Just how risky is shorting stocks?

By: ispeculatornew
Date posted: 02.11.2009 (4:00 am) | Write a Comment  (1 Comment)

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I wrote briefly last week about shorting stocks, how it is done, the strategy behind how I short stocks, etc. Of course, there is a lot of stigma that surrounds shorting stocks, and just how risky it is. We are often told that shorting a stock should not be done because you have an unlimited loss. Let’s examine that statement carefully.

Take a stock on Microsoft (MSFT). If you short the stock at 20$, your main risk is basically that MSFT will shoot up and become very expensive when you close your trade. Let’s say the stock goes up to 30$, a 50% increase, well, I am sorry to say you have lost 50% on your trade. Just to put this into context, I think quite a few investors have lost 50% on a trade in 2009. And since I am shorting using long/short strategies, this 50% increase would have to happen without the other stock going up for me to actually suffer this loss. Unlikely I’d say. Possible sure, but unlikely. And what about the unlimited loss? Well, yes of course, if the prices moves to 100$, then you have lost 400%, a much bigger amount than you could ever lose by simply owning a stock. But as I wrote, I will generally set a 20% loss limit on my trades, so again, not very likely is it?

In my opinion, shorting a stock is like any investment, it must be done with caution and with careful planning. The same people who say you should not use shorting as a strategy are often trading things like mining stocks or technology stocks, that are also very volatile.

One risk of course is that even with a limit you might not be able to close out your trade at your limit. For example, if you had a 25$ stop loss order to “limit” your loss to 25% on your short trade, you would lose more if MSFT announced major news and the stock instantly jumped to 27$. But again, what are the odds that MSFT will jump 50% overnight? Very very unlikely. And the two main periods when it could happen is basically during earnings announcements as well as because of takeover offers. For the first one, I’ve sometimes opted to close a short trade before earnings are released (even if I were to re-enter the trade after), simply because there is a lot more volatility and risk involved during these announcements (just to be clear, the same is true if you own the stock). As for takeover offers, there is no way to be 100% certain but some companies are better targets. Of course, I had said a while ago I would not short VCLK because it could potentially be purchased by another company.

I beleive that like any investment strategy, it is important to know what you are doing and what your objectives are and be discplined, nothing different from any other investment. We will soon be writing about why the mainstream media is not discussing this strategy more.

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1 Comment

  1. Pingback by Linkstuff Feb 13 — July 15, 2009 @ 9:54 am

    […] The Intelligent Speculator explains the reasoning behind Shorting Stocks. […]

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