I just saw a headline that said the Dow Jones Industrial Average is at its highest level since 2007. It’s not that I was surprised by this but the headline did grab my attention. You see, when you trade for a living like we do, you’re only concerned about your daily stock picks and not so much about the long-term performance of the major stock indices.
The Dow has obviously been doing quite well. But, what does this headline really mean to you, the trader? In our opinion, it says that the market is likely overbought and ready for a correction. We expect the next few months to be a wonderful time to be a trader. If you’re making your own stock picks and you’re always going long (like most do-it-yourself investors), you may need to reconsider that strategy. In a down market, there’s fear. And, where there’s fear, there’s money to be made for the astute trader.
Short Selling is a technique that you’ll need to become familiar with if you want to make killer stock picks in a declining market. Short Selling is the practice of selling a stock that you don’t currently own in the hope that its price will go down in the future so that you can buy it at the lower price. Your profit is the difference between the amount at which you sold-short and the amount at which you purchased `(less transaction costs). Is it risky? In theory, yes because your profit is limited to the price at which you sold the shares but your loss could be infinite if the price of the shares keeps rising.
Let’s consider the case of one of today’s hot stocks, AAPL, which as of this writing, is trading at around $670. Now, there are some analysts out there who are predicting a $1,000 target price over the next few months, years, etc. If you went short on AAPL, your maximum profit would be $670, and that would be if the company went out of business and their stock price went to zero. However, if the price goes to $1,000 or $1,500, your loss could be as high as $830/share. In this example, it’s clear that if the price of AAPL keeps rising, so does your loss. Therefore, it’s imperative when you’re short-selling to keep tight stop-loss orders in place and watch them carefully. The old adage of keeping your losses short and letting your gains run is just as true in a short-selling situation as when you’re considering stocks to buy.
Short-selling can be very profitable if you have the time to manage your stock picks. That’s the reason why most short-selling is done by professional traders and institutional investors. Why do you think some of the biggest hedge funds out there use this technique as a way to not only manage their risk but also to amplify returns for their clients? It’s because they know that in a down market, going long is fool’s game. They also have the time and resources to manage their short positions. The average trader doesn’t have the same time and resources and, therefore, is less likely to see the full potential of short-selling. But let me tell you one thing – if it wasn’t an effective technique, professional traders would not be doing it.
At some point, the market will change direction because the stock market is a cyclical game just like real estate and commodities. For those that believe that the market will continue to go up indefinitely, I’d recommend looking at the overbought market of the tech bubble in 1999/2000, when the market seemed untouchable and you could throw darts and find hot stocks. We all know how that turned out. The lesson to be learned from that episode was that some of the biggest profits that were made during that time were by people who knew that the market would turn and shifted their focus to short positions. Will you be ready when the market turns?