Explanation: Being a bear while everyone else is bullish is one of the most challenging propositions in investing. For instance, ‘Short selling is an incredibly lonely proposition,’ billionaire hedge fund manager Bill Ackman says. Yet, it can pay off big time if you get your TIMING right. However, since most people, even professional investors are terrified of shorting, I will introduce a quick series about short selling, proper risk management when short selling and the best way to maximize returns. This was to be a part of my never finished book (no time to finish it)…….
Let’s now take a closer look at each one of these points to see if they hold up to scrutiny.
- Unlimited Loss Potential:
When you open up a short position you open yourself up to unlimited losses. Theoretically. Let’s assume that you have done your research and you believe that Apple’s Inc (AAPL) stock price is about to decline from $100 a share to $50 a share. By going short at $100 and presumably getting out at some point in the future at $50 a share you are planning to generate a net gain of $50 or 50%. As a result, you take a short position at $100.
Unfortunately for you, the next morning Apple goes on to announce that it had created a time machine, went into the future and brought back technology from the year 2225. What’s more, they will make this technology available over the next few months and by doing so will literally take over the world and destroy the competition. As a result, Apple’s stock price precedes to surge to $1,000 or 900% a share higher even before the market opens
Guess what just happened to your short position? That’s right; you just lost $900 a share or 900%. It now becomes your responsibility to close this trade out at a massive loss before going and crying to your mommy and daddy. That’s what most in the financial industry mean when they indicate that your losses can be unlimited when you open up a short position.
Rebuttal:
The scenario above is hypothetical at best. In reality, very few stocks open up with gap ups of 5-10% higher, let alone 100% or higher. It does happen on rare occasions, but you shouldn’t be shorting such stocks to begin with. When it does happen, it typically happens to stocks in the Bio Tech industry after their drug is approved by the FDA or stocks that might be acquired in a merger or stocks with upside earnings surprises or perhaps stocks of companies that have just reached some sort of a favorable resolution in a big legal matter, etc….. Point being, large overnight gains or “gap ups” shouldn’t come out of the blue. If you approach the process of short selling from a well researched position, as you should, you wouldn’t be shorting such stock to begin with.
In terms of your short stocks appreciating over time, if you apply proper trading rules, this shouldn’t be a problem. Just as you should have trailing stop losses with all of your long positions, you should exercise the same discipline when going short. If the marker proceeds to move against your short position, the stop loss should take you out when the time is right. Either realizing gains or limiting losses in the process. Just as it would if you where holding a long position.
In conclusion, outside of seldom “God Event” occurrences in certain stocks, equities that you shouldn’t be shorting to begin with, short selling is about just as risky as going long when proper investment rules are applied.
- The Maximum Gain Is Only 100%.
It is true, the maximum gain you can achieve when going short is just 100%. Yet, that type of a return is unusual as well. For that to happen the underlying stock price must hit zero. An occurrence most typically associated with the underlying business filing for bankruptcy or otherwise being delisted from the exchange.
The financial crisis of 2008 presents us with a perfect opportunity to illustrate just that. In the darkest days of summer of 2008, stock prices of many of the subprime lenders collapsed in a matter of 2-3 weeks. In many instances going from $50-60 share to $1-2 a share before filing for bankruptcy protection and being delisted from the exchanges. A rare occurrence, indeed.
And while your gains are limited to 100%, it is not a bad thing when you consider what our primary objective in this case is. Remember, we are not trying to identify stocks that will appreciate 1,000% or more over the next 5 years. We are simply trying to protect our existing long positions while generating extra returns on the downside. Essentially, we are trying to minimize risk while moving with the overall market or underlying security. Short selling allows us to do just that.
To Be Continued Tomorrow……
It’s Hard To Be A Bear When Everyone Is Bullish. Part 4 Google