I know we normally focus on the "long" side of the market here at StreetAuthority. And on the rare occasions we discuss betting against a stock, fund or the broader market, we usually do so within the context of options.
For most, if you want to bet against a stock -- options are the way to go. As my colleague Amber Hestla will tell you, the risk/reward profile is much more favorable.
But first, let's be clear: Shorting is not a panacea. Most traders shouldn't make more than a few short plays within a given year. Others, perhaps only a few within their lifetime. (And some not at all...
So now, having said all this, be prepared to expand your horizons...
How To Short Stocks
Shorting a stock is as easy as going "long" a stock -- once you understand the basics.
When investors go long, it means they're buying shares of a stock in the belief that the price of shares will rise over time. If and when they do, they'll ideally sell the shares back to the market at a later date for a higher price than what they paid. If they're wrong, they'll sell the shares back for a loss.
When investors short a stock, the same thing happens, but in reverse. A trader will first sell shares of a stock by borrowing them from their broker, anticipating the share price will drop. If that happens, they'll turn around and buy these shares back for a lower price and return them to their broker.
So instead of buying, owning and selling shares back to the market... you first borrow, then sell, and then buy back (or "cover") shares.
There are few other key differences to take note of, however, and you need to understand the risks involved.
One aspect of shorting that often scares investors away is the idea of unlimited downside. Let me explain...
When you take a long position on a stock, your downside risk is limited. For example, if you bought a share of XYZ stock for $50, then the worst that could happen is the stock price moves to $0. Now, a 100% loss on your investment. Sounds awful, right?
When you sell a stock short, the share price could rise to $55, $70, $100 and higher -- all the way to hypothetical infinity. Since there is no limit on how high a stock's price can go, short sellers theoretically have infinite downside potential.
Sounds scary, right? This is probably the single biggest reason why most investors who understand shorting stocks don't do it.
But if you implement a few simple strategies, then you can capture solid returns and mitigate unnecessary risk. Honestly, you should probably consider using what I'm about to tell you whether you're going long or short on stocks. After all, one bad investment choice can ruin an entire portfolio.
Mitigating Downside Risk
First step: cut your losses. A 25% loser will mathematically require a 33% gain just to break even. If you let a loser fall 50%, then you have to make a 100% gain in order to get your money back. It gets worse the longer you let your losers ride. By cutting your losses, you'll never have to face that daunting task of picking the next triple-digit winner just to get back to square one.
The best way to do this is by using either a hard stop-loss or a trailing stop.
Let's look at an example...
Let's say you decide to implement a 20% trailing stop loss on that XYZ stock you bought at $50. If the stock hits at $40, then a sell order will be entered automatically, thus getting you out of the stock. It's a different animal if you choose to use a "mental" stop-loss instead of using one through your online broker. It's up to you to decide whether you have the self-discipline to actually carry this out on your own, though.
However, if the stock rises to, say, $60 after you buy, then your trailing stop moves up with the price of the stock. So now your new exit price would be $48 (20% of $60 is $12, $60 - $12 = $48).
The percentage loss that you decide on is up to you. But the important thing is that this gets you thinking about how much of a loss you are willing to accept before you find out later, when it's much more painful.
As a rule of thumb if you are buying a stock that tends to be more volatile, then you probably want to implement a wider stop-loss percentage. Volatility can easily be determined by looking at the stock's beta.
Whatever stop you decide to use -- a hard stop at a specific price, a trailing stop, a "mental" stop -- it doesn't matter as much as actually implementing the stop. It's the habit and discipline of following your exit strategy that is far more important than the actual number you use.
Next, you should always remember to use sensible position sizing. (That means don't bet the farm on one short trade.) Again, this applies whether you're going long or short. But since the hypothetical risk is elevated with going short, this is all worth repeating. Whether you're shorting stocks or going long, this is something every investor should implement in their portfolio.
An Important Announcement
Mark your calendars for Black Friday this year. On Friday, November 29, my colleague Amber Hestla will be hosting an online masterclass where she'll teach you everything you need to know to make simple, effective high-payout trades that will help you generate more income than you ever thought possible. In fact, we're so sure you can use his program to become an income millionaire, we’ll pay you $1,000 to get you started. Go here to learn more and sign up for this one-of-a-kind event.