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Short Sale Technical Details -- Stock Trading Analysis (11)
Short-Sale Technical Details Stock Trading Analysis (11) Short sale is the reverse of buy. You may sell a stock without owning it. That's why it's called a short. You wait for the price to come down. Then you buy it back at a lower price, thus making a profit. What if the stock goes up unexpectedly? You will lose by the price difference when you buy back. The big guys of Wall Street invented short sale to serve their own interests. When a big player with a huge holding wants to cash out, the price will surely come down. Why not short sell the same stock before the unloading to add some more profit? It is a sure win! You don't have this luxury as a small investor. So you sell short for a different purpose. You employ it to protect your investment, reduce your risk, or lock in your gain. First of all, you must understand the inherent dangers of a short sale. As a general rule, you should not bet on a business downturn because it only happens once a while. Besides, a bust lasts shorter than a boom. Likewise, you should not bet on the sky falling. Even if you are right, it won't benefit you because you'll be dead like all others. To illustrate, suppose you buy 500 shares at $10. Your investment amounts to $5000, which represents your maximum loss when the price goes down to zero. Imagine if you short sell 500 shares at $10. The stock then goes up and up, and it splits and splits. Your loss seems like infinity! Moreover, a takeover may happen tomorrow when the stock suddenly shoots up to $50. Therefore, it is never a good idea to sell short except when you already own the stock. You may want to do it under the following circumstances: Partial Protection Lets say you own 500 shares at $10 each. You may wish to sell short 400 shares at the same price. In this case, you manage to protect part of your investment. On the other hand, you also limit the potential for an upturn, because your gain on the buy side will be negated by the loss on the short sale. Therefore, there is a limit on potential gain when you try to protect your share holding. Compensate Risk Suppose you plan to hold the 500 shares bought at $10 for a few months. As you know, all stocks frequently pause and retreat temporarily even during the uptrend. This represents an opportunity to make some money while you are patiently waiting to cash out. All you need is to catch a few of those temporary retreats with a short sale. Suppose you have caught five retreats of $1 each. The total gain will be $1 x 500 x 5 = $2500. As long as you are holding the stock, your maximum loss is $5000 should the price goes down to zero. With the gains totaled $2500 made from the short sales, you have effectively reduced your risk by half. Lock in Gain The best scenario for short sale is to lock in your gain and let you play again at a lower price. Lets go through some simple math here: You've bought 500 shares at $10. The price now is at $15 where you make a short sale. You lock in your gain of ($15 - $10) x 500 = $2500. This gain is guaranteed wherever the price goes. A little math below will prove my point: (A) Suppose the price rises to $20. Sell the buy, profit = ($20 - $10) x 500 = $5000. Buy back the short, loss = ($20 -$15) x 500 = $2500. Therefore, net gain = $5000 - $2500 = $2500. (B) Suppose the price drops to $5. Sell the buy, loss = ($10 - $5) x 500 = $2500. Buy back the short, profit = ($15 -$5) x 500 = $5000. Therefore, net gain = $5000 - $2500 = $2500, which is the same as in (A). Once your gain is guaranteed regardless of future price, you have plenty of time to assess when you want to cash out and when you want to play again. The best alternative is to wait for the price to settle down lower. Then you reap the guaranteed gain, and plunge back in at a lower price. Here, we are only talking about one dose of investment (500 shares at $10). Suppose you have more capital to afford multiple doses. The lock-in gains for all the different doses will add up to be very significant. For further details, please email stockfessor@comcast.net.

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