The short, ugly daemons
I have made a couple of comments lately about the dangers of both short and ultra ETFs and short sales. I am putting them here, in depth, for future reference since I keep seeing this come up.
If you want to make money from falls in the price of an index, sector or stock, you have three choices - put options, short ETFs or short sales.
A put option is an option to sell a stock at a particular price. You pay for the privellege of selling the stock at a fixed price at some point in the future. Usually this price (the strike price) is about what the stock price is when you buy the option (called an at-the-money option). Put options are VERY risky and will mostly lose all their value over a short period, so in most ways they are by far the most risky of these choices. However, it is hard to get approved for options trading because brokers know this. Also, although options are hugely risky they also provide a way to hedge a long portfolio with a very small percentage of capital, and if only 1% of your capital is in well-chosed option hedges this is not such a risky strategy.
There's been much talk lately about the "ultra" and "ultrashort" ETFs, which are funds designed to mirror an index and move by a multiple of how that index moves. This sounds great - if you buy SPY, it will mirror the movement of the S&P. If you buy SSO, it will move by 2x the S&P. Similarly, SDS will move 2x in the opposite direction to the S&P. So, if you are a naive buy and holder and think the market has bottomed, you will maybe think about buying SSO instead of SPY. Or if you think it will be a bit lower in 2010 than now you might buy SDS. This is a BAD IDEA.
Since CAPS scores depend on movement relative to the S&P and the ultras are designed to move more than the index, ultras are often seen in all-star portfolios since they are an easy way to get points in CAPS. This does not mean they are a good investment in real life. The leverage (multiplied movement) of these ETFs is accomplished using stock options. Like options, Ultra ETFs are hard to trade because they have huge swings which are influenced by volatility as well as price, they suffer time / volatility decay and there are other serious problems. So over time, the value of your ultra will drop even if the index keeps moving slowly in the right direction. If the index is flat you will lose money for sure.
In addition there are tax complications to the ultras. I held SDS over the year end last year with disastrous tax consequences - DO NOT DO this with any ultra ETF. If the ETF is up on the year, it will make a capital gains distribution and you will lose this from the value of the ETF. You don't lose money then, but you lose big at tax time, because you can't deduct your stock losses from the money you gained on the capital gains distribution.
A short sale is when you borrow a stock from a broker, intending to buy the stock back at a lower price and thus repay your debt. New traders should also be aware that short sales carry a lot of risk. In particular, the potential monetary loss with a short sale is INFINITE (because there is no limit to how high a stock can go and thus how much money you will need to buy it back). This is much less of an issue with SPY than with say a beaten-down financial stock, but still worth bearing in mind. With an ETF, even an ultra ETF, you maximum loss is limited to the value of the ETF you purchased because it can only go to zero and not below.
The second issue is that clearly your broker will not let you take an infinite loss, because they too would go bankrupt. So once your loss on a short sale gets close to the total value of your assets, your broker will make a margin call. The margin call will force you to cover your short, potentially losing you not only the value of the short sale but much of the rest of your brokerage account where you will be forced to sell stock at whatever the market price is.
Thirdly, if you short a lot of a stock that is in short supply, the person you borrowed it from might want it back, and you can thus get forced to sell when you don't want to.
Short sales require a margin account, which a lot of beginning traders don't have. You might think this is a good thing, but it tends to lead them down the primrose path of ultra ETFs which have no requirement for margin or options trading. The presence of short ETFs in many CAPS all star portfolios only exacerbates this.
My suggestion is, if you are beginning trading, don't have a margin account, and you really really want to short and not just keep long-only positions, use only NON-LEVERAGED short ETFs. For example, SH is a fairly safe way to gain from a drop in price of the S&P, or to hedge against a sudden crash if you are afraid such a thing is close.
Hope this helps somebody!