Daily Gains Letter

Stuck in a Declining Market? Use This Strategy for Portfolio Growth

By for Daily Gains Letter | Apr 8, 2013

















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With financial media always talking about what to buy and where to buy, not a lot is said regarding the sell-high/buy-low strategy. Yes, I am talking about short selling—a way to make a profit in the falling market.

At the very basic level, short selling is the opposite of buying a stock—or “longing” a stock. When an investor longs a stock, their hope is that it will go higher in value, and eventually they can sell it for profit. In short selling, an investor sells the stock first and buys it a lower price—banking the difference between the two prices.

When an investor puts in an order for short selling shares of a company, they are essentially borrowing them, and selling them. Once the price reaches their perceived price, they buy them, and return those shares. Before going into further details, don’t worry; your broker will take care of this.

Short selling may be a familiar topic to many investors, but what you may not realize is that this strategy has many advantages that can help to grow your portfolio, even when the overall market is falling. Similarly, those who actively do short selling may not understand its underlying risks.

One of the biggest advantages of short selling is that investors don’t really have to wait for prices to drop for them to buy; rather, they can profit from them. In addition, it provides them with an alternative way of profiting—they can long when prices are going up, and short when prices are going down.

But while it has its advantages, short selling does have some disadvantages as well.

If you look at the long-term chart of the stock market and key stock indices, you will notice that they have risen in value over time. With short selling, the profits of individuals are limited, but their losses are unlimited.

When it comes to short selling, the most profit investors can make is 100%, but the loss can far exceed 100%—they can lose more than they have. Consider the following example.

You short shares of XYZ Inc. at $40.00 and believe that it will drop. On one hand, the lowest value XYZ shares can reach is zero—you earn a profit of $40.00 per share. On the other hand, what happens if the price goes to $100.00—your loss will be much more than 100%.

Short selling is a great opportunity for investors to profit when the prices are falling, but it can result in huge losses if prices turn upward. Long-term investors should keep in mind that over time, markets have gone up.

When employing short selling, investors should use very strict risk management strategies, because their risks are significant. Setting a stop-loss limit before even entering a trade can protect you from huge losses. Furthermore, you should also restrain yourself from becoming emotionally attached to your short position or keeping it in hopes that it will eventually decrease in value. Stock markets have generally trended higher in the past, and short selling for a long period of time may be like standing in front of a speeding car.

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