shortsellingLast week I wrote Part 2 in the Intro to Short Selling. This week I will cap it off and hopefully you will have taken in some pointers which can maybe make you more interested in this aspect of investing.

The Transaction of a Short:
Suppose that, after hours of painstaking research and analysis, you decide that company XYZ is dead in the water. The stock is currently trading at $65, but you predict it will trade much lower in the coming months. In order to capitalize on the decline, you decide to short sell shares of XYZ stock.

Step 1: Set up a margin account. Remember, this account allows you to borrow money from the brokerage firm using your investment as collateral. *You are borrowing money so have the funds to cover this or you will lose your shirt!

Step 2: Place your order by calling up the broker or entering the trade online. Most online brokerages will have a check box that says “short sale” and “buy to cover.” In this case, you decide to put in your order to short 100 shares.

Step 3: The broker, depending on availability, borrows the shares. According to the SEC, the shares the firm borrows can come from:

* the brokerage firm’s own inventory
* the margin account of one of the firm’s clients
* another brokerage firm

You should also be mindful of the margin rules and know that fees and charges can apply. For instance, if the stock has a dividend, you need to pay the person or firm making that loan.

Step 4: The broker sells the shares in the open market. The profits of the sale are then put into your margin account.

From your transaction, one of two things can happen in the coming months:

The Stock Price Sinks (stock goes to $40)
Borrowed 100 shares of XYZ at $65
$6,500
Bought Back 100 shares of XYZ at $40
-$4,000
Your Profit $2,500

The Stock Price Rises (stock goes to $90)
Borrowed 100 shares of XYZ at $65
$6,500
Bought Back 100 shares of XYZ at $90
-$9,000
Your Profit -$2,500

Clearly, short selling can be profitable. But then, there’s no guarantee that the price of a stock will go the way you expect it to (just as with buying long).

Shorter sellers use an endless number of metrics and ratios to find shortable candidates. Some use a similar stock picking methodology to the longs, but just short the stocks that come out worst. Others look for insider trading, changes in accounting policy, or bubbles waiting to pop.

One indicator specific to shorts that is worth mentioning is short interest. Short interest is the total number of stocks, securities or commodity shares in an account or in the markets that have been sold short, but haven’t been repurchased in order to close the short position. It serves as a barometer for a bearish or bullish market. For instance, the higher the short interest, the more people will anticipate a downturn.

NOTE: Shorting is very, very risky. You can either have a great time, or you can get trampled.

You can think of the outcome of a short sale as basically the opposite of a regular buy transaction, but the mechanics behind a short sale result in some unique risks.

1. Short selling is a gamble. History has shown that, in general, stocks have an upward drift. Over the long run, most stocks appreciate in price. For that matter, even if a company barely improves over the years, inflation should drive its stock price up somewhat. What this means is that shorting is betting against the overall direction of the market. So, if the direction is generally upward, keeping a short position open for a long period can become very risky.

2. Losses can be infinite. When you short sell, your losses can be infinite. A short sale loses when the stock price rises and a stock is (theoretically, at least) not limited in how high it can go. For example, if you short 100 shares at $65 each hoping to make a profit but the shares increase to $90 apiece, you end up losing $2,500. On the other hand, a stock can’t go below 0, so your upside is limited. Bottom line: you can lose more than you initially invest, but the best you can earn is a 100% gain if a company goes out of business and the stock loses its entire value.

3. Shorting stocks involves using borrowed money. This is known as margin trading. When short selling, you open a margin account, which allows you to borrow money from the brokerage firm using your investment as collateral. Just as when you go long on margin, it’s easy for losses to get out of hand because you must meet the minimum maintenance requirement of 25%. If your account slips below this, you’ll be subject to a margin call, and you’ll be forced to put in more cash or liquidate your position.

4. Short squeezes can drain the profit out of your investment. When stock prices go up short seller losses get higher, as sellers rush to buy the stock to cover their positions. This rush creates a high demand for the stock quickly driving up the price even further. This phenomenon is known as a short squeeze. Usually, news in the market will trigger a short squeeze, but sometimes traders who notice a large number of shorts in a stock will attempt to induce one. This is why it’s not a good idea to short a stock with high short interest. A short squeeze is a great way to lose a lot of money extremely fast.

5. Even if you’re right, it could be at the wrong time. The final and largest complication is being right too soon. Even though a company is overvalued, it could conceivably take a while to come back down. In the meantime, you are vulnerable to interest, margin calls and being called away. Academics and traders alike have tried for years to come up with explanations as to why a stock’s market price varies from its intrinsic value. They have yet to come up with a model that works all the time, and probably never will.

Hope this post has opened up your knowledge on shorting stocks. Its a risky play, that can be fun and prosperous for many. If you have the appetite for something new, risky and maybe even financially rewarding, look into shorts!

Happy Investing!

Aman, MBA

Related posts:

  1. Simplified Sunday #16 – Short Selling Intro (Part 1)
  2. Simplified Sunday #17 – Short Selling Intro (Part 2)
  3. Simplified Sunday #11 – Setting a Stop Loss