Stock market contracts are extremely intimidating. Everything is tied up in legal jargon and the word “risk” is plastered all over any honest explanation. I don’t recommend anyone’s first stock market transaction being anything other than a stock, or better yet, an index or mutual fund.
Despite all my “doom and gloom” predictions, I never have shorted any stock or fund. One reason is that inflation might raise the dollar price of a stock despite the actual value decreasing. A bigger reason is timing. When choosing stocks to buy you can hold your position for as long as you want and wait for the profits to emerge. When you short, you’re on a tight time frame. I don’t know enough to call that type of timing.
The final reason is that I’m just not ready for that kind of commitment. When buying stocks, you can only lose the money you put in. With shorts, you can lose an infinite amount of money.
My first, and thus far only time “Shorting” the Market:
I used to sell Mary Kay. It was as bad idea. I made a spur of the moment decision based on the fact that I could sell my unused inventory back if I decided to quit within the first year. I planned to get what money I could then quit with only profit and no loss.
Time went on and I was up against the 1 year mark. I was a lousy sales woman and was extremely busy with Differential Equations homework (YUCK). It was time to quit. I made many calls to my unit director requesting information on how to send my inventory back, but she never answered. The clock rolled past the date leaving me stuck with hundreds of dollars worth of stuff. Most things I would never be able to sell at a profit. I sold what I could deeply discounted to friends, then started listing on Ebay.
One listing I made was for “Sweet Raisin Nurishine Lip Gloss”. I had slow internet and a computer glitch which made me believe the listing didn’t go through. I listed it again and unknowingly ended up with two listings. One sold, and I sent it off. The second one sold and I realized my mistake. I had a contract to send someone sweet raisin lip gloss, something that I no longer owned.
It turns out there are a lot of Mary Kay ladies out there in the same boat selling on the Ebay market. At the time, there was a decent volume of sweet raisin lip glosses selling. I simply bought someone else’s listing that met my specifications and entered in my buyer’s name and address. Don’t try this at home kids. I imagine it was against Ebay’s Policy, but I was in a bind.
Timing and Pricing
I was lucky. By the time I realized that I had made the mistake and was told that none of the other colors that I did have would suffice, there were new listings selling at even lower prices. In the end, I earned $0.52 on the transaction (buyer paid $6.5 – $5 purchase from other seller – $0.98 fees = $0.52).
Had instead the price jumped, I would have lost money. What if a popular singer had declared Sweet Raisin Nurishine Lip Gloss the ONLY thing she would ever put on her lips? Or another company announced a contract to buy enough Mary Kay lip glosses to put them on back-order for years? The price could have jumped indefinitely.
Note: I lost $3.51 on the other Sweet Raisin sale (buyer paid $7.24 – $7.38 initial purchase – $1.09 fees – $2.28 shipping/ packaging = –$3.51), but that’s $3.87 better than losing my whole $7.38 initial purchase!
Shorting the Stock Market works almost exactly the same way:
Lets say you think a company is overvalued and will see a decline in the next week. You could place a short order with your broker for a number of the company’s shares (typically 100). The Broker will give you the 100 shares, which immediately get sold at the current market price. Part or all of that money is held by the broker/lender as collateral against your loan (margin account). You have until a set date (anywhere between a few days to months as agreed) to return the company shares. At this point several things could happen:
- You could wait until the price drops to a level you are happy with, have your broker buy themselves the 100 shares with your margin account, then you pocket any extra after fees. You can set this up to happen automatically with a trailing stop (percentage based) or a limit order ($ value based) so you can buy at or below your threshold even if it is only at that price for moments.
- You could get scared as the price trends upward and try to cut your losses by buying early (also may be done with limit orders or trailing stops). Again, you’d have the broker buy themselves the 100 shares with your money and any extra you have to put in, pay them their fees, and accept your loss. If the price goes up significantly, your broker may automatically buy the shares back to minimize their potential losses in a default (margin call).
- You could also wait all the way until the contract expires, and have them do the same thing. If the price went down enough to cover your fees, you’ll make a profit, if it went up, you’ll lose money.
In my lip gloss scenario, I had a contract that ended as soon as I realized it existed, so I was forced to buy at the current market price. Had my item been listed as ships within 1-30 days, I could have waited until I could find a really low price on Ebay at the risk of losing the low prices already on the market.
The good news is you’d never accidentally short the stock market like I did with lip gloss!
Market Insurance = Shorting with “Puts”:
Another type of shorting, that I am much more likely to use, actually LIMITS the amount you can lose. You buy fire insurance on your house because you can’t afford to lose it. As of June 2017, the median US House costs $263,800. According to a Merrill Lynch study, the average retirement costs about $738,400 (March 2017). You should only gamble with money you can afford to lose. If your stocks are your retirement, it might be worth looking into “insuring” them with puts.
The strategy goes like this: buy a contract that allows you to sell a preset number of shares at a specific agreed “strike” price (below current market). Even if the share price drops to zero, the buyer must buy your shares at your request at the predetermined strike price so long as the contract has not expired. For a recurring fee (like most insurances), you could potentially insulate each of your holdings from things like the huge 50% drops we’ve seen twice since the turn of the century and avoid the massive financial destruction that is yet to come. As Robert Kiyosaki (Rich Dad) says, “Professional investors always buy in pairs. One position is for growth, and the other is for protection.” (source)
Political Side Note:
If you follow financial commentaries for entertainment (let’s be friends!), you might have heard the phrase “the Yellen Put”. That is referring to the fact that Janet Yellen (current Federal Reserve Chairman) is unlikely to let the market tank. Should it be in peril, she will probably jump in with low interest rates and treasury bond purchases to push the market back up and save the day. Because we have money printing academics in charge, we are all somewhat “insured” against a crash.
Of course, this will mostly help the gamblers and hurt the savers in high inflation, but hey who wants to reward people for responsible actions anyways? On the other hand, now that Trump is taking so much credit for the high market performance and she’s likely losing her position anyways, Yellen might be a little more willing to let it fall than had Hillary won…
Just remember, like fire insurance, this is something that you hope to never actually use. You don’t want to choose lousy stocks just because you are protected. It is much better to have stocks that make you money than to lose less than your neighbor by forcing the other end of the contract to buy something above the market price.
Not all Puts are Defensive
This method can also be used offensively on stocks you don’t already own. It would be a great deal to buy a house after it has already burnt down at rock bottom prices, then turn around and collect insurance money on the original value of the home. You just have to have the foresight to buy insurance on the house with fire hazards before it happens.
Anyways… I hope I clarified market shorting a little better for you. Enjoy the ride!
Disclaimer: I am not a licensed or certified financial coach, planner, adviser, or anything else of the sorts. I just love money. Anything I recommend should be personally analyzed and discussed with your trusted financial adviser. I cannot be held accountable for any loss or poor performance.
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