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Short Selling - The Worst Trade You Can Make

InvestorEducation / Learning to Invest Dec 02, 2013 - 05:35 PM GMT

By: Investment_U

InvestorEducation

Alexander Green writes: Last week, The Wall Street Journal ran an article titled “Tough Year for Short Sellers.”

I’ll say…

Short sellers bet that stocks will fall rather than rise. You already know, for instance, that if you buy a stock at $20 and sell it at $25, you make $5 a share. But if you short a stock at $25 and buy it back at $20, you also make $5 a share. However, this has been an awfully difficult game to play this year.


Sure, there have been individual stocks that have cratered, like fallen tech star BlackBerry (Nasdaq: BBRY) and struggling developer The St. Joe Company (NYSE: JOE). But these are the exceptions.

The Dow is up 23% year-to-date. The S&P 500 is up 27%. And the Nasdaq is up 33%. (Ouch.) Historically, four out of five stocks follow the broad market trend.

Against the Tide

Shorting stocks in a market like this one can make you feel like you are shoveling sand against the tide. (And spending your time about as fruitfully.) Short sellers have had their heads handed to them.

As a result, fewer investors are wagering against stocks. There are only 25 hedge funds left that are pure short vehicles. Virtually all of them are posting serious negative returns.

There are another 3,700 hedge funds that follow a long-short strategy – going long some stocks and short others – but their returns, while better than the pure short funds, aren’t making shareholders shout “Hallelujah!” either.

Short selling is risky for two primary reasons. No. 1, history shows the stock market spends most of its time going up. Yes, bear markets are nasty and can send the indexes down 20% or more in a hurry.

But bear markets are sudden, unexpected and short-lived. The average bear market lasts less than 18 months. The average bull market, by comparison, lasts over two years and often considerably longer. The historic bull market of the ‘90s, for instance, lasted nine years.

The No. 2 risk of short selling is the downside. It’s unlimited. If you’re long on a stock, it cannot go lower than zero, handing you a 100% loss. But if you’re short on a stock, there is no limit to how high it (or your losses) might go.

For instance, if you short a stock at $10 and it goes to $20, you are down $10 a share (or 100%). But if it goes to $30, you are down 200%, to $40 and you are down 300%… and so on. That is why it is crucial for any short seller to use “buy stops” to strictly limit downside risk.

However, there is still another risk to short selling that is seldom recognized and somewhat counterintuitive…

Hidden Risk

In a down market, the stocks that drop the most are the worst companies with the poorest fundamentals. But you have to take a closer look to see how they actually get to the bottom.

Perversely, the stocks that rise the most in a sudden rally are often the worst ones. Why? Because just as most traders gravitate toward the best stocks, most short sellers bet against the same bad ones. Then when the market rallies – as it is wont to do from time to time even in a bear market – short sellers all rush for the exits, or “buy to cover,” driving these lousy shares up more than the market averages.

Because it is sensible to use buy stops for protection, it is much easier to get stopped out of a short position than a long one. And it is safer and more profitable to make money on the long side. After all, while there is no limit to how high a stock can go, it can only fall 100%. So a short seller actually has limited profit potential with unlimited downside risk.

In sum, short selling is for pros. And with the dusting up they have taken recently, this isn’t likely to be a very merry Christmas for them this year either.

Good investing,

Alex

Editor’s Note: Time’s running out to sign up for The Oxford Club’s free tax webinar, which will take place tomorrow. With tax season almost upon us, now is the time to learn about some of the most sophisticated (and legal) tax mitigation strategies that I’ve seen. Click here for more information.

- Andrew Snyder

Source: http://www.investmentu.com/2013/December/short-selling-worst-trade-you-can-make.html

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