Short Stocks Without Losing Everything

Lately, short-selling has gained in popularity as a great way to earn big profits when stocks go down. What sometimes gets lost in the shuffle, though, is the risk that can lurk in short-selling.

But even though selling stocks short creates the potential for huge losses, one simple strategy can help you limit your risk and still reap the benefit of a bet against a particular company.

Preventing monumental losses
There's a lot to be said for adding short-selling to your investing arsenal. As fellow Fool Matt Argersinger recently uncovered, when you look at stock returns from 1983 to 2006, you'll find that nearly 40% of stocks lost money during that period -- and nearly one in five lost 75% or more of their value.

But short-selling carries a big risk. When you buy stocks, even if everything goes wrong, the most you can lose is the money you invest in the first place. Even if the company files for bankruptcy and owes billions more to creditors than its assets are worth, those creditors won't come after you for the difference.

Short-selling, on the other hand, has the potential for much bigger losses if your bearish call turns out wrong.

During the worst of the financial crisis a couple years ago, many believed Ford (NYSE: F  ) would inevitably follow peers GM and Chrysler into bankruptcy, because of its huge overhanging debt load. But if you shorted $1,000 worth of shares on the last day of 2008, you would have lost more than $4,200 during the past year and a half, as the company continues to execute its turnaround.

And if you made the same mistake with Sirius XM Radio (Nasdaq: SIRI  ) , thinking that its long history of never having made a profit would continue, you'd have a $7,800 loss on your $1,000 short of a company that is now, finally, free cash flow-positive.

Needless to say, you can't afford multibagger losses very often. So how can you make sure that when selling short goes horribly wrong, it won't take your portfolio down with it?

Enter options
One way to reap the benefits of short-selling while limiting your losses is by combining short-selling with a simple strategy using options. In particular, by buying call options, you can ensure that you'll have the ability to cover your short position at the price you specify, no matter how much higher the stock may trade in the future.

Here's an example of how the strategy works. Say you think that AstraZeneca (NYSE: AZN  ) , which is banking on its blood thinner drug Brilinta gaining FDA approval tomorrow, won't get that approval because of discrepancies between its international and U.S. trial results.

You could short the stock now, but that'd leave you exposed if the FDA does approve the drug and the stock jumps. If, however, you also buy call options giving you the right to buy shares for $55 anytime between now and mid-October, you'd limit your loss to less than 5%. And those options would cost you just $0.44 per share.

Similarly, fellow Fool Jordan DiPietro recently listed several popular short picks that trade at very high multiples, but which he believes could easily backfire on short-sellers. If you still think they're good short candidates, but want to protect yourself, here's how call options could help:

Stock

Short Interest

Stock Price

Call Option

Option Price

Whole Foods Market (Nasdaq: WFMI  )

13%

35.50

November $40

0.76

Harley-Davidson (NYSE: HOG  )

11%

27.47

November $30

0.97

Titanium Metals (NYSE: TIE  )

9%

18.72

December $20

1.40

Intuitive Surgical (Nasdaq: ISRG  )

7%

285.91

October $300

5.60

Source: Yahoo! Finance. As of Sept. 14 market close.

It's true that protection doesn't come free. In the best case, you fully expect to lose everything you pay for your call option, since you expect the share price to drop. But paying a few percentage points of the stock's value may be worth it to you to prevent the possibility of a 400% or 800% loss.

What's the best move?
When figuring out which stocks are most likely to be profitable short candidates, while limiting your potential losses, you'll want to look for a combination of factors.

High valuations and unrealistic expectations are nice to see, but for great shorting opportunities, you'll also want to look for companies with troublesome traits. Unreliable accounting, management problems, and insurmountable business challenges are just a few of the things to watch for.

To learn more about finding stocks with potential profits from shorting, you'll want to take a look at a new report from leading forensic accountant John Del Vecchio. To get a free copy of his "5 Red Flags -- How to Find the Big Short," just enter your email address in the box below.

Fool contributor Dan Caplinger always looks to cover his bases. He has no position in any of the stocks mentioned in this article. Intuitive Surgical is a Motley Fool Rule Breakers recommendation. Ford Motor, Titanium Metals, and Whole Foods Market are Stock Advisor picks. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Fool's disclosure policy won't sell you short.


Read/Post Comments (8) | Recommend This Article (7)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 15, 2010, at 12:59 PM, tom2727 wrote:

    Why not just buy a Put option instead? Seems simpler (and probably cheaper) than shorting and buying call options to hedge.

