference between what you bought and sold it for. After buying it back, you give it back to your broker, and your exactly where you started, just with more money.
An example… In late August 2008, Ford was trading for around 4.50. If you decided to short 100 shares of ford at that point, then you would borrow 100 shares of Ford from your broker and sell them for a total of $450. In late October 2008, Ford was down to the 2.25 range. At that point, you could buy back the 100 shares you sold for $225, return the 100 shares to your broker, and all in all, you made $225. In essence, you sold high, then bought low. Its just like buying low, and selling high ” it just operates in reverse. This would be a good time to re-read this paragraph, its that important.
A more abstract, but ultimately easier way to think of shorting is a way of owning a negative number of shares. If when you own 10 shares, and a stock goes down by $100 , you lose $1000. If you own negative 10 shares, and a stock goes down by $100, you gain $1000. Simple as that. Naturally, an increase in price works the same way ” a price increase means owning a negative number of shares leads to a loss, but in a bear market, thats a rare thing.
Regardless of how you play the markets, an eye must be kept on the most important element of all ” risk. While shorting helps to remove some of the systematic risk from your portfolio ” a portfolio composed of both buying stocks, and short stocks, is less venerable to a market crash ” it does carry its own unique risks. Especially in a bear market, it pays to watch the news on your shorts. Any good news that comes out may raise the stock price of those that your shorting, and if a stock isnt going down anymore, its not a good stock to be short. The bigger risk to your short positions is the end of a bear market. When the new bull market ends, many short positions will quickly swing towards unprofitability, and so you must be quick to close them.
A typical risk-management choice many professionals use is the 5% rule. When your trading stocks, dont risk more then 5% of your portfolio on any one position, and preferably less. So with the $20000 portfolio, risk no more then $1000 on a trade. This doesnt mean you cant invest more then $1000 per trade. It just means that your stop loss should be triggered before $1000 is lost. So if you short a stock at $20, and have a stop loss at $25, then you can buy up to 200 shares (far more then the actual value of your portfolio). If your time span is shorter, then you should use a smaller percentage, while if your timespan is longer then a couple months, the 5% rule could be adjusted as high as 10% (for the risk-tolerant).
When it comes to stock picking, some people would call this a challenging market. And traditionally, we have been taught that buying low and selling high is the idea scenario, so looked at from that sense, perhaps it is a challenging market. Or is it? With everything covered already in this short document, you have already learned that a so called “challenging market” can be a bonanza for those who have learned how to short a stock or etf.
Confused about ETF’s shorting stocks, crashing markets or any of the other terms? Or just interested in cashing in on this once in a lifetime opportunity? Click here and Learn How to short stocks for fantastic gains
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