The Basics and Risks of Short Selling


A short sale is the exact opposite of the purchase of a stock, in that an investor makes money
when the stock goes down in price and loses money if it goes up.  In
a short sale an investor borrows shares of a company and sells them,
collecting the proceeds from the sale.  At a later date he purchases
shares on the open market, thereby replacing the shares that were
borrowed and closing the transaction.  The shares are sold first,
then bought later.  Like a normal stock purchase, money is made when
they sell for more than the purchase price.

Some of the terminology of short sales:

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).

Despite looking like a standard stock trade, but done in reverse, there are some special
nuances that must be understood about short sales .  These are:

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).

As can be seen, there are many specific risks and disadvantages with short sales; therefore,
they should be seen as a speculation, not an investment.   Still,
there are sometimes when selling short makes sense.

The time when it may be worth selling short is when the market is so unbelievably
over-valued, or the likelihood of the market falling is so great
(like in the summer of 2008), that stocks in general, or at least in
a certain sector, are much more likely to fall than to rise.  In
general, even in this case short selling is done only as a hedge for
long positions – trying to offset losses in long positions by going
short on other stocks.

For example, in the summer of 2008 the housing bubble was threatening to burst.  I owned
a lot of retailer stocks that I knew would be hurt if consumers were
no longer able to roll their credit card balances into their home
loans, but I did not want to sell the stocks outright.  I decided
therefore that shorting some of the lenders would be a good hedge.

Since the lenders had been doing very well and the price of their shares had risen a lot
over the past few years, I reasoned that their stocks were not likely
to go much higher unless I was very wrong about their earnings
prospects.  I also felt that they would get hit hard when the ARMs
reset and people stopped being able to make their payments.  At
least, I thought, that the number of new loans they would be
making-which is where they made most of their money-would decrease,
causing their stock price to fall since earnings would no longer be
growing at their previous torrid pace.  I therefore took up short
positions in several lenders.

I also saw that oil prices were very high, and that the price of oil stocks was probably
as high as it would get.  I thought that if the economy slowed down,
demand for gasoline would fall.  Because the shares were already at
high prices, I reasoned that they were unlikely to go a great deal
higher.

Even though I was eventually right and did very well in 2009 while most were taking
large losses, it was not uneventful.  Shortly after I took up a short
position in Golden West Financial, the stock was bought out, jumping
from about $20 to the mid-thirties in a day.  Eventually Golden West
Financial gave great heart burn to the company that acquired them.  I
was right about the future of Golden West’s business, but that was
of little solace to me because I had already lost quite a bit on the
trade when the company was acquired (I had a similar experience with
Snapple).

So to sum up, short selling can be profitable, but the interim movements of the stock you
are shorting can cause losses, even if you are eventually right about
the company.  Also, just because a stock is very expensive doesn’t
mean it can’t go higher for a while or that another company might
not buy it out for even more money.  I therefore only sell short when
I believe there are systemic risks in the market and I wish to hedge
against a fall rather than selling outright.  I also only short
stocks that I believe have gone up so much that they have more room
on the downside than the upside.

Your investing questions are wanted.  Please send to vtsioriginal@yahoo.comor leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. 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. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

The Price of Houses


With the bursting of the real estate bubble, everyone is asking when home prices will stabilize.  Even more, they are asking when the prices will return to those seen in 2007 before the bubble burst.  This expectation that the prices of houses should return to where they were during the boom is a common mistake that is seen in stock investors as well.

To understand the mistake, you first need to understand the psychology of bubbles.  Most bubbles involve substantial amounts of credit which allow people to bid up the prices of things beyond where they can be supported if everyone were paying cash.  One of the reasons the stock market crash was so great in the 1930’s was that a lot of the stock had been bought on margin.  Likewise, a lot of the homes bought in the 2000’s were purchased with no money down and very low payments (at least initially).  This meant that the normal price controls – in that if you raise the price high enough there is no one who has the money to buy it – did not work because people were able to purchase homes that were far out of their price range by using credit.  This lead to an increase in home prices, which caused more people to get these loans and bid the prices higher.  Like all bubbles, prices got to a totally unsustainable level.

The home bubble was even a bit more insidious in that people started taking out home equity loans on the inflated price of their homes, which allowed them to spend money they did not have on all kinds of stuff.  This produced a market for vacations, products, and services that would not have been there if people had been paying cash.  The size of the true economy was distorted.  All kinds of jobs existed to meet demand that was a fantasy.

When homes stopped going up in value, all of the borrowing stopped.  This meant that all of the people who were providing all of those goods and services to people who did not make enough money to afford those services lost their jobs.  While it appeared that there was enough business for 20 coffee houses and 30 movie theaters and 15 car dealers, there was really only enough business for about half the number of each.

This is the nature of bubbles.  The demand is not real demand – it is demand borrowed from the future earnings of people.  This creates an artificial economy.  The apparent value of things, like the homes, the stores, and the companies providing all of these services is not its true value.  It is a castle built in the clouds, ready to fall to earth as soon as the cloud vaporizes.

