A Six Part Short Selling Series

So You Want to Be a Short Seller?

Do you know that you can make a big profit when stocks go down? Professional money managers do it all the time, in bull markets and especially in bear or down markets. I am going to talk about this now while the market is going up because many people see this type of transaction as Un-American because you, the investor, is betting that the economy will contract. I expect to get a lot of negative comments for bringing up the subject.

Many investors make money on a decline in individual stocks. They really make out in a Bear Market. Brokerage firms do not promote this type of speculation with retail customers or with the working person. However, the concept of short selling is hard to understand. That is why we will talk about this over a six part series.

Many people think of investing or speculating as buying an asset, holding it while it appreciates in value, and then eventually selling to make a profit. Before speculators transact business, they will set up an account with a business or a brokerage service company. The account that's set up is either a cash account or a margin account. A cash account requires that you pay for your stock when you make the purchase, but with a margin account the broker lends the speculator a portion of the funds at the time of purchase and the security acts as collateral.

In purchasing stocks, you buy a piece of ownership in the company. The buying and selling of stocks can occur with a stock broker or directly from the company. When a speculator goes "long" on an investment, it means that he or she has bought a stock believing its price will rise in the future.

Brokers are most commonly used when purchasing "Long" positions. They serve as an intermediary between the speculating buyer and the seller. The broker will charge a fee for their intermediary services.

Shorting is the opposite of buying long. A speculator makes money only when a shorted security falls in value. More specifically, a short sale is the sale of a security that isn't owned by the seller, but the security is promised to be delivered. When a speculator goes short, they are anticipating a decrease in the price of the security.

Short selling has many unique risks. The mechanics of a short sale are relatively complicated compared to a normal buy and sell transaction. Here speculators face high risks and pitfalls for potentially high returns. Speculators must understand how the whole process works before they get involved
　
When speculators short sell a stock, the broker will lend the speculator money to make the transaction. The stock or some other security will come from the brokerage's own inventory, from another one of the firm's customers, or from another brokerage firm. The shares are sold and the proceeds are credited to the speculator’s account. Sooner or later, the speculator must "close" the short by buying back the same number of shares. This is called "covering." The security is returned to the speculator’s broker. If the price drops, the speculator will buy back the security at the lower price and make a profit on the difference between the buy price and the sell price. If the price of the security rises, speculator may have to buy back the security at the higher price. If this happens, the speculator will lose money.

　
Part 2: You Are Shorting Because?

　
Generally, there are two main reasons to short. The first is just pure speculation. The other is to hedge positions that you already have in your portfolio. Usually the people who short sell are; wealthy sophisticated investors, hedge funds, large institutions, and day traders.

Day traders are individuals who engage in the transfer of financial assets in any financial market, either for themselves, or on behalf of someone else. The main difference between a speculating day trader and an intelligent speculator is the duration for which the person holds the asset.

Most intelligent speculators tend to have a longer term time horizon, whereas day traders tend to hold assets for shorter periods of time in order to capitalize on short-term trends.

One main problem with engaging in short-term trading is commission costs. Because day traders frequently engage in short-term trading strategies to chase after profit; they often rack up large commission fees. However, an increasing number of highly competitive discount brokerages made this cost less of an issue.

It takes a certain type of person to short securities. Many short sellers have been thought of as pessimists. They are rooting for a company's failure, but they have also been described as disciplined and confident in their judgment. Not everyone can do it. It involves a great amount of time and dedication. Short sellers need to be informed, skilled, and experienced speculators in order to succeed. They must understand how securities markets work, trading techniques and strategies, market trends, and the firm's business operations.

Speculation

When you speculate, you are watching for fluctuations in the price of securities in order to quickly make a big profit off of a high-risk investment. Speculation has been perceived negatively because it has been looked upon as gambling. Playing the Pennsylvania Lottery is gambling because the risk is not to the players advantage. However, speculation involves a calculated assessment of the markets and taking risks where the odds appear to be in your favor. Speculating differs from hedging because speculators deliberately assume risk, whereas hedgers seek to reduce it. Speculators can assume a high loss if they use the wrong strategies at the wrong time, but they can also see high rewards.

Hedge

The majority of speculators use shorts to hedge securities that are already in their account. This means they are protecting other long positions with offsetting short positions. Hedging can be a benefit because you are insuring your stock against risk. The down side is that it can be expensive, meaning that a basic risk can occur.

