“Investors are worrying that a three-month surge in stocks might be overdone.” - So read a piece of market commentary from the Associated Press a few days, as the Dow, S&P 500 and Nasdaq all slumped.
Thanks for the heads-up, guys. You’re about two months too late. Not only did we call the bear market rally before it began, we’ve also spent the past couple of months warning you not to get swept away by the sudden surge of optimism and over-confidence as stocks have pushed higher.
Bear market rallies are fun while they last. But they’re only temporary. And the last week of sharp sell offs reminds us that the market has an uncanny knack of sucking the wind out of your sails when you least expect it.
But far from being gloomy, it also reminds us that there’s just as much opportunity to make money from the downside as the upside. But you need to do it the right. When you’re bullish on the market or a stock, you go long. When you’re bearish, you go short. Here’s how you can profit from market pullbacks with some short selling strategies and protect yourself in the process.
Short Selling Strategies – Dangerous For Pro & Rookie Investors
Short selling strategies can spell great risk and danger for rookies – and many professionals.
Many investors believe that the best way (and sometimes the only way) to make money from a falling market or stock is to “short” it. So let’s quickly go over the mechanics of how short selling works…
- You sell shares of an asset into the market before buying them. Because you’re anticipating a drop in price, you’re hoping to buy the shares back at a lower price once this happens. Short sellers sometimes aren’t popular because they’re hoping the market and/or stock goes down.
- You go short by “borrowing” the shares from someone who is long on the asset (you don’t own the shares when you go short) and hope that it tanks. So when you buy the shares, you’re essentially replacing the shares that you borrowed.
- If you’re right and the asset falls, you profit because the shares you buy back are cheaper than when you borrowed them.
But what if you’re wrong and the asset rises? The real danger is that a stock – theoretically – could go to any price and you’d be stuck with the difference. It’s the nightmare scenario…
The Short Squeeze: On the Wrong Side of Short Selling
Let’s say, you short an asset that you are convinced is about to decline, but it turns the tables on you and rises instead. You’re now on the hook to buy the shares at a higher price than you borrowed them – you’re on the wrong side of a short squeeze.
- A short squeeze puts short sellers in a losing position, faced with the prospect of unlimited losses as the asset rises. The more people who went short, the more severe the reaction will be.
- In a panic, they all pile into the stock at the same time, trying to buy back the shares to cover their trades and get out of them. This is known as short covering. The buying demand, coupled with the lack of sellers drives the price up even more, thus adding to your unlimited losses.
For example, let’s say you shorted 1,000 shares of Boeing (NYSE: BA) at $35 where it was three months ago. That would have given you $35,000. But you’d still have to replace those shares eventually because you only borrowed them.
But Boeing has performed very well over the past three months and is trading around $50 today, so if you hadn’t covered your shares till now, you’re forced to buy them back for $50,000 – at a loss of $15,000. And the more the stock rises, the more you lose on your original investment.
You never want to be in this situation, period.
Short Selling Strategies: Lower Your Risk With Put Options
Here’s an easy short selling strategy to make sure that you’re not on the wrong side of unlimited short losses again:
- If you think an index or stock is set for a fall, buy put options on it. This allows you to play the downside, but with far less risk than if you shorted the stock.
- When you buy a put, you have the right, but not the obligation, to sell the shares. That means your loss is only limited to the amount you pay to buy the option contract if the asset rises. No more. And if it falls, your put makes money.
For example, let’s say that instead of shorting Boeing shares at $35, you’d bought put options instead, trading at $1 per contract. Ten contracts (the equivalent of 1,000 shares, since one contract is made up of 100 shares) would have cost you $10, putting your total risk at $1,000.
That’s much better than the $15,000 you’d have lost by shorting the stock.
Short selling strategies can be extremely profitable if you’re right… but very risky if you’re wrong because your losses are unlimited.
So keep an eye out for stocks that are overpriced and ripe for a decline, or economic/company news that could drag them down. And if you want to play the downside, do it with put options.
Good investing,
Karim Rahemtulla
Investment U
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