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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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Bear markets are bad times for investment advisory services, owing to public psychologyShort Selling 101 Predominant opinions are generally the opinions of the generation that is vanishing. Benjamin Disraeli When I discuss the business with other advisory service owners, they tell me that it is difficult to sell their publications unless they advise buys, or to a much lesser degree a few sells, but in almost no case, sell shorts! (There are a few services who suggest shorts, usually balanced by longs, but they are a mere handful, and even they would experience tough going if they were to advise only shorting for prolonged periods.) Bear markets are bad times for investment advisory services, owing to public psychology. This is sad because there is big money to be made on the short side. But the public is not short-sell minded. We advise a toe-to-the-water approach. Try it slowly and see. Its not so cold. In fact, its fine once you get in. You gain confidence that you can handle any market direction! But know the ropes first. In theory, short selling can cost you more (because a stock you buy at $20 can only go to zero, but a stock you sell short at 20 can go to 60 or 400). But, if you follow the strategies outlined in this chapter, this would never happen to you. A simple stop-loss order gives total protection. Short selling in a bear market is investing with the trend, so no one should be afraid of it. SHORT SELLING DEFINED I will keep definitions and descriptions of shorting to a minimum because the intricacies of shorting tend to confuse people and add nothing of value to their knowledge, for it doesnt matter how the mechanics are done. If you just accept the fact that they are done automatically by your broker, it will be easier for you. However, for those who must have it spelled out and who expect it in a book on bear markets, I include the following minimum procedural explanation. A short sale is one in which borrowed securities are used for delivery to the buyer (in the transaction in which you sell short). The process is not complete until the seller discharges his obligation to the lender by delivering to him the securities to cover the short sale. Many will not grasp how they can sell what they do not own. It is possible because of your brokers facilities for borrowing stocks with which he is able to make delivery for you. When you sell short and your broker has borrowed a portion of stock and delivered it to the purchaser, the first part of the transaction is complete. COVERING THE SHORT As with all trades, there remains the second half, that of covering your short. That is, providing your broker with an equivalent amount of stock at a later date so he can return it to the person or broker from whom he borrowed it (which you do by telling him to buy to cover the short). But you can take your sweet time about this second half of the deal. Unlike if you buy a put option (which in simplified terms is a highly leveraged short sale), when you have a specific date by which you must exercise your option, you dont have to cover your short sale in any specified time period. In theory, this can be many years. There is no time limit, provided your account is in good order. Under US laws, short sales are only possible on upticks, which means the stock must move up 8 of a point, after reaching your short-sell price, to be executed. If a stock only moves down, youll never get short in it. (Laws vary from country to country.) So, you get an execution. They credit your account with the proceeds of the amount of shares you have sold short at the price at which you shorted it, just as in any other sale of stock. Now, lets say that stock dropped 10 points. You decided that was low enough and you wanted to take a profit. You called your broker and said, Buy 100XYZ to cover my short at 45 or better. In this case, or better means or less. Lets say an execution is made at 44. Now, ignoring the commissions, you made 11 points. You sold at 55 and later bought at 44. Its just the opposite of buying at 44 and selling at 55. SHORT-SELLING TACTICS But I believe short sales should always be protected with a stop-loss order so that if it does not immediately go as you planned, you are out with, say, a 1015% loss (based on the chart) and thats the end of it. No nightmares, no big risks. From bitter experience, Ive learned that the time to place a stop-loss order is the day you take a new position in a stock. At that point, you can do it objectively. Later, you start rationalizing. And, often, later never comes. So, put in the stop-loss order the same day you short. However, the chart pattern may change and alter the best place for a stop, so never just place a stop and forget about it. The stop-loss order on a short sale is just the same as on a long position, only in reverse. You order the stock bought if it goes up to a certain price. As a matter of tactics, I would warn against shorting after a stock has fallen sharply. Chances are always good that the stock will rally after a sharp fall, whether or not it later falls again. And that rally would