With down side plays are you doing only puts, or short as well, and can the targets and stops you recommend for puts be used for shorts? Also, do you recommend shorting in general and what are the risks in shorting? (June 17, 2003)
First we want to say that with the market rising, taking short positions is more difficult. We look for stocks that are in a continuing downtrend or are breaking down through support on volume and preferabley have moved up and failed an attempt to get back over that former support that we are looking to see now act as resistance. Even with that if the market continues to surge higher even those can pop up like basketballs held underwater. The market is showing signs of turning over and we are trying some downside positions here and there, but they will be more plentiful when the market starts to break its current very strong trend up the 10 day MVA.
As for shorting stocks versus puts, we prefer puts because we know our total risk going into the play, and that is the price we pay for the options. If the stock turns and flies to the moon and we let it go, we are out the cost of the options but no more. If we short the stock, i.e., sell shares we borrowed from the broker, and it runs higher, we are still going to have to replace that stock by going into the market and buying other shares. If the stock keeps running higher and higher, our losses keep on mounting. Theoretically they are infinite, but your broker will make you cover at some point.
Further, with shorting you have to sell on an uptick in price. If a stock is plunging you just cannot jump on board but have to wait for it to tick higher. With a put you can buy as it plunges. Now we often let a stock plunge through the buy point and then catch it as it makes a rebound in relief to better set up the move. But, we still have the flexibility to buy at any point during the move. Another problem that may arise with shorting is the availability of stock to short. With the new dividend rules, if you lend your stock to be shorted you do not get the lower tax rate on any dividends your stock pays. That may shrink the pool of stock available for shorting, but that remains to be seen.
The targets are set based on support and resistance levels. In other words, our initial targets on downside plays are the next support level as that is the level we would expect the stock to bounce if there is no other pressure on it. We analyze the plays carefully to make sure that if the stock makes the move there is enough room to fall to that support to make a solid gain. Thus the targets would effect that stock action as well for short positions that involved stock only. You would have to do the math to see if the move was enough to make the risk/reward ratio good enough for you. For example, if you want to short a $50 stock down to $45, if it works to plan and you sell at 50 and buy at 45, your gain is 10% ($5 gain versus $50 risk; margin will change that, but margin on short selling can be rough).
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