Take a look at the S&P 500 above. It’s nearly breaking the neckline of its recent head & shoulders pattern. A break of this level will signal that it’s time to start shorting individual equities again.
But before you begin shorting the coming down move, here are 10 things you need to know:
1) Since 1980, over 40% of companies in the Russell 3000 have had a PERMANENT 70% decline in their share price.
This statistic comes from a J.P. Morgan report on historical market performance. Survivorship bias keeps investors focused on market success stories. They tend to forget about the losers and miss the opportunities to be had by shorting these failures.
2) When you short, you’re going against the crowd.
The financial system is designed to promote bull markets. Banks, governments, institutions, financial advisors, and most everyone else benefit from rising prices. When you short, you’re going against giant institutional structures that will do anything to keep the market strong. Be prepared for sharp market retraces coupled with strong backlash for being a bear.
3) Outright shorts aren’t allowed in retirement accounts, but there are ways around it.
Regulators banned short selling in retirement accounts. But there are still ways to profit from down moves. For example, investors can buy inverse ETFs that appreciate when the market drops. They can also buy put options to bet on specific stocks falling.
4) You pay “borrow fees” when shorting.
Shorting involves borrowing shares from someone else and selling them. The “borrow fee” is the way you compensate the person you are borrowing from.
5) You have to pay a company’s dividends while short.
Many companies pay dividends. So when you short their shares, it becomes your responsibility to pay those dividends to the investor whose shares you borrowed.
6) It’s all about timing — don’t “short and hold”.
It costs money to hold shorts (see numbers 4 & 5). That’s why you normally don’t short something and hold the position long-term. The risk to reward is usually not worth it. As the stock price gets lower, it becomes more risky to hold.
7) Price action in bull and bear markets are very different.
Stocks “take the escalator up and the elevator down”. Longs usually grind higher and then consolidate sideways before continuing upward. Shorts drop fast and then retrace just as quickly. Be sure to manage your trades accordingly.
8) Volatility increases as stocks fall.
The further the market falls, the more volatile things get. That’s why you need to be ready to take profits quickly while shorting. Some of the strongest rallies occur in bear markets. You need to be able to manage for these “short squeeze” rallies.
9) Bear markets have shorter cycles than bull markets.
Bull markets last around 5 times longer than bear markets. Keep a tighter leash on your shorts than you do on your longs. Don’t get attached to the bear because the bull always returns.
10) Short exposure decreases as prices fall.
If a short is going your way, it will become a smaller part of your portfolio. Say you short 100 shares of a $100 stock. The stock then falls to $50. This means your original $10,000 short will turn into a $5,000 short. Your exposure decreases. It’s important to add to your shorts on the way down to maintain a constant level of exposure.
These 10 short selling tips should help you in the coming bear market. Good luck out there!
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