When the stock market is heading down, one of the best ways to profit is to short stocks! We recently discussed asset management in a crazy economy. If you believe that the stock market is heading lower, then it is foolish to buy and hold the stock market. However, if you feel quite certain that you understand the direction of the market, there is an opportunity to profit as the market falls. You can short stocks. Here’s how it works…
In a pure sense, to “short stocks” is to sell the stock before you buy it. You borrow the stock from another investor and then sell it. Thus you receive money up front for the stock and must later sell it so that you can give it back to the person you borrowed it from and “cover” your short. (This is not complicated; your broker handles the transaction without you needing to know the person whom you are borrowing from.)
To Short stocks is more aggressive than being buying and holding the stock market. This type of trade should not be entered into without fully understanding exactly what is happening with the transaction. For most people, the trade is far riskier than being long stocks with more potential for loss, however, this does not have to be the case as long as you fully understand what you are doing and you actively follow your position from beginning to end.
The reasons it can be riskier are these…
1) There is a more limited potential for gain, but an unlimited potential for loss. This is the opposite of the situation from the more common transaction of buying and holding a blue chip stock. In this scenario, you can buy a stock and forget about it with the assumption that you cannot lose any more than you have already put towards the purchase of the stock and that eventually, if you wait long enough (this might be many decades), it will be worth more in US Dollar terms than what you originally paid for it. Also, ideally you would have been collecting dividends the entire time you held it.
However, when you short a stock, all of these work in reverse. The highest possible sell price (and thus profit) is determined immediately (Maximum profit would occur if the company goes bankrupt), but you could potentially lose an unlimited amount of money because the stock could theoretically appreciate endlessly. (Ex. If you sell a stock short at 100 and then it goes up to 1,000,000 and you haven’t bought it back yet, you will need to buy it back at this price. So you would have lost $999,900 on your $100 speculation!) Of course, in reality your broker would never have let it get to the point of you losing more than you can handle because they would give you a margin call as your losses started to get out of hand and demand you to either put more money in your account to cover the position, or to buy to cover the stock and thus exit the position at a loss. Also, when you are short a stock, you must pay the dividend that the company pays since you have negative ownership of that stock. Many so called “investors” will buy a stock and forget about it so for the, this risk alone is reason enough to never short a stock! You must pay attention to what you are doing to short a stock.
2) The stock market goes up more often than it goes down. Thus, to be short a stock or the market in general is to go against the overall trend of the market’s movement. In other words, if you always maintained short positions on the market, over time you would lose money with this strategy. The market goes up more than it goes down, so you would be losing money most of the time. Obviously, you need to feel pretty sure that the market (or at least the particular stock or sector which you are shorting) is going to fall in order to make this speculation.
3) The market can stay ridiculously priced longer than you can stay solvent. This means that you may study either the economy or a particular company’s business and decide that it should surely go down. And you may be absolutely correct and still lose money on the trade! The reason is that the market is not rational and can often go way beyond rational valuations both on the upside and the downside. You might see that a company is losing money hand over fist and that the stock should surely come down, but if the market is rising, this stock can keep on rising to the point of stopping you out of the position. Once you’ve lost your speculation, the stock could end up doing exactly what you predicted, but because you were early, it didn’t matter to you. The position was a loss.
With all these reason why you might lose money shorting a stock or a sector, or the economy in general, why would anyone do it? We’ll cover that next…
If you have any thoughts or questions on this or other topics, please let us know.