by Karim Rahemtulla, Options Expert
Tuesday, July 20, 2010: Issue #1305
As a group, investors tend to be an optimistic lot.
At least, that’s what we’ve all been force-fed. It’s almost un-American in some circles to bet on a company’s share price heading lower.
It’s why many investment advisory services only focus on one-sided trades – those that assume the market will always go higher. It’s an erroneous assumption… but one that’s very easy to sell.
However, the truth is that over the past decade, the returns from cash-based investments have outpaced those from the stock market. That alone should tell you that stocks can – and do – go down.
You’ve probably experienced a few minefield investments that could have been avoided. So how can you turn a stock’s loss into your own gain?
Get Shorty
The obvious answer would appear to be to sell shares short – the strategy that everyone loves to hate, but works effectively if you use it properly.
And there’s the rub.
Short-selling is a tough gig to pull off. It’s complex. It’s risky. And if you get it wrong, you’re staring down the barrel of unlimited losses.
Here’s a quick-fire rundown of how short-selling works:
- You “borrow” shares of a company’s stock from your broker (you don’t own the shares when you go short).
- You sell those shares into the market, hoping that the price drops.
- If/when the stock drops, you’re aiming to buy the shares back at a lower price and “return” them to your broker. If that happens, you pocket the difference between the price at which you sold and the price at which you bought back the shares.
As I mentioned, short sellers often aren’t popular, because they’re hoping the market and/or stock goes down. But regardless of what people think about you, there’s an even darker side…
Short-Selling… The Elephant in the Trading Room
Remember that part about short-selling being complicated? It is…
- Since the shares have to be replaced, they first have to be “shortable.” This means your broker has to initially obtain shares that can be borrowed for sale. And that’s not always the case unless you are dealing with larger companies.
- Second, you have to be able to buy back the shares – something that can only occur when the shares are actually trading. If you happen to be unlucky and the stock you’re shorting makes a positive announcement before the market opens, your risk is virtually unlimited if the shares move higher.
Take Dendreon (Nasdaq: DNDN), for example. How would you like to have sold the stock short on April 28, 2009 at $7.50, only to watch in horror as it opened at $27 the next day?
Or let’s say you shorted Citigroup (NYSE: C) on March 9, 2009 when it was trading at $1 and it looked like the company was going out of business. Well, on March 11, 2009 the shares opened at $1.67 – a 67% loss on your investment virtually overnight. Not a pleasant feeling.
And it wasn’t done there. By March 19, the stock had shot to $3.89. You’d have been on the hook to buy the shares at a higher price than you borrowed them and desperate to get out of the trade.
This is known as a short squeeze. Faced with mounting – and unlimited – losses as a stock rises, short sellers all scramble to buy back their positions en masse. The spike in buying demand, coupled with a lack of sellers, triggers a jump in price, and adds to existing losses on the short side.
So think carefully before deciding to short a stock, as it’s a strategy that can backfire badly. It’s certainly not for rookies – and even the pros are often caught with their shorts down (if you’ll pardon the pun!)
I’m currently in Vancouver for Agora Financial’s annual Investment Symposium, but in next week’s column, I’ll share with you one of the best strategies to capture the downside on stocks with limited risk and unlimited returns.
Yes, it involves using options – but there’s a twist to it that you won’t want to miss!
Good investing,
Karim Rahemtulla
Related Investment U Articles:
- LEAP Bear Spreads: If You Want to “Go Short,” This is the Way to Do It
- Why This Investment Strategy Thrives During Market Flash-Crashes
- The Best Trade You Can Make in November
- Investing in Options: An Insurance Policy Against a Volatile Market
- How to Recover When Your Option Trades Turn Against You
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Dubbed a "market maven" by CNBC, Karim Rahemtulla is one of the country's foremost specialists in options trading. As founder and editor of The Smart Cap Alert, he focuses his efforts on all aspects of options trading – LEAPS, put selling/covered calls and spreads. 
