Short Selling Stocks
Profiting from Trading Stocks that are Going Down in Price
What Is Stock Short Selling?
The selling of a stock equity security that the seller does not own, or any sale that is completed by the delivery of a security borrowed by the seller. Short sellers assume that they will be able to buy the stock at a lower amount than the price at which they sold short.
Selling a stock short is the opposite of buying a stock long. Short sellers make money if the stock goes down in price. Short selling is an advanced trading strategy with many unique risks and pitfalls. Novice investors are advised to avoid short sales until they are properly educated in doing it.
Short selling has been around ever since the beginning of the stock market. But many people don't think short selling is good for companies and the market. They think its un-patriotic or damaging to the economic health health of companies and the country they are based in. The reality is that stocks go up and they go down for a multitude of reasons. Fair equal treatment to buy or sell short a stock provides liquidity and the best balance of fair value for the price of the stock.
People who don't invest or trade the markets at all, blame short sellers for some of the worst company failures in the world's financial markets. Company executives have accused them of driving down their company's stock prices. Governments have before and still do from time to time, temporarily halted short selling to help markets recover and have strengthened laws against some short selling techniques. Some governments have banned short selling completely. Some governments have even gone as far as proposing and implemeting strong legal actions against short sellers. This has happened throughout history in various countries and industries.
William O'Neil the founder of Investor's Business Daily and the CANSLIM stock investing method, wrote about short selling in his book "How To Make Money Selling Stocks Short", and concluded that "few investors really understand how to buy stocks successfully. Even fewer understand when to sell stocks. Virtually no one, including most professionals, knows how to sell short correctly."
The fact is that if done proprerly, the risks of short selling are about the same to the risk of buying long stock positions,.
In the stock options, futures and forex markets buying and selling short is normal practice. Let the free market have its freedom to do what it will. In the long term, all people will benefit much more than letting markets move parabolicly higher creating huge bubbles that end up in price collapses anyway.
What Is Bear Market in the Stock Market?
Trending in the stock market is often referred to as either bullish or bearish. A bull market is a period when stock prices are surging, while in a bear market, stock prices are declining. Investors use a rule of thumb to define bear markets, but a bear is usually pretty obvious to investors who see their investments going down in value.
The rule of thumb is that the stock market has experienced a bear market if the major stock indexes have declined by 20 percent or more from a recent market high. Stock market historians use the value of the Dow Jones industrial average to calculate whether the market is experiencing a bear market or just a correction, which is a decline of 10 to 20 percent. The Dow is used because the index has been in existence since before 1900, providing a historical picture of bull and bear markets.
Two types of bear markets can be found when looking at the long-term chart of the stock market. Primary or cyclical bear markets meet the standard definition of a 20 percent drop in the Dow, followed by a recovery from the low. These are shorter-term bear markets as the stock market swings from periods of moving up toward downturns. A secular bear market is a longer, multi-year slump that produces a much larger decline in the value of the market or is a string of bull and bear market cycles in which the end result is a lack of any meaningful gain in the stock market indexes.
A cyclical bear market occurs on average every few years. The bottom of the 2008-2009 bear market signaled the end of the 33rd 20 percent-or-greater decline in the market since 1900. The end of a bear market is determined when the stock market has moved up by 20 percent off a low, then that low is counted as the end of the bear market. Most market observers count five secular bear markets from 1900 through 2010. A secular bear market will include a series of cyclical bear markets in which the recovery does not reach the previous market high.
The length and depth of bear markets vary significantly, but some averages give an idea of what the typical bear market might look like. Of the 33 primary bear markets to date, the average length was about eight months, with a range of just a couple of months to almost two years. The average bear market decline was 34 percent, and more than one-third of the historical bear markets dropped by more than 40 percent. The stock market crash of 1929 to 1932 was the biggest decline, with the market losing almost 90 percent of its value. Secular bear markets have averaged five years in length, with an average decline of 54 percent. The longest secular bear market to date took nine years to run its course.
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U.S. Stockmarket Boom and Bust Cycles
Bear Markets Happen!
A Short History and How Any Trader Can Prepare By Dr. Van Tharp Trading Education Institute
"Education is the passport to the future, for tomorrow belongs to those who prepare for it today." — Malcolm X
In my opinion, the heading “Bear Markets Happen” states a simple fact, however, identifying bear markets at their start can be challenging if not impossible for the unprepared and unaware. Numerous boom/bust periods in markets have happened going back as long as we have recorded history. Some of the best-known examples from history include: The Tulip Mania of 1636 in Holland; The South Sea bubble in 1720 in England; and The East India Company collapse in 1772 in Amsterdam.
