I hope everyone had an enjoyable Thanksgiving. I know these can
be difficult times but Thanksgiving is a time to reawaken thoughts of
those things that are positive in our lives and perhaps change our
focus away from the negatives.
In the past couple of weeks, some subscribers have written and
asked about shorting stock. The markets are currently dealing with
levels of support that go back to 2003 and 2004 and we don't yet know
whether we are going to see another downward move or whether the
bottom has been hit. In any event, it is good to be aware of ways in
which a trader might profit in a down market even if it is to late to
do so in the current conditions.
Buy stock low and sell high is a common way investors see the
way to profits in the markets but that is only possible when the
market is moving up. What can be done to garner profits when the
markets are falling as has been the case in recent times? There are a
variety of ways to make money in a down market, many of which I detail
in my first book, "Trade Your Way to Wealth" . One of those ways is to
sell short.
Short selling is the same as buy low and sell high except it is
done in reverse. First, we sell the stock at a high price and later we
buy it at a lower price. The difference, less commissions, is our
profit. The first question that usually is asked by investors who are
unfamiliar with the strategy is how can I sell something I don't own?
The answer is that we borrow the stock from our broker and sell it on
the open market. That brings cash into our account. Since we have
borrowed the stock, from the beginning, we know that we are going to
have to replace it and that means that at some time we will have to
buy the stock on the open market to cover the short position. That is
known as buying to cover.
An example may be helpful. Suppose we see that the markets are
falling and the chip sector is particularly weak. One of the stocks
in that sector, XYZ has recently come down after hitting a resistance
and is trading at $60 a share. We can see that there is a support
around $50 a share so we decide to sell the stock short. First we
check to see that the stock is available to borrow from our broker
and, if so, we sell it short at $60 a share. Suppose we sell short
100 shares at $60. That means $6,000 will come into our account at
settlement. Now the stock goes the way we thought it would and begins
to fall in price. It hits the $50 mark and we buy the stock to cover
our position. That will cost us $5,000, but the market paid us $6,000
in the first place so we make $1,000 (less commissions for the two
transactions)on the downward move.
It is important to realize that selling short can entail very
high risk. If we are wrong on the direction, we are still going to
have to buy to cover the position at some time. Suppose we sell XYZ
short at the same $60 a share and then the company announces some new
mega-chip and the stock price takes off and gaps up to $70 a share.
Now, we would have to pay $7,000 to buy to cover our 100 share short
position and would lose $1,000 plus commissions. Theoretically, the
upside is unlimited and the stock could go to $100 or $300 a share so
great care must be taken to assure that we have an exit strategy in
place before we ever initiate the short sale.
Since we have borrowed someone's stock to sell it short, we
should also be aware that they would be entitled to dividends if any
are declared and since we have sold their stock, we are responsible
for those dividends.
As I mentioned earlier, selling stock short is just one of many
ways to profit in a downward move. The trader would be well advised
to read and learn other strategies as well so that he can determine
what is most suitable for his own situation. In "Trade Your Way to Wealth" , for example, I discuss at least 5 distinct strategies,
including short sales, that a trader can use to profit in a downward
move. In Appendix D, I summarize those along with bullish and neutral
strategies to illustrate a number of things such as relative risk,
capital required, time frame, whether protection is provided, and the
level of monitoring that may be required. Knowledge, as is generally
the case, is key to success.
Good Trading!
Bill Kraft
Success Trading Group -- by the Success Trading Group Team
Our Success Trading service delivers quality trading ideas for the elite investor that has the financial wherewithal and market nimbleness to profit on small moves in a stock's price. Become a member and you will be provided with email and/or PDA alerts intended to provide you with the opportunity to make many, many profitable trades.
Here is a play from the Success Trading Group:
US Bancorp (USB)
Our Success Trading Group members closed another winning trade this week. We
sold a position in US Bancorp (Ticker: USB) which we had opened just last
Friday, November 21. We have several stock on our radar and we are watching
for new entry points for stocks such as GE, VZ and MDU.
Have a great weekend and we'll trade next week.
Success Trading Group Team
