The Use Of P/E Ratios To Select Stocks Suggests That Short Selling – Considering Risk and Reward Before Selling Short

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Short Selling – Considering Risk and Reward Before Selling Short

I’ve noted from reading investment blogs and Yahoo Message board posts that there seems to be a great deal of interest in short selling. Maybe it is the general mood about the economy. Maybe some folks first tried short selling during the big slide in 2008 and found that they could do no wrong. (It is said that every buyer is a genius in a Bull Market. In a Bear Market, every short seller is a genius.) Maybe there have always been a lot of people dabbling in short selling and the blogs and message boards have just created better venues for them to advertise their adventures.

What has disturbed me, however, is some of the types of short positions that people are taking. While at first blush short selling seems no different from going long, there are some important differences that must be understood.

First of all in buying long, time is on your side. Because the general direction of stocks is up (because the economy is always growing), one can usually just wait out bad spells in the economy. If your stocks are all falling, the best thing to do is to just stop looking at them for a while. Usually you’ll be happier the next time you look (and not just because they’ve done a reverse 10 for 1 split). This is doubly true if you select stocks that have good long-term growth characteristics such as steady earnings growth. In short selling, time is against you. If you are wrong about a stock, because the markets tend to go up, your loses will normally continue to grow the longer you wait to close the position.

The second difference is that when you buy a dud, the size of the position becomes smaller relative to the size of your overall portfolio. If you’d bought Microsoft in the early 80’s and five other stocks that no longer exist, you’d probably have forgotten all about the other losers by now and be living on an island somewhere. What if you’d thought Bill Gates was full of hype, however, and shorted Microsoft? Even though the other five also went to zero, your Microsoft position would have grown to gargantuan size. You would have needed to work five jobs just to keep funneling enough cash into your account to avoid a margin call. There is no such thing as a limit to your losses when you sell short.

Given these traits, it is important to consider risk and reward when contemplating a short sale. While that stock that has fallen into the penny range from the teens may be likely to disappear completely, with 10,000 shares you might only make $5000 when it does so. If you are wrong and a venture firm decides to buy the company and offers $3.00 per share, you stand to lose $25,000. If the stock recovers and goes into the teens, you could lose hundreds of thousands of dollars. The potential reward is not worth the risk taken.

So, before taking a short position, consider the potential reward (how much can you make if the stock drops by 50%, and how likely is that to happen) and the risk (how likely is it for this stock to move upwards, and how much could it move if it does so). Look for stocks that are already so overvalued that it is very unlikely that they could go much higher. Find stocks with lots of cheerleaders and high PE ratios. If everyone likes the stock, they have already bought in and it will be difficult for them to push the price higher. It also helps if the market in general is nearing a peak, since when the whole market is falling every stock is a dog.

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