When A Short Position Goes Terribly Wrong ($AOL)

By: ispeculatornew
Date posted: 04.17.2012 (5:00 am) | Write a Comment  (0 Comments)

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Investing is risky. Long and short investing carries even more risk. Last week, when I was forced to close out my short position on AOL ($AOL), that was one more example of how things can turn out for the worst. The majority of investors carry only long positions which is certainly less risky? Rarely does a stock move so quickly in the down direction. It can happen over time, especially when it is a crappy stock/company. I could easily give you examples such as Netflix (NFLX) or Research in Motion (RIMM). Even BP, after its now famous oil leak, did not suffer a huge jump overnight.

Big Gains Are Much More Frequent

Companies can end up making a big discovery, selling off some of their assets, etc. The more common reason for a stock jumping though is M&A activity when rumors or real news comes out about the selling of part or all of a company. AOL which sold a large portion of its assets to Microsoft. There have been others such as MonsterWorldwide (MWW) that have seen their senior execs declare that the company was open to such strategic options. Sometimes, it’s all rumors.

Stop Losses Only Protect To An Extent

As most of you know, I usually close out trades once they close a day up or down 20% or more. Last week, when AOL surprised with the sale of its patents, the stock opened nearly up 50%… That left my trade down nearly 40% from one minute to another. It’s unfortunately a risk of long & short trades.

Protecting Against Such Trades

Obviously, I do my best to protect my portfolio against such events. First off, I try to stay away from stocks that I consider likely to have some M&A action because I do not think that I would be well positioned to have an opinion on such stocks. That is one big reason why I have stayed far away from Yahoo in recent years. Unfortunately, it is impossible to see all such moves coming. Some, such as AOL are big surprises. I simply hope that at the end of each year, I get as many of these moves to go in my direction as I will have against me. That has usually been the case so I can’t complain.

Only Invest What You Can Avoid To Lose

I got a question last week regarding how to make sure that short positions will not be “bought back” by the broker if they move against you. It should never be that close. If you want to have short positions in your account, you should have more than enough long positions to ensure that you will not have to worry about such things. Personally, while I do long & short trades, I also have a longer term, long only, portfolio that consists of ETF’s and dividend stocks.

Keep Perspective

While it is very frustrating to lose 50% on a trade, especially since there would have been no way for me to see this coming (realistically), it would be easy to get upset, to start overly questionning myself. The reality is that this happens, sometimes they work out for the best other times they don’t. I do however have a solid year so far, even including that pick, with a 40% annualized return or so. In fact, just a couple of days later, I got the other side when a stock I was long of, Travelzoo (TZOO) jumped up huge after announcing it might put itself up for sale.

Stick To The Rules

It could have been tempting to wait a bit longer before closing out the trade. I personally think the AOL move was blown out of proportion and would probably love to short the stock now (in fact, I did decide to short it yesterday). That being said, I did stick to my trading rule, got out of the position and looked over the numbers. Why? Because once I start bending the rules, it becomes very tempting to keep doing that. I believe strongly that my rules are a huge part of why my long & short tech trades work so well. Sticking to them is critical, even in tough times:)

What About You?

How do you react when a trade goes against you in a violent way?

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