Short Selling 101

First of all, let me explain what "short selling" is. Short selling is a term used in equity trading when a trader believes that a stock is too expensive and he/she borrows it from a dealer(usually a broker) and sells it. Goal is to buy it back later at a cheaper price and return these shares back to the dealer. If successful, you hope to pocket the profit due to price difference.

Let’s take an example. You are following a stock XYZ trading at $50 and you believe that it is going to fall to $40. What you can do is to short sell some shares, let’s say 500. Remember you don’t really own any shares, so you’ll borrow them from your broker. When you execute this transaction, your broker will create a balance of –500 shares in your account and will add sale proceedings from the sale. So excluding trading cost, selling 500 shares at $50 will result in a balance of $25,000($50 *500 = $25,000) in your account. This transaction is defined as “SHORT SELLING”.

Once you have entered a trade, real game begins. Once you’ve sold a stock short, you have to return those shares to your broker. Let’s say that after two weeks, stock falls to $45 and you decide to close your short position. What you have to do is to execute a buy order for 500 share(cost = $45*500 =$22,500). After executing this order, those shares are automatically returned to your broker(remember you had a –500 shares balance in your account, so buying 500 shares will cancel out that balance). End result – you made $25,000 - $22,500 = $2,500.

If you take a cursory look, this transaction doesn’t look bad and you made a profit of 10% in just two weeks. But if you pay a little more attention to selling short, you will notice that it could have as easily gone the other way too. What would have happened if stock had gone to $60? What would you have done in that case? Let’s assume that you would have closed the position at $60. In that case, you would have paid $30,000($60*500) to buy this stock back and would have lost $5,000. This is a very simple example. Most of the time, people don’t want to admit that they have been wrong on a trade and continue to hold a short position, hoping for it to fall one day. That could end up being a disaster in the end. As you can tell, most profit you can make on a short is 100%(if stock goes to zero), but the potential for loss is unlimited. So you have to be very careful if you want to experiment “Short Selling”.

The most important rule of short selling that most people ignore is identifying “momentum move”. Never ever short a stock when it has just broken out of a trading range or new high. No matter how strongly you’re convinced that it is over priced. I will give you one really good example.

Amazon.com(Symbol – AMZN) is a online retailer and if you trade tech stocks, you probably know all about it.

AMZN broke out of its range($40-$45) after earning report and move to $63 in just two trading sessions. For some inexperience short sellers, this move was too much too quick and they jumped in between $61-63 range. This short trade felt good for next 5-7 trading days when stock stalled around $63. This should have been the first red flag for short sellers. If stock fails to move down after a big move up, you should bail. Also, volume was anemic on those down days, another sign that it is going through consolidation and can move up big again. Some smart shorts closed their positions with small gains or losses based on their entry points. However, some refused to admit that they were worng and stayed in. Next big move came in with breakout 2 when stock moved from $61 to $74 in three trading days. At this point, you would think that majority of short sellers were out, you're wrong. Short sellers who went short after $63 and closed their positions earlier jumped right back in. Their argument - If this stock was too expensive at $60, it is now way too expensive at $70. You can go to any stock message board and when short sellers are posting excessively on how expensive a stock is or how hard it is going to fall, that's your time to go long because there is a short squeeze coming. Anyway, new short sellers were trapped when stock moved again with breakout 3 and lost even more money.

What can you learn from this? First of all, let me tell you that smart short sellers do make money. Short selling would have been long extinct if nobody was making money selling short. Trick is to figure out the right entry point. Anything that goes up too fast is bound to come down but you only want to be on short side when it comes down. If you're interested in selling short, here are couple of important pointers for you.

First of all, watch the volume. If you see AMZN chart, you will notice that volume was at least twice the normal volume on every breakout. You never want to go short when a stock breaks out with heavy volume - no matter how expensive you think it is. You should also pay close attention to volume on down days after breakout. An anemic volume on a down day is a clear indication that it is consolidating and about to move up again. Some short sellers mistake these low-volume down days as "stall" and start to belive that the "Run" is over. If you have been run over by stocks while going short, go back and take a look at those charts and you would see a clear pattern that you either didn't see or elected to ignore.

But there is a bright side too. Rather than going short, if you would have gone long, you would have made lot of money. So even if you're a short seller, either wait or go long until you find a break to the downside and then ride it down with your short position. Never sell short unless you see a breakout to the down side.

How to find breakpoints on the downside is a topic for another post.

Happy Investing!

Amplidyne

Conflict of Interest

If you're an online investor doing your own research, you're up against a community that is more corrupt than anything else you will even find in real world. Big Wall street firms will do anything and everything to make a quick profit. Investing in stock market today is very different as compared to what it used to be back in 80s or early 90s. Back then, 5-8% return was great and research firms have more honesty in serving common public interests in addition to their private clients. But it didn't really matter then. There wern't many individual investors back then. If you had money to invest, going to a stock broker or a financial advisor were the only options.

Today things have changed. There are millions of individual investors who believe they can invest in the stock market and earn a decent 6-10% return. They have a firm believe that they have access to all the research and screening tools that Wall Street elites do. But most of individual investors make no money, in fact most of them lose money when they invest themselves. Why does it happen?
To analyse the reasons why most individual investors fail, you'll have to first understand the system they are trying to rely on. If all of us can take responsibilities for our own financial planning and do it well, who would need giant Wall Street firms? Big Wall street firms are in the business of making money by investing it in the stock market and if an individual investor can do a better job, they wouldn't be in the business anymore. So when you decide to invest yourself, you're making a decision to go up against well established players in the market. If game is played fairly, these big boys will lose because of their sizes. Now why does size matter in this game? Well, it matters because size in this game represent the equity(cash). Here is a good example; You can invest $1,000 in a stock and close that position a couple of days later without impacting the price at all because when million of dollars worth of trading happens on a daily basis, $1,000 is insignificant. Now think of $100mil. If you change the amount to $100mil from $1,000, it is going to be difficult and sometime impossible to cover your track and others will know when you enter or exit a position. Since any big firm can't do anything about its size, it resorts to other tools that are not available to individual investors. You read it right - I did really say "Other tools". Big Wall street firms deploy an army of financial analysts, financial journalists, financial publications, TV shows and other online tools such as message boards, financial websites etc.

