Good morning! Today Troy continues about the investing for beginners series. You can check the previous posts about What are stocks and how to value them, How does Currency Trading Work, How are Currencies Traded, Investing in Commodities, What Fundamentals Affect Commodity Prices, What are ETF’s, What are Options, How are Options’ Prices Structured, Investing for Beginners Part 2 – Different Investment Strategies, When does Buy and Hold not Work, An Unconventional Approach to Buy and Hold, An Unconventional Approach to Buy and Hold Part 2, How the Investment Advisor Game is Played, An Introduction Into “Secular Investing”
In the previous post we covered what you should do in a cyclical bull market. But what do you do (as a secular investor) in a cyclical bear market? Investing in a cyclical bear market is very different from investing in a cyclical bull market.
By the end of a cyclical bull market, you will want to have liquidated all your longs (bullish positions) because the peak is in. Normally, you would go short in order to profit from a market decline if you see that the cyclical bear market is starting.
What Does it Mean to “Go Short”
Normally, buying into an investment is a bullish investment. If the market goes up, you make money. If the market goes down, you lose money.
“Going short”, or “short positions” is exactly the opposite. You’re betting that the market will go down. If the market goes up, you lose money. If the market goes down, you make money.
The concept behind going short is simple. You borrow securities (e.g. stocks) that you don’t own. You sell them at the current price. You buy these securities back in the future at the future price. If the future price is lower than the current price, you just made a profit. If the future price is higher than the current price, you make a loss. Here’s an example.
The current price of Apple is $500 a share. Let’s assume I short 1 Apple stock. If Apple stock falls to $400, I just made a $100 profit (500-400), which is a 20% profit. But if Apple stock rises to $600, I just lost $100 (600-500), which is a 20% loss.
Thus, when you buy (go long) a security, your losses are limited (max. you can lose is 100%), while your gains are potentially unlimited (b/c the stock price can theoretically go to infinity). When you sell (go short) a security, your losses are theoretically unlimited while your gains are limited (if the stock goes to $0, that’s a 100% profit). That’s why a lot of investors don’t like to short stocks – the risk:reward ratio isn’t very attractive.
Shorting is a very different concept. If you buy “long” (bullish) positions, it doesn’t matter if the market goes down. It doesn’t affect your cash positions. You can simply wait (use the time factor) for the market to turn around. But shorting is different. If the market goes against you (goes up), it eats into your cash position. This is known as margin problems. If you have longs and the market declines, all you have to do is wait until the market turns around. This is not true for a short position – you don’t have the luxury of time (waiting for the market to turn around). Here’s an example:
- You use 75% of your cash to short Stock A. If the market rises 33% (which eats into your remaining 25% of cash), you’re forced to liquidate your entire short position at the worst price possible.
As you can see, shorting requires your timing to be insanely accurate. Thus, all shorts are essentially just trades – with a time factor involved, shorting and secular investing are incompatible.
Shorts can’t afford time – you can’t wait for the market to turn around in your direction. So what can you do as a secular investor in a cyclical bear market?
Sorry to break it to you, but in the secular investing strategy, there is nothing you can do in a cyclical bear market to make money. But what you can do is not lose money, which is what happens to most investors in a cyclical bear market. Don’t try to “buy the dips”, because the “dips” often turn into hurricanes that kill all the bullish investors. Instead, all you can do is wait for the market to bottom and wait for the new cyclical bull market to begin.