Here’s another version. If you’re a farmer, you sign a contract in spring to sell your crop in the fall at a set price. If you think shorting stock is gambling, try doing it with a crop you haven’t even grown yet.
If you don’t get a good crop, you have to buy someone else’s crop to fulfill the order, and you lose money. You could go broke.
If you get an ordinary crop, you and the buyer both make a little money, and you’re both ready to go again next year.
If you and everyone else gets an exceptional crop, you make money, but the buyer is stuck paying way more than the market price, so he might go broke.
Au contraire, 100% of option plays end up as winners for someone. Options that expire unexercised are wins for the person who issued the option.
A common strategy if you are holding equities that you don’t think are going up is a Covered Call. Basically, you sell call options on equity you own, and if you are right that the price is not going up much, you keep pocketing option premiums, and since you actually own the stock underlying the call, the risk is limited.
If you could do this reliably, why wouldn’t you do this? Sure, maybe $2000/month isn’t worth the time and effort for full-time work, but just increase your initial outlay 5x or 10x. Probably because it isn’t that easy and there’s significant risk involved…
From the perspective of the economy markets exist to process information so that resources go to their highest value use. If someone thinks a stock is overpriced, that is information that could be useful and shorting the stock allows that bit of knowledge to be processed by the market.
This is one way to look at the market, but not one I necessarily agree with.
My opinion: stop orders are often counter productive and are defeated by a situation called “whipsaw”. This is a situation where a stock price moves a large amount in a short period of time, only to recover fairly quickly. Often, a whipsaw will reach your stop order and your stock will be sold, only to have the price recover quickly. These situations often happen with no regard to the underlying strength of the stock, but to people’s perception of the market. So all a stop order does is lock in your losses.
This type of situation often happens with volatile stocks such as technology stocks. I have used stop orders in the ancient past, only to get whipsawed out of a good stock that promptly recovered. If all that is important to you is the stock price, then stock investing truly is a casino. Short term stock prices are psychotic. They move without any seeming relationship to the actual strength of a stock. Long term stock prices flatten out this psychotic motion, and if it is a good stock, prices will rise. No offense intended to Exapno Mapcase, but a mature investor realizes that there are only 2 times the stock price is important: the day you purchase it, and the day you sell it. All of the fluctuation between those 2 days is meaningless noise.
In my opinion, you should analyze a stock and then buy stocks that meet good analysis criteria. A company that has 5 years of steady growth in both sales and earnings, with debt of less than 30%, a PE ratio of not much more than the growth rate, and current assets to current liabilities ratio of at least 2 to 1 is a reasonable company to consider further.
Then when you buy a stock, the only reason you sell it is if it fails to meet your growth expectation. What the stock price does, or what the market does is relatively meaningless.
What I’m describing here is a long-term buy-and-hold philosophy. Check out the NAIC(National Association of Investors Corporation) for more info about this. (Note: I’m a former member of this organization, but I have no relationship with them now. Primarily, this is a non-profit organization meant to help investment clubs.)
Buy-and-hold is certainly a solid investment strategy, and it’s especially good for individual investors who cannot put in the time and effort to watch every move of the market.
It isn’t a perfect strategy, because nothing can be. Some stocks will go down and stay down for a long period of time. You need to make decisions about what to do in those cases, whether it’s a stop order or a simple sell. At some point you will lose money in stocks (or metals or currency or real estate or any other investment) for this reason. You might net an overall profit across your portfolio, which is why a diversified portfolio is always a good strategy, but any individual investment is chancy.
That’s what I was saying to vomit_comet’s oversimplified model. You can’t simply tell people to buy low and sell high. The future is not predictable. Nor can you time your way though the market as his next post indicated. That’s a terrible strategy for individual investors. You’re never hitting the extremes because you’re following the market after the instantaneous trades made by institutional computers and worse, the fees for each transaction will eat through any profits.
One thing I’ve never seen clarified is who officially owns the shorted shares for purposes of dividends, voting in company elections, and such.
For example, suppose a company issues 1 million shares. Now short sellers come along and short 100K shares. The buyers of those 100K shares consider themselves full-fledged shareholders. But so do the people whose shares were borrowed and sold without their knowledge. Does that mean there are now 1.1M shares in existence? Who does the company pay dividends to? (I am aware that the short-sellers have to cover the dividends, but who do they pay it to? Does this mean that certain shareholders receive dividends directly from short-sellers versus from the company?) Suppose there are annual elections to the BOD. How many shares get to vote? And so on.
There’s actually a day-trading theory called “Point of Maximum Pain” (POMP) which maintains that as options expiration dates approach the price of stocks tends to gravitate towards that price which would render the maximum number of options worthless. I’ve forgotten the exact details, but IIRC it had to do with most buyers and sellers of options doing so as part of a broader strategy involving parrallel transactions involving actual shares.
It exists because there aren’t rules against it. To outlaw it, you would either have to prohibit people from loaning stocks to each other, or outlaw selling of loaned stocks. It isn’t seen to be enough of a problem that either needs to be done.
(To be fair, there is also naked short selling, where you sell the asset without first borrowing it. The SEC has banned that practice in 2008)
This is known as “timing the market”. Many have tried, almost all have failed over time. This is basically the strategy used by day traders, very few of whom ever come out ahead enough to make a living of it.
I don’t doubt most people aren’t successful at it. I talked to one guy that was day trading and was telling me about how he had a program that was set to sell when there was a dip in the price. I asked him what he did when the price came back up; he said “buy”. Doesn’t seem like a very prudent to make money trading anything.
From here, basically the person who loaned the shares loses the voting rights, and the person who buys the shorted shares gains them. Shares can only be borrowed from individual investors if they have accounts where they have specifically agreed to this.