The current market environment has left a sour taste in many an aspiring millionaires mouths. The vast loss of value that has occurred in capital markets has been of historic proportion, and seems to have struck without rhyme or reason. Yet with some sophistication, portfolios can be protected and even flourish during this era of falling stock market prices.
The technique Im referring to happens to be popular with hedge fund managers " those stock market whizzes pulling millions of dollars a year in exchange for managing their portfolios. This technique was also responsible for the creation of many a millionaire during the 1929 stock market crash. Yet this same technique is shunned by the public, due to its intrinsic counter-intuitive nature. Still, mastery of this technique " and its a lot simpler then you may think " its essential to doing well in bear markets such as this one.
Shorting a stock is actually a fairly simple process. When you buy a stock, you hope to buy low, and sell high. When your shorting a stock, your goal is to sell high, and then buy low. When you short a stock, you borrow it from your broker, and then sell it. You keep the money from this sale. Then, after the stock has dropped, you buy it back for less, pocketing the difference between what you bought and sold it for. After buying it back, you give it back to your broker, and your exactly where you started, just with more money.
An example... In early October, Kellogg (K) was trading for around $56.00 per share. Over the next two months, it dropped from just over $55.00, to $42.00 per share. Shorting 100 shares of Kellogg would have, in this instance, had a profit of $1400. The procedure would be the following. When you short the stock at $56.00, you borrow 100 shares from your broker, and sell them on the open market, giving you $5600. Later on, you decide to buy back those shares, and return them to your broker, while Kellogg is at $42.00. This costs you $4200. Now you have covered your short position, for a profit of $1400. Not to shabby for 2 months, and a $5600 investment.
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?).
Regardless of how you play the markets, an eye must be kept on the most important element of all " risk. While shorting helps to remove some of the systematic risk from your portfolio " a portfolio composed of both buying stocks, and short stocks, is less venerable to a market crash " it does carry its own unique risks. Especially in a bear market, it pays to watch the news on your shorts. Any good news that comes out may raise the stock price of those that your shorting, and if a stock isnt going down anymore, its not a good stock to be short. The bigger risk to your short positions is the end of a bear market. When the new bull market ends, many short positions will quickly swing towards unprofitability, and so you must be quick to close them.
One standard practice among investment professionals is the 5% rule. This rule is used when deciding how many shares of a company to buy/short, and is an invaluable tool when shorting stocks. Lets say you want to short a $15 stock, but your not sure how many shares to short. First take the amount of money in your portfolio, say, $10000. Then, take 5% of that. $500. That is the amount you can risk on this transaction. Next determine the most logical stop loss. Lets say you decide if the stock goes above $17.50, youll sell your shares using a stop loss. If you can lose 2.50 per share, and your willing to risk $500, then you would short 200 shares of the stock, maximum. Many risk adverse investors choose only 2 or 3%, but 5% serves as a good maximum for even most risk-tolerant investors.
The current trend in the market is down. This is the most important thing to keep in mind when deciding where youll invest your money at this point in time. When the stock market is in bear market mode, almost all stocks are moving downwards. When this happens, it doesnt make sense to buy-and-hold like the masses. A far more productive approach is to find out whats working and to use that method instead. In the context of a bear market, the easiest way to make money is to short stocks or etf's.
The technique Im referring to happens to be popular with hedge fund managers " those stock market whizzes pulling millions of dollars a year in exchange for managing their portfolios. This technique was also responsible for the creation of many a millionaire during the 1929 stock market crash. Yet this same technique is shunned by the public, due to its intrinsic counter-intuitive nature. Still, mastery of this technique " and its a lot simpler then you may think " its essential to doing well in bear markets such as this one.
Shorting a stock is actually a fairly simple process. When you buy a stock, you hope to buy low, and sell high. When your shorting a stock, your goal is to sell high, and then buy low. When you short a stock, you borrow it from your broker, and then sell it. You keep the money from this sale. Then, after the stock has dropped, you buy it back for less, pocketing the difference between what you bought and sold it for. After buying it back, you give it back to your broker, and your exactly where you started, just with more money.
An example... In early October, Kellogg (K) was trading for around $56.00 per share. Over the next two months, it dropped from just over $55.00, to $42.00 per share. Shorting 100 shares of Kellogg would have, in this instance, had a profit of $1400. The procedure would be the following. When you short the stock at $56.00, you borrow 100 shares from your broker, and sell them on the open market, giving you $5600. Later on, you decide to buy back those shares, and return them to your broker, while Kellogg is at $42.00. This costs you $4200. Now you have covered your short position, for a profit of $1400. Not to shabby for 2 months, and a $5600 investment.
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?).
Regardless of how you play the markets, an eye must be kept on the most important element of all " risk. While shorting helps to remove some of the systematic risk from your portfolio " a portfolio composed of both buying stocks, and short stocks, is less venerable to a market crash " it does carry its own unique risks. Especially in a bear market, it pays to watch the news on your shorts. Any good news that comes out may raise the stock price of those that your shorting, and if a stock isnt going down anymore, its not a good stock to be short. The bigger risk to your short positions is the end of a bear market. When the new bull market ends, many short positions will quickly swing towards unprofitability, and so you must be quick to close them.
One standard practice among investment professionals is the 5% rule. This rule is used when deciding how many shares of a company to buy/short, and is an invaluable tool when shorting stocks. Lets say you want to short a $15 stock, but your not sure how many shares to short. First take the amount of money in your portfolio, say, $10000. Then, take 5% of that. $500. That is the amount you can risk on this transaction. Next determine the most logical stop loss. Lets say you decide if the stock goes above $17.50, youll sell your shares using a stop loss. If you can lose 2.50 per share, and your willing to risk $500, then you would short 200 shares of the stock, maximum. Many risk adverse investors choose only 2 or 3%, but 5% serves as a good maximum for even most risk-tolerant investors.
The current trend in the market is down. This is the most important thing to keep in mind when deciding where youll invest your money at this point in time. When the stock market is in bear market mode, almost all stocks are moving downwards. When this happens, it doesnt make sense to buy-and-hold like the masses. A far more productive approach is to find out whats working and to use that method instead. In the context of a bear market, the easiest way to make money is to short stocks or etf's.
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