So be it houses or stocks, just because something once sold for some price does not mean that it was ever worth that price, or that it will ever sell for that price again.  Particularly if it was during a bubble that the prices were set.  The bad news is therefore that even after the economy begins to recover, it does not mean that the level of jobs will return to where it was, or the price of homes will return.  The good news is that it may not take as good paying a job to afford those homes.

Your investing questions are wanted.  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. 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. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

7 Financial Moves to Do Today in Preparation for a Double Dip Recession


It was widely reported that the raising of the debt ceiling was needed to avoid a US default, a lowering of the nation’s bond rating, and a double dip recession.  Unfortunately, despite the debt ceiling being raised enough to cover the Government’s overspending for a couple of years and an avoidance of a default (which was never likely unless the Executive branch chose to not pay the debt interest since revenues are more than enough to cover the interest on outstanding debt), the nation’s interest rate was lowered and it appears that we are heading into a double dip recession.  In the least, the market is clearly showing a downward trend.  Since the market is normally a leading indicator, it appears that at least investors are expecting a double dip recession.  Talk of default in Europe is certainly not helping matters.

With the current economic scenario, investors of all stripes are understandably nervous.  While it is fine to be nervous, rushing out and selling all of your investments would not be wise since doing so could lock in a loss, or even worse – result in missing a big upswing should the double dip not materialize.  Instead of selling it all, putting the money into gold and burying it in a mason jar in the backyard, here are seven things that one can do to prepare for the double dip:

  1. Build up and Emergency Fund:  Every family should always have at least 3 month’s worth of expenses saved up in a money market fund at all times.  This cash will prevent you from needing to go into debt when the air conditioner breaks, the car breaks down, or one of a number of life’s emergencies occur.  It will also allow you to continue to pay for food and the mortgage while looking for another job if layoffs occur.  Given that the chance of a layoff increases as the economy tanks, building up enough cash to pay for 6 month’s worth of expenses would be a good idea at this time.  This will allow time to find the right job.
  2. Increase your 401k Contribution:  The normal instinct when the market falls is to hold off on investing and sell stocks to build up cash.  Unfortunately, this is exactly the wrong thing to do.  Once the market begins to fall, a lot of the value is lost very quickly, so selling is like locking the barn door after the horses have been stolen.  Instead, one should increase investments since the greatest returns usually occur after large market drops.  If you hold stocks and sit pat after a fall, waiting for things to look better, you will be even numerically when the market finally comes back but you will have lost a lot of time.  If you are investing regularly during the dips, you’ll be ahead when the market recovers.  Even in a sideways market those who buy on the dips make money.
  3. Free Up Cash Flow for Investing:  In addition to increasing 401k contributions, increasing investments in mutual funds and stocks through taxable accounts also makes the most sense in downward markets.  During 2009, investment returns of 100-300% were made on individual stocks.  Being able to take advantage of the dips requires freeing up cash from other uses.  Take a look at expenses and find things you can do without – maybe the membership in that wine club, those extra features on you cell phone, or some of the meals out.  Cut back to the bone and start investing the savings.  This will also make expenses lower should you lose your job and need to live on your emergency fund.  The investments you make may also be liquidated as needed.
  4. Sell Gold Jewelry:  Gold has risen to high heights on speculation and worry about the economy.  Instead of rushing out and buying gold with the pack, only to be the one left holding the bag when it returns to $500 per ounce for the next 20 years, take this opportunity to raise some cash by selling old unwanted jewelry.
  5. Buy Term Life Insurance Independent from your Work:  One should always have at least ten times one’s yearly earnings in term life insurance unless one has enough money saved in investments to take care of one’s family in the event of a death.  This means that there will be enough money to replace your income if needed.  With the risk of a layoff, it makes sense to have at least half of this in a privately bought insurance policy.  While this may cost a little more than the group policy at work, term insurance is generally cheap – about $20 per month –  and having your own policy will prevent the tragedy of a destitute family where the bread-winner was laid off, losing insurance benefits, and then passed away.
  6. Raise Cash needed if Retiring within Five Years:  It is never a good idea to have money invested in stocks that is needed within five years.  With the uncertainty in the markets, it makes even more sense to sell stocks and invest in CDs to have a stockpile of cash ready.  Because interest rates are likely to rise, CD terms should be limited to a year at most.  Investing in CDs may not offer the returns of stocks, but it avoids the risk of not being able to retire due to a dip in the markets.
  7. Research Quality Stocks:    Just as all stocks, good and bad, rise in a bubble, all stocks, good and bad, drop in a down market.  Many great companies have lost 20% or more in the last two weeks.  Do your research to find the great companies that are out there, see which have been unfairly beaten down with their deserving kin, and pick up shares as the market dips.  When the economy comes roaring back and their competitors have gone out of business, you will make truly spectacular returns.

Don’t get caught up in all of the doom and gloom in the news.  Realize that down markets present once-in-a-lifetime opportunities to make some serious gains.  Also be smart and make sure you have the cash and insurance ready to weather the storm.

Your investing questions are wanted.  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. 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. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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