either scare you out or hit your stop-loss order; either one causes you an unnecessary loss. The time to short is at the start of the fall, based usually on its chart pattern and/or perhaps on your analysis that the market as a whole is due for a fall. SELECTING STOCKS TO SHORT Great care should be exercised in picking stocks to short to get the most mileage for your position. Stay away from stocks with a small number of shares outstanding. Avoid stocks that already have so many people short in them that the situation can boomerang. (See financial pages for a list of short sales, on approximately each 20th of the month.) I generally stick to shorting blue chips. That may sound dangerous, but in reality they are the safest, for they are heavily traded. The Nasdaq offers more tempting and profitable shorts, but only the nimblest of traders (and chartists) are at home there. Short selling is a tricky business, but those in a position to do a little homework can weed out the most logical candidates for profitable shorting especially during bear markets. Our number-one rule for short sellers is: Short positions should be protected against more than a 10-15% loss with a stopbuy order placed with your broker at the time you make the short sale. To select the best shortscharts are a mustmake use of one of the bar chart services (see Resources chapter for names). Go through their charts and make a list of the stocks that meet some of the requirements listed below. Dont just do it on screen, online. Print out charts from a chart service. You need paper charts in hand to enable you to properly compare stocks with one another, and draw in lines and curves: Once you have made up a list of stocks containing some of the above characteristics, give preference to the ones that: show greatest downside volatility in past chart action; are in industries on the downgrade; have just completed a very bearish chart pattern such as a double top or head-and-shoulders; are very popular, widely traded. traders, there is nothing more satisfying than having a good short position in a bear market, because stocks fall much faster than they rise, and in many cases a good short may be held for the long pull if it is in a long major downtrending chart pattern. Novices are advised to delay shorting till they experiment on paper first, to get completely oriented to the technique. One final rule: Once you have a profit, move your stop down and keep it moving as the price falls (a trailing stop-buy order). RELATIVE STRENGTH In a bear market or downtrend that you assume may be a bear market, it is vital to study the (up) reactions. Stocks that rally least on such upswings are probably the best candidates for shorting. They are low in relative strength to the market as a whole or to their industry group. The same thing is true when you buy stocks long. Relative strength should also be watched to help determine when to cover a short. Relative strength can be calculated easily. If a stock falls from 30 to 27, it has fallen 3 points, which is 10%(of 30). If at the same time the market average falls from 10,000 to 8,500, it has fallen 15%. So, in this example, the stock was stronger than the market, because it fell less. You should favor holding or buying stocks that are stronger than the market. You should consider selling or shorting stocks that are weaker than the market. Gauge both by this relative strength concept. THE MATH OF SHORTING It is true that the mathematics of shorting is unfavorable regarding the percentage of profit made on capital required, comparing, for example, a stock rising from 100 to 150 with a stock falling from 150 to 100. But, the fact remains that shorting can be infinitely more profitable if measured in time. The crash phases of bear markets are swift, and shorts make a faster killing. Fortunes can be amassed in days or even hours in a disintegrating market. WATCH VOLUME The Wall Street axiom, Never sell a dull market short during a bull market, can be used in reverse in bear markets, as, Always sell a dull market short during a bear market. Dull, here, means low volume. WHY BEARS PROFIT As said above, the reason bigger profits are possible in bear markets than in bull is that, on average, prices move faster (i.e., in a shorter time). Loosely speaking, over the last 22 bear markets, prices have fallen fast and sharp, while most bull markets see prices move up more slowly over a longer time. Of course, there are exceptions, but they are few. And the panic phases or crash phases of bear markets are the most profitable of all. There, you can often see the market drop 15 to 25% in a few days. This almost never happens on the upside. Obviously, this offers the biggest potential gain possible in any kind of market. When the averages drop 20%, it means the majority of stocks are dropping 40% and the more speculative stocks 60%. Thus, you can make a fortune in just one bear market, in fact in just one crash phase of just one bear market. Bull markets normally require years of patient trading to build a fortune. But a bear market crash can gain you big profits in a matter of days or weeks. BEAR RALLIES ARE SHARP One note of caution, which I deal with further in the next chapter. When you are short, remember that