If you recall, I suggested that people buy Ford Motor Stock at $7 or below. I also suggested selling half of your position at $14 and the rest at the top of the market. But instead of selling the stock, let’s hedge the stock by shorting it at $16 and shorting the rest at the top of the market. This strategy is called, "Shorting Against The Box." Let’s say that you were able to accumulate 600 shares averaging $5 per share. You "Shorted Against The Box", 300 shares at $16 per share. That locked in a profit of $3,000 ($4,500 minus $1,500). Let’s say that the market started moving sideways and Junk Bond prices started to show low interest rates. You decide that the market is at or near the top. You short the additional 300 shares at $80, locking in an additional profit of $22,500 ($24,000 minus $1,500).

No matter what happens to the market and the stock, you hedged your bet or "boxed in" your $25,500 profit. If the stock goes to $2,000, you keep that profit by buying back the stock and getting out of your short position. If the stock goes to $5 after the next stock market crash, you cover your stock (buy it back and give it back to the broker) and you have the stock and the $25,500 in cash in your account. Remember, you owned the stock in the first place.

　
Part 3: What are the drawbacks to Shorting?
　

Shorting securities is not as easy as I make it out to be. You have rules that you must follow and these rules might get in the way of you making money. Shorting must be done in a Margin Account. That is an account that would allow you to borrow cash and securities. Once in the 1980s, I borrowed the money to buy myself a new car putting up my securities as collateral. I had the title to the car but the broker had the title to my securities. If the price of my securities in my portfolio would fall, I may have to come up with cash to put into my account in three business days. If I do not, my securities are automatically sold. Someone in their superior wisdom may decide months or years later to declare that my securities are no longer marginable. That could make my debt become due in three business days.

Most of the time, you can hold a short for as long as you want, although interest is charged on margin accounts, so keeping a short sale open for a long time will cost money over a period of time. However, when shorting, you can be forced to cover if the lender wants the stock you borrowed back. Brokerages can't sell what they don't have, so in your account, you will either have to come up with new shares to borrow, or you'll have to cover. This is known as being "called away." It doesn't happen often, but is possible if many speculators are short selling a particular security.In shorting stock you don’t own, you are borrowing stock then selling it. You must pay the lender of the stock any dividends or rights declared during the course of the loan. If the stock splits during the course of your short, you will owe twice the number of shares at half the price.
　
Restrictions

Many restrictions have been placed on the size, price, and types of stocks, traders are able to short sell. For example, Penny Stocks cannot be sold short, and most short sales need to be done in Round Lots or 100 share increments. The Securities Exchange Commission (SEC) has these restrictions in place to prevent the manipulation of stock prices. As of January 2005, short sellers were also required to comply with the rules set in place by "Regulation SHO", which modernized the rules overseeing short selling and aimed to provide safeguards against "naked short selling", that is shorting stock that the speculator does not own. For instance, sellers had needed to show that they could locate and get the securities they intended to short. The regulation also created a list of securities showing a high level of persistent sales to deliver. In July of 2007, the SEC eliminated the "up tick or zero plus" rule. This rule required that every short sale transaction be entered at a higher price than that of the previous trade and kept short sellers from adding to the downward momentum of a security when it was already experiencing sharp declines. The rule has been around since the creation of the SEC in 1934. One of the reasons it was put in place was to slow rapid and sudden declines in share prices that can occur as a result of short selling. In July of 2008, the SEC used its emergency powers to put an end to market manipulations, such as spreading negative rumors about a company's performance and sharp price declines. The markets had been volatile as a result of the mortgage and credit crisis. The SEC wanted to establish a renewed confidence. For a month, it didn't allow naked short selling on the stocks of 19 major investment and commercial banks, which included the mortgage finance companies Fannie Mae and Freddie Mac.

The SEC took further measures in September of 2008, once again using its emergency authority to issue six orders to minimize abuses. This included a move to halt short selling in shares of 799 companies in cooperation with the United Kingdom's Financial Service Authority. 170 companies were later included in the ban, which ended after the passage of the $700 billion U.S. bailout plan in October 2008. Another order required short sellers get a sale and immediately close it by making sure the shares were delivered. It later became a rule.

　
Part 4: Doing a Naked Short Sell

Let’s say as a new speculator to naked short selling, you want to do your first naked short sell. You find that XYZ Stock is over priced in your opinion. 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.

What steps would you take to make this short sell a reality?

Step 1: Set up a margin account with a brokerage firm. Remember, this account allows you to borrow money from the brokerage firm using your investment or cash as collateral.

Step 2: Place your order by calling up the broker or entering the trade online. Most online brokerages that allow online short sells will have a check box that says "short sale" and "buy to cover." Here, 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:

1. the brokerage firm's own inventory
2. the margin account of one of the firm's clients
3. another brokerage firm

Keep in mind, you should consider the margin rules and know that fees and charges that 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. One of two things can happen in the coming months:

1) The stock goes to $40, the target price that you set for yourself. You borrowed and sold at $6,500 - $4,000 giving you $2,500 profit.

