Many folks have been looking for good short selling investments lately. It’s a reasonable idea, considered the 20% run for the market since Thanksgiving and the general feeling that the music will have to stop eventually.
But rather than offer some specific trades, I’d like to tackle some short-selling basics to help you protect your investment portfolio.
“Shorting” is commonly used as a catch-all way to refer to investors who play the downside of an investment. But short selling — that is, selling shares of a stock first so your portfolio is “short” and then buying shares later at (hopefully) a lower price to cover your trade — is not the only strategy.
And frankly, for most investors the short-selling game is very risky for two simple reasons: You have a risk of huge losses if things go wrong, and you are essentially using borrowed money to make your gamble.
First, let’s talk about the risk of huge losses in short selling. Believe it or not, your losses can be infinite. Obviously if you’re buying a stock, the worst you can do is for it to go to zero… a 100% loss. Best case scenario is that it goes up forever for infinite gains — or at least 1,000% or some crazy number like that. But when shorting, zero is the “best” you can do and the worst you can do is for a stock to soar and cause you 200%, 500% or 1,000% losses.
Put another way, there will never be a short trade that wins you more than 100%. Yet there is always a risk your losses could in fact be more than 100%.
This is rare, but indeed possible. Just consider what happened to Sears (NYSE:SHLD) this year as a case study. It was under $30 in January… and peaked at $82! That’s a 170% loss in short order. From a dollars and cents angle, you would have been better off buying a dud like Kodak and riding it to zero.
It’s also worth noting that short sales are made on “margin,” or with borrowed money from your brokerage firm where your investment is your collateral. After all, you’re selling first so you have nothing to show for the first leg of your trade.
It’s easy for losses to get out of hand with margin trades unless you are very disciplined. Think of it this way: You’re playing poker and have a great hand, but no money to raise your opponent. Your pal lends you $100 to increase the ante … a good idea if you wind up winning the hand, but if you lose you’re not just out your initial bet but you also still owe your friend a hundred bucks.
And then there’s the dreaded margin call — when your brokerage forces you to make a trade to raise cash and pay what you owe them, whether you like it or not…
A much safer way to play the downside for many investors is to open an account with a brokerage that allows you to trade options contracts instead.
What are options? On a basic level, an options contract gives you the right but NOT the obligation, to sell a stock at set price within a specified time. That’s why they are called “options” – because it’s your choice to fulfill your contract or not. The contract itself costs money, but that is the only skin you have in the game.
There are many different options strategies, but playing the downside via “buying puts” entails buying a contract to sell a stock at a price … even if in real trading it winds up significantly below that price. Your profit is the difference between the two.
Let’s go back to the stock that’s at $5. You buy puts on this company to sell it at $5… spending $500 on an options contract to sell 1,000 shares at that price. The stock drops to a nickel, meaning you can buy 1,000 shares at 5 cents on the open market and then sell them at $5 immediately. Not too shabby! You could also sell your contract to someone else if you wanted to.
But what if the price doesn’t drop below $5? What if it goes to $111? Well, then you say, “There is no way I am exercising my options contract! I’ll just let it expire unused.” You lose the whole of your $500 buy-in in that scenario.
Nobody likes that 100% loss. But hey, if the stock goes to $111, losing $500 is a heck of a lot better than being on the hook for a 1,000% loss.
There are many nuances to options, such as the expiration of contracts and the pricing of contracts. But I encourage you research this route if you are concerned with having a way to play the downside of the market.
Puts aren’t just for bears, either. Here’s an informational article about how to use put options to protect your profits or hedge your investments, even if you are long.
Of course, if you want a no-brainer way to play the downside? Try inverse ETFs the AdvisorShares Active Bear ETF (NYSE:HDGE), ProShares Short Dow30 (NYSE: DOG) or the ProShares Short MSCI Emerging Markets (NYSE: EUM). These “inverse ETFs” do the work for you, and move up as the market goes down.
Jeff Reeves is the editor of InvestorPlace.com. Write him at email@example.com, follow him on Twitter via @JeffReevesIP and become a fan of InvestorPlace on Facebook. As of this writing, he did not own a position in any of the aforementioned stocks.