rallies in bear markets are traditionally sharp, which means they can be frightening to bear positions. Be prepared, psychologically, for this, and use stop-buy orders. LEARN BY DOING After you try paper trading, the real test to learn short selling in the stock market is by doing. Just as you didnt get the feel of the market until you bought your first stock, so too you will not get a feel for shorting (and overcome your fears of it) until you take your first short position. Once in, youll find (we hope) the waters fine (provided you dont forget the stop loss). I do not wish to minimize the risk of losses that might occur from short sales that are not protected by stop-loss orders (which are really buy-stop orders) placed above the market. To repeat, these orders are so placed that the short seller can calculate the possible loss before placing a short sale in motion. But this gives peace of mind, for you know that if the action does not go as expected, the loss is going to be minimal and predetermined. No one can deny that more money has been lost on Wall Street via long purchases than via shorting. THE 1990s WERE UNIQUE The latter part of the 1990s was a time when almost every investor made money in that trending market. But, as times get ever more turbulent, only those who can cross the crowd and be flexible will make money. Since the crowd (or public) is predominantly and almost perpetually invested on the bull side, it will benefit the trader to know when to act with the successful minority. The minority includes, in bear markets, a sizable portion of short sellers. ILLOGICAL TO STAY LONG To stay long of stocks during a bear market for income purposes is illogical, not to mention costly. The purpose of investment is, first, to protect your capital from loss in either amount or value, and, second, to secure an adequate return in line with the risk involved. To protect capital from depreciation, one must be alert to spot trend changes and quickly exit the long side, regardless of the current dividends being paid on stock, your need for income, or vague hopes that this downturn will be short lived. You must be willing to sell stocks that show substantial profits, regardless of the need for income from them, if you determine the bull market is exhausted and a change of trend seems at hand. It is logical for the investor to sell early in a bear trend, and allot a small portion of the proceeds for selling short, and into hedge funds, while putting money you cant afford to risk into defensive issues such as bonds, preferreds, utilities, Munis, or, in the case of an inflationary bear market, bonds and tangible assets. Even living off capital at such times is cheaper in the long run than holding stocks that decline. This investor may not be able to bring himself to sell stocks short. But one who sells out during bear markets sells the situation short anyhow by accepting cash in advance of an era when cash is king and stocks erode in value. LIMIT YOUR SHORT ORDERS When you place an order to sell short, it is usually best to place it with a specific price limit. Otherwise, if you guess right that the stock is about to fall, it may fall quite a distance before a market order can be executed, in accordance with the uptick rule. Usually, the market and individual stocks show some minor weakness before they enter a crash or violent fall phase, so it is during this modest weakness period that a short order can best be placed. An at the market order should be used mainly when its time to cover your short, and not an occasion for shaving an extra half-point. PLAN AHEAD It is wise to plan ahead in the matter of selection of stocks to be shorted when the time is right. A campaign should be formulated. Watch stocks that fail to hit highs when others in their industry group do, or fail to rally as much and fall more (relative weakness). Use Stochastics to help your timingit measures overbought and oversold conditions. THE MORALITY OF SHORTING A chapter on short selling is not complete without a bit on the matter of the morality of shorting. Many people instinctively feel there is something indecent about it. But, when the facts are clearly brought to light, opposition to it disappears. Napoleon, for example, thought short selling in the French Bourse was unpatriotic. But Gaudin explained to Napoleon that those who did so were expressing their judgment of future events, and not their wish for the country. After the September 11, 2001 attack, John LaFalce of the House Financial Services Committee wrote to the Securities and Exchange Commission (SEC) demanding that it consider inhibiting short selling. The sentiment is understandable, in that certain members of terrorist organizations apparently made money for their networks, in advance of September 11, anticipating the panic their attack would cause. These people are criminals, and should be punished to the full extent of the law. But their crime, evil though it was, was insider trading, not short selling. And inhibiting the ability to short by legitimate investors would destabilize markets much more than allowing free markets to operate. Short sellers provide much needed liquidity to markets by creating a cushion of potential buyers during a period when