With the market routinely setting new all-time highs, it's easy to feel like the ride will never end. But I'm old enough to remember feeling the same thing in 2007 -- before the financial crisis. Same goes for 1999 -- before the tech bubble burst.
I could go on, but I think you get the idea.
Stop me if you've heard me say this before, but remember: The bull market may not end tomorrow, but make no mistake, we're much closer to the end than the beginning.
With this in mind, I'd thought we'd spend some time today talking about how to "short" a stock -- that is, how to bet against a stock or fund in the hope that it will fall.
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. In fact, my colleague Jared Levy is one of the best bearish options traders I've ever seen.
For most, if you want to bet against a stock -- options are the way to go in our opinion. As Jared will tell you, the risk/reward profile is much more favorable.
But what if you want to ignore my advice and short stocks anyway? After all, everyone's situation is different. Maybe you have your reasons. Or maybe you simply want to have a better understanding of how shorting works before you decide to follow our advice and use options to hedge your losses and maximize your upside.
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 short plays within their lifetime. 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 sell the shares back to the market at a later date for a higher price than what they paid for them. 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 to the market 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 from the market.
There are few other key differences to take note of, however, and you need to understand the risks involved.
Mitigating Downside Risk
One aspect of shorting that often scares investors away is the idea of unlimited downside. But if you implement a few simple strategies, then you can capture gains and mitigate unnecessary risk.
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, a 100% loss on your investment.
When you sell a stock short (again, say, XYZ for $50), 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.
Let's be clear: This is probably the single biggest reason why most investors who understand shorting stocks don't do it.
But you can steer clear of this scary proposition with a few simple steps. Honestly, you should probably consider using them whether you're going long or short on stocks. After all, one bad investment choice can ruin an entire portfolio -- whether it's a long or short position.
Let's take a look at what I mean...
You have ten stocks in your portfolio and the majority of them are in the green (or positive year-to-date). There are two stocks that sport negative returns since you bought them, but you continue to hold on... you just know they are bound to turn around. You wouldn't dare sell them at a loss, because hopefully they'll rebound.
Well let me tell you something: Hope isn't a strategy. Sell those stinkers like stinkers they are. Those two bad stock investments have the potential to turn your entire portfolio from a possible double-digit winner into one that is barely staying afloat. It's simple math.
If you let a loser fall 50%, then, in order to get your money back, you have to make a 100% gain. It gets worse the longer you let your losers ride.
Even a 25% loser will mathematically require a 33% gain just to break even again. 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.
So what can be done to avoid allowing a couple stocks to decimate your entire portfolio whether you're going long or short? Simple... Cut your losses by using either a trailing stop or a stop loss and use sensible position sizing.
Sounds easy, but there's a reason study after study shows that closing a position is one of the hardest tactics for investors to implement.
That's because following the daily chaos of the stock market can make just about anybody insane. A trailing stop loss or a hard stop loss -- whichever exit strategy you decide to follow -- will help you sleep better at night and limit your losses.
Having an exit strategy in place will immediately put you head and shoulders above the crowd when it comes to investing. And the great thing is that it's extremely easy.
Let's look at an example:
Let's say you decided to implement a 20% trailing stop loss, and you bought one share of XYZ's stock 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 obviously 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 can enforce the self-discipline to actually carry it out 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 to implement is up to you, but as a rule of thumb if you are buying a stock that tends to be more volatile, then you 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.
By following an exit strategy and cutting your losses, you will dramatically increase your investment results. Whether you're shorting stocks or going long, buying for the long-run or trading, this is something every investor should implement in their portfolio.
A Better Way To Bet Against Stocks
I mentioned earlier that we here at StreetAuthority typically prefer using options to bet against stocks. Jared's strategy will be detailed in full in tomorrow's issue, but here's a little preview of what you can expect.
For those who don't know him, Jared is one of the market's foremost experts on options. He developed his trading strategy at the age of 16, was making $600,000 a year with it by 18 -- and has since gone on to one of the most impressive trading careers of anyone around. As Chief Strategist of Profit Amplifier, Jared shows his premium readers how to hedge risk and maximize profit from both the upside and downside of stocks and funds by using his simple options strategy.
In tomorrow's issue, Jared will discuss how to use put options to bet against stocks. Since beginning his Profit Amplifier service two years ago, his average put option trade has remained open for only 28 days, while delivering an annualized return of 658%. If you can't wait until tomorrow, or don't need any more convincing, I invite you to click here.
This article originally appeared on Street Authority.