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Avoid Risky (Illegal) Trading Tools to Build Returns

Lower then Historic Returns Tempt Investors


When returns and expectations of returns in the stock market are below historic averages, some investors look to exotic and/or risky alternatives.

Don't let the desire for higher returns cloud your judgment about risk or the appropriateness of the tool.

For example, it is not uncommon for stock brokerages to offer an exotic product that combines risky tools such as futures, forward contracts of some kind and other bright and shiny temptations.

There may be nothing illegal or even unethical about some of these products, however that doesn't mean they are right for you.

The real danger is that investors will buy a product without fully understanding the all of the risks.

One of the more common plans involves options, which are very legitimate financial tools, but should only be used by experienced investors.

Another less common plan, naked short selling, is not only a bad idea for investors, but it is also illegal. However, thanks to an ineffective monitoring system, this practice continues, but often "under the table" or called by another name.

If your image of naked short selling is a group of hedge fund managers sitting around in the nude, I would like to put that disturbing image out of your head.

Naked short selling is an even higher risk version of a legitimate, yet often frowned on, form of market trading.

The Securities and Exchange Commission regulates the practice and stepped in to halt short selling of financial stocks during the turbulence following the credit crisis in 2008.

Many blame short sellers for driving down stock prices, although there is little evidence that this is true.

Traditional short selling involves "borrowing" shares of stock you believe is over-priced and headed for a fall.

You sell the borrowed stock and when the price does drop, you buy back shares at the lower price and replace the stock. You have sold high and bought low. The difference is your profit.

Of course, if the stock's price rises instead of falling, you must buy back the stock at a higher price to replace the borrowed shares - you sold low and bought high.

Uses Leverage

Because short selling is done in a margin account, the trader uses leverage to increase profits (or accelerate losses if the trade goes bad).

Naked short selling raises the level of risk and potential reward.

With naked short selling, the trader sells shares they do not own or borrow. Critics claim this type of trade drives down stock prices.

The naked short trader does not plan to deliver the shares she shorted. The idea is to cover the short (buy actual shares on the open market) before the mandatory delivery date of the short sale - usually three business days.

The trader closes out his position by buying the shares on the open market at the lower price and delivering those shares.

When traders use naked short selling to purposely drive down the price of a stock, it is considered market manipulation and is against the law.

Short sellers, naked or otherwise, can get caught at their own game in what is known as a short squeeze.

Rising Share Prices

This happens when the shares of a shorted stock rise instead of falling. Short sellers are forced to buy shares on the open market to cover their position, but if enough short sellers try to buy the same stock it will only push up the price further increasing the loses.

The Securities and Exchange Commission has alternately placed restrictions on short selling and then lifted them. Critics claim the rules are much too loose.

You can count on the subject staying before regulators as long as the markets are volatile.

Short selling and especially naked short selling is not recommended for inexperienced investors. The practice is just short of gambling and that's not the way you want to handle your nest egg.

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