Investment U's  Instablog

Investment U
Send Message
It’s a shame, really, that much of what is offered here – at no charge – is not taught in the public schools. Why is it that you can graduate in the top of your high school class and know next to nothing about credit card debt, adjustable-rate mortgages, or 401(k)s? Founded in 1999, the goal of... More
My company:
My blog:
Investment U
My book:
The Gone Fishin' Portfolio
  • Are You Scared Shortless?  0 comments
    Jul 21, 2010 9:28 AM | about stocks: DNDN, C
    Source Are You Scared Shortless?

    by Karim Rahemtulla, Investment U's Options Expert
    Issue #1305

    As a group, investors tend to be an optimistic lot.

    At least, that's what we've all been force-fed. It's almost un-American in some circles to bet on a company's share price heading lower.

    It's why many investment advisory services only focus on one-sided trades - those that assume the market will always go higher. It's an erroneous assumption... but one that's very easy to sell.

    However, the truth is that over the past decade, the returns from cash-based investments have outpaced those from the stock market. That alone should tell you that stocks can - and do - go down.

    You've probably experienced a few minefield investments that could have been avoided. So how can you turn a stock's loss into your own gain?

    Get Shorty

    The obvious answer would appear to be to sell shares short - the strategy that everyone loves to hate, but works effectively if you use it properly.

    And there's the rub.

    Short-selling is a tough gig to pull off. It's complex. It's risky. And if you get it wrong, you're staring down the barrel of unlimited losses.

    Here's a quick-fire rundown of how short-selling works:
    • You "borrow" shares of a company's stock from your broker (you don't own the shares when you go short).
    • You sell those shares into the market, hoping that the price drops.
    • If/when the stock drops, you're aiming to buy the shares back at a lower price and "return" them to your broker. If that happens, you pocket the difference between the price at which you sold and the price at which you bought back the shares.
    As I mentioned, short sellers often aren't popular, because they're hoping the market and/or stock goes down. But regardless of what people think about you, there's an even darker side...

    Short-Selling... The Elephant in the Trading Room

    Remember that part about short-selling being complicated? It is...
    • Since the shares have to be replaced, they first have to be "shortable." This means your broker has to initially obtain shares that can be borrowed for sale. And that's not always the case unless you are dealing with larger companies.
    • Second, you have to be able to buy back the shares - something that can only occur when the shares are actually trading. If you happen to be unlucky and the stock you're shorting makes a positive announcement before the market opens, your risk is virtually unlimited if the shares move higher.
    Take Dendreon (Nasdaq: DNDN), for example. How would you like to have sold the stock short on April 28, 2009 at $7.50, only to watch in horror as it opened at $27 the next day?

    Or let's say you shorted Citigroup (NYSE: C) on March 9, 2009 when it was trading at $1 and it looked like the company was going out of business. Well, on March 11, 2009 the shares opened at $1.67 - a 67% loss on your investment virtually overnight. Not a pleasant feeling.

    And it wasn't done there. By March 19, the stock had shot to $3.89. You'd have been on the hook to buy the shares at a higher price than you borrowed them and desperate to get out of the trade.

    This is known as a short squeeze. Faced with mounting - and unlimited - losses as a stock rises, short sellers all scramble to buy back their positions en masse. The spike in buying demand, coupled with a lack of sellers, triggers a jump in price, and adds to existing losses on the short side.

    So think carefully before deciding to short a stock, as it's a strategy that can backfire badly. It's certainly not for rookies - and even the pros are often caught with their shorts down (if you'll pardon the pun!)

    I'm currently in Vancouver for Agora Financial's annual Investment Symposium, but in next week's column, I'll share with you one of the best strategies to capture the downside on stocks with limited risk and unlimited returns.

    Yes, it involves using options - but there's a twist to it that you won't want to miss!

    Good investing,

    Karim Rahemtulla

    Editor's Note: As we mentioned here last week, the U.S. Treasury Department is in the middle of a massive "cash dump" - an effort to return all the financial bailout money back to taxpayers and investors.

    It's doing so by selling all the company shares it acquired during the financial crisis - worth a total of $25 billion. So far, it's unloaded close to $11 billion, so there's still around $14.5 billion left to go.

    Few people have heard about this campaign because the Treasury obviously isn't publicizing it. But Karim Rahemtulla has verified the details within the SEC report that the Treasury filed - and estimates that it could hand nimble investors a payday of more than $100,000.

    However, the deadline for taking advantage of this opportunity is today. Be sure to check out this report right now, as it has all the details you need to know.

    Disclosure: No Position
    Stocks: DNDN, C
Back To Investment U's Instablog HomePage »

Instablogs are blogs which are instantly set up and networked within the Seeking Alpha community. Instablog posts are not selected, edited or screened by Seeking Alpha editors, in contrast to contributors' articles.

Comments (0)
Track new comments
Be the first to comment
Full index of posts »
Latest Followers

Latest Comments

Most Commented
Instablogs are Seeking Alpha's free blogging platform customized for finance, with instant set up and exposure to millions of readers interested in the financial markets. Publish your own instablog in minutes.