Shorting Stocks: Risk Reduction Strategy, Or Risky Business?

This article is adapted from a column written by a contributor to the Bear's Den.

If you have read the short selling advice that appears on The Bear's Den and other web sites, you may be a bit confused. On the one hand, you are told shorting is an extremely risky strategy, for stocks can depreciate only 100% but in theory there is no limit to price appreciation. On the other, you are told you could use shorting strategies to reduce your market exposure in an overheated market. You may be wondering which is the right view. Should you short stocks at all? And, if so, to what extent?

At some point in your investment education, you may have learned that stocks appreciate slightly more than 10% per year, on average. So you conclude that, although "the sky is the limit" concerning stock prices, the short-term prognosis should not get that bad. After all, even at a hefty 36% annual rate of return, the average monthly appreciation is only 3%.

If you think things cannot get that bad, think again. Many stocks have surged in price. Some have tripled or more in a very short time. Look, for example, at the chart for Juno Web Services (JWEB) in mid-December 1999. JWEB's stock price shot up from under $17 per share to a high of $87 per share in three days.

The key to surviving a sudden surge is to limit any one short position to a small percentage of your total portfolio. If you short a stock, it is a good idea to set a hard limit on the size of your initial position in the stock, unless you have some very good reasons to do otherwise.

My rule of thumb is to limit the initial total value of the short position to no more than 3%-4% of my trading portfolio's value (I usually build this position over a series of trades). By doing this, the five-fold increase of JWEB would limit the decline in your portfolio to 15%-20% of its value - not too pleasant, but much better than being wiped out.

If your initial short position in JWEB was in the 3%-4% rage, after the spike in the stock price, the value of the JWEB short position would be up to 15%-20% of your portfolio's value. This is well above the 3%-4% limit, and you must decide whether to do nothing or trim your position closer to your target. Again, this is a matter of your personal taste as well as your attitude towards risk. A disciplined investment approach would call for progressively trimming your position towards the 3%-4% target by covering some of the JWEB short. People with guts and significant margin power may decide to "wait it out." Without a doubt, the smaller your position, the longer you're likely to be capable of waiting comfortably.

A large short position that moves against you may require you to close out your position when the stock is near its highest point, because any further financial losses would be too much to absorb. With a large position, you also risk that your emotions will crowd out more rational analysis as fear, panicked thoughts, and self-doubt make it difficult to think clearly.

With a smaller position, you are in a better position to wait out the stock surge and to judge the longer-term prospects of your position. Even better, you are not forced to close out your position whether or not you want to, for fear that any further losses would wipe you out.

Limit your bets, so if your luck is bad, you still have enough in reserve that you can come back to the table and try your fortune again.