While these are certainly dated, they have certain similarities with today’s post ‘great recession’ boom — while this is also a very different kind of boom as a result of the unprecedented involvement of the world’s central banks. Consider that since 1854, the US has seen 33 cycles with the boom periods lasting three and a half years on average while the busts have lasted a year and a half on average. The table below includes the cycles from the depression of the 1930s until the present day which provides us an account of the recurring nature of the bull and bear market cycle. When you study the table for even a short while, you see plainly that this cycle is simply how the markets work. Perhaps that is no surprise given that markets are nothing more than a collection of people — whose emotions vacillate over time.
U.S. Boom and Bust Cycles Since 1929
As Confucius Said . . .
History and historic information is certainly limited in its usefulness but it is better than no information. As Confucius said, “Study the past, if you would like to divine the future.” Using history, we can’t predict the precise timing and exact degree of the next bear market cycle but those historical cycles do help us prepare to profit from the next bust when it comes. Having a plan and working that plan stacks the odds in our favor as traders.
Through researching bear markets, I have come to understand one psychological aspect that I had observed previously but never fully grasped: bears cause many people (even professional money managers) to become very conservative. A lot of people worry about bear markets a lot — whether a bear market actually occurs or not. They worry a lot about the potential to suffer great losses during the cycle. You don’t have to look very hard to read a lot about the doom and gloom heading our way — there are many analysts and newsletters that specialize in this — some even promote it. As a result, many people’s fear causes them to miss the great opportunities available in bear markets.
During my years as a fund manager and as a prop trader, I saw many CIOs, CEOs, and other financial services executives hindered by a fear of a “pending” bear market. From a career preservation standpoint, a C level executive is being completely rational by “preparing” for the next bear. But when an executive constantly “prepares” for the next bear, that kind of behavior hurts returns to unit holders and investors. For an individual trader, a fear of bear markets is definitely suboptimal as this market type actually provides great trading opportunities — for those who are ready. For the unprepared, one aspect of bear markets (volatility) can shock unprepared traders and cause a powerful psychological reaction — as well as the potential for a sudden and dramatic loss.
Another Interesting Bear Market Psychological Phenomenon
You have heard Van state the importance of understanding market types and using trading systems that fit you. It is critical, therefore, that you “know thyself” before attempting to trade a bear market. Generally, I have noticed that introverts and extroverts handle bear markets quite differently. Introverts generally focus more on all the warning signs and the risks, which can then prevent them from profiting greatly from the full cycle. On the other hand, extroverted traders tend to focus more on the huge rewards available so they can miss the signs the markets provide about shifts in market type. Missing the signs of a shift in market type can then result in catastrophic losses at the extreme.
Creating Your Plan for the Next Bear
In the process of updating and teaching the bear market trading workshop for Van, I have completed nearly a year of extensive research on bear markets. The Bear Necessities Workshop, is about you planning for a bear market BEFORE you have to deal with one and we will thoroughly cover the various ways you can trade in bear markets. Even though I developed the following list for the workshop, it’s also a good list for any trader to review and think about now - in advance of a market downturn.
Clarify who you are as a trader and what your important values and goals are. Without this understanding, you won’t understand what fits you as a trader.
Outline your objectives for trading — both for bear market types, other market types, and overall.
Understand the big picture and its various components.
Ensure you have a monitoring plan to follow for the big picture.
Understand how you intend to evaluate market type.
Know if or how you plan to use options or other hedging methods and what additional work you will require to become proficient with these critical tools.
Evaluate what others have done to immunize their portfolios and determine what fits your trading. Various trading methods can be used throughout the entire cycle and certain ones do particularly well in down markets.
Analyze bear market trading systems and strategies and determining which fit you. The opportunities in this area range from simple to complex. Consider which you can use to profit from bear markets given your objectives. I teach these systems and strategies at the workshop.
Being prepared and having a thorough plan will provide you many benefits including the following abilities:
to embrace opportunities for every phase of market cycles,
to fully understand the risks and the opportunities of bear markets,
to face the next bear market with peace and confidence,
to allow you to exit the next bear market in better shape than when it started, and
to allow you to benefit even more from the following bull market.
You can certainly consider how this thinking applies to the broad, global equity markets but you can also apply equally to other specific markets. For example, think of the huge busts in oil and gold in the last few years. Even though we have experienced mostly a bull phase in the equity markets, everything we discuss in this workshop could have been applied in those two markets (for handsome returns!). Regardless of what equities are doing, you can always find a bear market somewhere.
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