Be Prepared for the Best Short Market in Years

Gary's Note: Last week, I said we'd look at exactly how you can profit from a falling market. So today Dan Amoss returns to tell you exactly what you need to know. Not to be dramatic, but this is information will prove to be vital in the coming weeks and months. The crisis in Greece is just a small sample of the carnage about to work its way through the world's markets. Read on to learn exactly what simple steps you need to take right now in order to be ready to profit instead of being wiped out financially.

by Dan Amoss
June 7, 2010
York, Pennsylvania, U.S. 

Be Prepared for the Best Short Market in Years

Shorting stock is probably one of the most unusual ways to make money on Wall Street. And I think the best way to explain it is with a story. 

Say a friend lets you borrow his brand-new car for an extended time. So for all intents and purposes, the car is yours. 

One day, a complete stranger sees you with the car and says, “I’ll give you $52,000 to sell this car to me.”  Unsure of what to say, you take his phone number and say you’ll think about it. 

You’re very curious, so when you go home, you do some research and discover that $52,000 is a very fair price for the car. But you also learn that the local car dealership is having a big sale in two weeks, so there’s a good chance the car will sell for a lot less than it sells for today. 

You call up the man who wants the car and agree to the sale. You meet him, and he hands you a check for $52,000. That’s a nice chunk of change…but now your friend is out a car. Luckily, you know what you’re doing. 

Two weeks later, the car sale starts, and you’re able to buy the exact same model of car — from its color to its option features — for $42,000. You’ve now replaced your friend’s car and kept a nice $10,000 for yourself at the same time. 

What you’ve done is known as short selling. And short selling a stock works pretty much the same way.

Make Money Selling Something You Don’t Own

When you want to short a stock, you simply call your broker and say how many shares of a company you want to short. 

The broker then “borrows” the stock shares, either from his firm’s account or from other investors. He then immediately sells those shares on the open market. The money from the sale is yours to keep. 

So if you short 100 shares of stock at $50, your broker will borrow 100 shares of the stock, sell them, and then deposit the $5,000 into your account. 

But don’t make the mistake of thinking this is free money. Always remember that you will need to return the borrowed shares at some point. This is called “covering the short,” or “buying to close” your position. 

The goal is to cover your short for a lower price than what you borrowed it for. For instance, if the stock you shorted falls to $40, you can instruct your broker to buy shares to close your position. Your broker buys 100 shares at $40, taking $4,000 from your account to pay for the transaction. The shares he bought are then returned to whom he borrowed them from.

Meanwhile, you’re left with $1,000 of pure profits.  But notice that the lowest a stock can go is to zero. So your maximum gains will never be higher than what you earned when you initially sold the stock. In the example above, you’ll never make more than the $5,000 you got for shorting the stock. 

Now, the downside to this strategy should be clear. 

If the stock rises, you could be in trouble. You might have to buy back the stock at a higher price than you sold it for. For instance, if you cover your short at $60 per share, your broker will need to spend $6,000.  Since you got only $5,000 when you originally shorted the stock, you’ll need an extra $1,000 in your account to pay to close the position.  If the stock goes to $70…$80…$100…you’ll have to pay that much to cover the short. In other words, your risk is theoretically unlimited. 

But it probably won’t come to that. Since you’ll need enough money in your account to cover the short, your broker may ask you to deposit more money.  (This is sort of like a margin call.) 

Short traders know this. So when a stock seems to be on a run, they’ll often race to limit their losses by covering their short positions. Unfortunately, their buying can run up demand for the stock. And as you know from basic economics, increased demand leads to higher prices. 

 

This is called a short squeeze — traders covering their shorts artificially boost a stock’s price.

Another thing to keep in mind is that when you sell someone else’s stock, they are still eligible to receive the stock’s dividends. Since you borrowed their stock, you must pay any dividends the stock pays out. 

So as you can see, shorting the stock itself is a good idea only in very certain situations (situations that will be coming up this very summer, by the way). You are forgoing the biggest gains, but your trade will tend to be less volatile. Often, this is our best route if we are confident that a stock will fall, but less confident about when. 

Also, some good short-selling targets are so small that they have no exchange-listed options. 

See you then.

Regards,
Dan Amoss

P.S. While I recommend shorting stocks only in some situations, a lot of those kinds of situations will be cropping up very soon...