2) The stock price goes against you. You get a "margin Call" at $90 and you don’t have the money to cover it. Because of the rules of your brokerage firm, you are forced to cover, $6,500 - $9,000 giving you a loss of $2,500.

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 go. You have the same problem with buying long.

　
Part 5: Naked Shorts Are Very Risky!

Naked Short Sales are not the opposite of a regular buy transaction like people would have you believe. 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 up the stock price. 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. A stock is not limited in how high it can go. So a speculator has unlimited risk to the upside. For example, if you short 100 shares at $65 per share, hoping to make a profit but the shares increase to $90 per share, you end up losing $2,500. But what is the stock goes to $100, $200, or $1,000 per share? The best you can do in making a profit is the stock goes to zero. On the other hand, buying long, a stock can't go below zero, so your downside is limited. As a result: you can lose more than you initially invest in a short sell. 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%. But this margin requirement may change due to your brokerage house rules, SEC Rules, or Federal Reserve Rules. If your account slips below the maintenance requirement, you'll be subject to a Margin Call, and you'll be forced to put in more cash/securities or they will liquidate your position. I can’t stress that enough!

4. Short squeezes can take 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 problem is known as a "Short Squeeze." Most of the time, 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 create a Short Squeeze. A Short Squeeze is a great way to lose a lot of money extremely fast. This is why it is not a good idea to short a stock with high 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. These short shares have not been repurchased in order to close the short position. It serves as a barometer for a bearish or bullish market.

5. Even if you are right, it could be at the wrong time. The final and largest complication is being right too soon. Timing is everything! 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. Speaking of timing, take a look at the dotcom bubble. Speculators could have made a killing if they shorted at the market top in the beginning of 2000, but many believed that stocks were grossly overvalued even a year earlier. The people who did are in the poorhouse now if they had shorted the Nasdaq in 1999! That's when the Nasdaq was up 86%, although two-thirds of the stocks declined. This is contrary to the popular belief that pre-1999 valuations more accurately reflected the Nasdaq. However, it wasn't until three years later, in 2002, that the Nasdaq returned to 1999 levels.

One big rule that you want to follow, never stand in the way of momentum in the market place. Whether in physics or the stock market, it is something you don't want to stand in front of. All it takes is one big shorting mistake to kill you. Just as you would not jump in front of a 100 car freight train, going 80 miles an hour, don't fight against the trend of a hot stock!

Part 6: Ethics In Short Selling

Short selling is another technique you can add to your trading toolbox. That is, if it fits with your risk tolerance and investing style. Short selling provides a sizable opportunity with a hefty dose of risk. As I told you in so many words in the beginning of this series, Short Sellers aren't the most popular people on Wall Street. Many investors see short selling as "un-American" and "betting against the home team" because these speculators are perceived to seek out troubled companies and act against them. Some critics believe that short sales are a major cause of market downturns, such as the crash in 1929 and 1987.

But despite its critics, it's tough to deny that short selling makes an important contribution to the financial markets:

1. Short Selling adds liquidity to share transactions. The additional buying and selling reduces the difference between the price at which shares can be bought and sold.

2. Short Selling drives down overpriced securities by lowering the cost to execute a trade

3. Short Selling increases the overall efficiency of the markets by quickening price adjustments

4. Short Selling acts as the first line of defense against financial fraud. In 2001, famed short seller James Chanos identified fraudulent accounting practices that occurred with Enron Corporation, an energy-trading and utilities company. The company's activity became known as the Enron scandal when the company was found to have inflated its revenues. It filed Chapter 11 bankruptcy at the end of 2001.

While the conflicts of interest from investment banking keep some analysts from giving completely unbiased research, work from short sellers is often regarded as being some of the most detailed and highest quality research in financial markets. It has been said that short sellers actually prevent crashes because they provide a voice of reason during raging bull markets.But short selling also has a dark side, thanks to a small number of traders who are not above using unethical tactics to make a profit. Sometimes referred to as the "short and distort," this technique takes place when traders manipulate stock prices in a bear market by taking short positions and then using a smear campaign to drive down target stocks. This is the mirror version of the "pump and dump," where crooks buy stock, take a long position and issue false information that causes the target stock's price to increase. Short selling abuse like this has grown along with internet trading and the growing trend of small investors and online trading.

If you want to study more about Short Selling, read the following books at the following web site:
http://www.hedgefund-index.com/shortselling.asp