Stock Market: Going Shorting Stocks (Pt 3)

by Wes Bridel on August 6, 2010

in Stewardship

Shorting Stocks helps you make money when the stock market is heading south.  We’ve been discussing shorting stocks.  We recently talked about the advantages & disadvantages of shorting stocks.

Today, let’s look at a couple ways to be short the stock market

1)      As we’ve explained, you can sell short a particular stock.  Again, unless you have particular knowledge that a company is really on its last leg, you would not want to do this in a rising stock market environment.  Once you start paying attention to these things, you will be amazed how the price of a really bad company can continue to rise simply because money keeps pouring into the market.  Remember the saying…“A rising tide lifts all ships.”  However, if you feel that the market is likely to fall, it might be a great idea to find a company that you see is particularly in bad shape and short that stock.  It might fall a lot harder than the overall market because other investors will know that they are in trouble and jump ship as the market starts falling.

2)      Short ETF’s are an easier way for shorting stocks by sector, or larger indexes of the stock market.  A Short ETF (Exchange Traded Fund) goes up when the underlying market goes down and it goes down when the underlying market goes up.  A Short ETF is a security that trades like a stock, but is actually made up of derivatives used to approximate the opposite of the market or sector index it is intending to short.

There are both advantages and disadvantages to using Short ETF’s as opposed to shorting individual stocks.

Some Advantages to Short ETF’s are

A)     You can short an entire market or sector with one position instead of betting on only one company.

B)      You can invest in a Short ETF in non margin accounts such as retirement funds that might not otherwise allow you to short a stock.

C)      You are “buying” the Short ETF and thus your losses are limited to the amount that you invest.

D)     You can buy a Leveraged Short ETF which attempts to move at 1.25X, 1.5X, 2X, 3X or more the opposite of the movement of the underlying index.  If you are correct that the index you are speculating against goes down, then you will be rewarded when the Leveraged Short ETF goes up by a multiple of the price movement.

Some Disadvantages to Short ETF’s are

A)     There are certain costs inherent within the mechanism of a Short ETF so that over time, the position has drag that does not keep up with the opposite of the underlying index it is attempting to be the opposite of.  In other words, this type of trade works pretty well in the short term, but the longer you hold the position, the less it does what you are expecting/hoping it will do.  What happens is the volatility you experience in any market slowly eats away at your position so that if the price moves up and down between 5 and 10 over the course of the year and at the end of the year you sell the ETF while the underlying index is at the same number you bought it at, the ETF will be worth less than when you originally bought it.

B)      If you use a Leveraged Short ETF, and you are wrong and the price moves against you (remember you’re betting against the long term trend of the index) you will LOSE money at a multiple to the rate of increase of the underlying index.  This is a very fast way to lose a lot of money!

If you really believe strongly that the stock market is heading down (or you simply want to hedge some long positions in your portfolio by shorting stocks, I hope your eyes are open to some new possibilities.  We’ll continue this discussion in the next post.

If you have any thoughts or questions on this or other topics, please let us know.

Shorting Stocks helps you make money when the stock market is heading south. We’ve been discussing asset management in a crazy economy. We recently talked about the advantages & disadvantages of shorting stocks.

Today, let’s look at a couple ways to be short the stock market

1) As we’ve explained, you can sell short a particular stock. Again, unless you have particular knowledge that a company is really on its last leg, you would not want to do this in a rising stock market environment. Once you start paying attention to these things, you will be amazed how the price of a really bad company can continue to rise simply because money keeps pouring into the market. Remember the saying…“A rising tide lifts all ships.” However, if you feel that the market is likely to fall, it might be a great idea to find a company that you see is particularly in bad shape and short that stock. It might fall a lot harder than the overall market because other investors will know that they are in trouble and jump ship as the market starts falling.

2) Short ETF’s are an easier way for shorting stocks by sector, or larger indexes of the stock market. A Short ETF (Exchange Traded Fund) goes up when the underlying market goes down and it goes down when the underlying market goes up. A Short ETF is a security that trades like a stock, but is actually made up of derivatives used to approximate the opposite of the market or sector index it is intending to short.

There are both advantages and disadvantages to using Short ETF’s as opposed to shorting individual stocks.

Some Advantages to Short ETF’s are

A) You can short an entire market or sector with one position instead of betting on only one company.

B) You can invest in a Short ETF in non margin accounts such as retirement funds that might not otherwise allow you to short a stock.

C) You are “buying” the Short ETF and thus your losses are limited to the amount that you invest.

D) You can buy a Leveraged Short ETF which attempts to move at 1.25X, 1.5X, 2X, 3X or more the opposite of the movement of the underlying index. If you are correct that the index you are speculating against goes down, then you will be rewarded when the Leveraged Short ETF goes up by a multiple of the price movement.

Some Disadvantages to Short ETF’s are

A) There are certain costs inherent within the mechanism of a Short ETF so that over time, the position has drag that does not keep up with the opposite of the underlying index it is attempting to be the opposite of. In other words, this type of trade works pretty well in the short term, but the longer you hold the position, the less it does what you are expecting/hoping it will do. What happens is the volatility you experience in any market slowly eats away at your position so that if the price moves up and down between 5 and 10 over the course of the year and at the end of the year you sell the ETF while the underlying index is at the same number you bought it at, the ETF will be worth less than when you originally bought it.

B) If you use a Leveraged Short ETF, and you are wrong and the price moves against you (remember you’re betting against the long term trend of the index) you will LOSE money at a multiple to the rate of increase of the underlying index. This is a very fast way to lose a lot of money!

If you really believe strongly that the stock market is heading down (or you simply want to hedge some long positions in your portfolio by shorting stocks, I hope your eyes are open to some new possibilities. We’ll continue this discussion in the next post.

If you have any thoughts or questions on this or other topics, please let us know.

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