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Let’s Short Stocks!

With all the stocks dropping in my portfolio why aren’t I doing this all the time? Many investors don’t short stocks (including me) because it’s enough trouble finding stocks that go up. And Wall Street hasn’t ingrained in the public that money can be made on both sides of the market.

Wall Street doesn’t want everyone to feel comfortable shorting for a couple of reasons. They make money when you buy stocks.

If a broker from Merrill Lynch called and said “You have to short Whole Foods! No one eats organic anymore and they’re about to be sued in a class action suit.” You could either take his advice and short. Or, sit on the sidelines and do nothing. If you do nothing, Merrill Lynch doesn’t make a commission.

If Merrill was trying to woo Whole Foods as a client, an investment banker will come downstairs and smash a chair over that broker’s head. Why jeopardize a client relationship. That’s why Wall Street doesn’t give many “sell” recommendations.

Short selling is a strategy that in many cases, makes money faster than waiting for a stock to go up. While the stock market can grow at about 8% – 11% per year, stocks can drop at least that amount in a day. Even during the internet boom of 1999, over 60% of all stocks declined. Ok, enough build-up. How do we make money?

Which stocks should we not attempt to short? The market leaders. Market leaders are risky to short even if they’re going down. Wall Street may think they have an undervalued stock on their hands and start accumulating.

What stocks should we short? Losers in a losing industry. Go to Yahoo! Finance and find the worst-performing industry groups. Then find the worst stocks. If the whole industry has poor performance, then Wall Street is avoiding it. You know how sympathetic stocks can be to each other. As goes a few, as can go the group.

Purchase from a group of losers and you minimize the chance of breakouts. Wow. I can’t believe I’m saying this.

There are also stocks that have risen fast and will appear extended. These are good shorting candidates as well. Wall Street will be looking to take profits on these. Be careful you’re not shorting a stock that is just taking a breather. But you can safeguard against this with limited orders. Always use limit orders

It’s relatively easy to find stocks with problems. Just set your stock screening low relative strength and lousy technicals. As I mentioned above, make sure the industry has problems too.

Bad fundamentals rule over bad technicals. A financially challenged company is not going to have its stock price turn around in the short term. A company with solely poor indicators may present a buying opportunity.

You can play a bear market with put options. Granted you’ll have more leverage. But options expire. When you short stocks there is no time element to worry about.

Selling shorts also protects your equity portfolio. Own a lot of technology stocks? If Dell, Microsoft and Oracle release lower than expected earnings your tech holdings could take a hit. You can hedge yourself by shorting a couple of poor performers or even the NASDAQ 100.

Speaking of which, if you believe a certain stock sector will experience hard times, you can short the ETF that corresponds to that group.

Believe the banking industry still has the “worst yet to come”? Try the UltraShort Financials ProShares (SKF). You don’t even have to go through the process of shorting. This ETF comes “short ready”. Just buy it.

The fact that the price is going up does not mean the banking sector is doing well. Au contraire Monsieur.

An UltraShort ETF that has a rising price is doing well…..because the underlying index is doing poorly. 

How does it work?

When you go long, you buy at $10 and pray it goes to $18. When you short, you sell at $18 and hope it just goes lower.

The process goes like this: You place an order to “sell short” 500 shares of WFMI. Your broker lends you the shares from his firm’s inventory. The shares might come from another account holder’s portfolio. Bigger, more liquid stocks are easier to short.

You can place a limit order and fix the price you’ll get when the shares are initially sold; but you may not get the order filled. Most firms do not offer Good-Till-Canceled orders on shorts. You’ll have to try again tomorrow if you can’t get filled.

When your short order gets filled, you’ll be part of the minority that hopes WFMI crashes.

Assuming you sold short on November 1st, with a big fat smile on your face you would place a “buy to cover” 500 shares of WFMI on November 29th. The shares are returned to the owner and you make $5,000 in a couple of weeks. Some Stipulations

  • You must have a margin account to short stocks.
  • The short squeeze: This happens when your broker must return your borrowed shares to the owner. This rarely happens. If it does, you must buy back the shares regardless of price.
  • You cannot short stocks in a retirement account.
  • Short sellers are responsible for paying any dividends that are issued.
  • Your broker must have the stock available in inventory.
  • Penny stocks, low priced stocks and foreign stocks may be off-limits. They’re too risky.
  • If your short stock position goes against you at about 20% – 25%, buy to cover and cut you losses. Successful short-sellers just like their friendly longs, minimize losses with exit rules

People are turned off by short selling because of horror stories. If you have a short position and it starts to rise, they say it can rise forever thereby wiping you and future generations out. First of all, stocks do not rise forever. Second of all, if you had an exit strategy, the losses would be minimal. There are plenty of short potentials. If you are short on margin you can increase your upside potential.

75% of all stocks follow the broad market. If the indexes are looking bearish it’s even easier to find a loser. A sinking tide sinks all boats. Let’s face it. We have a war going on, the price of oil rising, credit crisis, mortgage problems, national debt at an all-time high, U.S. banks getting slammed…the list goes on. The bad news is good news, for shorts.

With that being said, I still wake up each morning feeling optimistic. However, by following the rules listed above short selling is a good way to profit from stock market misery.

Conclusion: 

short selling is a little bit difficult, but it generates efficient profit through the rise and drop of the stock market. In this area, we explain How short sellers work and how shorting stock works in the market. Check here the advantages and disadvantages of shorting stocks. 

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