Amazon.com Inc. (AMZN) is a stock that attracts die-hard believers and skeptics due to its unique business model. The company has shunned profits in favor of winning market share. Although this is quite typical for early-stage companies, Amazon continues down this path more than 20 years into its existence. Amazon’s stock price has trended higher for much of its existence as it has found investors who share Amazon founder and CEO Jeff Bezos’ vision.
For those who do not believe that Amazon can start converting its market share into profits, there are a number of ways to short the stock. If investors lose faith that Bezos will be able to continue gaining market share with new product launches, or that at some point this market share will translate into earnings, Amazon’s stock will certainly take a steep tumble. High-multiple momentum stocks that fail to meet investors’ expectations can create big profits for short-sellers.
The simplest way to profit from a decline in Amazon’s stock price is to short the stock with a broker. Shorting a stock through a broker involves borrowing the stock and then selling it at market or with a limit order. At some future point, the stock must be bought back to close the trade. When the stock is bought back if the price has risen, then the investor loses money on his short sell. If the stock price has fallen, then the short-seller profits from the difference between the sell price and the price at which it is bought back.
To learn more about Amazon’s competitive environment, read Who are Amazon’s main competitors?
However, there are considerable risks involved in shorting a stock. There is a borrowing fee that accumulates over time. This fee is modest for a liquid stock such as Amazon, but it can increase if there is strong demand to short the stock. Another risk of shorting a stock is that the mechanics of shorting are stacked against the short-seller.
For a long position, the most an investor can lose on a stock is 100%. When shorting, in theory losses are unlimited. The most a short-seller can make is 100%, if the stock goes to 0. Therefore, short-selling is considered appropriate only for sophisticated traders who understand the risks involved. Another risk involved with shorting a stock is the potential for a short squeeze. Stocks such as Amazon with rich valuations tend to attract short-sellers, especially when the stock price or company show signs of faltering.
This creates its own risk as a bullish catalyst can lead to big gains. The gains can become quite exaggerated as shorts are forced to cover to limit losses or due to risk management. Of course, shorts covering leads to even more demand, pushing it even higher. Therefore, short sellers should have a plan to handle short squeezes and countertrend rallies. One tool that can be used to evaluate the potential of a short squeeze is to examine a stock’s short float, which can be found through a broker.
Another method to profit from a decline in the stock price is to buy puts. The advantage of buying puts is that the most a trader can lose is the amount he paid for the put option. Put options are contracts to sell a stock at a certain price at a certain time. For example, someone can buy a put option to sell 100 shares of Amazon at $ 200 in January 2016.
On the expiry date for the option, if Amazon’s stock price is above $ 200, then the option expires worthless. If the stock price closes at $ 150, then the option will be worth $ 50. Clearly, put options offer considerable leverage for traders with high conviction with capped downside as opposed to shorting the stock. The downside is that traders need to be correct about the direction and timing of the stock in order to profit.
For more on option investing, check out The Best Options Strategies To Trade Southwest Airlines.