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Lessons From China MediaExpress

Rick Pearson is a Beijing-based private investor focusing on U.S.-listed China small-cap stocks. He is a contributing writer to TheStreet whose views on these stocks are independent of TheStreet's news coverage.

BEIJING ( TheStreet ) -- Until quite recently, China MediaExpress (CCME) was the house favorite stock to own. The stock has tripled in a few months and was recently ranked No. 1 in Forbes China 200 small- to mid-cap company survey and has Deloitte as its auditor.

Yet yesterday, a negative report by Muddy Waters research lopped more than 30% off the value of the stock on more than 10 times daily volume. This follows closely after a similar report by Citron Research which dropped the stock by 15-20%. As of now the stock is off by more than 50% from its highs of just a week ago. China Agritech (CAGC) was also the subject of a short report, dragging its stock down by around 10%.

The purpose of this article is not to express an opinion on the validity of CCME, but is rather to point out how investors can (and should) reduce their risk in these types of situations.

I have received a large number of emails on CCME in the past two days. Most of it, I find very concerning. The concerns are not regarding CCME itself, but regarding investors' excessive risk-taking with this stock. One investor told me that even after the first short report by Citron that CCME still comprised 40% of his portfolio. Another investor told me that at a price of $17.50 he was aggressively selling naked puts to "capture the excessive volatility."

The stock traded as low as $10.31 with put option prices increasing by as much as 3-5 times. Everyone had the right to make their own investment decisions, but these decisions clearly reflect excessive confidence in a single stock which is always very dangerous.

It is my belief that a big contributor to the size and speed of the decline was the fact that many bullish investors held huge positions on margin. Everyone knows that margin magnifies both gains and losses -- that is nothing new. But what some people fail to realize is that their broker can change the maintenance margin on a whim, resulting in an immediate margin call and potentially an immediate involuntary liquidation of stock, permanently locking in a loss even if the stock rebounds.

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