Wednesday, November 11, 2009

Short selling and risk

At the suggestion of my developers, I requested a review of Shortscreen by John Chow's site. You have to pay to have your site reviewed by John Chow, but he and his team are free to write whatever they want about it: they have complete editorial control. The review is up now; you can read it here: Screening Stocks for Short Selling.

A couple of the commenters raised reasonable questions about the risks of shorting. I addressed those questions in the comment thread there, but it's worth recapping here too.

Question/comment: Additionally, short selling as a whole is risky because you can lose an unlimited amount of money because a stock can go up an unlimited amount theoretically.

Answer: There is a way to limit your downside, if you want to bet against stocks: you can buy puts on them instead of shorting them. As with shorting, you’ll profit if the stock drops, but in the case of buying puts, your maximum loss is limited to what you paid for the put. You can use Shortscreen to screen for candidates to buy puts on as well as to short.

I personally don’t limit myself to buying puts, because I believe there are often better short selling candidates among stocks that aren’t big enough to have options traded on them. There is of course a risk that I will lose money on some trades, but by limiting myself to shorting stocks that a highly accurate model predicts are headed for bankruptcy, I believe the odds are on my side.

Question/comment: Selling stocks short is a good way to also LOSE A LOT of money.

Answer: Although there are risks involved in short selling, it’s important to note, as a previous commenter alluded to above, that, for knowledgeable investors, adding short selling (or buying puts) can reduce the overall risk of your portfolio.

For example, although it is risky to own (i.e., to be long) one stock in a particular industry, and it is risky to short one stock in the same industry, it may be less risky to do both at the same time. As Investopedia notes, this strategy, called a pairs trade, is often used by professional investors to hedge against sector and overall market risk.

For more on this general concept, see, for example, this essay by Ken Hawkins: Make Your Portfolio Safer With Risky Investments.

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