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.

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