It's one of the oldest tricks in the bag and it has a terrible reputation. But the sooner you learn how to use it, the sooner you'll be able to sleep soundly at night.
Bloomberg recently called it “ One of [Wall Street's] darkest arts. ”
Time says, “ It's a trick that has been hastening market crashes for at least 400 years .”
New York State's Attorney General Andrew Cuomo likens this strategy to “ looting after a hurricane. ”
Worst of all, it's always the first “fall guy” for politicians and media (check out the recent “expose” from the Daily Show as the perfect example) when times get tough.
It has been called evil, un-American, and destructive. Despite it all, it's one of the most profitable things you can do and one of the best ways to keep yourself protected in a bear market.
Before we go any further, I ask you to hear me out completely. Read this entirely until the end. And if you still disagree that's fine.
I'm about to ask you to think about something 99% of investors refuse to. I want you to put aside the old rules which have held up over the past 27-year bull market. Forget about the elegant and simple “buy low, sell high” rationale for the moment.
I want to talk about short selling.
Sell High and Buy Low
That's right. The maniacal, the unpopular, and little understood practice of short selling a stock.
In essence, it's a very simple practice. You borrow the shares from your broker. You sell them into the market. Then buy them back (the lower the price, the better) and return them to who you borrowed them from.
Sounds, pretty simple right? Well, it is if you do it in very liquid stocks, but most investors refuse to.
The reason most average investors don't do it is because of the simple math of investing. If you buy a stock, it technically has an unlimited upside. In theory, a stock's price can go up forever. When you sell short, you're maximum gain is 100%.
This couldn't be more wrong. From what I've learned from watching average investors, they will sell very quickly and won't hold out long enough for that “infinite” rise in value. And they probably won't even be holding on for the big gains in the long run. So that rationale doesn't really fit in most cases against short selling.
In the end, short selling successfully is based on the exact same rule of investing successfully, buy low and sell high. When you're selling a stock short, you just do it in reverse. You sell high first. Then you buy the share back at a low price.
At the risk of oversimplifying short selling, if done properly with reasonable stops and limit orders, it is just as safe as investing – if not safer. And it's a heck of a lot safer in bear markets (like what we're still in now).
Short-Selling is Not Bad
The “math” isn't the only thing holding most people back from short selling. It's also one of the worst marketed strategies for investing successfully.
We've all seen one of those infomercials on TV with some guy in a sports car who got rich thanks to some magic trading system and leveraged stock options trading. There are also those ads on the Internet that promise instant fortunes through currency trading. And there are plenty of others including “free money” and “checks from the government” and…well, anything that will get someone to bite.
All of those ads are painstakingly constructed by marketers trying to get a few people to do two things – to believe and to open their wallets. As I'm sure many buyers eventually realized, it really isn't as easy as it seems.
Also, the short-sellers are doing well while most everyone else is losing out big. Think of the ultra-successful short-sellers who uncovered problems at Enron, Worldcom, and Bear Stearns. They made money when other people were losing fortunes.
Naturally, they would be easy targets for the government regulators who failed to uncover the same problems. Also, the same folks who worked at Enron and would gladly collect bonuses, paychecks, and free shares from a company they had front row seats to watch.
Still though, despite all the odds being stacked against you when buying stock or currency options (the declining time values being the big culprit), they are still marketed as a “sure-fire” way to get rich quick.
Meanwhile, very few people try and make short-selling out to be nearly as glamorous even though it's much less risky than most people realize.
We've been over how stocks move a few times before. As the old saying goes, stocks climb up stairs and fall down the elevator. Every decade or so we get a big reminder of this and short-selling is the best way to take advantage of the way stocks naturally move – especially in a bear market.
There is one more very important thing most investors make the first time they “go short.”
The mistake is that they look at it as a trade instead of an investment. When most people sell a stock short, they look at it like a trade. They'll go in for the initial ride down, but when it turns against them, they jump out quickly.
I think most of them start thinking of the “unlimited” downside with a short sale on the slightest uptick. It's completely irrational especially if you're using trailing stops or other types of risk reduction strategies. But how many times are most investors rationale?
That's why I encourage investors to look at short selling as “uninvesting.”
As an uninvestor, you don't do anything extraordinarily different from when you buy a stock. You buy (in this case sell short) the same amount as you would normally when you buy a stock. You have the same time frame. You set the same stop points to limit risk if it goes against you. You do everything the same, you're just in position to benefit as the stock goes down.
The reason I bring this up today is because I believe there will be a tremendous opportunity to “uninvest” during this rally. The entire economic landscape is changing and the market has yet to anticipate all of them.
At the Prosperity Dispatch , we've talked about how many industries will get hit hard from new policies and regulations (i.e. payday loans, insurance, healthcare, etc.) and how the banking industry will be much more fragmented (“too big to fail” size will probably be outlawed by the time this is all said and done). On top of that we'll have all kinds of tax code changes which will further impact a lot of industries for good and bad (i.e. solar vs. coal).
Like it or not, we are facing a period of great change and the best thing to do is take advantage of that change. The willingness, knowledge, and ability to “uninvest” will be an invaluable tool to capitalize on that change.