Continuation from yesterday…..(Buy Low, Sell High, Go Short & Cover)
Wikipedia defines short selling as a practice of selling securities or other financial instruments that are not currently owned, and subsequently repurchasing them (covering) to exit the transaction. If you are not familiar with the process, it is not as complicated as it sounds. Going short or taking a short position is the exact opposite of going long or purchasing stock in anticipation of a price increase. When you go short you anticipate or you bet on the upcoming price decline. The transaction is initiated when you borrow shares of the underlying stock and immediately sell it in the open market. If your forecast proves accurate you will close the transaction at a later date by repurchasing the stock at a lower price and returning it to its rightful owner. Keeping the spread between your entry and exit points. And while it might sound complicated, the entire transaction can be done with one click. Just as if you were going long.
Now, the financial industry has done a fairly good job brainwashing the public into believing that short selling is inherently more risky than going long. Why? For a few primary reasons when short selling is compared to taking a long position. First, the potential loss on a short sale is theoretically unlimited as compared to a 100% maximum loss when going long. Second, the maximum gain is limited to 100% while your maximum gain on going long is theoretically unlimited. Third, most markets and individual stocks are naturally long centric, increasing in value over time. Finally, there are extra costs associated with taking a short position.
Let’s now take a closer look at each one of these points to see if they hold up to scrutiny.
- Unlimited Loss Potential:
When you open up a short position you open yourself up to an unlimited loss. Theoretically at least. Let’s assume that you have done your research and you believe that Apple Inc (AAPL) stock price is about to decline from $100 a share to $50 a share. By going short at $100 and presumably getting out at some point in the future at $50 a share you are planning to generate a net gain of $50 or 50%. As a result, you take a short position at $100.
Unfortunately for you, the next morning Apple announced that it created a time machine, went into the future and brought back technology from the year 2225. What’s more, they will make this technology available over the next few months and by doing so Apple will literally take over the world. As a result, Apple’s stock price surged to $1,000 or 900% a share even before the market opened.
Guess what happened to your short position? That’s right, you just lost $900 a share or 900%. It now becomes your responsibility to close this trade at a massive loss before going and crying to your mommy and daddy. That’s what most in the financial industry mean when they indicate that your losses can be unlimited when you initiate a short position.
Rebuttal:
The scenario above is hypothetical at best. In reality, very few stocks open up with gap ups of 5-10% higher, let alone 100% or higher. It does happen on rare occasions, but you shouldn’t be shorting such stocks to begin with. When it does happen, it typically happens to stocks in the Bio Tech industry after their drug is approved by the FDA or stocks that might be acquired in a merger or stocks with upside earnings surprises or perhaps stocks of companies that have just reached some sort of a favorable legal resolution in a big legal matter, etc….. Point being, large overnight gains or gap ups (before the market opens), shouldn’t come out of the blue. If you approach short selling from a well researched position, as you should, you wouldn’t be shorting such stock to begin with.
To Be Continued On Monday……
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