I hope everyone had an enjoyable Thanksgiving. I know these can be difficult times but Thanksgiving is a time to reawaken thoughts of those things that are positive in our lives and perhaps change our focus away from the negatives.
In the past couple of weeks, some subscribers have written and asked about shorting stock. The markets are currently dealing with levels of support that go back to 2003 and 2004 and we don't yet know whether we are going to see another downward move or whether the bottom has been hit. In any event, it is good to be aware of ways in which a trader might profit in a down market even if it is too late to do so in the current conditions.
Buy stock low and sell high is a common way investors see the way to profits in the markets but that is only possible when the market is moving up. What can be done to garner profits when the markets are falling as has been the case in recent times? There are a variety of ways to make money in a down market, many of which I detail in my first book, "Trade Your Way to Wealth." One of those ways is to sell short.
Short selling is the same as buy low and sell high except it is done in reverse. First, we sell the stock at a high price and later we buy it at a lower price. The difference, less commissions, is our profit. The first question that usually is asked by investors who are unfamiliar with the strategy is how can I sell something I don't own? The answer is that we borrow the stock from our broker and sell it on the open market. That brings cash into our account. Since we have borrowed the stock, from the beginning, we know that we are going to have to replace it and that means that at some time we will have to buy the stock on the open market to cover the short position. That is known as buying to cover.
An example may be helpful. Suppose we see that the markets are falling and the chip sector is particularly weak. One of the stocks in that sector, XYZ has recently come down after hitting a resistance and is trading at $60 a share. We can see that there is a support around $50 a share so we decide to sell the stock short. First we check to see that the stock is available to borrow from our broker and, if so, we sell it short at $60 a share. Suppose we sell short 100 shares at $60. That means $6,000 will come into our account at settlement. Now the stock goes the way we thought it would and begins to fall in price. It hits the $50 mark and we buy the stock to cover our position. That will cost us $5,000, but the market paid us $6,000 in the first place so we make $1,000 (less commissions for the two transactions) on the downward move.
It is important to realize that selling short can entail very high risk. If we are wrong on the direction, we are still going to have to buy to cover the position at some time. Suppose we sell XYZ short at the same $60 a share and then the company announces some new mega-chip and the stock price takes off and gaps up to $70 a share. Now, we would have to pay $7,000 to buy to cover our 100 share short position and would lose $1,000 plus commissions. Theoretically, the upside is unlimited and the stock could go to $100 or $300 a share so great care must be taken to assure that we have an exit strategy in place before we ever initiate the short sale.
Since we have borrowed someone's stock to sell it short, we should also be aware that they would be entitled to dividends if any are declared and since we have sold their stock, we are responsible for those dividends.
As I mentioned earlier, selling stock short is just one of many ways to profit in a downward move. The trader would be well advised to read and learn other strategies as well so that he can determine what is most suitable for his own situation. In "Trade Your Way to Wealth," for example, I discuss at least 5 distinct strategies, including short sales, that a trader can use to profit in a downward move. In Appendix D, I summarize those along with bullish and neutral strategies to illustrate a number of things such as relative risk, capital required, time frame, whether protection is provided, and the level of monitoring that may be required. Knowledge, as is generally the case, is key to success.
by Bill Kraft, Editor
Copyright 2008, Makin' Hay, Inc.
All Rights Reserved
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