Should I Sell Short to Protect My Portfolio?


The ABC News report yesterday reported that the markets were down for a second straight day after the election due to fears of “Washington gridlock.”  This is very unlikely since gridlock would actually cause the markets to rally.  You see, the markets hate uncertainty, and having gridlock would mean that things are unlikely to change legislatively, meaning that it would be easy to predict earnings and taxes since there will not be any new laws passed.  Markets like certainty – prices rise when there is less risk due to uncertainty.

It is more likely that the markets have been falling because 1)they had rallied when it looked like the Administration would be replaced, since this would mean that Obamacare might not be enacted and 2) a Romney administration might have meant less Government interventionism in the markets.  The effect of Obamacare enaction will be large additional costs on companies as healthcare costs rise, a large number of layoffs (which are happening already) as companies pare down their workforces to reduce the burden of the bill, and reductions in sales since as people start to pay a greater share of their income for healthcare they will have less money to spend.  The effect of government interventionism may be more pernicious, in that it is difficult to run a business if the government may give a lot of money to your competitor or decide to raid your business as was done with Gibson Guitars.  This all adds uncertainty, and once again, investors demand a higher return when uncertainty increases.  Therefore, expect lower stock prices when there is uncertainty.

The question then comes on how to protect your portfolio from large market drops during this time of uncertainty and as we enter another depression.  As I’ve stated in the past, you need to invest with the understanding that if you know a piece of news, everyone else knows also.  As soon as the election results were in, the effects were already included in the prices of stocks, at least as well as investors could predict them.  If restaurants can be expected to see a 10% drop in earnings, the price of their stocks would have dropped by 10% at the opening of the markets.  It is therefore never a good idea to act on news – you’ll always be too late.

Still, what if things are worse than people are expecting?  There are times when there is such an obvious bubble, you can predict that the markets will drop.  I saw this back at the end of the 1990’s with the dot com bubble and again in 2007 with the mortgage bubble.  These were very predictable – heck, there were articles in The Wall Street Journal at least once per week a year before either of these bubbles burst.  It wasn’t a question of if the markets would drop, but when.

One strategy in this type of situation is to short some stocks, perhaps effectively going “neutral” where you pretty much break even because the losses on your long stocks will be offset by gains on your short stocks.  If you go heavily short, you might even make a bit of money as the market falls, and then make more money as the market recovers.  I was short dot com stocks back in 1999 and mortgage lenders, basic material suppliers, and oil refiners in 2007.

One thing I discovered is that while it is easy to see bubbles, figuring out when they will burst is another thing.  In 1999 I was short theglobe.com and thestreet.com, both in the $20 range.  While these stocks were both ridiculously overpriced and eventually dropped to nothing, they both jumped into the $30 range in a single day after I shorted them, forcing me to cover and take 50% losses.  I was right about them being overpriced and ripe for a fall, but this didn’t keep them from getting more overpriced before the fall.  It is difficult to predict when the biggest idiot, who will pay the most for the shares, will arrive.

I did better in 2007.  I made a lot of money as people started driving less and refineries were hurt by both high oil prices and slackening demand.  I also did well as lenders fell in price when the adjustable rate mortgages started adjusting and people started defaulting.  I did have some setbacks, however.  For example, I was short Golden West Financial, which was bought (I believe by Countrywide).  After the stock was purchased there were complaints by the acquiring company that Golden West’s financial situation was overstated, but that didn’t help me – I had already suffered a big loss when the merger was announced.

Understand also that short selling is extremely dangerous since you cannot predict how much you can lose.  If you buy a stock for $2000, the most you can lose is $2000.  If you short a stock for $2000 and it triples in price, you will lose $4000 even though you only started out with a $2000 position.  There is no limit on your losses.

A safer strategy is to simply sell some stock and sit on the sidelines with some cash.  You should always be in cash with money that you will need in the near-term (near-term in this case meaning within the next 5 years or so) since you since you cannot predict where stocks will go over short periods of time.  If I were planning to retire next year, for example, I would sell stocks until I had at least 5 years’ worth of expenses in a money market fund and bank CDs (maybe 10 years’ worth right now).

If you have a long time until you need the money, however, you might be sitting in cash for several years before anything happens.  Worse yet, you could be absolutely wrong and miss out on a huge rally.  For this reason, it is usually best to simply be invested for the long-term in good growth stocks that can weather downturns in the economy (and come out stronger when their competitors fail).  If things fall, they will generally be back within a couple of years.  You could also save up cash from your work on the side and just invest a little periodically when you see an opportunity.  That will both allow you to make back your losses more quickly and also give you psychological support when the market does tumble.

A final strategy is to write covered calls on your stocks.  This will only protect you a little (you collect a small premium from the sale of the calls, which helps offset losses) and is probably better when the markets are stagnant since it allows you to generate income from your investments even if prices hold steady.  It can force some difficult decisions, however, if the price of the stock falls (since then you need to figure out if you should write another call at the lower price) or if the stock rises (because then you need to decide if you’ll let the shares be called away or if you want to  buy an offsetting call and close the position).  You also will limit your gains since your shares will be called away if they are above the strike price on expiration day, and maybe before that.

Please contact me via vtsioriginal@yahoo.com or leave a comment.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

3 comments

  1. Shorting stocks is something I don’t fully understand. I get the concept, but it sounds like without a real solid understanding of it you could lose money.

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