Tahoe-Truckee Market Beat: Be careful when short selling
November 24, 2015
In the equity markets, short selling means selling a stock that you don't own. With a brokerage account, you can borrow shares and then sell a stock without ever owning it. The shares are purchased later to close out the position.
Short sellers hope to profit from a drop in the stock price. Many hedge funds and mutual funds practice short selling and it can be very profitable.
The practice is riskier than owning stocks. If you purchase a stock, the worst case scenario is that the stock drops all the way to zero and you could lose everything you paid for the stock. When you sell short, the stock could rise dramatically, causing losses far greater than just the initial amount you opened the position with.
According to a recent article in Market Watch, there was a trader who had a $37,000 account at a major online brokerage. He shorted a bio tech stock that traded with pretty thin volume. Some good news broke out on the stock overnight, and it soared 800 percent before the market opened the next day.
When he woke up, he discovered that his short position had gone against him and he owed the brokerage over $106,000. Apparently, he put out a plea for help on "GoFundMe" and it went viral. I think he actually got some contributions.
A margin account is required for short selling and caution should be used anytime you use leverage. It's very important to know what the worst case is.
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A long-term investor who buys stocks or mutual funds should be prepared to hold his or her investments through times of turbulence, use long-term money in the stock market, and be sure that investing in stocks is suitable for him or her.
People who re more aggressive or speculative in their trading should be aware of the risks and know how to hedge against "tail risk," which is the risk of a large adverse price movement.
One consideration is position sizing. If you're making risky trades, and the absolute worst case happens, you must be able to limit your loss to maybe 2 percent of the funds you have designated for aggressive trading. That means that with a hypothetical $100,000 trading account you should never lose more than $2,000 on any one trade.
Call options can be used to hedge short positions; a long call can limit your loss in the event of a large upside move. I would recommend that most investors forget about short selling, but if you do, be sure you understand the risks involved.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.