Continuation from yesterday…..(Buy Low, Sell High, Go Short & Cover)

Wikipedia defines short selling as a practice of selling securities or other financial instruments that are not currently owned, and subsequently repurchasing them (covering) to exit the transaction. If you are not familiar with the process, it is not as complicated as it sounds.  Going short or taking a short position is the exact opposite of going long or purchasing stock in anticipation of a price increase.  When you go short you anticipate or you bet on the upcoming price decline. The transaction is initiated when you borrow shares of the underlying stock and immediately sell it in the open market. If your forecast proves accurate you will close the transaction at a later date by repurchasing the stock at a lower price and returning it to its rightful owner. Keeping the spread between your entry and exit points.  And while it might sound complicated, the entire transaction can be done with one click. Just as if you were going long.

Now, the financial industry has done a fairly good job brainwashing the public into believing that short selling is inherently more risky than going long. Why? For a few primary reasons when short selling is compared to taking a long position. First, the potential loss on a short sale is theoretically unlimited as compared to a 100% maximum loss when going long. Second, the maximum gain is limited to 100% while your maximum gain on going long is theoretically unlimited.  Third, most markets and individual stocks are naturally long centric, increasing in value over time. Finally, there are extra costs associated with taking a short position.

Let’s now take a closer look at each one of these points to see if they hold up to scrutiny.

1. Unlimited Loss Potential:

When you open up a short position you open yourself up to an unlimited loss. Theoretically at least.  Let’s assume that you have done your research and you believe that Apple 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 announced that it 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 Apple will literally take over the world. As a result, Apple’s stock price surged to $1,000 or 900% a share even before the market opened.

Guess what 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 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 initiate 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 legal resolution in a big legal matter, etc…..  Point being, large overnight gains or gap ups (before the market opens), shouldn’t come out of the blue. If you approach short selling from a well researched position, as you should, you wouldn’t be shorting such stock to begin with.

To Be Continued On Monday……

What You Ought To Know About Short Selling Google

 Continuation From Yesterday…...(The Gospel Of Goldman Sachs)

• Growth Investing:  For the most part, growth investors are not concerned with finding undervalued securities.  In fact, in most of the cases and for a lot of the growth investors’ valuations become somewhat irrelevant. Only the growth of the underlying business is all that matters. This approach presumes that if the underlying business continues to grow fast, the stock price will continue to appreciate much faster than the overall market.  Yielding market beating results. Yet, this approach carries inherently more risk when compared to value investing. For instance, should the company disappoint in their growth trajectory, investors can find their stocks tumbling down 20-50% or more in a matter of days, if not hours.

• Active Trading:  This particular approach to the market is inherently more difficult to define as it contains millions of different strategies. Everything from simple day trading to using supercomputers to run complex algorithms to trading based on planetary movement. It is highly probable that each individual trader who is serious about participating in financial markets will have his or her own strategy. Developed though years of experience and trial and error. Understandably, the amount of risk each trader takes depends entirely on the strategy used.  Yet, one truth reigns supreme in this category as well. Most traders fail to outperform the market. What’s more, a high percentage of people who attempt to make a living through this craft get washed out in the first few years. Due to losses, inexperience and unwillingness to improve on their skill.

So, which investment approach is the best for our newly enlightened investors?

We’ll get to that in a second, but before we do there is yet another intricacy that you should be aware of.  Whether it is the mutual fund industry mantra of buying and holding forever or any of the investment approaches above, they all have one thing in common. Most investment approaches are Long Centric. In other words, most investors invest only in anticipation of rising markets or higher stock prices. Completely disregarding the other half of the equation.   That stocks do fall. Sometimes substantially so and sometimes they do so over extended periods of time.

A bear market of 1966 to 1982 gives a perfect opportunity to see just that. The Dow topped in 1966 at around 1,000. Over the next 16 years the market proceeded to oscillate up and down, yielding negative results and at least three gut wrenching sell offs of 30-50%. When a bear market ended in 1982 most investors had nothing but a 25% loss to show for their efforts.

Yet, this devastating loss of time and capital could have been entirely avoided if investors concentrated on both sides of the equation. Long and short. Instead of sitting and waiting for the stocks to appreciate over the long-term, investors should have moved with the market. Going both long and short as the market oscillated during that time.

The problem is, the same mutual fund industrial complex has drilled a certain thought into investor’s minds. That short selling the market or individual stocks is not only inherently more risky, it is darn un-American.  In fact, every single time the market sells off or corrects, just as it did in 2000-2002 and 2007-2009, there are loud calls to either curb or outright ban short-selling.  Mostly due to the misinformation that short sellers are causing the underlying collapse.  In fact, financial medial oftentimes portrays short sellers as outright criminals who should be grouped together with murderers and be shipped off to prison.  Better yet, Siberia.

To Be Continued Tomorrow……

Buy Low, Sell High, Go Short & Cover  Google