  • Report this Comment On September 15, 2010, at 1:17 PM, pondee619 wrote:

    "Why not just buy a Put option instead?" Because the fool is starting a short selling service;

    On September 14, 2010, at 9:19 PM, TMFKopp wrote:

    "yes, you're correct that we're launching a new service around short selling... Matt"

    If the fool were selling a service around Put buying they would be advocating Put buying. But they are launching a service around short selling so you get lots of "articles' about short selling.

  • Report this Comment On September 15, 2010, at 1:25 PM, IIcx wrote:

    First rule of shorting, wait for the market and the stock to take a clear direction.

    We don't have a direction at this point so the wise money is in the weeds waiting for the topping process in this cycle to complete.

  • Report this Comment On September 15, 2010, at 5:14 PM, TMFGalagan wrote:

    @tom2727 -

    You're right that buying a put option is equivalent to shorting stock plus buying a call. The question, though, is how long you expect to hedge. If you want to be short generally but want to do a short-term hedge, then it's easier to take off the hedge yet still stay short with the short + call strategy.

    best,

    dan (TMF Galagan)

  • Report this Comment On September 16, 2010, at 4:45 AM, garifool wrote:

    Yes we are getting lots of articles about short selling these days!

    "Time to get short!": The Fool has a new "free" expensive newsletter to sell!

    "Corporate earnings quality is at its lowest in decades"... ouch! the other Fool newsletters won't like this one!

    But this article doesn't teach us much what short sellers do not already know!

    Just because it has a new Newsletter, the Fool has not invented "shorting" as a new trading trick!

    But the author seems to be pretty novice in the matter of shorting, and just quickly Googled around to give birth to his article.

    He forgot (amongst other things) to Google "Insiders activity"....

    This article somewhat contradicts another one:

    "Doom, Gloom, and Boom: 6 Stocks Dragged Down by Excessive Pessimism"

    http://www.fool.com/investing/general/2010/09/15/doom-gloom-...

    Netflix was the first one on the list!

    A few days ago (Sept 10) we were explained how cheap NFLX was!

    "Is Netflix Stock Cheap Right Now?"

    http://www.fool.com/investing/general/2010/09/10/is-netflix-...

    Here is not the place to comment the other articles, since The Fool hires authors, but does not care to have a "editorial view" on what is written.

    Still I wonder how come Netflix is not mentioned, in the present article, in the list of those stocks where one should be careful?

    NFLX has a short float of 20.6%, much higher than any of the 4 mentioned!

    It really looks like a good possible good short!

    It went up 231.30% since it's 52 weeks low! Could be due for a correction, even if it should reach new highs.

    But too bad, Netflix has been a recommendation of the Motley Fool Stock Advisor for such a long time! So long that even the insiders seem sick of it: they keep selling since over a year!

    But .. no no, don't touch this one!

    ----------------------------------------------

    I too wonder why one should buy call options, and not put options. Maybe it was a typo from the author.

    Anyway, long or short, any trader who lets his (her) investment lose 400% or 800% really doesn't pay much attention! (When he plays poker, I think that the author is more concentrated as when he shorts a stock!)

    Very few stocks loose or gain so much in a few days!

    But most of all, before you lose the 400 to 800%, there are good chances you'll get called.

    And as a reminder, in case you not pay attention, unless you have unlimited cash, you have those daily mark-to-market settlements that you do not have when you own your stock.

    So if an investor can buy and hold for years, a shorter seldom shorts for very long.

    I've been successfully shorting for years, in bull and bear markets, and never bothered paying extra money for call or put options, as a "loss insurance".

  • Report this Comment On September 17, 2010, at 12:33 AM, 2humble2fool wrote:

    I can picture it now in a backroom at MF headquarters - one of the upity shmucks saying "Lets slap some lipstick on this pig and sell it!!!" If shorting stocks is such a great idea how come it took these geniuses almost twenty years to write about it?

  • Report this Comment On September 17, 2010, at 1:06 AM, starbucks4ever wrote:

    Let's face it, the Fool has always been and will always be a peddler of get-rich-quick strategies based on the latest hot trend. This one is particularly dangerous though, and the intensity of the sales pitch is unprecedented. In 10 months time they will shut down the service after losing subscribers some 25% or 30% of their capital.

  • Report this Comment On September 17, 2010, at 2:19 AM, Starfirenv wrote:

    Attention KMart shoppers- We have a Blue Light special in the subscription aisle.

    Yes, very dangerous path. I'm with the Russion on this.

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