Every day, the stock market seems to continue its precipitous drop towards worthlessness, crushing hopes, dreams, and investors in a flurry of dizzying price movements. Yet there is an answer; a light in the darkness, used by the masters of investment to generate excess returns even - no, scratch that, - especially in falling markets like this one.
Masters of short term stock speculation have long known about an ill-understood trading technique shunned by the masses. This technique makes money as stock prices fall, rather then profiting as they rise. This technique is known as shorting stock. Unlike purchasing a stock, where you buy it, and then hope that it goes up in value, or that you can collect the dividends from the stock far into the future, shorting a stock is a simple technique the masters use when they believe the stock will go DOWN.
A risky play under normal conditions, but in a market like this, where most everything is dropping like a rock, its much safer then buying stocks.To short a stock is essentially to sell it, and then buy it at a later date. Counter-intuitive, no? In the shorting process, you borrow the stock from your broker, sell it on the open market, and when the price has fallen sufficiently, you buy it back again, and return it to your broker.
An example... In late September 2008, Bank of America was trading for around $35.00. Shorting the stock at that point in time would've been extremely lucrative, as by late November, it was trading for around 15.00$. Shorting even 100 shares of bank of America, you would have made 2000$ (100 shares * $20 price drop). The process is something like the following. 100 shares of the stock, in this case, bank of America are borrowed from your broker, and then sold. You pocket the $3500. 2 months later, you buy back the shares for $1500, and return them to your broker, keeping the $2000 difference between what you bought them for, and what you sold them for.
Another way to think of shorting stocks is to own a negative number of shares... If you own 100 shares of a stock, and it goes down $10, then you lost $1000. If you own -100 shares of a stock (or your short 10 shares of a stock), and it goes down 10$ then you gain $1000. Of course, if the unthinkable happens, and the stock appreciates by 10$, then your down $1000 (What, did you think it was riskless?).
Of course, when playing the markets, there is always potential for losses. When shorting during a bear market, you should keep an eye on recent developments. A bailout such as the one received by financial stocks could easily send some once floundering stocks into a new uptrend, and when such things occur, you must be quick to cut your losses. Perhaps the biggest risk to a short play is the end of the bear market. The end of bear markets are typically highlighted by a powerful upwards move, regardless of the bad news going on at the time. When in doubt, get out.
A typical risk-management choice many professionals use is the 5% rule. When your trading stocks, don't risk more then 5% of your portfolio on any one position, and preferably less. So with the $20000 portfolio, risk no more then $1000 on a trade. This doesn't mean you can't invest more then $1000 per trade. It just means that your stop loss should be triggered before $1000 is lost. So if you short a stock at $20, and have a stop loss at $25, then you can buy up to 200 shares (far more then the actual value of your portfolio). If your time span is shorter, then you should use a smaller percentage (1-2% is completely reasonable), while if your timespan is longer then a couple months, the 5% rule could be adjusted as high as 10% (for the risk-tolerant).
In a bear market, there is just one, singularly important, yet amazingly simple truth that must always be kept in mind. Everything's going down. Throw 3 random letters together, and pull up a stock chart, and every time, you'll see declining prices throughout a bear market. With this in mind, shorting is the only thing that makes sense. Masters of this technique have been pulling millions in from the market since the dawn of the last century. As far back as the 1929 crash, Jesse Livermore made $100 MILLION using this technique. In a strong bear market, shorting is a brutally efficient cash machine.
Recession Riches - Money From Crashing Stocks