Page 416 - How to Make Money in Stocks Trilogy

286 BE SMART FROM THE START

whether it’s right for you. More active and seasoned investors might con-
sider limited short selling. But I would want to keep the limit to 10% or 15%
of available money, and most people probably shouldn’t do even that much.
Furthermore, short selling is far more complicated than simply buying
stocks, and most short sellers are run in and lose money.
What is short selling? Think of it as reversing the normal buy and sell
process. In short selling, you sell a stock (instead of buying it)—even though
you don’t own it and therefore must borrow it from your broker—in the
hope that it will go down in price instead of up. If the stock falls in price as
you expect, you can “cover your short position” by buying the stock in the
open market at a lower price and pocket the difference as your profit. You
would sell short if you think the market is going to drop substantially or a
certain stock is ready to cave in. You sell the stock first, hoping to buy it back
later at a lower price.
Sounds easy, right? Wrong. Short selling rarely works out well. Usually the
stock that you sell short, expecting a colossal price decrease, will do the unex-
pected and begin to creep up in price. When it goes up, you lose money.
Effective short selling is usually done at the beginning of a new general
market decline. This means you have to short based on the behavior of the
daily market averages. This, in turn, requires the ability to (1) interpret the
daily Dow, S&P 500, or Nasdaq indexes, as discussed in Chapter 9, and (2)
select stocks that have had tremendous run-ups and have definitely topped
out months earlier. In other words, your timing has to be flawless. You may
be right, but if you’re too early, you can be forced to cover at a loss.
In selling short, you also have to minimize your risk by cutting your losses
at 8%. Otherwise, the sky’s the limit, as your stock could have an unlimited
price increase.
My first rule in short selling: don’t sell short during a bull market. Why
fight the overall tide? But sooner or later you may disregard the advice in this
book, try it for yourself, and find out the same hard way—just as you learn
that “wet paint” signs usually mean what they say. In general, you should save
the short selling for bear markets. Your odds will be a little better.
The second rule is: never sell short a stock with a small number of shares
outstanding. It’s too easy for market makers and professionals to run up a
thinly capitalized stock on you. This is called a “short squeeze” (meaning
you could find yourself with a loss and be forced to cover by buying the
stock back at a higher price), and when you’re in one, it doesn’t feel very
good. It’s safer to short stocks that are trading an average daily volume of 5
to 10 million shares or more.
The two best chart price patterns for selling short are shown on the two
graphs on page 288.