Investing while the market is crashing around one’s ears. What an absolutely mad thought? Or is it?
Even yoda might have trouble figuring out the current market environment. In a world of falling prices, how can wealth be protected? I have some news for you. Even in a falling market, wealth can be not just preserved; it can be created. With just a few simple techniques, I’ll show you how to supersize your portfolio.
Shorting stock. The phrase sends a blood-curdling chill down many a buy-and-hold investors spine, frightening them into a shock-induced state of confusion. Yet for masters of this easier-then-it-sounds technique, its an extremely profitable oasis within the uncompromising desert that is this bear. Confused? Its like this… the vast majority of investors only buy stocks. When you buy a stock, there are two ways to make money. Stock price appreciation (buy low, sell high), and dividends. Which is all well and good when the market is going up, but for markets such as the one we’re currently embroiled in, we need a whole different animal.
To short a stock is essentially to sell it, and then buy it at a later date. Counter-intuitive, no? In the shorting process, you borrow the stock from your broker, sell it on the open market, and when the price has fallen sufficiently, you buy it back again, and return it to your broker.
An example… In late August 2008, Ford was trading for around 4.50. If you decided to short 100 shares of ford at that point, then you would borrow 100 shares of Ford from your broker and sell them for a total of $450. In late October 2008, Ford was down to the 2.25 range. At that point, you could buy back the 100 shares you sold for $225, return the 100 shares to your broker, and all in all, you made $225. In essence, you sold high, then bought low. Its just like buying low, and selling high – it just operates in reverse. This would be a good time to re-read this paragraph, its that important.
Another way to think of shorting stocks is to own a negative number of shares… If you own 100 shares of a stock, and it goes down $10, then you lost $1000. If you own -100 shares of a stock (or your short 10 shares of a stock), and it goes down 10$ then you gain $1000. Of course, if the unthinkable happens, and the stock appreciates by 10$, then your down $1000 (What, did you think it was riskless?).
Even still, shorting stocks has risks. If you choose the one stock of 100 that is about to start trending upwards, you could lose some money on that. Different sectors of the economy may also be effected by events that cause exceptions to the “everything goes down in bear markets” rule. The recent auto bailout could feasibly cause industrials to go up for a while, so shorting industrials could choose to be a bad choice. The biggest risk is that the bear market turns into a bull market while your not paying attention – that could rack up losses on many positions at once.
A typical risk-management choice many professionals use is the 5% rule. When your trading stocks, don’t risk more then 5% of your portfolio on any one position, and preferably less. So with the $20000 portfolio, risk no more then $1000 on a trade. This doesn’t mean you can’t invest more then $1000 per trade. It just means that your stop loss should be triggered before $1000 is lost. So if you short a stock at $20, and have a stop loss at $25, then you can buy up to 200 shares (far more then the actual value of your portfolio). If your time span is shorter, then you should use a smaller percentage, while if your timespan is longer then a couple months, the 5% rule could be adjusted as high as 10% (for the risk-tolerant).
In a bear market, there is just one, singularly important, yet amazingly simple truth that must always be kept in mind. Everything’s going down. Throw 3 random letters together, and pull up a stock chart, and every time, you’ll see declining prices throughout a bear market. With this in mind, shorting is the only thing that makes sense. Masters of this technique have been pulling millions in from the market since the dawn of the last century. As far back as the 1929 crash, Jesse Livermore made $100 MILLION using this technique. In a strong bear market, shorting ETF’s and Stock can be a brutally efficient cash machine.