I'm not sure I remember exactly how I felt in February, but like most investors I was interested in what the New Year would bring.
I suppose there's a certain amount of optimism that goes with that. The S&P 500 had just finished two pretty good years, with total returns of 15.1% in 2010 and 26.5% in 2009. My guess is I was trying to find which companies would be the biggest winners in another "up" year.
And buy them.
But that strategy is, at best, half-baked. It only represents half the action going on in the market at any given time. Of all the investors trading stocks exactly 50% are buying -- and 50% are selling.
I can hear what you're thinking. Something along the lines of, "Well, duh." But does your portfolio strategy reflect the seemingly self-evident point that at any point in time, half the players in the market are betting against a stock?
My guess is no. My guess is you have a portfolio full of stuff you've bought.
Too bad. If all you did was buy and not sell, then you invariably missed out on a winner I picked in February.
Epocrates (Nasdaq: EPOC) is a dog of a company. It has one product, a smartphone app for doctors and medical professionals. Everyone in the industry signs up for the free version, but few upgrade to the very pricey paid version. I wrote in February that the company would continue to bleed paid users until it was sold off piecemeal or went the way of Pets.com. When I penned those words, Epocrates was at $21.80 a share. It was nearly a $500 million company.
Today, the shares are just north of $8. The market cap has fallen to $195 million. So if you bought at $8 and sold at $21.80, you'd have captured a beautiful 162.7% gain.
Most investors would say that's impossible. They'd say the market doesn't work like that. But it does.
Right now at your brokerage, there are a jillion shares of a stock no one is using. They just sit there. And assets in piles always drive brokers nuts. So they came up with a nifty idea: The short sale.
When I think Epocrates is about to plummet, I tell my broker I want to short the stock. He lends me 1,000 shares. They are worth, at the time of this trade, $21.80.
Quiz: What do I owe my broker?
Well, the natural reaction is to take the 1,000 shares times the $21.80 price and decide that I owe my broker $21,800.
That's incorrect, though. I can only give back what I have borrowed, and I didn't borrow a dime. I borrowed 1,000 shares. Then I sold them. I have $21,800, -- the proceeds of the sale. But I only owe my broker the shares.
When shares of Epocrates -- which I need to buy back at some point to return to the brokerage -- hit $8.30, I decide to get out. So I sell the shares for that price, which deducts $8,300 from my trading account. Of the cash from the original sale, the balance is $13,500. The brokerage is, of course, going to deduct some fees for this -- and I had to have some cash on the table in a margin account to be allowed a short sale -- but this trade nevertheless returned a triple-digit gain.
I've seen every market model and read every investment theory known to man or God, and I can tell you this. Only one paradigm governs the trading of equities, and that is the "greater fool" theory. I buy shares of Apple (Nasdaq: AAPL) at $10 and ride them to $400. Then I sell them to another (greater) fool, who thinks he can make an additional gain on them. Good luck to him.
Or, to put it another way, at any given time in the market, half of the market is trying to get out of positions where they see no additional upside. They're looking to sell to any dimwit who will pay in cash. As the investment sage Gordon Gekko said, "A fool and his money were lucky to get together in the first place." This seems especially true in a tough year like this.
As 2011 ends with a whimper (and the promise of a presidential election next year), the inescapable truth is that you can't afford to have only one part available in the great Wall Street passion play. You can't afford to be cast as the fool in every trade. Yes, I know there are thousands, millions, even billions of trades where the trader was able to fulfill the basic reason d'etre of every investor: Buy low and sell high.
There's nothing wrong with that -- when it works. But why limit yourself? Why not put yourself in a position to benefit from both sides of the market? When you see a company like Epocrates, which has what looks like an inevitable future of falling revenue and red ink, then why not find a way to profit from it? Well, the simple answer is you don't have to. Your broker, who is here to help, has already done it for you. All you need to do is sign the forms to authorize short sales.
Buy low, sell high. It is a universal, unmitigated truth that is the only way to make money in the market. But there's no rule that says you have to do it in that order. Short sales sell high and buy low. And as anyone who heeded my call on Epocrates can tell you, a short sale sometimes isn't just the best choice, it's the only choice.
Risks to Consider: Nothing comes without risk, and in this case, short sales can carry a lot of it. When you buy, it's always healthy to keep in mind that any stock can go to zero. But when you short a stock, the exact opposite can happen, too.
Action to Take--> Talk to your broker today about how to execute short sales. And, if you want, start with Epocrates. It still has a long way to fall.