Asset Management- Going Short Stocks (Pt 2)

The stock market is crazy, should you short stocks?  We recently started discussing the rewards and perils of going short stocks.  Our last post was about the reasons shorting stocks can be risky in any stock market environment.  Today we’ll look at the benefits to be had when you short stocks.

There are a number of reasons it could be very smart to short stocks when you feel confident the stock market will fall…

1)      If you study the stock market and see that a fall is very likely, then this can be the only profitable way to profit from that understanding.  Typically when the stock market falls, it falls fairly quickly, so it is possible to do quite well in a short amount of time if you can see the market (or a particular stock or sector) is going to fall and act on that knowledge by shorting it.   If you have this knowledge and are unwilling to go short, the best you can do is get out of the market and not lose money.  By shorting, you can take advantage of the understanding that you possess and profit from it.

2)      Most investors only buy stocks long and thus leave an unfair advantage to those who are willing to go short.  Since most people will never go short stocks, you have an advantage over most other investors if you know how to profit when everyone else is losing money.  Sometimes it’s easier to identify an overpriced loser stock that is sure to fall than it is to find an undervalued stock that is sure to rise.  For example, General Motors had lost money 19 out of 20 years before the government bailed them out.  There was absolutely no logical reason for the stock to be valued as highly as it was before it crashed because they were a giant money losing enterprise.  Who wants to invest in a company like that?  Well, many Americans wanted to because they saw GM as being an old reliable “red blooded American” company.

Millions of Americans were shocked to see GM fall apart, but if you could step back from the emotion and notice the fact that they lost money every year and had to continually borrow money to pay the interest on the money (bonds) they had previously borrowed, it was obvious that this would all come crashing down.  It was an easy situation to profit from.  Yet because most people let their emotions carry them away, they couldn’t see it coming and kept bidding the price up to the point that free money was left there for anyone willing to be bold enough to short the stock.

3)      If you have strict stop losses on all your positions then you can’t lose any more on a short than you can on a long position, so the scare of unlimited loss doesn’t apply to you.  Again, shorting a stock is not something that you can do, forget about, and hope for the best.  You must actively follow the position.  This means once a day checking in and seeing how it is doing.  This only takes 5 minutes of your time, but it is essential to ensure that your position doesn’t run away from you.

4)      If you add short positions to your portfolio of long positions, you can reduce the volatility and overall risk of your portfolio.  If you have long positions (stocks you have bought and are holding for the long term) and you have no short positions, then your portfolio will take a large hit when the market crashes as it does from time to time.  However, if you own long positions in stocks that you love for the long haul, and you hold short positions in stocks that you believe are headed for zero….you have a hedged position.  If there is not particular news for your stocks but the market goes up, you will probably make money on your long position and lose money on your short position.  Hopefully the strong company that you have bought goes up more than the weak company you have sold short.  If on the other hand, the market falls, you will make money on your short position and lose money on your long position.  Overall, your portfolio is less volatile than the market because it neither goes up as much or down as much as the overall market does.  This gives you longer to ride out the waves of the market and be correct on both positions.

Ok, so now we’ve looked at both the reason for and against selling short a stock or the stock market.  If you understand the risks and are willing to take them and you fell certain the market will fall, what are the ways to speculate in this area?

If you have any thoughts or questions on this or other topics, please let us know.  We’ll continue with Pt 3 soon.

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