Having defined a short sale in a previous post, today I will go into some of the nuances of short selling. First some terminology:
Cover: To buy back shares that were sold short, closing the transaction.
Buy Long: To buy stocks or other securities in the normal fashion, such that increases in price result in profits.
Naked Short: A trade in which the shares are not borrowed before being sold short. This is an illegal transaction because it can allow for a great deal of shares to be sold short that don’t exist, upsetting the balance between buyers and sellers, causing price manipulation.
Short and Ultrashort ETF: Funds designed to go down when the underlying index goes up, with equal percentages on a day-to-day basis. These are typically not recommended (see post DIG and DUG).
And now some nuances:
Tax implications: Short sales are always considered short-term trades, no matter how long they are held open, probably because short selling is considered somehow sinister or evil. (Disclaimer: Note that as with all tax advice, this should be checked with a CPA since I am not one and could be wrong).
Time Frame: Short sales are inherently short to mid-term investments. Because the tendency of the stock market is to increase in price, time works against the short sale. Going short a stock and then forgetting about it is not a good strategy. For this reason, selling short is more speculation than investment.
Risk: It is often said that short selling is more risky than buying long because your loss is limited when buying long (the stock can only go to zero), while a stock can go up forever. While this is technically true, the risk is manageable because stocks don’t go up infinite amounts as long as the investor is very disciplined and has a firm price target above which she will cover and close the transaction, no matter what. Note that if the company is bought out or other big news occurs, the stock may shoot right through the target, but even then stocks don’t just go from $10 to $500 in a day. Still, because time works against the short sale to some extent, there is more risk in selling short than going long.
Effect of bad positions: If one buys long and a stock goes down, while a loss is being taken, the position becomes a smaller and smaller percentage of the portfolio as the stock declines. With short selling, if the stock goes up, the position becomes larger and larger. If the amount owed for the short sale goes above the amount of cash in the account, the investor will need to add more cash or start paying margin interest to the brokerage (which is where firms actually make their money). If the stock rises far enough, a margin call can be executed that will force the investor to cover the position and lose substantial amounts. Also, if a loss is taken on a short sale, money must be found to pay for brokerage commissions in addition to the loss, where with selling at a loss on a long position at least the money gained from the trade will at least cover the brokerage costs.
Margin Interest: While a stock is sold short, it is a liability against the account. If there is not as much cash in the account as the value of the short sale, the investor will need to pay margin interest on the difference. Also, this cash will not receive interest (it is held against the short sale).
In a future post, I’ll go into when it makes sense to sell short.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.