Thoughts for beginners 3: Is shorting as risky as they say?
I am more of a macro investor than individual stocks...not the best with those. I remember there were a bunch of questions that I had that confused me when I was brand new. A handful of CAPS players got me to where I am today, so I am offering my opinion on a few misconceptions. There will probably be about 10 of these blogs over the course of a few weeks.
In this blog I want to explore the common misconception that shorting is much riskier than going long, and that only very experienced players can short.
What is short selling? You open a margin account and elect to short a stock. This means you are betting on a decline. You are borrowing somebody elses shares, selling them, and then to close the position you buy it back later on, hopefully at a lower price.
First, I would like to point out that 1) Shorting can be very hard compared to going long 2) Shorting based on valuation alone is a TERRIBLE idea (as I said in a response to my first blog, a stock who had no problem getting a p/e of 120 will have no problem getting it to 300, and momentum can be very powerful) 3) Theoretically, you can lose more than 100%
It is point number 3 that scares people too much to go short, that you can lose more than 100%
I do not recommend shorting as a long-term strategy. That is, if you are a long term investor, I think shorting is a bad idea because you are fighting inflation, fighting the productivity of mankind, and most importantly your upside is capped to 100%
However if you are a newcomer looking to getting into swing trading, shorting is something you should probably learn how ot do.
Theoretically you can lose more than you risk. How? If you short something at $10, and it goes to $30, that's how.
But how likely is that to happen?
Never, ever short a penny stock or a biotech company (even though it is near impossible to do so). These companies can get bought out or the very low share float can have the price explode easily.
But look at the history of how stocks move. Stocks move up slowly for a long period of time, and then when they fall, they fall much faster than they rise. Staircase up, elevator down.Your broker will close your position long before you lose more than you have.
If you short the S&P, it is not going to go up 100% overnight before the broker can close it out.
What about large cap companies? Think about this one. What is more likely...a large cap company more than doubling overnight, or a company being unraveled as a fraud or filing bankruptcy overnight? Look at enron, or the banks in 2008...thoe stocks fell FAST...have you ever seen a large cap company rise that fast? No way. Maybe a small cap, or even a midcap. But GE isn't going to double in a week.For these reasons I actually think going short is a SAFER short term strategy than going long, even if I don't think returns are as good, I think there is a better chance of not getting stopped out 10% worse than where your stop was.
Long term investors need not short. But short term traders need to not be scared to do it if they want to be successful. The risks are overstated as long as you stay away from small stocks.
Shorting is hard, and there has to be a very, very good reason to short, but don't be discouraged if you want to learn how to do it.