the last thing on the average investors mind is buying shares. Making short selling illegal was in fact tried for short periods in Germany during their monetary chaos of the 1920s and 1930s. But, each time it was tried, it was rapidly seen that the absence of short selling made for more turbulent markets, so the prohibition against shorting was repealed. It is because shorts have to cover sooner or later, that they help a falling market. As the market falls, shorts buy to nail down their profits when almost no one else cares to buy. Shorts also buy when rallies scare them. This arrests or lessens the decline. Whenever shorting was ruled illegal, markets were seen to drop as into a bottomless pit. BEARS UNLOVED When W.O. Scroggs wrote, Nobody loves a bear, in 1930, he coined a phrase that has often been used since and has much truth. But its because of lack of understanding about the good a bear does in maintaining orderly markets that causes that feeling. In 1932, The Nation magazine ran an article called: Sacred Bulls and Sinister Bears. That typifies the attitude of many, even today, though it is not nearly as bad as it once was. In 1932, W.T. Foster wrote in The Atlantic Monthly of Selling the United States short in short selling. Often, it seems a bear is unpopular because his success reminds those who have stocks with huge losses from the last bull market how wrong they were. People never dislike bears in bull markets or when they lose. It is the successful bear that arouses ire. Thus, it is probably little more than natural envy with some very misguided ideas that it is unpatriotic to make money when most of your fellow citizens are losing. To which I reply, Free markets and freedom are only possible when citizens are self-reliant, willing to take risks and are solvent. For an investor to willingly lose money, when there are ways for him to make a profit, is silly, unpatriotic, and clueless. Object to short selling, if you must, on the ground that it is contrary to our natural optimistic spirit, but not on the grounds that it is unethical. And remember, solvent citizens are of more use to society than insolvent ones who then become a burden on others. ANOTHER DEFENDER OF SHORTING Edward Meeker also comes to the defense of the short seller in his 1930 book: The Work of the Stock Exchange. He points out that when a man buys a stock on margin he is causing a short sale of money and conversely that every short sale of stock inevitably causes a margin purchase of money. Then, as now, bears were criticized and depicted as villains, and Meeker defended them as I do today. Meeker said, The sheer nonsense of such statements is apparent to anyone who knows anything at all about the stock market, a knowledge which these critics of stock market speculation often hasten to disclaim at the outset. He also points out that a big bear operator may be able to depress a share price for a time through short selling, but he can no more destroy intrinsic values than he can lower the temperature by putting ice on the thermometer bulb. SHORTS SAVE MARKETS The most impressive testimony ever offered in defense of short sellers was spoken by the president of the New York Stock Exchange in 1914, just before it closed, as World War I had been declared. Mr Noble said, A heavy short interest furnished the best safeguard against a sudden and disastrous drop. This short interest was a leading factor in producing the extraordinary resistance in New York which caused so much favorable comment during the few days before the stock exchange closing. It were well if ill-informed people who deprecate short selling would note this fact! Further evidence is the dramatic fact that the violence of the 1929 panic can be largely attributed to the remarkably small short interest in the market. Even after the first-phase crash, the short interest was found to have been small. Another NYSE president (Whitney) investigated rumors of tremendous bear raids and reported that short selling was so small as to be almost inconsequential, being only about one-eighth of 1% of the value of all stocks listed. HISTORIC OPPOSITION The question of the legitimacy of short selling is almost as old as the question of speculation itself. A hostile legislative committee investigated short selling in 1913, and the Pujo Committee reported finally that, there seems no greater reason for prohibiting speculation by way of selling stock in the expectation of buying it back later at lower prices, than by way of purchasing it in anticipation of at once reselling it at higher prices. Short selling has been misunderstood for decades. It still is. It was forbidden in England in 1733, but the law failed to halt the practice (as most unjust laws do) and it was repealed in 1860. Napoleon I was dissuaded from forbidding it by his finance minister. Later, the French did legislate against it, only to repeal the law after its harmfulness was clearly shown. New York tried the same experiment and with the same result: banned in 1812, repealed in 1858. These experiments were costly. It seems to be human nature to condemn short selling, but global history proves that genuine economic benefits result from its use. |
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