And here is how it works;

Have you ever bought a stock because it had a good earning report and you felt that it would move up? Most of us have. What happened next? You saw a downgrade from a stock analyst and reason - their "own channel checks on the company and business". Well, if they knew something was not right about the company, they should have just shorted the stock. Why they had to tell the world that something bad was going to happen? It is a simple question, but answer is very complicated.

Even though most people believe that Wall Street research firms are seperate from the firms who actually invest money for their clients, truth is far from it. In fact, there is a very complex relationalship among these players that federal goverment or SEC can't do anything about. Remember WorldCom and Saloman Smith Barney? When everyone in the world was suspecting bad things at WorldCom, Saloman Smith Barney's analysts were upgrading the stock.

Here is another example that is fairly recent. Let's use satellite radio industry. XM satellite and Sirius are the only players and there was a rumor for months that they would merge and in anticipation of this news, their stock prices were going up. If you also believed the hype you probably bought some stock on your own. There is nothing wrong with using a rumor to make money because you probably have heard it before - Buy on rumor and sell on news. Everything looked normal and things were calm. However, in a totally unrelated press conference, a "journalist" asked FCC commissioner about the merger possibility and commissioner replied that it can't happen since this would create a monopoly in the market and FCC would reject such a proposal.

Next morning both companies took 15% hit on their stock prices with heavy volumes. Most people thought that it was obvious that speculators were fleeing these stocks and some small investors who bought their positions on margin had to close out to meet the margin calls. Some sold it in dissapoitment because they heard it from FCC commissioner himself and there was no reason to believe that he way joking? Well, couple of days later FCC commissioner was again asked about the merger possibility by another "journalist" and this time his answer was "We can't comment until we see a proposal and rules can be changed to allow such a merger". What happend here? Didn't the same guy said that he would reject such a proposal 72 hours ago? Of course he did, but it was his opinion and he was entitled to change it. This time both stock took off and gained over 20% in next week. Two months later, a formal merger announcement was made. End result - thousands of innocent investors lost money because some "journalist" was asking some "simple questions". What really happened here was that some big players used this opportunity to shake weak individual investors and took their shares fairly cheap and made pretty good money in just a few days.

This is exactly what big financial firms can do. "Conflict of interest" has no place in
Wall Street business model. It is illegal to do business when you have "conflict of interest" but it is so hard to prove in court. And who has time, resources and money to file court cases for hundreds of violations that happen on a daily basis?

Bottom line - Don't get distracted by the "noise" in the stock market. If you have done your homework and like a stock, you don't need to call into a "TV show" or read a "Stock picking magazine" to make your decision. Also remember, buy and hold doesn't work anymore due to the fact that there are so many palyers who are trying to make a quick buck. So set your rules and stick to them. Cut your losses early and if you make a profit, make sure that you keep some of it.

Happy investing!
-Amplidyne

Trading Against a Monster

Do you trade stocks online? Do you have an online brokerage account? In this age and time, most people do have access to financial markets as individual but whether you take advantage of it or not, it depends on your confidence level and past experience. Most of the current individual investors got started during internet boom time. How could you not jump in when you see a stock doubling in price every other week? There were mutual funds created specifically for internet sector with astronomical three digits returns. Moving forward to 10 years later, where are those funds now?

Well, financial market in 21st century is a very different place. Hedge funds who started in internet boom time have become Monsters. Rules and guidelines for hedge funds are not as strictly regulated as for mutual funds. This has helped them grow faster and bigger. They have become so big that individual investors often get killed in the stampede that occurs when a company fails expectation and stock takes the punishment. Naked short selling has become a norm of the modern day trading.

If you're an individual investor and have made a decent return in stock market, you should feel pretty good about it. This obviously shows that you have learned a thing or two. But majority of individual investors lose their life savings in stock market. They don't understand what has happened to that old golden strategy of "Buy and Hold". If you still trade with old principals, chances are you're going to lose money and going to lose a lot of it. There are too many big players in stock market today and every one has to deal with the pressure of good returns and consistent performance. An individual investor in most cases in no match to the power and clouts of a big financial house. They use sophisticated computer trading programs that have decade of trading trends and data available to them. On top of that, they have "connections" with big Wall street research firms that can "downgrade" or "upgrade" a stock for no apparent reason and can cause you lot of pain in you are caught on the wrong side.

However, their big size could also be used for your advantage to make money. This is what is going to be the topic of a article later this year. So get ready to learn the dirty little secrets that Wall Street never wanted you to know.


-Amplidyne

Time to fund your IRAs

Well, It's tax time and most of us are busy doing our income taxes. Most people will get a refund and that's some extra case that you can really use. Remember, this is also the time to fund your retirement accounts if you don't have a company sponsored 401(K) or 403(b) plan. You can open a traditional IRA account and benefit from the upfront tax break with traditional IRAs. If you have a company sponsored retirement plan, you can still invest money in a Roth IRA account if you meet certain income restrictions. Current contribution limits are $4,000 for individual unless you're over 50 years old.
So don't let your retirement planning slide another year and do something about it. If you don't have a lot of money to put in an IRA, start may be with $50 a month.

-Amplidyne