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Short Selling 101

You've got your basic Bermuda shorts athletic shorts and casual shorts but my personal favorites are stock shorts'.  Normally you wouldn't want to get caught with your Bermuda shorts down but in the case of stock shorts I don't mind when they are down around my ankles.  I'm talking about short selling stocks and the lower they go the better.  For those of you who are less experienced in the market I'll explain short selling briefly in this Bulletin because we may do a little more of this type of trading in the future if the market continues to decline.  

Short selling a stock is when you borrow shares from your broker that you do not own and then sell them to a buyer in the open market.  You are betting on the stock price declining so that at some point in the future you can buy back shares at a lower price to cover your position.  You buy shares and then give those back to the broker to replace the shares that you borrowed and sold.  You profit if the stock goes down by keeping the difference between your cover price and the price you sold them at in the first place.  

If the stock goes up you lose money when you pay back your broker.  Not everyone lost money with the stock market decline that started in 2000.  Short sellers made huge amounts of money during that 3 year period.  I for one did very well but the pros don't want you to know about short selling.  They want you to believe there is only one way to profit and that is on the long side.  Shorting stocks is just another tool that will allow you to be profitable even when the markets go down.   

The best time to short sell stocks is in a bear market or general market decline.  I very rarely sell short stocks that are above their 50 or 200 day moving average.  Stocks that are below this average are prime candidates to short.  I don't like short selling stocks above these averages because if the price is above these longer term averages then the trend is up and we don't short stocks trending up (that is financial suicide in my opinion).  

We don't buy stocks going down so why would we want to short stocks going up For short term short positions we can short above these averages but only into strength and as they reach resistance levels to likely pullback from. 

A Word of Caution
If you purchase a long position in a stock the worst you can do is to loose 100% of your investment.  A stock bought at $5 that goes bankrupt and drops to $0 will be a 100% loss.  

However when you take a short position you risk an exponential loss.  A stock that you short at $5 can go to $10 or even $20.  Instead of simply losing $5 or 100% you can lose 200% 300% and so on.  That is why protective stops are vital when short selling a stock.  
Placing a protective stop is a must when shorting a stock.  

I remember back in 1999 an acquaintance of mine shorted CMRC.  That stock was rising $50$100.00 a share each day.  The stock price was eventually $1000.00 a share in the mania that existed during the bubble years.  We all knew the rise in the stock was ridiculous and knew it had to eventually come back to earth but the thing is it's too hard to guess a top.  It's the reverse of trying to catch a falling knife when a stock is going down.  You wait for support and for the stock to base and start going up before taking a long position; this is called the bottoming process'.  Same with shorting you won't short the very top but if you wait for the trend to reverse then it will be a less risky trade.  

Needless to say my acquaintance loss a lot of money he was force to cover his trade on a margin call with a substantial loss (more than 100%).  There is no limit to losses when shorting; it is an extremely risky way to trade.  He had the right idea when he shorted this stock but he was way too early in doing so.  The stock had a 31 split and from there its demise began with the bubble burst in March of 2000.  The stock now trades at 1.89 and that is after a reverse stock split of more than the original 3 for 1 split.  

The person I spoke of above could have made a tremendous amount of money if he had not shorted too early.  He tried to short the top.  The point here is: like any long trade you never want to be too early.  Wait for the trend to be established before you take the trade.  Shorting too early without the use of protective stops is a recipe for disaster and a great way to get caught with your shorts up.

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