After investing a while many people get interested in short selling. In short selling, one borrows shares and sells them, collecting the proceeds from the sale. Later on the shares are repurchased. If the stock has gone down in the mean time one will make a profit. If the stock has risen in price one will suffer a loss. It is very similar to buying stocks long, except the order is reversed.
There are some unique aspects of short selling of which one must be aware. These are:
1) Losses are “unlimited,” in that a short position gets bigger and bigger as the stock goes up in price. One cannot limit losses as one can do when buying stocks long. In practical terms it is unlikely that a stock will rise more than 20-30% in a very short period of time as long as one does not try to short stocks that are very low in price. One must definitely pay closer attention to short sales than long positions, however.
2) For taxes, all short sales are considered short-term capital gains, regardless of the time period held, and therefore are taxed at a higher rate. (Always check with a CPA before believing tax advice, but this has generally been the case.)
3) The cash received from a short sale must remain in the account until the position is closed or one may end up in margin and be charged margin interest. If the stock price rises above the price at which it was shorted additional cash must also be placed in the account to avoid a margined position. If the stock rises far enough a margin call may result where one will need to put additional funds into the account or the short sale will be closed by the brokerage house regardless of the loss the the investor. Note that margin can be a very dangerous tool and short selling without a large amount of cash available can lead to a margin situation.
4) When one shorts a stock one must pay any dividends that a company pays while the short position is open. Shorting stocks that pay a significant dividend is therefore not recommended.
Given these aspects I would generally recommend against shorting stocks. The natural flow of the market is upwards, so when one goes short time is against you rather than on your side. The only exception is when the market in general or a certain segment of the market is clearly in the late stages of a bubble. In this situation the stocks have risen so high that there is not much room for them to rise higher. For example, in 2008 the home builders, banks and thrifts, and oil stocks had completed a long run-up in price and it was unlikely that they could climb much further. For that reason selling some stocks in those segments short as a hedge against declines in other long positions was a reasonable strategy.
Even in that case, however, some stocks rose quickly in price. For example, Golden West Financial was purchased and jumped in price by about $10 per share in one day. The company that bought them later realized their mistake and even accused Golden West of misrepresentation of their financial position, but that would be little consolation to the short seller who suffered a severe loss when the buy-out was announced. Maintaining a sizeable cash position to allow one to absorb such losses is therefore recommended even when shorting frothy stocks.
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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. In addition the writer of this blog is not an accountant and writings should not be taken as tax advice which should be left to a CPA. 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